The Implication of Investor’s Veto Right to Oppose a Prospective Investment in the Company

December, 2012 / EKW

In large parts of investment transactions, investors demand (and actually receive) preffered rights exceeding their share of holdings in the company. This, investor whos holdings constitute a minority in the company, demand receipt of rights granting him preffered economic rights along with legal preffered rights enabling him to supervise and rule over significant resolutions of the company.

One of those major resolutions refers to raising a prospective investment in the company, and the terms of such investment. Thus, a dominant investor requests receiving a right to oppose joining of other prospective investors to the company. This right – although granted in virtue of an agreement with the company itself (and considerably also its shareholders) – is not conclusive, and dwells next to significant duties as the duty of trust, duty of fairness and the duty of care towards the company and its shareholders, all in accordance with the specific circumstances.

In this article we shall try to focus the deliberation on these duties, which at times investors tend to misunderstand their full significance and implications.


In mostinvestment agreements, sophisticated investors require receipt of effectivesupervisory rights over the company’s operation and its resolutions acceptance.Thus, even investors which after completion of the investment round areminority shareholders, seek toreceive preferred legal rights in the decision making process of the company.

Theunderlying logic in the basis of such request is trivial: an entity that invested money in the company wishes to receivean effective supervisory right over the decision making process in the company.Furthermore, a large part of sophisticated investor’s contribution to thedevelopment of the company (let alone in case of pre-mature companies), is the improvementof the company’s management and its decision making. Thus, investors receive aright to appoint a representative in the company’s board of directors, and inlight of them being a minority shareholders,they demand receiving a veto right (usually negative) over significantdecision-making in major issues in the conduct of the company.

One ofthe significant issues on which an aforesaid veto-right is requested is thejoining of a prospective investor to the company. In other words, a certaininvestor can decide whether a company in which he is invested shall raise money from an additional investor and theterms of such an investment round.

The first investor’s representative in the companyencounters a complicated situation: on the one hand,in his capacity as a director of the company, he ought to weigh considerations favoringthe exclusive benefit of the Company, in distinction from its shareholders’ interests. On the other hand, as a representative of the first investor, he considersthe investor’s interests, the advantages and disadvantages implicated on him byjoining the additional investor to the Company, inter alia in-light ofthe terms of the investment which shallbe agreed between the company and such additional investor.

Veto-Rights – opposing a Prospective Investment

The relationship between shareholders which are pure investors and between companies in which they invested is of a dynamic nature. The investor constantly examines the feasibility of his investment in the company, and that is, inter alia, in-light of additional investments made in the company.
Thus, an investor that considers once again investing in the company on a future investment round, will request doing so in the lowest possible share price, but as to an additional investor, it will request to set an extremely high price tag for the Company and its shares, for obvious reasons.
It’s important to note that on most cases companies turn to fund raising due to financial needs. On these cases, suspicion rises that the Company shall be left baled spotted in either way. That is, the first investor’s representative will not approve of the Company to be bound to an investment agreement with an additional investor, due to the attempt keeping on the first investor’s interests. However, as far as the first investor does not offer the Company an alternative investment, the first investor externalizes its interests on the Company and its financial situation.
On account of the aforesaid, many companies find themselves in impossible situations: the Company desperately needs finance, there is an investor willing to invest in the Company on terms acceptable by the Board of the Company excluding the minority director nominated by the first investor which opposes to such investment but doesn’t offer the Company any alternative constructive solution for the finance it seeks.
This situation should be understood in a broader context: on most companies’ control battles contests, certain shareholders exercise use of various leverages for exertion of power and pressure on groups of other shareholders in the Company. One of these leverages is the financial situation of the Company itself. Thus, shareholders might deliberately ignore a deteriorating financial condition of a certain Company, and even bring it to devastation and facing liquidation, all in order to promote their interest which is lowering the share price.
Incidentally, on the opposite, it could be argued that investors which became shareholders in the company preformed their investment and weighed the risks and chances, did so in reliance on the veto-right granted to them by the investment agreement in order to preserve their investment, their share value and their barging power over managing their investment.

Alternative Investment Offer Obligation

Officers at general and directors in particular, bear various duties towards a company, and towards its shareholders. One of these main obligations is the duty of trust (see section 254 of the Companies Law, 5759 – 1999) (the “Companies Law”). In the frame of this duty the director is obligated, inter alia, to act in good faith and for the benefit of the Company, to avoid conflict of interests, to avoid competing with Company’s business, and also to avoid abusing business opportunities of the company in order to gain personal or for others benefits.
We are of the opinion that a director preventing a company from contracting in a funds raising transaction, carried out on “Market Terms”, that is: on the best terms the company accomplished to obtain, and does not offer the company a substantial alternative to the fund raising could be considered as embezzling his duties and duty of trust.
Moreover, under circumstances on-which the same director has been nominated to the Company’s Board by the first investor, which probably has a significant narrow interest of preserving his rights in the Company, and may possibly be considering an additional prospective investment in the Company, bears an increased duty of trust over other directors of the Company, since the company organ which nominated him to the Board is inflicted with an intrinsic conflict of interests on aforesaid situation.
In opposite, and not to harm reliable directors, it could be argued that such opposing director is capable of weighting practical considerations and taking into account only the company’s benefit, by arguing the company can raise funds on better terms. On such case, a defined schedule can be set by the Company, and within such timeframe the director may offer the company an alternative investment offer on better terms than of those opposed to by him. Without such alternative investment offer – he could ne obligated to approve the original investment.
In that context it is important to note that also the prospective investor/shareholder identity (and not necessarily the sum of his investment), is occasionally an advantage for the Company. Thus, the opposing director’s right should be restrained also in cases in which the investment in the Company is carried out by a strategic investor where his contribution to the Company is larger than the sum of the “formal” investment characteristics.
Before concluding, in sake of clarification, it shall be noted that on certain instances along with the board, also the company’s shareholders general meeting could be required for approval of investment transactions. It is important to note that also shareholders of the company owe duty of trust towards the Company and its other shareholders. Section 192 of the Companies Law determines that also shareholders owe the duty to act in good faith and in an accepted manner, a fairness duty and should avoid from abusing their power in the Company, but that’s a matter for a separate article.

Summary & Conclusions
Grant of veto-rights to minority shareholders is a frequent and accepted mechanism in investment transactions with sophisticated investors, which is logical and required on most cases. As in any legal right, also with respect to the veto-right there is a duty to act in good faith and accepted manner. This duty intensifies in cases of conflict of interests which a director may face between his sender’s interests and between the interests of the company in which he serves.
In the event that a company is in need of cash, reached an agreement with a particular investor on an investment transaction, a transaction which the other directors of the company approved, the best interest of the company could establish an obligation for the first Investor and the director on his behalf to offer the company an alternative investment, as not doing so may expose them to claims by the company and other shareholders of breach of their duties towards them.