Take care when drafting the right of pre-emption in a private company’s articles of association

Drafting a private company's articles of association without proper care can have problematic consequences. One of Lawsure’s panelists, Prof Bob Williams, gives valuable advice as to why it is important to consider the right-of-pre-emption clause very closely when drafting the articles of association.

Source: www.lawsure.co.za

*This article was first published by Siber Ink as a part of the Corporate Law, Partnerships and Trusts Sibergramme 3/2006 and is reused here with permission. Click here for more information on the Corporate Law, Partnerships and Trusts Sibergramme. RC (Bob) Williams, BA LLB (Cape) LLM (London) H Dip Tax (Wits) PhD (Macquarie), is also a LawSure panellist.

In this age, with the blessing and the curse of the computer lying heavily upon us, the drafters of trusts, contracts and other legal documents have a great temptation to flip through their computerized data base for a “precedent” to use when receiving instructions in a new matter, alter a few words here and there, and then simply press the print button. The client is then given what is essentially a one-size-fits-all document, and sent on his way with a cheery word and a hefty bill for “professional services rendered”.

Like an off-the-peg suit bought from a chain store, a mass-produced legal document may cover the essentials, but it is much inferior to a tailor-made product. Thoughtlessness in the drafting of a company’s articles of association may take years to come to light, but can then unleash animosities amongst the shareholders that destroy the company.

When it comes to drawing a company’s articles of association, there is a strong temptation to run off the computerized text of Table A or Table B with few if any changes to suit the needs of the particular company and its members.

The importance of the right of pre-emption

A conscientious professional, when drawing the articles of association for a private company (particularly one which is a quasi-partnership) will realize the great importance of the pre-emption clause.

The articles of a private company must contain a restriction on the transferability of its shares (see the Companies Act 1973, s 20(1)(a)). This restriction often takes the form of a right of pre-emption in favour of the other shareholders; in other words, a member who wishes to sell his shares must first offer them, pro rata, to the other shareholders.

The underlying reason why the Companies Act insists that private companies must restrict the right to transfer their shares is that a private company is conceived of as being a relatively small group of persons who have some measure of mutual trust and confidence or an established working relationship, at least to the extent that they would not want a stranger to be permitted, willy-nilly, to buy into the company. (See Ord v Calan Health Properties Ltd [2004] 2 NZLR 122 at [19].) Hence the appropriateness of a right of pre-emption in favour of the other shareholders when a shareholder wishes to dispose of his or her shares.

A thoughtlessly-drafted right of pre-emption is often so widely expressed that it applies to any change in legal title to shares of the company. So, for instance, if a shareholder dies, the pre-emption clause might apply to the transfer of shares to his executor. A wide pre-emption clause might also be triggered where some members of a private company have held their shares in a trust of which they are beneficiaries, and the trust now wants to transfer the shares to those individual beneficiaries. If the right of pre-emption is triggered, the trust beneficiaries may – to their fury – find that the other members of the company snap up the shares.

The right of pre-emption can even be triggered where shares are registered in the name of the trustees of a trust, and there is then a change of trustees, which necessitates a change in the share register. This was what happened in Ord v Calan Health Properties Ltd [2004] 2 NZLR 122, and the New Zealand High Court observed (at paragraph [1]) that the case –

“highlights a trap for those administering family trusts that hold shares in unlisted companies. The trap is that a routine change in the trustees of the family trust can [depending on the wording of the company’s articles in regard to the right of pre-emption] result in an inadvertent loss of the trust’s shares in the company by triggering the pre-emptive rights of the other shareholders”.

In this case, the court held (at paragraph [11]) that the word “transfer” connoted the transfer of legal title to shares, even though there was no transfer of the beneficial interest.

This decision was reversed on appeal (see 2005 (2) NZLR 96), not on a matter of principle, but on the correct interpretation of the pre-emption clause in the company’s articles. Hence the warning, quoted above, regarding the “trap” remains apposite.

If a shareholder dies and bequeaths his or her shares to one of the existing shareholders, the pre-emption clause may be triggered, with the result that the shares have to be offered to all the existing shareholders, and cannot simply go to the person to whom they were bequeathed.

In short, it is vitally important, when drafting the pre-emption clause in the articles of a private company, to specify the circumstances in which the right of pre-emption will not be triggered. So for example, the articles could state that the other shareholders have no right of pre-emption –

·      on the death of a shareholder, when the shares are transferred to his or her executor;

·      when shares, held by a trust, are distributed to a beneficiary (or perhaps, to a beneficiary who is also a shareholder         in his personal capacity).

It may be equally important for the articles to provide that certain situations will be deemed to constitute a change of ownership in shares (thus triggering the right of pre-emption), for example where shares are held by a company and control of that company passes to different persons.

Another important dimension to the right of pre-emption in a company’s articles of association is that where one is drawing a will for a shareholder in a private company it should be pointed out to the client that, unless the pre-emption clause in the articles does not apply, there can be no guarantee that shares bequeathed to a particular person will, in fact, be transferred to that person, for the right of pre-emption may result in the shares being taken up by another shareholder.

 

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