There are a number of scenarios whereby an investor, or a business counterparty might wish to secure an interest in a company. In this article we set out different approaches, their pros and cons, and possible applications in the UAE.
Modern business has led to increased requirements for flexibility whereby shares and their attached rights (such as dividends) can be utilised in transactions: for example, the shares may be used as security for a loan, as “earn-in” rights in a joint venture, or provided by a distributor to a supplier in lieu of payments for on-sale of products.
The following are different means of securing rights to shares (along with their advantages and disadvantages), and are set out in perceived increasing levels of sophistication:
1. Contractual option
An option is a right given by a shareholder to another to purchase the shares within a certain timeframe and on certain terms (such as price). On granting the option, the selling shareholder loses the discretion of whether to sell the shares – it passes to the third party and if the third party exercises the option, then the seller is bound to dispose of the option shares to the third party.
Pros and cons
An option is relatively cheap and easy to prepare and put in place (including in the UAE). However, it is only effective between the parties involved, and so third parties would not be aware of such an option. There is a risk therefore that the giver of the option could deal with their shares in contravention of the option agreement. Also, the giving of the option by the shareholder might be in breach of other commitments, such as rights under a shareholder agreement (rights of first refusal, lock-in rights or drag or tag along rights).
The option holder in this case would therefore only have an action for contractual breach if an issue arises.
2. Share pledge
A more sophisticated means to secure a future right to shares is by a pledge of shares, whereby a register of share pledges is maintained by the relevant authority. The authority will not permit a transfer of the pledged shares except in accordance with the terms of the underlying share pledge agreement.
In keeping with its priority in ensuring general ease of doing business, the UAE has now various jurisdictions whereby pledges of shares may be registered, such as the ADGM and DIFC financial free zones. These free zones also provide additional flexibility such as different classes of shares.
Pros and cons
A share pledge generally provides greater certainty and protection to the person benefiting from the option to purchase the shares. Additionally, the financial free zone entities are relatively cheap and simple to incorporate.
The option to pledge shares is not yet available to entities which are incorporated outside of the free zones which offer share pledges, and the legislative approach to charges and security generally limits security over assets to financial institutions registered with the Central Bank of the UAE. There are solutions by means of restructuring which may be used for these mainland entities if cost-effective.
Additionally, in certain structures there may be a risk of underlying assets being dissipated, therefore effectively reducing or negating the value of the shares. Again, there are solutions available to mitigate or remove these risks depending on the location of the underlying assets, etc.
3. Other structures
We have set out below a brief description of some other structures that could be considered to secure an interest in a company in the UAE:
Convertible (Loan) Notes – these are effectively loans which are capable of conversion into shares on terms and conditions and within a time period set out in the note. These are contractual rights generally popular with start-ups.
Foundations – these are independent legal entities, often set up for legacy planning and asset protection. However, given the flexibility permitted within the by-laws of the Foundation, effective ownership of the assets may be granted to a third person. We are preparing a separate article on Foundations to discuss these in further detail.
Conclusion
There is a great deal of flexibility on how to achieve the desired aims of securing an equity interest in a company in the UAE. Selecting the right structure will be on a case-by-case basis, taking into account the client’s requirements and the nature of the matter. As with all transactions, there is risk involved and thought has to be given to how to reduce it.
This Article is prepared by Gerry Rogers, Corporate Partner, and Paula Villegas Guevara, Senior Associate, at Habib Al Mulla & Partners Law Firm.
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