Greater clarity needed on preferential share details

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Bui Ngoc Hong, partner at lawyers LNT & Partners, discusses the regulation on preferential shares under the current Law on Enterprises (2005) and how they are enforced.

The current Law on Enterprises includes four categories of preferential shares: voting, dividend, redeemable and other types.

What are preferential shares?

Preferential shares are those that provide their holders with special rights compared to holders of ordinary shares. These special rights may fall within the categories of decision-making rights (political rights), for example the right to participate in other management roles; financial rights, for instance, entitlement to certain profits of the company; or ownership rights, which is basically the right to dispose of shares. All of these special rights must be recorded in the company’s charter.

Where are the limits for preferences?

The law does not appear to limit the extent of preferences that can be vested in certain types of preferential shares. Article 78.2(d) of the Law on Enterprises leaves it up to shareholders whether to provide in a company’s charter “other types of preferential shares”. In practice, however, authorities do not accept preferential shares other than the three specific types mentioned above. The primary reason cited by authorities is the lack of implementing guidance.

Revisiting the rationale for restrictions on preferential shares

The maximum time period of three years for holding preferential shares is not necessarily reasonable, and should be the decision of the shareholders. Take for example, a case where three investors with different needs and strengths would like to co-operate to establish and operate a company. Shareholder A is recognised by the other two as having special managerial skills, but Shareholder A lacks the needed capital, while the other shareholders have deeper pockets. In this case, allocating voting preferential shares to Shareholder A seems reasonable because it enables them to take a decision-making role in the company.

However, as voting preferential shares expire after three years, Shareholder A would lose their assigned preference in management after this period. If the other two shareholders only want financial and ownership preferences, it would be simple to maintain Shareholder A’s decision-making power by allocating non-voting preferential shares to the other two. However, such an allocation does not work if the other two shareholders would also like to engage (though not decisively) in the management of the company.

The stipulation that financial preference and ownership preference excludes political preference may need to be reconsidered. Consider also the case where an inventor has created something new but has no money or business capacity to market the invention. In that case it may still be agreeable for the inventor to accept limited political rights and/or financial rights while perpetually leaving the controlling political rights and financial rights to other business-minded shareholders.

The current provisions in the law do not accommodate a preferential share type where political preference (voting) is combined with other non-voting preferences. This should be changed so the shareholders can decide themselves whether or not to provide these rights.

Contractual ways to provide “other preferences” to shareholders

To deal with the time limit on voting preferential shares and the restriction on combining non-political preference and political preference shares, one solution a company can use is to only issue ordinary shares, but bind the shareholders in the agreement to allocating certain preferences to some, but not others.

There are numerous ways to provide preferences other than those set out by law. For example, a new investor in an existing company taking a minority stake may, through the shareholders agreement or share subscription agreement, get the existing shareholders to waive certain rights or to provide the new (minority) shareholder with some special rights (e.g. share redemptions, right to co-sell shares at the same price that majority shareholders are offering to a buyer, or the ability to nominate certain managerial positions in a company).

In the above example, the existing shareholder has rights equal to those of the new shareholders holding the same share type but it means existing shareholders waive their rights and entitle the new shareholder to more preferences. Therefore, the transaction should be recognised and enforceable.

So, when the law does not fit, an agreement between the parties can help navigate around the obstacle.