By Catherine Tian and Jeff Li
A principal objective of most shareholder agreements, including a unanimous shareholder agreement (USA), is to regulate potential shareholder conflicts. This objective is achieved by prohibiting share issuances and transfers except as specifically permitted by the agreements. Common mechanisms used to control the issuance and dispositions of shares are pre-emptive rights, shotgun clauses, rights of first refusal, piggy-backs, and drag-alongs.
- Pre-emptive rights
A pre-emptive right clause gives existing shareholders the first right to purchase any new shares that a corporation proposes to issue. For example, if a shareholder owns 10% of the shares, he/she will typically have the right to purchase 10% of any new issuance of shares before such shares could be issued to any other shareholder or a non-shareholder. If provided for in the shareholder agreement, when other shareholders do not exercise their own full pro rata pre-emptive rights, he/she can also have a right of over-subscription to purchase more than the initial 10% allocation. This right allows a shareholder to limit the dilutive effect of treasury offerings.
- Shot-gun clauses
Sometimes conflicts among the shareholders are so severe that they cannot work together anymore. One or more shareholders must quit, or be forced to quit. In such a situation a shotgun clause will be extremely helpful. The shot-gun is a mechanism whereby any shareholder can sell his/her own shares or acquire the shares of other shareholders. A shareholder may fix a fair price for the purchase of another shareholder’s shares, or for the sale of his/her shares, and deliver a notice to buy or sell to the other shareholders. The recipient of the offer can choose to buy the shares offered in the notice, or sell his/her own shares, at the same price fixed by the offering shareholder. A shotgun provision generally only works equitably where each of the parties has sufficient financial capacity to exercise a purchase. Where the parties are not of equal financial capacity, this type of clause can work unfairly against the party of limited means.
- Rights of first refusal
Rights of first refusal provide that before a shareholder can sell his/her shares to a third party, he/she must first offer to sell such shares to the other shareholders. The offer to sell would be made on the same terms and conditions as set out in the original offer from the third party. A right of first refusal can be a significant restriction on the ability of any shareholder to dispose of his/her shares. In fact, it is very difficult to dispose of shares subject to a right of first refusal without actively and directly involving the shareholders who benefit from this right in the sale process.
- Piggy-backs
A piggy-back clause can be used both in lieu of and in conjunction with a right of first refusal. It requires that when a selling shareholder received an offer from a third party to acquire his/her shares at a fixed price, he/she should obtain a bona fide offer in writing from this third party to acquire the shares of all other shareholders at the same price. In most cases where a piggy-back clause is used in a shareholder agreement, it is intended to provide minority shareholder protection when a majority shareholder is selling his/her rights.
- Drag-alongs
A drag-along is the corollary to a piggy-back right. It applies to the circumstances that an offer is made for all or substantially all of the shares/assets of a corporation, and such offer is supported by the owners of, typically, at least a majority of the shares. A drag-along cause then requires all shareholders to vote in favour of and, if applicable, tender their shares to the offer. A properly drafted drag-along provision in a shareholder agreement effectively provides that minority shareholders must support a transaction approved by the majority shareholders.
In addition to the aforementioned provisions, a USA will stipulate restrictions on the management of the business and affairs of the corporation by the directors. It may mandate certain matters (e.g. that a particular bank will be the banker of the corporation) and require that certain actions can only be taken with the consent of the shareholders. In many shareholder agreements, consideration is also given to the financing of the corporation, and may deal with the sources of financing and any obligation of shareholders to contribute to the financing.
In sum, if a corporation has more than one shareholder, a shareholder agreement should be seriously considered.