Pre-emptive rights allow certain shareholders to acquire additional shares in the company before they are offered to other shareholders or new investors and, as such, hold significant value for the shareholders holding those rights. However, pre-emptive rights provisions can be difficult to administer, and careful drafting and interpretation is essential to minimise the risk of unintended consequences. In this article, Andrew Windybank, Principal of our corporate and commercial team, considers the potential pitfalls of pre-emptive rights provisions.
The primary purpose of a pre-emptive rights regime is to give existing shareholders the opportunity to protect their ownership interest in the company from dilution as a result of new share issues or share transfers (as the case may be).
Shareholders may be particularly concerned to maintain their percentage shareholding where the company is small and the membership is closely held, and less concerned during periods of high growth, where the value of the company has increased substantially.
Contractual rights of pre-emption are common in company constitutions and shareholders’ agreements. They may also be included in other agreements such as option and merger agreements, or subscription agreements under which new investors subscribe for shares.
There is a statutory pre-emption provision set out in section 254D of the Corporations Act 2001 (Cth) that applies to new issues of shares in proprietary companies, unless it is modified or replaced by the company’s constitution. Section 254D(1) states that, before issuing shares of a particular class, the directors must offer them to the existing holders of shares of that class on a pro-rata basis.
Shareholders of listed companies do not have pre-emptive rights. However, a listed company is required to seek shareholder approval to issue more than 15% of its issued shares (or 25% for small companies) in a 12-month period, in accordance with the ASX Listing Rules.
Issues concerning the scope and operation of contractual pre-emptive rights provisions frequently arise in the context of a transfer or assignment of shares by a shareholder. Three scenarios are considered below.
Generally, acquisition or takeover bids should be framed to comply with any pre-emption provisions that require shareholders to offer their shares to another party before they can be acquired by the bidder.
Where shares in a target company are subject to pre-emptive rights, it may be necessary for the bid to remain open for an extended period of time to allow shareholders to comply with applicable notice periods and time frames in accordance with pre-emptive rights provisions.
Notably, pre-emptive rights will not be triggered by a proposed scheme of arrangement that is approved by the shareholders of the company and the Court. Similarly, it may be possible to truncate pre-emptive rights processes by calling for a shareholder vote at a general meeting in certain circumstances.
In RJL Investments Pty Ltd v Oceania Healthcare Technology Investments Pty Ltd  NSWSC 483 the New South Wales Supreme Court held that an intention to vote in favour of a scheme of arrangement did not constitute a ‘proposal to transfer shares’ under the company’s pre-emptive rights regime, even if by operation of the scheme the shares would be transferred to the bidding company.
It is sometimes assumed that a pre-emption provision dealing with share transfers will not impede a company’s ability to buy-back its own shares, but this will not always be the case.
In determining whether or not a pre-emption right is triggered by a share buy-back, the Court will have regard to the meaning of the provision as well as its context.
This issue was considered by the Federal Court in Lion Nathan Australia Pty Ltd v Coopers Brewery Ltd (2006) 156 FCR 1, in which Lion Nathan Australia Pty Ltd (Lion Nathan) alleged that a buy-back by Coopers Brewery Ltd (Coopers) of its shares constituted a breach of the pre-emptive rights regime set out in the Coopers constitution.
Article 38 of the Coopers constitution stated that:
No member may make any transfer of shares and the Directors must not register any transfer of shares without complying with Articles 40-53.
Articles 40-53 established a three-tiered pre-emptive rights regime, under which Lion Nathan had the opportunity to acquire shares if they had not first been taken up by existing shareholders or their relatives, or secondly by the trustees of the Coopers Superannuation Fund.
It was held that share buy-back transfers did not fall within the pre-emptive rights regime in the Coopers constitution, as Coopers did not have the power to buy back shares at the time the pre-emptive rights provisions were adopted, and evidence (which included an explanatory memorandum provided to members at the time the provisions were adopted) suggested that the provisions were only intended to apply to transfers between shareholders rather than transfers from shareholders to the company.
The change in ownership or control of a corporate shareholder may also enliven shareholders’ rights of pre-emption.
In Burbank Trading Pty Ltd v Allmere Pty Ltd  VSCA 82, the Victorian Court of Appeal found that the appointment of a voluntary administrator by Allmere Pty Ltd (Allmere) amounted to a ‘change in ultimate control’ of Allmere within the meaning of clause 10.2 of the shareholders’ agreement, which enlivened the pre-emptive rights of Burbank Trading Pty Ltd (Burbank).
As a result, Allmere could not prevent Burbank from selling Allmere’s shares in the joint venture company, in which they were sole and equal shareholders.
In reaching its decision, the Court of Appeal found that the relevant consideration was whether there was a change in ‘the supreme or authoritative decision-making power’ of the company, as opposed to whether there had been a ‘long term or final change’ in ownership.
Once it becomes apparent that a pre-emptive rights provision has been breached, the question then arises: will a purported transfer of shares to a purchaser be invalid? Recent authority suggests (perhaps unsurprisingly) that the answer is ‘not necessarily’.
In Rathner v Lindholm & Ors  VSC 399, Whelan J found that the assignment of shares in Australian Enterprises Pty Ltd (AEPL) by the mortgagee of a company known as Advanced Communications Technologies Australia (ACTA) to the administrator of ACTA (Plaintiff) was in breach of AEPL’s pre-emptive rights regime, which applied to sales, transfers and assignments of AEPL’s shares.
It was held that, although legal title of the shares did not pass to the Plaintiff due to the breach of AEPL’s pre-emptive rights provisions, the Plaintiff had an equitable proprietary interest in the shares.
In his reasoning, Whelan J stated that a purchaser’s equitable proprietary rights will bind the vendor of the shares, however where a conflict exists between the rights of the purchaser and the rights of shareholders other than the vendor, the equitable rights of the other shareholders will usually prevail.
In these circumstances, the vendor would hold legal title to the shares on trust for the benefit of the purchaser or, if it subsequently complies with the pre-emption provisions and sells the shares to another party, it will hold the proceeds of sale on trust for the purchaser.
Pre-emptive rights require careful consideration before embarking on an acquisition strategy (for a third party bidder) and on receipt of a bid (for a company and its shareholders). In our experience, the issues can be misunderstood or poorly managed.
To avoid the pitfalls (including those summarised in this article), companies should ensure that pre-emptive rights provisions in contracts are appropriately drafted and regularly reviewed, taking into consideration the intended purpose and circumstances in which the provisions may be enlivened.
Equally, interpretation of pre-emption provisions should not focus solely on the terminology of the provision, but also on its context and purpose.
This article is not legal advice. It is intended to provide commentary and general information only. Access to this article does not entitle you to rely on it as legal advice. You should obtain formal legal advice specific to your own situation. Please contact us if you require advice on matters covered by this article.