What makes Side Agreements in UAE valid?

Many foreign investors prefer setting up businesses in the United Arab Emirates (UAE), for it is known as one of the busiest hubs where various commercial activities and transactions take place. It would be improbable to say that these investors would not want to enjoy complete or major ownership of such fortune made out of these businesses. In UAE, the preferred form of setting up of businesses is limited liability company (LLCs) for its worthwhile benefits as offered by different Emirates. While setting up an LLC in Dubai, the benefits that can be enjoyed by the investors include, no specific minimum capital requirement, not just as a depositor but can have a partnership, visa permits with certain leverages, has an opportunity to rent an office or even commence branch offices in UAE and abroad as well, they enjoy extreme security and reliability as the assets and capital during the business tenure are assigned under the name of the company and not in the name of UAE national partner and wide scope of trade all across the UAE. 

However, one of the major issues experienced by the foreign investors is that the LLCs formed in UAE, ought to have a UAE national as one of the partners, who gets to hold 51 per cent of the ownership of the company and its economic benefits, whereas, the foreign investors gets to hold only 49 per cent of the ownership of the company. Hence, the foreign investors and the UAE nationals enter into something called the ‘side-agreements’, as an ancillary to the original contract, whereby, the UAE national waives their rights to all the economic benefits and the ownership of the company and acts merely as a silent partner. 

 

Let us dive deep into understanding what is an LLC, its side agreements, its benefits and its legality in UAE. Article 71 of Federal Law Number 2 of 2015, on Commercial Companies (the Companies Law) defines an LLC as an entity, where the partners shall be held liable only to the limit of their shares in the capital and shall have a minimum of two (2) partners, but not exceeding more than fifty (50) partners. The feature of the limited liability company helps in securing the personal interests of the partners during any unwanted crisis. 

The name of the limited company shall be derived either from the objective of such business or from the names (s) of one or more partners, which is to be followed by the expression ‘Limited Liability Company’ or in short ‘LLC’ as mentioned in Article 72 of the Companies Law. As per Article 10 (1) of the Companies Law, one of the major requirements to be implemented while setting up an LLC is having at least one or more UAE nationals as a partner, holding 51 per cent of the share capital of the company. 

Hence, as a recourse, the foreign investors enter into nominee shareholder agreements (NSAs) or side-agreements with the UAE national partner in order to have a complete and authoritative hold of the financial interests of the company. Here arises a conflict on the validity of such side-agreements for it is in contradiction to what is specified in the Companies Law with regards to the percentage of ownership between the partners. Before expounding on the validity of the side agreements in UAE, it is better to acquire complete knowledge and understanding of how these side agreements work. A side agreement is an agreement that is made apart from the primary contract or agreement as an instrumental to include certain provisions or details which are missed out in the primary contrary for due reasons. Side agreements are primarily used for the reasons like:

• to further elucidate the obligations which are not specified in the primary contract; or
• to add extra points to the main contract; or
• to make amendments to the primary contract.

 

However, in UAE, the partners of the LLC companies, enter into side agreements as a way out to gain complete ownership of the company. The UAE national shareholder by consenting to such agreements waives all the rights to receive dividends, to cast vote in the general meetings and also to receive any takings of the sale which is nominally held by LLC. In simple terms, the UAE national shareholder relinquishes all the legal rights and the benefits of having 51 per cent ownership in the shares of the company and becomes a silent partner, thereby holding the economic interests on behalf of the foreign investor, which is otherwise originally held by the UAE national shareholder. As per the provisions of the side agreement, the UAE national shareholder shall be paid an annual fee for being the silent partner or a silent registered owner of the shares. Now, the question in conflict is the validity or the legality of such side agreements as it bypasses the provisions specified in the Companies Law and the clauses of the primary contract, which states the ownership of the UAE national shareholder to be 51 per cent. 

Article 29 (3) of the Companies Law, holds a memorandum of the contract to be void if it deprives the partners of the profits or exempts them from loss or receiving a percentage of profits. Article 395 of the Federal Law Number 5 of 1985 on the Civil Transactions Law (the Civil Code), states that, if the parties to the contract conceal the original contract with an ostensible contract, in this case, the original contract shall be effective and valid. On considering the above legal provisions, the enforceability of the side agreements can be debatable, as well as which agreements will be recognized by the court in case of dispute between the foreign investor and the fictitious UAE national shareholder pursuant to the side agreement.

 

Position of UAE Courts on Side Agreements

There were several occasions, where the UAE Courts had to tackle the disputes between the foreign investors and the UAE national shareholder pertaining to which agreement will be prevalent between the side agreements and the primary contract and has decreed different judgements, sometimes in the favor of the foreign investors and sometimes in favour of the UAE national shareholder. Let us take a look at a few cases and the judgements that were passed to assess the legal status of the side agreements in the UAE. 

 

Civil Appeal 30 of 2015: 

In a landmark judgement, the Abu Dhabi Court of Cassation had to decide if a UAE national can later claim profits from a foreign investor after voluntarily selling his shares to the foreign investor in the form of a side agreement and thereby, agreeing to be a silent partner to meet the requirements of the Companies Law. 

 

The facts of this case are as follows: 

The company was facing a downfall in the business. Hence, the UAE national (claimant) decides to not be a part of this company which is running at a major loss and sells his part of the shares to the foreign investor (defendant) in exchange for UAE Dirhams five million (AED 5,000,000) and agrees to be a silent partner to meet the legal requirements prevalent in the country for an annual fee of UAE Dirhams one hundred and fifty thousand (AED 150,000), to this both the parties voluntarily enter into side agreement in the year 2004. However, this sale agreement was not registered with any competent authority or been notarized, nor was it registered on to the company’s record or registrar or the commercial registered. It happens to be that in the succeeding two years, this company started to make great profits and on knowing this the claimant brings an action against the defendant to receive the share in the profits of the company by claiming that this sale agreement is void. The Court of Appeal dismissed the plea of the claimant by stating that the defendants have fulfilled their obligations as per the voluntary agreement with the claimants and hence, cannot be entitled to share the profits of the defendant’s company. The aggrieved claimant further appealed this judgement to the Court of Cassation, where it overturns the judgment of the Court of Appeals and returns the case to another panel. The panel declares that the sale between the parties cannot be valid as it is in contradiction to the existing provisions specified in the Companies Law. It also further directed that the parties shall be reinstated to the same positions as they were before entering into such side agreement and held the side agreement to be void ab initio. 

In any case, where it is not possible for the claimants to be restored to their original positions, then the claimants shall be entitled to compensation of UAE Dirhams twenty million (AED 20, 000,000). The defendants were not convinced by this ruling of the court of appeal and re-appealed the decision. In this appeal, the defendants claimed that the side agreement defines the actual relationship of the parties and clarifies the fact that the claimant is just a nominal partner and has allowed the defendants to take benefits of the claimant’s status of UAE national. On hearing all the arguments by the claimant the Court of Cassation while dismissing the ruling of the Court of Appeal, held, that the claimants had entered into this agreement, despite being fully aware of the fact that such agreements are in violation of the provisions of the Companies Law, making the side agreement invalid and stated that nobody should be allowed to take due advantage of their wrongful conduct. The defendants are liable to only pay profits from the date of the court of appeal judgement and not from the date of entering into such side agreements with the claimants. It further directed the claimants to return the annual fee received since the time of such agreements and the amount to which the shares were sold to the defendant. This decision is an exception to the general rule where parties are supposed to be restored to their original positions prior to entering into such side agreements, thereby entitling them to a share of the profits. 

 

Cassation number 211/2009, Civil Cassation, dated 1 November 2009:

In another case the Dubai Court of Cassation agreed with the Court of First Instance and Court of Appeal and rejected the plea of the fictitious partner and stated in its decision that, the plea has been rejected on applying Article 395 of the Civil Code which states that the contracts entered into concealing the true contract or relationship shall not be valid and further the Lower Courts have considered the above rules and grounded its judgement on the declaration made by the appellant, which was dated later than the date of the Memorandum of Association (MOA) of the company, where the appellant admitted that he had made no contribution to the capital of the company and has no rights in its profits or any of its assets and that the respondents paid all the capital on behalf of the claimants, hence, all the profits and assets of the company shall belong to the claimants. In this following case, the Court of Cassation has acknowledged both the side agreement and the actual contract and stated that:

• The apparent (actual) contract shall be considered as if it never existed at all; and
• The side agreements, which are in contradiction with the provisions of the Companies Law shall be null and void.

Thereby, declaring the company which concealed the true relationship between the parties to be a bogus company and it shall be abolished completely. 

 

Cassation number 7/2009, Commercial Cassation, dated 11 May 2009: 

Yet again, in another case, the Court of Cassation explicitly clarified that only the companies where the actual partners share liability in the company shall be considered as the true company, whereas, if it is proved that the company is running in contradiction with MOA of the company, then such company shall be non-existent and Articles 274 and 275 of the Civil Code shall apply, whereby, the two parties to the null contract shall be restored back to the same positions as they were in before entering into such contracts. This implies that any side agreement entered into between the parties shall also be declared null and void. 

 

Cassation number 77/2010, Commercial Cassation, dated 11 May 2010:

In another case, the Dubai Court of Cassation establishes a parameter for a side agreement to be recognized is only if such a side agreement is entered into writing.

 

Legal Analysis

Irrespective of the fact that the written side agreements are taken into consideration at times by the courts, will not make it legal in any manner, as it is still considered to be as circumventing the provisions of the Companies Law. As per Article 353 of the Companies Law, a fine of a minimum of UAE Dirhams twenty thousand (AED 20,000) to a maximum of UAE Dirhams two hundred thousand (AED 200,000), can be sanctioned if it is proven that the UAE nationals’ ownership is less than 51 per cent as stipulated by the provisions of the Companies Law. As well as Federal Law Number 17 of 2004 on Commercial Concealment, strictly restricts the UAE national from concealing a foreigner or allowing such foreigner to use his or her name or license. However, there are other alternatives to gain complete ownership without having to opt for an illegal way, such as entering into side agreements. Some of the alternatives include setting up a UAE branch of a foreign company instead of a UAE LLC, as to open a branch, the only requirement is to have a UAE national agent, who does not have any kind of ownership or participate in the managerial rights of the business. You may also consider appointing a corporate service provider as the UAE national, as their primary work is to provide the services of companies owned by the UAE nationals, for a specific fee and many such alternatives which will not jeopardize your business.