Preventing legal risk from shareholder preemptive rights

Equity investments typically involve three modes: Establishing a new company; acquiring equity; and expanding capital through stock issuance. The legal risks vary depending on investment mode. This article explores legal risks and preventive measures concerning shareholders’ preemptive rights in the context of share transfer to benefit investors.

LEGAL PROVISIONS

Article 71(2) and (3) of the Company Law stipulates that when shareholders intend to transfer their shares to a non-shareholder, they must obtain the consent of more than half of the other shareholders, providing them with written notice seeking agreement on the share transfer. If the other shareholders fail to respond within 30 days of receiving the written notice, their silence will be considered consent to the transfer.

However, if more than half of the other shareholders do not agree to the transfer, those dissenting shareholders have an obligation to purchase the transferred shares. Failure to do so will also be deemed as consent to the transfer.

Where shares are transferred with the consent of the shareholders, under equal conditions, other shareholders have preemptive rights to purchase the transferred shares. In cases where two or more shareholders claim to exercise the rights, they must negotiate and agree upon their respective purchase proportions.

If an agreement cannot be reached through negotiation, the preemptive rights shall be exercised based on the proportion of their respective capital contributions at the time of the transfer.

Article 21 of the Provisions of the Supreme People’s Court on Several Issues concerning the Application of the Company Law (IV) (revised in 2020) stipulates: “If a shareholder of a limited liability company transfers shares to a person outside the shareholder group without seeking the opinions of other shareholders regarding the share transfer, or if they engage in fraudulent or malicious collusion to undermine the pre-emptive rights of other shareholders, and if other shareholders claim the rights to purchase the transferred shares on equal terms, the people’s court should support such claims.

“However, this excludes cases where other shareholders fail to assert their preemptive rights within 30 days from the date they knew, or should have known, about the exercise of such rights on equal terms, or cases where more than one year has passed since the date of share transfer registration.”

INVESTOR INTEREST RISK

In accordance with the legal provisions, an investor acquiring shares of a target company without obtaining prior consent from the other shareholders infringes their preemptive rights. In such cases, those shareholders have the right to file a lawsuit and claim the right to purchase the transferred shares under equal conditions.

Once the other shareholders exercise their preemptive rights, the investor will face the risk of investment failure. To prevent other shareholders from claiming preemptive rights after share transfer, causing trouble and losses to investors, it is essential to take the following legal risk prevention measures:

• Include waiver of preemptive rights by original shareholders as a prerequisite for payment of share transfer consideration in the share transfer agreement. The specific provision can be expressed as: “Both parties acknowledge and agree that the transferee shall only be obligated to pay the agreed transfer price as stipulated in this agreement if all of the following conditions are met: … (3) The existing shareholders of the target company have waived their respective pre-emptive rights …”
• Before paying the share transfer consideration, investors must rigorously review whether the prerequisite has been fulfilled. In practice, there are generally two forms of waiving pre-emptive rights by shareholders ‒ through resolution of a shareholders meeting, or declaration of waiving pre-emptive rights. Although some judgments consider the signatures of all shareholders on the amended articles of association as a waiver of pre-emptive rights in share transfers, it is important to note that China is not a common law country. Therefore, it is advisable to require the transferor to obtain a written waiver of pre-emptive rights declaration, signed by the other shareholders, before transferring shares.
• Complete the share transfer process promptly. In numerous cases involving disputes over share transfers, shareholders often file lawsuits claiming infringement of their preemptive rights. According to the above-mentioned legal provisions, the exercise period for shareholders’ preemptive rights does not exceed one year from the date of share transfer registration. To avoid the unnecessary burden of litigation, expediting the share transfer process and completing registration as quickly as possible is crucial.
• In the share transfer agreement, liabilities for breach of contract shall be clearly defined. According to article 9 of the Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts, where other shareholders exercise their preemptive rights, the request of the transferee, who is not a shareholder, to continue performing the share transfer agreement may not be supported. But it does not affect their right to request the transferor to bear corresponding liabilities for breach of contract according to the agreement.

To prevent investors from incurring losses resulting from failure of an investment due to original shareholders asserting their preemptive rights, investors should include a provision in the representation and warranty clause of the share transfer agreement.

This provision should stipulate that the transferor must ensure that other shareholders waive their pre-emptive rights. Failure to do so would hold the transferor liable for any breach of contract and associated consequences.

BEWARE ‘SPLIT TRANSACTIONS’

During the author’s research of relevant judicial cases, it was observed that some shareholders employ a split transaction method for share transfer to circumvent other shareholders’ preemptive rights.

This involves initially notifying other shareholders of a higher term for external share transfer. Once they have waived their preemptive rights, an immediate industrial and commercial change registration of the transferee as a company shareholder is conducted.

Parties then enter into an additional share transfer agreement, employing an intra-shareholder format to transfer the remaining shares at a lower term. This transaction strategy appears to comply fully with the law and successfully circumvent the preemptive rights of other shareholders.

But in Zhejiang Kangqiao Motor Industry And Trade Group v Ma Binxiong and Zhejiang Wanyin Automobile Group (2015), the court held that the transferor had maliciously infringed the preemptive rights of other shareholders; by obstructing the realisation of equal conditions to exercise their preemptive rights. As a result, the court supported the other shareholders’ claim to rescind the share transfer agreement.

Liu Yufang is a senior counsel at Zhilin Law Firm