In corporations and closely held companies, business ownership is measured by the number of shares a shareholder owns. A shareholder who owns 100 of a company’s 1,000 shares, for example, would be a 10% owner.
For minority shareholders, there are real and warranted concerns when it comes to threats against their ownership interests. If a corporation issues 1,000 additional shares to its preexisting 1,000 shares, for instance, that same 10% shareholder would suddenly become a 5% owner. This is known as shareholder dilution, and it is a common form of minority shareholder oppression and squeeze-out.
However, shareholders with preemptive rights may be able to prevent this type of wrongful dilution.
What Are Preemptive Rights?
Preemptive rights are a shareholder’s right to buy pro rata shares in any future issue of company stock (or other securities) before shares are available to the public. In terms of corporate ownership and shareholder oppression, preemptive rights can function as a mechanism to prevent dilution. Preemptive rights, also known as “anti-dilution provisions,” may be included in shareholder agreements, a company’s governing documents, and other securities, merger, or option agreements.
Establishing preemptive rights is the only legal way to protect against dilution, and can allow existing minority shareholders to avoid suffering damages in the form of diluted voting power and value of their investment, if the selling price is lower than actual value. In some circumstances, preemptive rights may:
- Protect a shareholder’s right centage;
- Preserve a shareholder’s right to maintain voting power if new shares are issued;
- Protect early investors from loss if new shares are priced lower than initial shares;
- Provide incentive to early investors and majority shareholders for the risk they take on;
Though stock issuance or dilution is not necessarily harmful in and of itself, it can certainly be used for squeeze-outs and minority shareholder oppression. As such, a number of states grant preemptive rights as a matter of law. While Texas following an opt-out approach for corporations formed before September 1, 2003, however, shareholders in Texas companies formed after that date do not have preemptive rights, unless they are expressly provided for in the Articles of Incorporation (or the bylaws). This means:
- Corporations formed after 9/1/2003 do NOT have preemptive rights unless stated otherwise in the company’s Articles of Incorporation / Certificate of Formation / governing docs; and
- Corporations formed prior to 9/1/2003 have preemptive rights unless stated otherwise in the AOI / Certificate of Formation / governing docs.
Given this approach, preemptive rights are not the norm for shareholders in Texas, and are not typically granted to all shareholders. Preemptive rights (also called “anti-dilution provisions”) are more likely to be granted to majority owners who want to maintain the size of their stake in a company if and when additional shares are offered, to early investors who take on risk when financing a new venture, and sometimes as an incentive to raise money (especially from early investors) in later funding rounds. However, granting preemptive rights can be time-consuming both for the corporation and the shareholder, and may potentially hinder the ability to quickly rally fresh financial resources.
For those looking to form a corporation in Texas, invest in new ventures, or even rally capital to overcome challenges created by COVID-19 and the coronavirus pandemic, due diligence during business formation, contract drafting and negotiation, and the creation of shareholder agreements should involve thorough assessment of preemptive rights and dispute mitigation strategies.
Because issuing new shares can also be a key ingredient in the recipe for litigation, any corporation looking to raise money should carefully consider the implications of granting preemptive rights in their governing documents or agreements.
Experienced attorneys like those at Hendershot Cowart P.C. can assist start-ups, shareholders, and established businesses in proactively addressing preemptive rights and protections against dilution or other forms of shareholder oppression, while balancing the need for a business to retain financial flexibility and raise capital.
Preemptive Rights Exceptions
Shares sold by corporations may come from newly authorized shares, previously authorized shares never issued, or treasury shares that have been issued and repurchased by the corporation. They may also be issued for consideration in kind, such
When corporations issue new shares or sell treasury shares, a shareholder with preemptive rights has a type of first right of refusal to purchase their proportionate share of the new offering on the same terms – thereby maintaining their ownership percentage and avoiding dilution of ownership through issuance. There’s no obligation that they must purchase any shares; preemptive rights only provide an opportunity to do so.
However, Texas law exempts certain issuances from preemptive rights, unless a share’s certificate provides otherwise. Per Texas Business Organizations Code § 21.204, exceptions include:
- Shares issued or granted as compensation to directors, officials, agents, or employees of company of subsidiary or affiliate;
- Shares issued / granted to satisfy conversion or option rights created for compensation;
- Shares authorized in a corporation’s Certificate of Formation issued no later than the 180th day after corporation’s formation; or
- Shares sold, issued, granted by a corporations for consideration other than money.
As these exceptions show, even shareholder with preemptive rights may be unable to stop corporations or majority holders from successfully diluting by issuing shares under an exception. Because preemptive rights only provide an opportunity to purchase additional shares to maintain their ownership percentage when new shares are issued, minority shareholders who lack the financial means or willingness to make the purchase may find little benefit in having such rights.
Legal Remedies For Shareholder Dilution
Because preemptive rights are not a fail-safe protection against shareholder dilution, and because Texas’ shareholder oppression doctrine was eliminated in the Texas Supreme Court’s 2014 decision in Ritchie v. Rupe, minority shareholders experiencing a squeeze-out through stock issuance may need to explore other options for legal remedy.
Fortunately, there are a number of legal remedies in the post-Ritchie world for minority shareholders facing dilution, oppression, and violation of their rights. While different statutes of limitations may apply depending on the claim, actions based on preemptive rights in Texas must be brought no later than (whichever is earliest):
- 1 year from the date of written notice of the violation; or
- 4 years from the (latest) date of issuance, sale or distribution.
Though every case is unique and every course of action tailored to the specific facts and circumstances, there are a number of potential actions by which minority shareholders can seek legal remedy. Examples include:
- Breach of fiduciary duty over the issue of a large number of shares for inadequate consideration (shares below FMV), and / or for loss of value to the corporation’s shares;
- Derivative lawsuits to pursue a damages remedy;
- Individual shareholder claims over breach of fiduciary duty, breach of trust and confidence (i.e. a breach of informal fiduciary duty), or stock conversion, which may allow for legal or equitable remedy such as a buyout;
- Breach of contract of a shareholder agreement;
- Fraud, including claims of inducement, fraudulent conveyance / transfer of stock, or state or federal securities fraud;
- Ultra vires actions over unauthorized acts of a corporation or its officers.
Some of these claims relate directly to Directors’ fiduciary duties, which are a flexible and powerful instrument for limiting directors’ discretion in issuing shares, and ensuring their transactions are fair to the corporation. Our team at Hendershot Cowart P.C. can help evaluate your situation to determine the most appropriate path for legal action.
Preventing Disputes & Oppression
Mitigating risks of disputes, oppression, and litigation requires a comprehensive approach. Among these are three key areas of focus that can help strike a balance between shareholders’ rights and the ability of corporations to maintain optimal financial structure:
- Corporate bylaws regarding the allocation of power for determining how and when new shares are issued;
- Preemptive rights in the even new shares are issued and sold; and
- Fiduciary duties of directors who issue and sell new shares.
At Hendershot Cowart P.C., our award-winning attorneys leverage over a century of collective experience to guide clients through a range of matters involving business law, transactions, and shareholder rights. This proactive counsel for individuals and entities in matters of:
- Business formation and incorporation
- Governing documents, bylaws, and contracts
- Disputes over distributions, dividends, and compensation
- Drafting shareholder agreements
- Dispute mitigation planning
- Buy-sell agreements
- Contract review and negotiation
- Corporate restructuring
For shareholders, majority owners, and corporations who need to pursue or defend against legal action, our team can provide representation in mediation, arbitration, or litigation over partnership or shareholder disputes, direct and derivative lawsuits, and other related claims.
Have questions about preemptive rights, shareholder dilution, or how Hendershot Cowart P.C. can assist in your legal matter? Call (713) 909-7323 or contact us online to request a consultation.
