This article has been written by Bivash Roy, pursuing a Diploma in US Contract Drafting and Paralegal Studies from LawSikho. It has been edited by Zigishu Singh (Associate, LawSikho).  

Introduction

Investors of a company need to be prioritized over all other functionaries and giving rights to investors is one of those incentives, to keep them invested. Pre-emptive rights are just one of those tools in the hands of the company. The rights given to an investor are Country specific i.e. rights applicable in the US, may or may not be applicable in India. In this article, we will try to provide some deep insights into the topic for a general understanding of the readers. 

What are pre-emptive rights?

Pre-emptive rights allow the shareholders to buy additional shares in any future issue of the company’s common stock before the shares are offered to the public. A pre-emptive right is also called anti-dilution provision or subscription rights. It allows an investor to maintain a certain percentage of ownership in the company as the company issues more shares. A US company may give preemptive rights to all its shareholders, but this is not required by law. The same will be mentioned in the company’s charter. The shareholder may also receive a subscription warrant, entitling them to buy several shares of a new issue usually equal to their current percentage of ownership. 

Preemptive rights are usually an incentive for early investors and a way for them to offset some of the risks of investment, specifically if the newly offered shares are priced lower than the original shares. They are in the form of contract clauses that grant investors the option to buy additional shares. 

A preemptive right is essentially a right of first refusal. The shareholder may exercise the option to buy additional shares but is under no obligation to do so. The preemptive right clause is commonly used in the U.S. as an incentive to early investors in return for the risks they undertake in financing a new venture. The preemptive rights give the investor the option to convert the preferred shares to common shares after the company goes public.

This right is not mandatory but is routinely granted to shareholders in the U.S. Several states grant preemptive rights as a matter of law but even these laws allow a company to negate the right in its articles of incorporation.

Types of Pre-emptive Rights

A contract clause may offer either of two types of preemptive rights, the weighted average provision or the ratchet-based provision.

The weighted average provision allows the shareholder to buy additional shares at a price that is adjusted for the difference between the price paid for the original shares and the price of the new shares. 

The ratchet-based provision, or full ratchet, allows a shareholder to convert preferred shares to new shares at the lowest sales price of the new stock. 

Benefits of Preemptive Rights

Major Investors   

The rights are generally useful for major investors having large numbers of shares in the company. The major shareholders due to their percentage of shares in the ownership also hold a major share in maintaining a voice in overall company decisions. Also, those who are likely to benefit are the early investors and company insiders. 

Shareholders

Preemptive rights protect a shareholder from losing voting power as more shares are issued and the company’s ownership becomes distributed. Since the shareholder is getting an insider’s price for shares in the new issue, there also can be a strong profit incentive. In the worst case, there is the option of reducing losses by converting preferred stock to more shares if the new issue is priced lower.

Companies

It is less expensive for a company to sell additional shares to its current shareholders than to issue additional shares on a public exchange. Issuing stock to the public entails paying an investment banking service to manage the sale of the shares. The savings in direct sales to existing shareholders lower the company’s cost of equity, and hence its cost of capital, increasing the firm’s value. Preemptive rights also are an additional incentive for a company to perform well so it can issue a new round of stock at a higher price.

The offering of Pre-emptive rights in the US

U.S corporations are not required by law to offer their common shareholders preemptive rights, and most don’t. The presence of a subscription warrant, while purchasing the stock, is a guarantee that preemptive rights have been bestowed with. On the contrary, the U.K and European Union recognize the preemptive rights of common shareholders. However, in the U.S, such rights are generally offered to the early investors and other insiders, who have purchased shares or have been awarded options in the company, that are yet to go public. 

In the U.S, the preemptive rights can be waived off, provided both the parties agree to the same. In the U.K, a waiver has to be signed by each shareholder for it to be recognized in the eye of law. 

Pre-emptive rights in India

The Companies Act has always found a mention of the preemptive rights of shareholders. Section 105C of the Companies Act 1956 has an exclusive mention of the presumption rights of the existing shareholders. It states “Where the directors decide to increase the capital of the company by the issue of further shares such shares shall be offered to the members in proportion to the existing shares held by each member (irrespective of class) and such offer shall be made by notice specifying the number of shares to which the member is entitled and limiting a time within which the offer if not accepted, will be deemed to be declined; and after the expiration of such time, or on receipt of an intimation from the member to whom, such notice is given that he declines to accept the shares offered, the directors may dispose of the same in such manner as they think most beneficial to the company.”

Under the Companies Act, 1956 a company is obligated to follow the procedure prescribed in Section 81 (including pre-emptive rights of the existing shareholders) only if the company has been in existence for two years (or) at “any time after the expiry of one year of the allotment of shares”.

In the case of Sahara India Real Estate Corporation vs SEBI, the Honourable Supreme Court held that section 81 of the Companies Act 1956, postulates a pre-emptive right on the part of the existing shareholders to the new issue of shares. 

Conclusion

Preemptive rights in the U.S. are relevant primarily to shareholders with a significant stake in a company who want to maintain that stake. Generally, they are early investors in a company or other major stakeholders who are given the contractual right to buy additional shares of any new issue to maintain the size of their stake. The ability to buy additional shares also cushions any losses they will incur if the newly issued shares bear a lower price. In India, the preemptive rights to an existing shareholder are guaranteed by the Companies Act 1956.

References

• https://www.investopedia.com/terms/p/preemptiveright.asp#:~:text=A%20preemptive%20right%20is%20essentially,in%20financing%20a%20new%20venture.
• https://elibrary.law.psu.edu/cgi/viewcontent.cgi?article=1279&context=fac_works
• https://www.thebalance.com/what-is-the-preemptive-right-358100
• https://www.mondaq.com/india/securities/698196/enforceability-of-pre-emption-rights-call–put-option
• https://core.ac.uk/download/pdf/143655966.pdf

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