Preventing the dilution of shares
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Dilution of shares means a reduction, either in value
(economic dilution) or relative ownership (percentage dilution). If a
company issues new shares and one shareholder doesn't buy more shares
from the new issue, then the number of shares he owns as a percentage
of the total number issued decreases. One of the most illustrating
cases on dilution of shares involves one of the directors of Facebook,
Eduardo Saverin, who was ousted from his position as Finance Director,
by the other board members allegedly diminishing his share capital from
34% to 0.03%.
Why should we be aware of the issue of shares of a company?
After a dilution, shareholders will lose their power to control the
company simply because it will cause a variation of their class rights.
For example, it will reduce the relative power that a shareholder has
in setting the direction of the company and controlling its operation.
It dilutes the shareholder’s ability to control issues that require
shareholder approval which have a greater impact on the value of his
Thus, the Company’s Act 2004 (CA 2004) has always protected
this kind of situation by giving provisions to minority shareholders to
Directors are restricted in their right to allot shares.
Section 549 of CA 2004 stops the directors from issuing shares to
anyone unless they are authorized to do so in the articles or by
shareholders passing an ordinary resolution (section 551). This ban
also covers an agreement to issue shares and the grant of options that
will result in a future issue of shares. We should note that this rule
does not apply to a private company with only one class of share.
The most famous provision is called the pre-emption rights.
Indeed, Section 561 obliges a company to offer new shares first of all
to its existing shareholders in the same proportions they already hold
shares. It upholds shareholders’ right to be protected from dilution if
they are willing to pay the price asked for the new shares. Such an
offer must be open for at least 21 days, but some conditions are
required: the statutory pre-emption regime does not apply to certain
shares, including bonus shares, shares issued partly or wholly for
non-cash consideration, and shares held under employees’ share scheme.
Section 561 can be disapplied, along with section 549, either
in the articles or by a shareholder vote, though only by a special
resolution (in order to pass a special resolution 75% of shareholders
present at the meeting at which the resolution is proposed must vote in
Pre-emptive rights can also arise from the company’s articles
of association or under the terms of a shareholders’ agreement. Both
Table A (for companies registered before 1 October 2009) and the Model
Articles (for companies incorporated after 1 October 2009) include
pre-emptive provisions. Any new shares issued for cash have to be
offered to existing shareholders first. But it does not apply to new
issues of shares that are allotted as wholly or partly paid up or
issued for a non-cash consideration. This regime can be disapplied and
replaced by a bespoke procedure for allotment.
To conclude, the shareholder agreement generally sets out the
limits, scope and position of each shareholder, which will minimize any
issues later. To avoid Saverin’s situation, you must be careful to
always read the clauses in the shareholder agreement and to not just
sign it based on trust, because you will need to rely on those
provisions if any issues do arise in the future.
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Article Published/Sorted/Amended on Scopulus 2014-01-24 12:41:10 in Legal Articles