DILUTION AS A REMEDY FOR A DEFAULT BY A SHAREHOLDER
| Jurisdiction | United States |
(Apr 1999)
DILUTION AS A REMEDY FOR A DEFAULT BY A SHAREHOLDER
Placer Dome Exploration, Inc.
San Jose, California
In many countries, the use of an unincorporated joint venture is not available where two or more parties wish to jointly explore, develop and operate a mining property. It is often the case that a corporation will have to be used. While there are a number of articles which deal with dilution as a remedy for default in an unincorporated joint venture,1 there are very few which discuss dilution in the context of a corporation.2 One commentator has stated that trying to include a dilution provision in a corporate setting is forcing the issue3 . This paper will raise some of the issues encountered when trying to include dilution as a remedy for default in a corporate setting.
Dilution
Dilution of a shareholder's interest can occur in one of two ways.4 First, the corporation can issue additional shares to the nondefaulting party. Alternatively, the defaulting party can transfer such of its shares to the non-defaulting party, until the newly specified proportions of ownership are reached. There are two issues that need to be resolved with either of these approaches; namely, the mechanics by which the new proportions are reached and the valuation of the transaction. The following section will review an example of how difficult the mechanics of a dilution transaction can be under local law. The example looks at the mechanics of getting shares to a nondefaulting party in an incorporated joint venture in Russia.
The assistance of Philippe Max of Clifford Chance, Moscow, particularly with the section on Russian Joint Stock Companies, is gratefully acknowledged.
[Page 2B-2]
Example of Mechanics of Dilution under Local Law
The Russian law on Joint Stock Companies was passed in 1995 and entered into effect on January 1, 1996.5 There is very little jurisprudence on this law so it is difficult to know exactly how it will be applied. If the corporation is going to issue new shares, the nondefaulting party must overcome the following:
— Each time new shares are issued and if the company qualifies as a "company with foreign investment" (which in practice applies when shares are held by non-residents), the charter must be amended. In addition, a prospectus must be prepared if the nominal value of the issue exceeds an amount, currently equivalent to US$170,000 (even if it is a non-public, closely held corporation).
— If the new shares to be issued constitute more than 25 percent of the shares previously distributed, it is a major transaction under Article 78 of the law and the resolution to issue them must be made unanimously by the board of directors. If a unanimous decision of the board is not reached, the question may go to a general shareholders meeting where it must receive a three-fourths majority vote of shareholders holding voting shares and present at the meeting in order to pass.
— If the new shares to be issued constitute more than 50 percent of the balance sheet value of the company assets, the decision to issue them must be made by a three-fourths majority vote of the shareholders.
— Shareholders who vote against a major transaction which nevertheless passes are entitled to request redemption of their shares.
— Under Article 83 of the law, a transaction with an interested party (one that owns alone or through an affiliate, 20% of the company, sits on the board or occupies a position in another company management body) must be approved by a majority vote of directors who do not have an interest in the completion of such transaction.
— If the interested party transaction value exceeds 2 percent of the company assets or involves the placement of more than 2 percent of the voting shares the transaction must be approved by a majority vote of the shareholders who do not have an interest in the transaction.
— All new shares must be issued for a sum not less than the fair market value.
Given the foregoing, it is very difficult to see how the non-defaulting party could legally require that new shares be issued to it. Let us then look at mechanisms to transfer shares from the defaulting party to the non-defaulting party.
[Page 2B-3]
— A pledge of shares is possible under Russian law so the idea of each party creating a pledge on its shares to the other party comes to mind. However, execution on a pledge requires sale at a public auction. The public sale would probably cut off the rights of the nondefaulting party under the shareholders' agreement, including any right of first refusal.
— Other ideas such as call options or escrow arrangements can be conceived to contractually bind each party to accomplish the share transfer. However, under Decree No. 47 of 11 November 1998 of the Federal Securities Commission, one cannot undertake to transfer shares before state registration of their issuance, although this may be solved by including a condition precedent in the agreement.
— Once shares are issued and registered, a transfer from one party to another will require the transferor to sign a transfer order. The transfer order is taken to the registrar who can then note the change of ownership.
— Approval of the Ministry of Anti-Monopoly Policy may also be required if more than 20% of the shares are to be sold before a transfer can be made.
While it may be possible to make some arrangements to satisfy the above with regard to initial shares that a company will earn by its initial work or funding commitment, it would be quite difficult, if not foolhardy, to try to make the transfer procedures work in case of dilution. Having both parties sign transfer orders in blank for their shares does not seem to be the way to start off a new business venture.
Other Considerations
The foregoing analysis is not atypical of trying to make dilution work in...
To continue reading
Request your trial