Rights issues and dilution of shareholding

A rights issue is an offer of shares to existing shareholders giving them the right to purchase additional shares, in proportion to their existing shareholding in the company. This is often as a result of pre-emption rights dictated on the sale of another shareholder’s share when they wish to exit the company.

Share sales

If a company wants to raise capital through the issue of additional ordinary shares for cash to improve cashflow, then it is obliged under the Companies Act to offer first refusal to existing shareholders. Otherwise it is not allowed to sell shares to any other person unless existing shareholders have either rejected or ignored the proposal.

• there are certain provisions that mean that this right of first refusal can be dis-applied;
• these may be contained in the company’s Articles of Association or in a shareholders agreement.

If the statutory pre-emption rights of first refusal have been successfully disapplied by a private limited company and therefore the company is no longer obliged to offer the sale of shares to existing shareholders first (often at a reduced price), then theoretically it can offer shares to a third party.

Directors duties to act in good faith to all shareholders

When selling shares, the directors must pay close attention to their duties towards the company and in particular to act in good faith to promote the success of the company for the benefit of its members as a whole.

Directors also have a specific duty to act in accordance with the constitution of the company. They must exercise their powers for the benefit of the company and for no other reason. For example,

• if the directors appear to sell shares in order to raise capital, but in fact their intention is to dilute a shareholder’s interests in the company, possibly ensure that unfriendly shareholder has a lower voting power than before, then this will be a breach of their duty as directors;
• the prejudiced shareholder could bring an unfair prejudice claim against the company.

The company should also be careful to check that if shares are allotted to others, that this allotment doesn’t breach rights contained under a shareholders agreement which requires that specific class rights are complied with.

A company having a share capital might have different classes of shares. Certain shares are considered to be a different class from the other shares in a company if there are differing rights attached to one class compared to the other classes. For example,

• companies might issue a mix of ordinary shares, preference shares, deferred shares or redeemable shares, which all have different rights. These confer separate rights on the members;
• If the allotment of new shares breaches or amends the class rights of another, then this may dilute the rights of that particular shareholding, and amount to a breach of duty to that class of shareholders.

A further issue of shares to existing holders of the same class won’t necessarily constitute a variation of the rights of another class, but this might lead to a dilution of their voting rights or a reduction in the level of dividends available to them.

In this way the issue of rights and allotment of shares and any subsequent dilution of shareholding is a risk to shareholders which they may not be able to affect.

Minority shareholders

Minority shareholders in particular who are concerned about further dilution should obtain legal advice to ensure that the documentation surrounding their class of shareholding and the rights contained within that class is clear. This would inevitably be set out in a shareholders agreement. For example, a shareholders agreement may state that an issue of new shares to other classes of shareholders will be considered a variation of the class rights of the shares held by shareholders not benefiting from that allotment and so those shareholders must consent before such a new allotment can take place.

This is a complex issue and the dilution of shareholding generally can only be prevented by careful drafting of a shareholders agreement and/or by amending the company’s Articles of Association around the issue of shareholding.

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At Francis Wilks & Jones we frequently act for shareholders requiring advice on how they can protect their position and in dispute resolution. We can provide assistance and guidance for any shareholder in this position, or a company wanting to ensure shareholders are treated correctly. Contact our team to talk through your options today.