The current legislation provides for the right of a participant of a limited liability company (hereinafter referred to as LLC) to alienate his participatory interest to third parties. However, there are certain restrictions on such transactions. First, Articles of Association of the LLC may prohibit such alienation. Second, in the case of alienation under a sale and purchase agreement, the preemptive right of other participants to purchase a participatory interest is valid.
In practice, in the process of exercising the preemptive right, conflict situations often arise between business partners (participants of the LLC). The reason for such conflicts is the imperfection of the legal regulation of issues related to the practical application of the preemptive right and, as a consequence, errors in the development of constituent documents of the LLC. There are also not so rare cases, when participants of the LLC fail to effectively protect their preemptive right in court because of the poorly built legal strategy.
In this material, we will try to outline the main problems and subtleties related to regulation, implementation and protection of the preemptive right to purchase a participatory interest offered for sale to third parties (preemptive right) by participants of LLC.
Preemptive right: legal meaning and regulation
At present, at the legislative level, issues of the preemptive right of participants are regulated in provisions of Part 2 of Article 147 of the Civil Code of Ukraine (hereinafter referred to as the CC of Ukraine), which are fully duplicated in Part 3 of Article 53 of the Law of Ukraine “On Business Associations” (hereinafter referred to as the Law on Associations).
After analyzing these provisions, it is possible to distinguish the conditions and mechanisms for the implementation of such a preemptive right:
- The preemptive right is valid only in case of sale of a participatory interest to third parties, who are not participants of the LLC. Therefore, the consent of other participants is not required in the case of selling a participatory interest to one or more of current participants of the LLC (Clause 4.5. of Resolution of the Plenum of the Supreme Commercial Court of Ukraine No. 4, dated 25.02.2016 “On some issues in practical resolving disputes arising from corporate legal relations” (hereinafter referred to as Resolution No. 4).
- By default, the preemptive right applies only in the case of sale and purchase of a participatory interest, and therefore does not apply in the case of alienation of a participatory interest otherwise or transfer of rights to it on other grounds.
Such an approach has already become routine (including in case law) and does not raise objections, and is also one of the most used mechanisms to circumvent the preemptive right. For example, Paragraph 2 of Clause 4.10. of Resolution No. 4 states that the preemptive right does not apply to inheritance, succession, gift and other free-of-charge alienation of a participatory interest in the authorized capital of the LLC or SLC, as well as to the exchange of this participatory interest (its part) for another individually determined property.
At the same time, participants of the LLC may depart from the basic rule and extend the preemptive right to other types of transactions, under which alienation of a participatory interest occurs, by fixing the relevant provisions in Article of Association of the LLC. Although the Law on Associations does not expressly provide for the possibility of expanded application of the aforementioned provisions, such application is not prohibited either, which allows us to conclude that such provisions may be implemented in practice.
- The preemptive right is exercised by the parties subject to the principle of proportionality: an alienated participatory interest may be acquired by other participants only in the amount proportional to the amount of a participatory interest belonged to such a participant. Of course, such a principle of proportionality applies only in situations, where several participants have expressed their intent to use their preemptive right.
- Purchase of a participatory interest subject to the exercise of the preemptive right is carried out under the same conditions (including the price), under which it is offered to third parties for acquisition.
- A participant, who wishes to sell his participatory interest to third parties, is obliged to inform other participants about his intention and ask them to exercise their preemptive right (this obligation is not expressly stipulated, but it follows from the meaning of the provision).
- Participants may exercise their preemptive right within 1 month from the date of notice of the sale of a participatory interest (another term may be established by the Articles of Association or by agreement among the participants).
The abovementioned provisions of the legislation do not fully regulate all issues related to the preemptive right, which entails problems in the process of its implementation and protection.
Shortcomings of the existing mechanism for the transfer of rights
To date, the specialized legislation does not describe the consequences, as well as the algorithm of the participant’s actions in case of violation of his pre-emptive right. To answer these questions, it is necessary to use the general provisions of civil law in the area of joint ownership.
For example, Part 4 of Article 362 of the CC of Ukraine provides for the right of a co-owner of joint partial ownership to file a legal claim for transferring to him rights and obligations of the buyer in case of violation of his preemptive right by other co-owner during the sale of his participatory interest.
Such a provision is traditionally applied by analogy to cases of violation of the preemptive right of participants of LLC, as evidenced, in particular, by conclusions of the higher courts. For example, Paragraph 3 of Clause 4.9. of Resolution No.4 stipulates that the above provision is applied by analogy to cases of violation of the preemptive right of a participant of the LLC (SLC) to purchase a participatory interest in its authorized capital. A provision of similar meaning can be found in Resolution No. 13 (Paragraph 1, Clause 31), but it is supplemented with the reservation that violation of the preemptive right cannot be protected by invalidation of the disputed agreement.
It should be noted that in this case the term “violation” has to be interpreted widely and include in its meaning not only the sale of a participatory interest without the prior notice of other participants. The SCU points this out, stating that the grounds for filing a legal claim for the transfer of rights also include the premature sale of a participatory interest (before receiving a response from other participants) and the sale on more favorable terms than those offered to other participants.
This approach allows us to extend the application of Article 362 of the CC of Ukraine also to the cases of intentional overpricing the sale of a participatory interest by a participant, when offering it to other participants, and its subsequent sale to third parties at a lower price.
When applying Article 362 of the CC of Ukraine, it is necessary to pay special attention to the restrictions provided therein, as this provision applies to the relevant legal claims of participants of the company, only if they are observed. Such restrictions include a limitation period reduced to 1 year and the necessity to deposit money to a court’s deposit account.
Although there are no problems with understanding and implementing the conditions for a reduced limitation period, as for the deposit, there are a few practical questions. For example, Part 4 of Article 362 stipulates that a plaintiff is obliged to simultaneously deposit the amount of money that the buyer is obliged to pay under the agreement to a court’s deposit account. The deposit, by its legal nature, is the guarantee contribution of a plaintiff, which, in case of satisfaction of the claim, warrants a reimbursement of the alienation (redistribution) of a participatory interest in the company, taking into account the constitutional principle of equality of parties before the law.
At the same time, the legislation (procedural and material) has no provisions that would regulate the consequences of non-deposit of money to a court’s deposit account. Only in Paragraph 3 of Clause 18 of Resolution of the Plenum of the High Specialized Court for the Examination of Civil and Criminal Cases (hereinafter referred to as the HSCU) No. 5, dated 07.02.2014, “On judicial practice in cases concerning the protection of property rights and other substantive rights”, we can find a reservation that the non-deposit of money to be paid by the buyer under the agreement to a court’s deposit account simultaneously with the failure to file a claim constitues the reason to dismiss the claim.
From the context of the explanation provided by the HSCU, it can be concluded that the fact of non-deposit to a court’s deposit account simultaneously with filing a claim will in any case result in dismissal of the claim. However, in practice, courts have repeatedly allowed depositing money to the courts’ deposit accounts during the trials.
Taking into account such ambiguous case law, it is necessary to clarify the legislation in relation to determining the time period for depositing money to a court’s deposit account and the consequences of their non-deposit.
Also, the procedural law lacks any provisions regarding a court’s obligation following the trial to resolve the issue of repayment of money to the plaintiff in case of dismissal of the claim and transfer of money to the party under the disputed sale and purchase agreement in case of satisfaction of the claim.
As noted above, the preemptive right is exercised in accordance with the principle of proportionality. This means that in case of acquiring a participatory interest by just one of several participants he will be able to redeem it in full. At the same time, the legislation does not regulate the issue of the necessity to take into account, when determining the proportionality of participatory interests, those participants, who do not wish to exercise their preemptve right.
It is also likely that during the conclusion of a disputed sale and purchase agreement, the preemptive rights of more than one particpant of the company may be violated. In such circumstances, it is necessary to involve other participants (as co-plaintiffs or third parties) in the case.
In this regard, albeit with regard to joint-stock companies, HCCU, in Clause 4.26. of Resolution No. 4 clarified that the commercial court during the resolution of a dispute related to violation of the preemptive right of shareholders of a PrJSC to acquire shares being sold (shareholders of a PJSC, in the process of private placement of ordinary shares) shall involve all shareholders in the matters of this company, since all shareholders have the preemptive right to acquire the shares.
Considering that similarly to the case of sale and purchase of shares, in the case of the sale and purchase of participatory interests, the legal relations shall be governed by similar provisions, and for a LLC, existence of the preemptive right is obligatory (at least, until the Law on LLC comes into force and/or old Articles of Association be brought in line with the latter), this clarification may be applied by courts in both aforementioned cases.
However, by allowing the possibility and necessity of involving other participants of the LLC to participate in a trial, we are confronted with questions of determining the appropriate moment and the amount of a deposit. After all, if the claim is initially filed by several plaintiffs, who demand transferring rights of the buyer to the disputed participatory interest in the amount proportional to the amount of their own participatory interests, then it is logical that the deposit shall be distributed among them proportionally. In cases, where the identification of all stakeholders is not possible on the day, when the application is filed, it is obvious that the final determination of the amount of money to be paid by the plaintiff and/or other participants is possible only during a trial. Therefore, the imposing of an obligation to pay the deposit in full at the time of filing a claim on the plaintiff is not fair.
Unfortunately, we do not have provisions or clarifications of the higher courts on these issues.
Improvements in the new law
On 06.02.2018, The Ukrainian Parliament adopted Law of Ukraine No. 2275 “On Limited Liability Companies” (hereinafter referred to as the Law on LLC), which takes effect on 17 June 2018.
The Law on LLC aims to change the rules of the most popular organizational and legal form and contains a number of new provisions on the regulation of the activities of LLC, including the elimination of existing imperfections in the implementation of the preemptive right, namely:
- now, at the level of the law, the mechanism of its implementation is described in more detail, in particular, it explicitly points to the participant’s obligation to inform in writing other participants about his intention to sell his participatory interest;
- in case participants avoid from concluding a sale and purchase agreement, on the basis of his preemptive right, the participant, who is selling, has the right to choose one of two possible options: to legally demand recognition of such a sale and purchase agreement concluded or to sell a participatory interest to a third party;
- the legislator has abandoned the imperative effect of the preemptive right; now the participant will not be able to use the latter, if it is expressly not provided for by the Articles of Association or the corporate agreement, to which such a participant is a party;
- from now on, the specialized law (Part 5, Article 20) expressly describes the consequences of violating the preemptive right: the possibility for a participant to demand in court transferring to onesel rights and obligations of the buyer of a participatory interest (part of a participatory interest).
The restrictions regarding the limitation period of up to 1 year is also duplicated in the Law on LLC (Part 5, Article 20).
The provisions related to the consequences of violations of the preemptive right is probably one of the most important in the context of regulating the mechanism to protect the preemptive right by participants. The existance of such a reservation in a specialized law resolves the question of the proper remedy and contributes to ensuring legal certainty in the statutory regulation.
We believe that, when interpreting provisions of the Law on LLC, it is also necessary to proceed from a broad understanding of the term “violation” and to apply a mechanism for transferring rights, including in cases of intentional overpricing the sale offered to other participants of the LLC.
As in the current legislation, the Law on LLC basically provides for implementation of the preemptive right only in respect of the sale and purchase of a participatory interest. At the same time, participants of the company are given the opportunity to establish a different procedure for exercising their preemptive right in the Articles of Association (Part 6 of Article 20 of the Law on LLC), and therefore they can equally extend the validity of the preemptive right to other transactions. The existence of such a direct provision, as well as the general discretion of the new law, guarantees a more effective implementation of such provisions in comparison with the Law on Associations.
Also, the Law on LLC explains in detail the issue of compliance with the principle of proportionality when exercising the preemptive right. Part 2 of Article 20 states that, if several participants of the company use their preemptive right, they acquire a participatory interest (part of a participatory interest) in proportion to the amount of their participatory interests in the company’s authorized capital. Consequently, the question about the necessity to take into account participatory interests of the participants, who do not exercise the preemptive right, is resolved.
In addition to the general provisions on the preemptive right, the Law on LLC incorporates provisions aimed at optimizing the legislation regarding procedural mechanisms in trials involving the protection of the preemptive right and elimination of its abovementioned shortcomings.
For example, Clause 4 of the final and transitional provisions stipulates certain rules, which will be applied during trials initiated on a claim for transferring rights and obligations of the buyer, before the relevant changes to the Commercial Procedural Code of Ukraine have been made, namely:
- The plaintiff’s obligation to deposit to a court’s deposit account money in the amount paid by the buyer for the fulfillment of the sale and purchase agreement for a participatory interest (part of a participatory interest) specified in the court decision
In our opinion, from the analysis of this provision, it can be concluded that the legislator, admitting the possibility of determining the amount of money in the court decision, departed from the necessity of depositing simultaneously with the filing of a claim. We hope that this understanding of this provision will find its support in case law.
Consequently, a plaintiff in the case will no longer be obliged to pay money in full amount of the disputed agreement and will be able to postpone their depositing until the moment of establishment and identification (if necessary) of all other participants of the LLC, who wish to exercise their preemptive right in a trial.
We believe that the existence of a reservation on the necessity to determine the amount of deposit in a court order shall not prevent a single participant, whose rights have been violated (if only two participants or if all other participants were informed and/or waived their preemptive right), or a few “offended” participants, who act in concert, from the very beginning, to deposit money in the required amount, in proportion to the amount of his/their participatory interest(s).
- The consequence of non-compliance with the requirement to deposit money to a court’s deposit account is a dismissal of the claim
Now the law clearly defines procedural consequences of non-deposit of money to a court’s deposit account, while the application of the mechanism for dismissing the claim is more rational and reasonable in view of the possibility of filing a new similar claim.
- The obligation of a court in its decision to decide on the transfer of money deposited in the court’s deposit account to the buyer, or on their return
After the Law on LLC comes into force, the legislation will clearly define the obligation of a court to decide on the future of money in the deposit account: whether to return them or transfer to the buyer. At the same time, this provision does not take into account all possible terms of a sale and purchase agreement, in particular, the terms of settlements.
Very often, parties to a sale and purchase agreement stipulate the possibility of delayed or deferred payments. Therefore, it is possible that at the moment of filing a claim and a trial on transfer of the buyer’s rights, settlements under the agreement will not have been made or will have been made not in full.
First, under such conditions, it would seem unfair to impose on a plaintiff the duty to transfer the entire amount that the original buyer has to pay under the disputed agreement, since it is the latter, who has not yet made all the necessary settlements. Such discrimination may often interfere with the plaintiff in protecting his violated preemptive right and may be used by unscrupulous participants of the LLC.
In practice, we once dealt with a case, when the preemptive right of a participant of the LLC was violated: a sale and purchase agreement for a participatory interest was concluded for the benefit of a third party without the relevant prior notification of other participants. Under the terms of the disputed agreement, the buyer was given a deferral of up to 1 year for payment. At the same time, the plaintiff, wishing to transfer to oneself rights and obligations of the buyer, had an obligation to pay the full amount, which was sufficiently significant, simultaneously with filing a claim; this became a significant obstacle for him to protect his violated right.
Second, in the case of satisfaction of the claim, there are no grounds for transferring money from a court’s deposit account to the buyer, since the latter at the time of the decision might have not made settlements with the seller or made them in part.
Given that in the relevant disputes both rights and obligations under the agreement (unfulfilled in whole or in part) are transferred to a plaintiff, in such situations plaintiffs also have to use the “concessional” terms of the disputed agreements, including the terms of settlements. Besides, courts shall decide on the transfer of money (in full or in part, not paid by the old buyer) to the seller who has not received the remuneration due to him under the agreement.
However, provisions of the Law on LLC do not take into account such possible features of contractual terms and do not allow a plaintiff to delay/defer payments or to decide on the transfer of money from a deposit account to sellers by court decisions.
From the analysis of case law, it can be concluded that plaintiffs in disputes about the transfer of rights very often use additional, derivative remedies. The most common options are the following: invalidating the decision of the general meeting; invalidating the Articles of Association (in full or in part); canceling registration actions; obligating a state registrar to make registration actions related to the change of participants/founders in the USR. However, we believe that not all of these mechanisms should be used in this kind of disputes.
For example, a decision of the general meeting on the change of participants and the redistribution of participatory interests after the sale one of them to a third party is made on the basis and on the execution of the respective transaction. In case of satisfaction of the claim for transferring rights of the buyer of a participatory interest to the plaintiff, such a plaintiff shall be considered and recognized by the buyer in all other legal relationships that have taken place after the conclusion of the disputed sale and purchase agreement.
Guided by this logic, we can assume that the new buyer “replaces” the old one, including in the decision of the general meeting, and hence in the Articles of Association. The invalidation of such a decision of the general meeting/Articles of Association will lead to a legal vacuum: the buyer in the legal relationship has been replaced, but the ground for recognizing him as a new participant is invalid.
A similar approach may be applied to cancellation of the registration action: the replacement of the old buyer with the new one by a court decision shall be recognized as having legal consequences and for the information in the USR. However, if, in the case of decisions of the general meeting, its changing/making a new one by enforcement following a court decision is impossible, then in the case of registration actions, the legislation expressly provides for such a basis for entering information in the register as a court decision to cancel the registration action/record in the Unified State Register, as well as the obligation to commit registration actions.
Given that participants of the LLC are able to directly exercise their corporate rights only from the moment, when the relevant information has been entered in the USR, the only real effective derivative requirements will be to cancel the registration action, by which the old buyer was legalized, as well as to commit a new registration action to include information about the person, to whom rights of the buyer as a new participant were transferred, and to make related changes to the constituent documents.
In this case, the court decision shall clearly indicate who should be listed in the register as a new participant of the LLC, with the obligatory reservation about the final (taking into account the transfer of rights) amount of a participatory interest and contribution to the authorized capital. All these details shall be filed in the claim in order to avoid possible delays in the execution of the decision in the future.
As we can see, the Law on LLC resolves certain issues related to the judicial protection of the preemptive right, which should contribute to the correct resolution of this category of disputes. However, there are other inaccuracies that should be dealt with, when making appropriate changes to procedural law or in the enforcement process.
In order to avoid ambiguous interpretations of the constituent documents and, as a consequence, conflict situations related to the future operation of the company, we recommend not to use template Articles of Association and involve professional advisers in their preparation. The latter can detail the mechanisms for exercising certain rights by participants, including the preemptive right, taking into account the potential probability of complications in relations between business partners in the future.
In the process of protecting the preemptive right, the establishment of all circumstances of the disputed sale of a participatory interest plays an extremely important role: whether other participants of the LLC have been notified of such a transaction, or they are exercising their preemptive right or waiving it, or the buyer has made settlements for the participatory interest acquired by him in violation of the preemptive right, etc. The algorithm of how the potential plaintiff commit processally meaningful actions in the case depends on the answer to all of these questions. That is why it is desirable to entrust this work to professional lawyers, who, having established all such circumstances, can correctly file a claim, taking into account all nuances and procedural subtleties. Particular attention should be paid to the formulation of claims. In no case can we forget the derivative claims, without which it will be impossible to become a real participant with an increased participatory interest in the LLC. The success in the protection of the violated right will depend on the professionalism of legal advisers, therefore the competent legal advice and the creation of effective procedural tactics and strategy plays an extremely important role in this process.
Stanislav Rodionov, associate, Corporate and M&A practice
for “Yurydychna Gazeta”, №16, 18.04.2018