What are pre-emption rights?

‘Pre-emption rights’ are a shareholder’s right of first refusal over the issue of new shares in the capital of a company (or, if provided for under a shareholders agreement or the company’s articles of association, the right of first refusal over the transfer of existing shares). Pre-emption rights help protect shareholders from being diluted without their consent.

So, where can pre-emption rights be found? There is a statutory pre-emption right contained within the Companies Act 2006 which states that on an issue of shares, all existing shareholders of the company will be entitled to purchase a number of those new shares which are pro-rata to their existing shareholding.

However, if the company in question has different classes of shares (say, A B and C shares) and the company only issues B shares, it is worth noting that only the holders of B shares will be entitled to purchase those shares under the pre-emption right, again in proportion to their existing B shareholding, as the pre-emption rights are also specific to existing share classes.

It is equally important to note that a pre-emption right does not entitle existing shareholders to ‘free’ shares in proportion to their current shareholdings, it merely reserves them the right to purchase their proportion of new shares on whatever terms the company is offering the new shares. If the existing shareholders do not take up any new shares, they are in effect waiving their right of pre-emption and the remaining shares can be offered to the other existing shareholders who may wish to purchase more than their current shareholding proportion. If the other existing shareholders then fail to purchase the outstanding newly issued shares, the remaining shares can be offered to third parties (i.e. new incoming shareholders) on the same terms.

It may however, be decided that a pre-emption on newly issued shares does not go far enough to protect shareholders’ existing shareholdings. In this instance, pre-emption rights on a transfer of shares can be created by inserting such provisions into the company’s articles of association or a shareholders agreement (or both).

In some cases, for example where the company is seeking to raise investment from third parties by way of a new share issue, the company will need to seek waivers of pre-emption from the existing shareholders before issuing the new shares to any investor(s) in exchange for their investment. Failure to seek such a waiver will leave the company open to a claim from the existing shareholders for failing to observe their rights of pre-emption.

Pre-emption rights are an important tool in company law for shareholders to protect their shareholdings. It is therefore crucial that articles of association and shareholders agreements are checked when a new issue of shares or a transfer of shares is proposed so that directors know the correct procedures to be followed to ensure pre-emption rights are either observed or correctly dis-applied.