Introduction
The moment when new shares are issued within a joint-stock company is extremely delicate. A fair balance between the various interests involved has to be struck by the legal rules governing this phase of a company’s life. On the one hand, shareholders’ interest is to maintain their respective prerogatives intact. If the new shares are not offered to existing shareholders, the latter may suffer two types of damages: first, their voting power within the corporation is diluted; second, the value of their investment can be reduced if the selling price is lower than the actual value of the shares.[1]On the other hand, it is the company’s interest to be able to quickly obtain fresh financial resources when market conditions are favorable. This ability may be hindered by the time-consuming activity consisting in offering the new shares to existing shareholders.
There are different ways how legal systems can handle such a delicate situation and thus find an acceptable balance between the protection of existing shareholders, on the one hand, and the ability of the corporation to pursue its optimal financial structure, on the other. The examples of the U.S. and of the Italian legal systems may suffice to show in a clear way the different possible approaches to the matter. While in the U.S. directors enjoy broad powers in the issuing of new shares and shareholders are mainly protected through directors’ fiduciary duties, in Europe shareholders are protected through statutory rules that mandate preemptive rights, which can be waived only in limited circumstances.
Competence to resolve upon capital increases
As regards, first, the rules governing the competence to resolve upon a share capital increase, the U.S. system is characterized by a structural delegation of capital increase transactions to the directors of the company (so-called blank check authority).[2] The power to issue new shares is, in other words, primarily entrusted to the board of directors, which enjoys a great degree of freedom in this regard. In resolving upon the issuance of new shares, however, directors have to comply with one important limitation (i.e., they cannot exceed the amount authorized within the charter of incorporation).[3] The practice, however, is to provide for a number of authorized shares significantly larger than the number of outstanding new shares, so that if new financial resources are needed, directors can easily issue new shares.[4]
On the other hand, under Italian law the power to decide the increase of capital is primarily in the hands of the shareholders, because the issuing of new shares for a consideration is an amendment to the corporate charter that can only be approved by the extraordinary shareholders’ meeting. The latter may delegate the matter to the directors, but only for a maximum period of five years.[5]
Preemptive rights
Preemptive rights are regulated in Italy by the paragraph 1 of article 2441, according to which newly issued shares and convertible bonds should be offered to shareholders in accordance with the previously held shareholdings. If there are convertible bondholders, they should be entitled too, along with shareholders, based on the conversion ratio. According to Italian law if an effective capital increase is in progress shareholders are thus entitled to acquire new shares pro-rata, meaning in proportion with the previously held total shareholdings. Preemptive rights could be exercised in relation to shares as well as convertible bonds, since these are financial instruments entitling the owner with the right to convert debt into equity in line with the conversion ratio.
The national regulation is quite different from other European States’ business laws. First, the abovementioned preemptive right is also nationally granted to convertible bondholders due to their nature of potential shareholders. However a recent European Court of Justice sentence condemning Spain for having granted preemptive rights to convertible bondholders, thereby contravening the Second Company Law Directive[6], has created a debate about the legality of the equally stated Italian provision.[7] A further distinctive feature is provided by paragraph 3, according to which shareholders of unlisted companies can exercise the right to purchase shares not previously acquired by other shareholders (so-called diritto di prelazione). Even though this right is a direct logical consequence of the preemption right, it is not mentioned by article 29 of the Second Company Law Directive.
The subsequent paragraphs of article 2441 provide for a number of cases in which preemptive rights could be limited or excluded at all. In agreement with the Second Company Law Directive this occurs in case of: (a) non-cash capital contribution; (b) when it is required by the company business interest; (c) if newly issued shares are to be subscribed by company employees. The Italian and European legislator’s objective is here to find a balance between the company interest to gather the necessary financial resources to carry on the business and the shareholders’ interest in not having to suffer a share dilution in voting power and value.[8] The Italian law protects stockholders from abuse through paragraph 6 of article 2441, which states that members of the management board should submit a report to the shareholders, showing the economic reasons justifying a limitation or exclusion of preemptive rights and the methods used to determine the soon-to-be-issued share price, which should be estimated on the basis of the net assets and, if the shares are traded in regulated markets, taking into due account the share price trend of the last semester. Shareholders are thereby compensated for the dilution in voting power resulting from the limitation of preemptive rights. The amount exceeding the nominal share value should be allocated to a capital reserve and it could not be distributed until the legal reserve reaches its minimum amount.[9]
With regard to US law, preemptive rights were originally granted to shareholders for newly issued shares, except if otherwise stated in the company articles of incorporation or in the bylaws (so-called opt-out rule). One of the first cases thereof was the 1870 Massachusetts Act. In spite of this, in the Sixties many state company statutes were revised and an opt-in rule was widely adopted. According to chapter 156B section 20 of the MBCA, “[n]o stockholder shall have any pre-emptive right to acquire stock of the corporation except to the extent provided in the articles of organization or in a by-law adopted by and subject to amendment only by the stockholders”.[10]
Fiduciary duties of directors
Directors’ fiduciary duties are an effective instrument that comes into play when preemptive rights do not apply and allows for reducing directors’ discretion in issuing new shares. In particular, when directors have an interest conflicting with that of the company, as a general rule the transaction must be approved by disinterested directors or shareholders or it must be entirely fair to the corporation.[11] A tricky situation may arise when directors issue shares to themselves at a fair price. In this case, since the transaction is fair to the corporation, the rule applicable to conflicted transactions would not be very helpful: instead, according to some judgments, directors must demonstrate a corporate purpose for the transaction.[12] Another problematic situation is where directors offer new shares to all shareholders at a bargain price, but some shareholders do not have sufficient financial resources or willingness to buy such shares. In this case, formally speaking, all shareholders had an equal opportunity to buy the discounted shares, but, also in this instance, courts have required a business purpose.[13]
On the other hand, under Italian law directors are liable to the corporation or to a single shareholder for a violation of their duty of care and loyalty, including the duty to act lawfully.[14] As a consequence, a violation of the mandatory rules concerning the procedures required for issuing new shares can result in liability. For example, if directors illegally exclude preemptive rights, they may damage shareholders by diluting their investment. Moreover, setting an issuing price below the fair value when the preemptive right is excluded may damage both the corporation and the shareholders. However, this type of lawsuit is rare, because the tight legal regulation of the procedure to issue new shares tends to prevent directors’ discretion to be exercised unlawfully, as well as because the Italian system relies on private litigation as an ex post mechanism to govern corporation less than the U.S. system.
Conclusions
The question about whether shareholder rights are better served through preemptive rights or fiduciary duties is bound to remain unanswered. Many academic papers were written to identify the reasons according to which different legal instruments apply to different countries. This topic of interest is called legal transplants, which is described as “the moving of a rule or a system of law from one country to another, or from one people to another”.[15] National legal mechanisms are a result of different cultures, traditions and historical roots, other than the law system as a whole. An interesting work by Martin Gelter focuses on some factors that could have caused derivative suits against managers not to be particularly popular in Europe: minimum share ownership requirements, the costs and allocation of litigation risk and limited access to information by shareholders.[16] In conclusion no legal system could be deemed to be better than another, but law systems’ divergence is a factor that should be taken into account in investment decisions.
BIBLIOGRAPHY
1) Marco Ventoruzzo, Issuing New Shares and Preemptive Rights: A Comparative Analysis, 12 Rich. J. Global L. & Bus. 518 (2013).
2) Maria Lucia Passador, L’aumento di capitale tra disciplina statunitense e diritto societario della crisi, 2 Osservatorio del diritto civile e commerciale 499 (2018).
3) See Sections 141, 151, 152, 153, 157, 161, 166 Delaware General Corporate Law.
4) Marco Ventoruzzo, supra note 1; see also Andreas Cahn & David C. Donald, Comparative Company Law 205 (Cambridge University Press, 2010), according to which, in Delaware “within the limits of the authorized stock, the board of directors is free to issue stock on its own authority until all the authorized stock has been issued. Delaware law thus places considerably more power in the hands of the board than either Germany or the United Kingdom”.
5) See Article 2443 of the Italian Civil Code. See also the Second Council Directive, Dec. 13, 1976, 1977 O.J. (L 026) 1, updated by Directive 2006/68/EC of the European Parliament and of the Council of 6 September 2006, 2006 O.J. (L 264) 32 and Directive 2009/109/EC of the European Parliament and of the Council of 16 September 2009, 2009 O.J. (L 259) 14.
6) Second Council Directive, Dec. 13, 1976, 1977 O.J. (L 026) 1, supra note 5.
7) See European Court of Justice, Case C-338/06 Commission of the European Communities v. Kingdom of Spain.
8) See Marco Ventoruzzo, supra note 1.
9) See articles 2430 and 2431 of the Italian Civil Code for further details.
10) Another case is provided for by Section 102b(3) of the Delaware Code.
11) Franklin A. Gevurtz, Corporate Law 135 (West, 2000).
12) Schwartz v. Marien, 335 N.E.2d 334 (N.Y. 1975).
13) Katzowitz v. Sidler, 24 N.Y.2d 512, 301 N.Y.S.2d 470, 29 N.E.2d 359 (1969).
14) Marco Ventoruzzo, supra note 1; see also Holger Fleischer, Legal Transplants in European Company Law-The Case of Fiduciary Duties, 2 Eur. Company and Fin. L. Rev. 378 (2005).
15) See Holger Fleischer, Legal Transplants in European Company Law – The Case of Fiduciary Duties, 2 Eur. Company and Fin. L. Rev. 378-397 (2005).
16) See Martin Gelter, Why do Shareholder Derivative Suits remain rare in Continental Europe?, 37 Brook. J. Int’l L. 843 (2012).
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