Main clauses relating to the maintenance of the structure of the share capital

In our previous « MNKS booklet » dedicated to shareholders’ agreements[1], we briefly described the main clauses restricting the transferability of shares in a Luxembourg commercial company: clauses of inalienability, approval clauses and pre-emption clauses.

Alongside such clauses, which are usually designed to prevent the entry of one or several unwanted third-parties into the share capital of a company, there is another group of contractual clauses[2] designed, for their part, to primarily ensure stability and balance between shareholders.

As an overview, these clauses relating to the maintenance of the share capital structure can be divided into two broad categories: on the one hand, the stand-still clauses and on the second hand, the anti-dilution clauses. However, in our view, it is necessary to add a third category dealing with ratchet clauses. Such clauses are designed to protect their beneficiaries less against a capital dilution risk in the strict sense than against a risk of dilution/loss of the economic value of their shareholdings in the event of subsequent share capital increase(s) of the company.

In the first instance, the stand-still[3] clauses are clauses frequently used in shareholders’ agreements governed by Luxembourg law. In essence, stand still clauses prohibit their signatories from acquiring or subscribing for, as the case may be, additional securities of a given company during a determined period, from other holders of securities or from the company itself. As summarised in a particular piece of doctrine, the stand-still clause is to some extent the « negative » of a clause of inalienability.

Several variants of this type of clauses exist. In some cases, they only impose those engaged to inform the beneficiary(ies) of the clause before any effective increase of his/her shareholding in the company. In other cases, they prevent those who are engaged from increasing his/her shareholding in the company by any proportion whatsoever. In yet other cases, they tend to prevent their debtor from increasing his/her shareholding in the company above a certain percentage compared to his/her initial shareholding or a certain threshold that was originally agreed.

According to their drafting, stand-still clauses can indirectly result in « closing » the share capital of a company towards third-parties or more simply, maintaining a balance of participation between certain referenced shareholders only. In order to be completely effective, stand-still clauses have to bear the obligation for the persons they bind not to acquire or subscribe for shares (in the strict sense) of the company concerned, but also any other financial instruments that can be converted into shares of the company (such as, for example, subscription rights or warrants, convertible bonds, bonds redeemable for shares).

Stand-still clauses are particularly common in listed companies, joint ventures or in the framework of private auctions.

Doctrine and case law unanimously recognise their validity, with no rules or general principles having been identified, to the best of our knowledge, which would allow such clauses to be challenged.

Secondly, anti-dilution clauses are also frequently used in shareholders’ agreements. Their purpose is to allow their beneficiaries to maintain, if they wish, their initial shareholding percentage in a given company in the event of one or several subsequent changes to the share capital during the lifetime of such clauses. From a strictly capitalistic level, they constitute either a useful complement to the common law and public order preferential subscription right mechanism in public limited liability companies[4] and a priori in partnerships limited by shares[5], and therefore act as the only protection against a potential dilution for minority shareholders in other forms of Luxembourg commercial companies (unless they have, directly or indirectly, a blocking minority in the context of a share capital increase). At an economic level, they also represent a possible complement to the share premium mechanism[6].

There are also several variants of anti-dilution clauses that may be used. Certain clauses allow their beneficiary to (i) participate in all future share capital increases, with or without a preferential subscription right, in order to maintain its level of participation or determine the consequences of a modification of the latter, (ii) prevent to all or part of the other shareholders to subscribe or acquire new shares without its prior approval. Other variants of such clauses allow their beneficiary to participate to a share capital increase alone, if desirable, and within a specific time period, after its potential dilution to offer it the possibility to return to an agreed level of participation. Other variants still allow the beneficiary to obtain a surrender of shares from other shareholders of the company who participated in a capital increase. Other versions provide for the consequences of an increase of the shareholding of one or several parties in the event of restructuring transactions (such as a merger, a demerger, a contribution of a branch of activity…).

In order to achieve an optimal effect, anti-dilution clauses, like the stand-still clauses, must cover not only the shares of a company, but also any convertible instruments.

Finally, their validity also appears to be unanimously admitted by doctrine and case law, with the absence of any provision challenging their implementation on the basis of the principle of contractual freedom.

In the last instance, ratchet clauses[7] are less frequently used in shareholders’ agreements relating to companies which are economically mature. Imported from common law, these clauses are nonetheless used more and more frequently in venture capital operations and more particularly in the context of investment and shareholders’ agreements.

Unlike conventional anti-dilution clauses, ratchet clauses are not intended to prevent the dilution of a shareholder[8], but rather to allow the dilution of the latter in order to maintain the economic value of its investment in certain cases. Ratchet clauses can effectively be defined as clauses designed to allow an investor to multiply – in principle automatically and without a new contribution – the number of securities it holds in a company in a certain agreed proportion[9] in case a share capital increase is carried out under conditions of subscription more favourable than those that were granted to it at the occasion of its own entry into the share capital. It should be noted, however, that there is a second category of ratchet clauses designed to allow the founders or manager shareholders of a company to benefit from an accretive effect (“effet relutif”) in certain determined economic circumstances. That said, we will not deal here with this second type of ratchet clause, the latter being more a mechanism to motivate the management rather a mechanism to maintain the (value of) the shareholding and therefore going beyond the scope of this booklet.

Like the two other type of clauses mentioned above, there are several variants of ratchet clauses. On the one hand, there are “full ratchet”[10] clauses (in terms of the multiplying factor) and on the other hand, “weighted average ratchet”[11] clauses. In terms of the technique used to implement the multiplying factor then, for example, the issuance of divisible securities in case of the satisfaction of certain conditions which may be confirmed by the management body of the company[12], or the recourse to the issuance and the subsequent exercise of preferential subscription rights, or the use of share repurchase mechanisms (“mécanisme de retrocession”) between shareholders[13].

Being the subject of a few studies made by the Luxembourg (or Belgian) doctrine, the validity of ratchet clauses does not seem to initiate any debates[14].

Their implementation in the articles of associations of a Luxembourg company may, however, give rise to various practical questions as well as certain unexpected surprises, such as, in particular, the obligation to establish special reports as provided by the law on commercial companies at the time of their implementation (notably if the ratchet clause is likely to lead to the creation of shares below par value for example). Prohibition of shares with multiple voting rights, equal treatment of the shareholders in case of existing categories of securities, prohibition of unconscionable clauses (clauses léonines) and preferential subscription rights are all principles to bear in mind when drafting such clauses, with such drafting generally requiring recourse to professional advisors who are familiar and knowledgeable about the legal complexities involved, particularly given their false appearance of simplicity.
[1] This terminology refers to any partnership agreements or shareholders’ agreement of a company.
[2] May alternatively be provided for in the articles of association of the given company for enforceability reasons.
[3] Also referred to as prohibition to purchase clauses or non-aggression clauses.
[4] Which, as a reminder, does not allow the shareholder of a public limited liability company to fully protect himself against a dilution of its shareholding if the preferential subscription right for example (a) cannot be used in the case of an increase of the share capital by way of a contribution in kind (b) only relates to securities representing the share capital and not, for example, beneficiary’s’ interests (c) may be waived under certain conditions by the general meeting of shareholders or the board of directors or, (d) may not be exercised, if the articles of association so provide, in the framework of the issuance of a single class of shares by a company that has issued several classes of shares concerned by the issuance.
[5] The provisions on preferential subscription rights appear to be applicable to partnerships limited by shares on the basis of the reference made to the rules relating to public limited liability companies contained in article 600-2 of the law on commercial companies dated 10 August 1915, as amended. Please see in this respect: Alain Steichen, Précis de Droit de Sociétés, 5e édition 2017, page 774 ; T. LOESCH, C. KREMER et A. SCHMITT, « Les régimes déterminés par renvoi : SCA, Coop, Transferts d’Actifs », in Cent ans de droit luxembourgeois des sociétés, Larcier 2016, page 485 and the reference quoted in the note at the bottom of page 49.
[6] Which, as a reminder, makes it possible to demand a subscription price higher than the nominal value of the securities already issued and as such, maintain an economic balance with regard to the overall value of the company by making the new entrants pay a price of the wealth accumulated by the Company as a result of the efforts of the existing shareholders.
[7] Also qualified by some authors as anti-dilution clauses or accretive clauses (“clause de relution”).
[8] Although they could technically be specifically structured for such purposes, subject to associated tax implications.
[9] Based on a ratio calculated between the subscription price paid by the investor and the new subscription price offered after his entry.
[10] Where the multiplying factor corresponds to the division of the initial subscription price by the new subscription price, which is the most favourable mechanism to the investor.
[11] Where the multiplying factor is equal to the division of (a) the sum of the initial subscription price multiplied by the initial number of securities and the new subscription price multiplied by the new number of securities by (b) the aggregate number of securities after the issuance.
[12] B. Feron, « Les conventions de vote et le fonctionnement de la société », in Les pactes d’actionnaires. Quelles clauses privilégier ?, Séminaire Van Ham & Van Ham, 3 March 2005, p.21.
[13] In our view, only the first technique constitutes a true ratchet mechanism within the meaning of common law.
[14] See notably: V. SIMONART et T. TILQUIN, « Le Ratchet », in Mélanges John Kirkpartick, Bruxelles, Bruylant, 2004, beginning p. 875.