The French government took advantage of the Ordonnance on securities reform of June 24, 2004 to introduce a new category of securities called actions de préférence, or preferred shares. This type of instrument, now valid under French law, is a well-known device in international finance.
There has long been a lack of a French legal instrument to meet the conditions of a typical round of financing in which Anglo-Saxon standards, particularly those of California, have prevailed. Even more disadvantageous to French companies was the fact that English, Dutch and Israeli laws, among others, were familiar with this type of instrument. While many companies are seeking capital, investors favour simplicity: They select the investment option that looks the most familiar. Under the pressure from CroissancePlus (a nonprofit lobbying association), later joined by the Association Française des Investisseurs en Capital and the MEDEF as well as a few others, the government has chosen preferred shares as its response to the expectations of the private equity markets.
The preferred shares phenomenon is not totally new in France, since mechanisms allowing shareholders to benefit from special rights (priority shares - actions de priorité, priority shares without voting rights - actions à dividendes prioritaires sans droit de vote, certificats d’investissements…) already existed. However, the new Articles L.228-11 to L.228-20 of the French commercial code introduced by the Ordonnance have the merit of framing and harmonizing those practices, as well as giving them the flexibility that, paradoxically considering their number, they lacked. By creating preferred shares and authorizing their conversion to ordinary shares, preferred shares of another category or even buy-back under conditions set forth in the by-laws, the government obviously is intending to reinforce the appeal of the Paris private equity market and place French companies on an equal footing with foreign companies to attract capital.
In Anglo-Saxon practice, preferred shares include, in addition to traditional shareholder rights, certain governance and financial rights. The "governance rights" guarantee investors access to privileged information, management participation or control, and the right to approve (or be consulted on) certain decisions. The financial rights, on the other hand, provide preferential rights to the proceeds in the event of a liquidation. These rights also protect investors against the consequences of a later round based on a lower purchase price, thanks to a ratchet mechanism that adjusts the number of shares to be held by the investors.
The new French preferred shares combine the possibilities offered by already existing categories of French securities. They are similar to the actions de priorité with regard to the advantages granted, and to the actions à dividendes prioritaires and the certificats d’investissements regarding the voting rights organization. Indeed, preferred shares may be issued without voting rights or with specifically tailored voting rights (which was prohibited for the actions de priorité).
Actions de priorité (priority shares), long recognized under French law, allowed liquidation preference rights reduced to the actual winding up or bankruptcy of the company and governance rights. They did not, however, meet investors’ needs regarding preferential rights to the proceeds in the event of a sale or merger of the company, or regarding price protection (the investor’s valuation of the company). In fact, with respect to the latter, the price paid by the investors at their first entry into the company’s capital is to be reduced in the event of a subsequent down round, using one of the following methods: (i) the "full ratchet," which adjusts the post-conversion price to the level of the lowest valuation, (ii) the "weighted average ratchet," which adjusts the post-conversion price to an average of lower valuations during a given period, and finally (iii) the "pay to play," which limits the investor’s protection, regardless of the ratchet chosen, in relation to the investor’s participation in the subsequent rounds. Without a simple instrument, the practice of attaching warrants to the investors’ shares has developed to allow the issuance of a number of shares at par value, so that the average purchase price per share is adjusted to the appropriate level.
Regarding the preferential liquidation rights, practitioners up to now have not found a simple approach: Liquidation preference rights in case of winding up or bankruptcy are generally incorporated in the by-laws via actions de priorité, while liquidation preference rights in a sale or merger of the company are more often the subject of particular provisions in the shareholder agreement.
Are Preferred Shares the Solution?
Will preferred shares allow all of these rights to be embodied in a single instrument?
There is no doubt that it will serve the purpose for liquidation preferences or management rights protection. Preferred shares replace actions de priorité and allow everything formerly allowed by actions de priorité.
As for price protection, the ratchet may now be included in the preferred shares to determine its rate of conversion to ordinary shares. Nevertheless, the drafters of the Ordonnance did not specify how the conversion would work. In a previous article, we had suggested that the shares, issued at par as a result of the conversion of the preferred shares, should be paid up using the issuing premium paid for the existing shares, therefore within the limits of the issuing premium. Unfortunately, nothing has been provided in the Ordonnance to this effect. This could mean that, at times where the mere existence of the notion of capital is questioned by the law (cf. possibility under French law to incorporate a SARL with 0.02 euro of capital only), it is possible to imagine shares issued for free. Or else, as the by-laws no longer have to mention a nominal value and the law therefore allows the par value of ordinary shares to vary, the par value of the shares would vary with the successive conversions of the shares. The quantity of "guillotine" nullifications contained in French company law, which the authors of the Ordonnance did not wish to delete, will most likely lead to prudence at first.
Regarding the preferential liquidation rights, it is now possible to convert preferred shares into ordinary shares (or into another category), using the price of the sale or merger of the company as a reference. Some were already using warrants (bons de souscription) to this effect, thus allowing a given investor to increase the percentage of share of capital held by it to the level of the percentage of the price that it was agreed the investor would receive. The numerous practical problems that were encountered in the exercise of the warrants continue to exist for conversion rights of the preferred shares. The Ordonnance provides for the fate of the preferred shares in the event of merger, thereby appearing to acknowledge the complexity of the problem and to provide a solution. Nevertheless, the use of the qualifier "equivalent" for substitution rights in the event of a merger makes the law unclear. As regards a sale, we have always held that the allocation of the sale price is ultra vires, and therefore falls outside the realm of corporate powers. Furthermore, the mere complexity of today’s sales (partial payment in shares, partial payment in cash, earn out provisions, etc.), makes it difficult, to say the least, to use any type of security. The existence of preferred shares does not change the situation. Again, the "guillotine" nullifications probably will result in the current by-laws/shareholders agreement distinction being maintained, and in our opinion for the better.
Finally, the Ordonnance authorizes the company’s buy-back of its preferred shares, which opens the door to the redemption of the shares. However, as the protection of creditors has not been waived, the buy-back may place beneficiary companies in opposition to their creditors and, in any case, slow performance will be the rule.
The regime applicable to the preferred shares is very flexible, at the moment of their creation as well as in the course of their management. The rights pertaining to the preferred shares are set forth in the by-laws or in the issuing agreement (contrat d’émission) and can be of all kinds. The functioning of the preferred shares is flexible as well; their preferences may be temporary or permanent, and they may also be terminated. However, preferred shares with no voting right cannot represent more than half of the share capital (or more than a quarter in the case of a listed company), without risking invalidation of the issuance.
The introduction of preferred shares under French law has opened the way to a wide range of possibilities. The new article L.228-20 of the French commercial code even permits the distinguishing between the place where the right is exercised and the place of its issuance, in the case of subsidiaries that are directly or indirectly 50% controlled. A subsidiary will be able to issue shares, the rights of which will be exercised in the parent company or vice versa. This ability did already exist under French law but only in one direction (the issuance of rights by the subsidiary giving the right to shares of the parent company). This feature is well known in the United States, where even triangular mergers are allowed, a possibility that is not yet available in France.
In addition, French law, similar to US law, now allows tracking shares (actions reflets ou traçantes), the attached financial rights of which depend on the performances of one of the company’s particular activities. A company can now issue shares that give the right to a dividend calculated on the basis of the results of a subsidiary or of the parent company. Thus, preferred shares could provide means of additional financing by attracting investors that are interested in the activity of a specific company.
The legislator thought it necessary to require the procédure des avantages particuliers "when these shares are issued for the benefit of one or several shareholders designated by name." This procedure, which already applied when the preferences associated with actions de priorité were linked to the individual as opposed to the share, implies that an auditor, independent from the issuing company, files a report on the value of those benefits. The procedure applies to any issue of any preferred share reserved to shareholders of the issuing company, regardless of whether or not it is tied to the shareholder or to the share. This reporting requirement is useless, first because it seems to us that it is time to consider shareholders as competent, capable and responsible persons, and second because experience shows that the auditor’s report almost always concludes that it is impossible to appraise the benefits that constitute preferential rights.
Finally, the new law allows preferred shareholders to request from the issuing company’s auditor a report on compliance with the particular rights associated with preferred shares. With all due respect to auditors, entrusting an accountant with the mission of verifying the compliance with the rights attached to preferred shares is questionable. It is true that the August 2003 financial security law paved the way by entrusting the auditor to write a report on the chairman of the board’s report on corporate governance. But what authority will the opinion of an accountant on legal compliance have? An expert designated by the commercial court would be the most appropriate solution. The cost of the expert’s mission should be borne by the requesting shareholder so that this right be exercised without excess.
But let us not be negative. Practitioners have awaited this step forward for too long for us to turn up our noses now. Let us use this new law for the future of our companies, be they industrial, technological or commercial. Let us allow this practice to be implemented and trust that the lobbyists and legislators will polish the language in the near future.
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