Month: December 2020

Shareholders’ Agreements

There are a number of options that a client can choose when starting up a new business. A number of legal forms can be used, including:

1. a limited liability company;
2. a limited liability partnership (under the LLPA 2000);
3. a limited partnership (under the LPA 1907);
4. a partnership (under the PA 1890);
5. a Societas Europea; and
6. a simple contractual agreement.

In this post, we are going to concentrate on some of the issues that arise when two or more parties decide to enter into a business venture together and conduct the business using a limited liability company (thereby becoming shareholders in the company). The particular focus is how these issues can be dealt with in a shareholders’ agreement.

In practice, a shareholders’ agreement can be referred to as a ‘Joint Venture Agreement’, a ‘Subscription Agreement’ or an ‘Investment Agreement’.

As the parties are going to be doing business through a limited liability company, they are going to become shareholders (the owners of the company). While the parties could rely solely on the Articles of Association (Articles) to govern how the company is run, in most companies owned by more than one person a Shareholders’ Agreement will usually be entered into. The Shareholders’ Agreement acts as a kind of extension to the Articles in terms of governing how the company is run and can contain provisions that the law does not permit the Articles to contain. The specific provisions in the Shareholders’ Agreement will depend upon the reason why the parties are entering into the business venture. Such reasons include:

1. setting up in business for the first time. This is the most basic scenario. Two or more persons decide to run a business and they decide to do so by setting up a limited liability company and becoming shareholders in it. An example of why a Shareholders’ Agreement is useful to the parties in this scenario is (amongst other things) if they have unequal shareholdings but want to set down how they will decide on certain matters irrespective of what their shareholdings are;
2. a joint venture arrangement. A typical joint venture arrangement involves one party, often an entrepreneur or a business, who has expertise and experience in a particular area and another party who sees a potential business opportunity and provides the capital to help the entrepreneur or business develop a particular product or service. A Shareholders’ Agreement is useful in this scenario to detail (amongst other things) what each of the parties is contributing to the arrangement and the precise terms of the joint venture relationship. Joint venture arrangements can also involve two companies who combine their different attributes to run a new business and share the risk and rewards of the new business;
3. venture capital investment. This is similar to reason (ii) above but can also cover the situation where an institutional investor or high net worth individual is looking to invest money in a company and make a return on the investment. A Shareholders’ Agreement is useful in this scenario as (amongst other things) it will set out the terms upon which the investor shareholder is investing (e.g. any preferential rights attaching to shares, any special voting rights the investor shareholder has, and when and how the investor shareholder can exit the arrangement); and
4. private equity buyout. A typical private equity buy-out is a transaction whereby the private equity house acquires a struggling business with a view to making it profitable. The private equity house often retains the senior management of the target business as they know how the business works. Where the private equity house acquires the struggling business through a limited liability company (i.e. the company is the purchasing vehicle) the senior managers usually become shareholders in the company alongside the private equity house. A Shareholders’ Agreement is required in this type of arrangement to regulate (amongst other things) the relationship between the private equity house (who will invariably be the majority shareholders) and the managers (the minority shareholders).

When considering a Shareholders’ Agreement it is important to establish whether a company is a deadlocked company (where two shareholders or alliances of shareholders each control a 50% share), or a company where the percentage of shares held by the shareholders or alliances of shareholders are unequal. This distinction is important as it will impact upon the nature of the provisions contained in the Shareholders’ Agreement. If the company is deadlocked, deadlock resolution provisions will be necessary. Other typical provisions include provisions relating to the appointment of directors and the quorum for meetings.

The relationship between a Shareholders’ Agreement and the company’s Articles of Association

Articles govern the day to day management of a company by prescribing the procedures which that company (acting through its directors and shareholders) must follow in order to transact the company’s business. In particular, the Articles will include provisions that deal with the directors’ powers and responsibilities, the methods by which the directors may make decisions, the procedure to be used for the appointment and removal of directors, any special rights attaching to different classes of shares, the procedure for transferring shares, the procedure for making distributions of the company’s profits and the procedure to be followed in connection with decision making by shareholders.

It is important to understand why it is necessary and/or preferable for shareholders to enter into a Shareholders’ Agreement rather than to rely solely on the Articles to regulate the relationship between themselves and their company.

• A Shareholders’ Agreement is a contract between some or all of the shareholders, in which they can agree between themselves how to regulate the affairs of their company. They can, for instance, agree not to change the Articles of the company and not to exercise their power under s.168 Companies Act 2006 (CA 2006) to remove any director of the company unless they are all in agreement. Such provisions in a Shareholders’ Agreement will constitute personal rights and obligations on the shareholders, including how they will exercise their voting rights on certain decisions.
• The Articles are treated as a contract between the company and its shareholders in their capacity as shareholders pursuant to s.33 CA 2006, and do not therefore deal with shareholders’ personal rights and obligations. The provisions of the Articles are subject to CA 2006, whereas a Shareholders’ Agreement is an arrangement arrived at between the shareholders in their personal capacities.
• The CA 2006 gives companies certain statutory powers. One should not, therefore, include any provision in the Articles which would require the company to fetter (restrict) its statutory powers, since any such provision would be void and the CA 2006 would override the conflicting provision in the Articles.

For example, s.168(1) CA 2006 permits a company to remove a director by ordinary resolution, which only requires a simple majority. An agreement not to remove a director unless there is unanimous shareholder approval should not be placed in the Articles (which would be a fetter on the company’s statutory powers). However, a Shareholders’ Agreement could stipulate that no director will be removed without the unanimous consent of all the shareholders, because shareholders can make a private agreement amongst themselves as to how they will vote on certain matters (for example the case of Russell v Northern Bank Development Corpn Ltd [1992] 1 WLR 588).

It is important to note, though, that such a provision does not remove the statutory right of the majority shareholders to remove a director under s.168 CA 2006, as a company is bound to accept the vote of a shareholder even if that shareholder is voting in a way that breaches the provisions of a Shareholders’ Agreement. In a situation where a resolution is passed without the required unanimity and therefore contrary to the terms of a Shareholders’ Agreement, provided a simple majority voted in favour (in accordance with CA 2006), the resolution would still be valid and the director would be removed from office. The remedy for breach lies against the shareholder concerned and not the company. The shareholder’s vote would still be effective but the other shareholders (including the director removed if he were also a shareholder) would be able to bring an action for breach of contract (i.e. the Shareholders’ Agreement) against the miscreant shareholder (i.e. one shareholder can sue another for breach of contract and there is the possibility of equitable remedies such as specific performance).

This may give the impression that a minority shareholder has only minimal influence. However, in reality the threat of a breach of contract claim effectively means that the minority shareholder is able to influence whether or not the resolution is passed, despite his or her minority shareholding. To this end a Shareholders’ Agreement minimises the effect of the principle of majority rule. Such provisions are sometimes known as veto provisions.

Where the shareholders agree between themselves in a Shareholders’ Agreement as to how to regulate the affairs of the company, the company should not be a party to any terms which restrict its statutory powers. This does not mean, however, that the company should never be a party to a Shareholders’ Agreement: only that it should not be a party to those provisions that restrict it from exercising its statutory powers. For example, the company should be a party to the Shareholders’ Agreement if it imposes any positive obligations on the company: for example, if the company is required to repay loans made to it by the shareholders. The company must be a party to the agreement to ensure that it is contractually bound by the positive obligations directly imposed upon it. As a practical point it should be made clear in the recitals to the Shareholders’ Agreement and in the Shareholders’ Agreement itself that the company is party to the Shareholders’ Agreement for certain specified clauses only and that its obligations are severable from other provisions that would otherwise be unenforceable if the company were a party to them.

• It may be more difficult for shareholders to enforce certain provisions in the Articles against the company or against fellow shareholders. Shareholders can only enforce rights against the company that are relevant to their capacity as shareholders (such as the right to vote or the right to a declared dividend). While it is true that the Articles are a contract between each of the shareholders of a company, it has been established by case law that shareholders can only enforce their rights against another shareholder through the company or through a liquidator representing the company. Therefore, if a shareholder wishes to enforce rights or obligations directly against another shareholder, a Shareholders’ Agreement is the most effective way of achieving this.

• Another key reason why Shareholders’ Agreements exist is because they can be kept private (unless they are explicitly referred to in the Articles). This contrasts to the Articles which must be filed at Companies House and are therefore documents of public record. As such, the shareholders may want to include any commercially sensitive terms in the Shareholders’ Agreement instead of the Articles.

• It is also important for shareholders to bear in mind the procedural steps required for amendments to the Articles and Shareholders’ Agreement respectively. Section 21(1) CA 2006 requires a special resolution to amend the Articles. This means that one party who has a minority interest (e.g. less than 25% of the voting rights) will not be able to prevent changes being made to the Articles by virtue of a special resolution. Like any contract, it is usual for any changes made to the Shareholder’s Agreement to require the unanimous approval of all parties to the agreement. This effectively gives a minority shareholder a veto over any amendment.

If you are involved in the drafting of a Shareholders’ Agreement, it is important to draft the provisions of the Shareholder’s Agreement carefully in order to avoid binding shareholders as to how they should vote in their capacity as directors of the company. Any restrictive provisions could potentially fetter directors’ discretionary powers and amount to a breach of their duties as directors. From previous sessions, you should now understand that directors may act in different capacities as the managers and owners of the business. A person can potentially have a number of different distinct roles all at once. A person can be a director, a shareholder and an employee of the company.

You may find in practice that some provisions which are included in the Shareholder’s Agreement are also included in the Articles and vice versa. If this is the case it is important to ensure that any provisions contained both in the Articles and in the Shareholders’ Agreement are consistent. The Shareholders’ Agreement and Articles should be drafted together and not independently in order to ensure that there is no conflict between the two. It is common for there to be a provision in the Shareholders’ Agreement stating that in the event of a conflict arising between the provisions of the Articles and the provisions of the Shareholders’ Agreement, the provisions of the Shareholders’ Agreement will prevail.

In a large listed public company, it is easy to see that the shareholders (the public) are distinct from the directors who are managing the company. It is also easy to see why the shareholders are not liable for the company’s debts and do not directly own the company’s assets. The company, as a separate legal person, owns the assets, whereas the shareholder owns only shares in it. It is also easier to see that the shareholder receives a return in the form of dividends and can easily sell their shares on the market.

In small private companies, the lines between the directors, shareholders and the company may be more blurred. You need to have a firm understanding of the separateness of the persons and entities involved (and the different provisions of the Articles and the CA 2006 that govern them). This is because the reality in small companies often appears to cut across these fundamental principles.

For example, if a small company is set up by two family members, who are also its directors and take all the decisions, it is harder to identify in what capacity they are acting: shareholders or directors. They may have put restrictions in the Articles as to whom their shares can be transferred. The shareholders might even have personally provided guarantees to repay the company’s debts (cutting across the notion of limited liability). The only real difference between a partnership and the situation described may be in the fact of incorporation and in the ensuing result of separate personality.

As a lawyer, one of your key roles is to ensure that the company is governed correctly and in compliance with all relevant legislation and the company’s Articles.

The statutory framework

In the UK, the Financial Services and Markets Act 2000 (FSMA 2000) (as amended by the Financial Services Act 2012 (FSA 2012)) provides the framework for the statutory regime of financial services regulation. On 1 April 2013 the Financial Services Authority was abolished and most of its functions were transferred to two new regulators, the Financial Conduct Authority (FCA) (which took over the majority of its functions) and the Prudential Regulation Authority (PRA). On the same date, the Bank of England took over the Financial Service Authority’s responsibilities for financial market infrastructures.

Section 1B FSMA 2000 sets out the strategic objective and three operational objectives of the FCA. It is useful to bear these objectives in mind because they inform the FCA’s actions in supervising the industry. They also provide the rationale for much of the legislation and regulation.

The strategic objective is to ensure that the relevant markets function well.

The three operational objectives are:

• to ensure an appropriate degree of protection for consumers;
• to protect and enhance the integrity of the UK financial system; and
• to promote effective competition in the interests of consumers.

The FCA has a role (i) as a conduct regulator, (ii) as a markets regulator, (iii) in countering financial crime and (iv) in promoting competition.

The FCA’s aim as a conduct regulator is to address actual or potential risks, for instance by requiring firms to withdraw or amend misleading financial promotions.

The FCA has responsibility for the conduct of business regulation of all firms authorised under FSMA 2000 and the prudential regulation of all firms not regulated by the PRA.

The PRA is responsible for the prudential regulation of systemically important firms, including banks, insurers and certain investment firms. The conduct of business regulation of these firms is still the responsibility of the FCA, so these firms are often referred to as ‘dual-regulated firms’.

The FCA as a markets regulator

In its capacity as markets regulator the FCA has a number of functions, the following being the most important for our purposes:

• acting as the UK competent authority for the LPDT Rules; and
• acting as the conduct supervisor and regulator of the financial services sector generally (including authorising firms to carry out certain types of financial services business, supervising those firms and writing the rules which those firms must follow).

The FCA’s financial crime role

The FCA has responsibility for taking regulatory action to counter financial crime by:

• imposing penalties for market abuse;
• undertaking criminal prosecutions for insider dealing and market manipulation; and
• acting as competent authority for the purposes of the Money Laundering Regulations 2017.

The FCA’s role in promoting competition

Amongst other things the FCA has the power to request that the Competition and Markets Authority considers whether features in the UK financial services market may prevent, restrict or distort competition.

Important secitions of FSMA 2000 and FSA 2012

The general prohibition (s.19 FSMA 2000)

It is a criminal offence for anyone who is not authorised by the FCA (or exempt) to carry out any regulated activity. For example, it would be unlawful for anyone to operate a business offering financial advice or arranging investments without obtaining authorisation.

This is known as the general prohibition and the maximum penalty for breaching this prohibition is two years in prison and/or an unlimited fine (s.23 FSMA 2000). For the purposes of the BLP module it will be important for you to be able to correctly determine when you may, and when you may not, give advice on a particular issue.

Restriction on financial promotions (s.21 FSMA 2000)

Financial promotions can only be made if allowed by s.21 FSMA 2000, otherwise the person making the promotion will commit a criminal offence for which the maximum sentence is two years in prison and/or an unlimited fine.

This provision aims to ensure that investors, particularly vulnerable and inexperienced investors, are not exposed to misleading sales pitches. An example of this would be the so-called ‘boiler rooms’, where unauthorised stock promoters cold call, or send spam e-mail to, potential investors with high pressure sales pitches for investments that are often worthless. Such calls and e-mails would generally contravene s.21 FSMA 2000.

The criminal offence under s.21 FSMA 2000 is to ‘communicate an invitation or inducement to engage in investment activity’ in the course of business unless the requirements of s.21 FSMA 2000 are satisfied. There are two ways of satisfying those requirements:

1. To have the promotion made or approved by an authorised person, for example an investment bank which is authorised and regulated by the FCA. In such circumstances, the authorised person is expected to ensure that the promotion is clear, fair and not misleading.
2. To rely on an exemption established by statutory instrument under s.21 FSMA 2000. Detailed exemptions are available, one of which, for example, covers promotions which are made only to investment professionals, who are less likely to be deceived by a clever but misleading promotion.

Misleading statements and impressions (ss.89 & 90 FSA 2012)

Sections 89 and 90 FSA 2012 provide various further criminal offences in relation to misleading statements and impressions. These include:

• making a statement, promise or forecast which you know to be false or misleading in a material respect;
• recklessly making a misleading statement;
• dishonestly concealing a material fact; and
• engaging in a course of conduct which creates a false or misleading impression.

In very simple terms, the conduct involved must, in each case, be carried out for the purpose of inducing another person to take action, or to refrain from taking some action, in relation to an investment. The maximum penalty for infringing s.89 or s.90 FSA 2012 is seven years in prison and/or an unlimited fine.

Insider dealing (s.52 Criminal Justice Act 1993 (CJA 1993))

Insider dealing is a further example of a type of behaviour which the FCA aims to reduce. Section 52 Criminal Justice Act 1993 (CJA 1993) makes it a criminal offence for an individual to deal in price-affected securities on the basis of inside information.

This would cover a situation where an insider (such as a director of a listed company) purchased shares at an advantageous price, before a public announcement of a profitable contract by that listed company. The director’s knowledge of price sensitive information, as yet undisclosed to the market, about the existence of the contract, would be inside information. He could be prosecuted for buying shares on the basis of that information.

Market abuse (‘MAR’)

This is a separate civil offence and from 3 July 2016 it has become wider in scope. The legislation to put this into effect was adopted by the Council of the EU on 14 April 2014 and consists of a regulation on market abuse (known as ‘MAR’) and a directive on criminal sanctions for market abuse (‘CSMAD’). This package of legislation is known as MAD II.

The changes introduced by MAR included:

• new market abuse offences of attempted market manipulation and attempted insider dealing; and
• an expanded definition of ‘inside information’ for the market abuse behaviours of insider dealing and improper disclosure.

CSMAD makes insider dealing and market manipulation criminal offences if carried out intentionally. The UK has opted out of CSMAD and so is not bound by it. The UK government’s view is that UK law already covers all market abuse offences covered by the CSMAD and it currently extends further than the CSMAD (by covering market abuse activities that are committed recklessly or intentionally).

Market abuse is described in MAR as ‘a concept that encompasses unlawful behaviour on the financial markets’ (recital 7 to MAR). This includes behaviour such as:

• insider dealing;
• unlawful disclosure of inside information; and
• market manipulation.

Market abuse is a civil offence and is therefore easier to prosecute than insider dealing under the CJA 1993. This is because the civil standard of proof applies to market abuse (balance of probabilities), rather than the criminal standard for insider dealing (beyond reasonable doubt). It should therefore be a more useful tool to the FCA in tackling market misconduct.

In addition, the offence of market abuse can be committed by companies (for example, the listed company itself) as well as by individuals (for example, the listed company’s directors). Only individuals can be found guilty of the criminal offence of insider dealing.

The penalties for market abuse are set out in s.123 FSMA 2000 (financial penalty or publication of a statement that a person has engaged in market abuse) and are, of course, less onerous than criminal penalties for insider dealing.

Once a company becomes listed it is subject to further regulation and the directors of a listed company become far more accountable to the company’s shareholders than those of a private company. The obligations that a company must comply with once its shares are listed are known as ‘continuing obligations’. Continuing obligations are imposed on listed companies to protect parties investing in or affected by the operations of the relevant listed company. A listed company must comply with its continuing obligations at all times.

The aim of the rules relating to continuing obligations is to ensure:

• timely and accurate disclosure of all relevant information to shareholders;
• equal treatment of all shareholders and protection of existing shareholders; and
• the maintenance of an orderly market in shares.

The rules achieve these aims by three methods:

1. the disclosure of certain information to the market and to shareholders of a listed company;
2. the approval of a listed company’s shareholders before key transactions are entered into by the listed company; and
3. regulating (and in certain cases requiring FCA approval of) the information sent to shareholders.

Certain transactions involving listed companies cannot be carried out by the board without the company first having satisfied certain requirements.

These rules relate to two different types of transactions:

1. transactions classified by size; and
2. transactions with related parties.

The aim of the controls is to keep shareholders informed of relevant transactions and to give them a right to object to large or sensitive transactions.

Introduction to listed companies

Although listed public companies are less numerous than unlisted public companies and private companies, they tend to be valuable, important and/or well-known and they require additional regulation which goes far beyond that contained in the Companies Act 2006 (CA 2006).

Often listed companies operate their various businesses through subsidiaries which are private companies. Although such private companies are not listed themselves, they will be affected by the rules which govern their listed holding companies.

Seeking a listing is the third stage of development for many companies after converting to public company status. Most commercial investors want to be able to deal freely in their investments and a stock exchange listing allows the shareholders of a company that freedom, making the company more attractive as an investment.

A company must be a public company before it applies to have its shares listed on a stock exchange. However, as already mentioned, most public companies do not apply to have their shares listed.

The London Stock Exchange (‘LSE’)

The LSE is solely responsible for admission of shares to trading on its own exchanges.

The LSE operates the various markets including:

• Main Market (for debt and equity securities); and
• AIM (for equity securities only).

The Main Market

The Main Market is the largest market. In order to have its shares admitted to listing on the Official List and traded on the Main Market, an applicant will need to comply with the Listing, Prospectus, Disclosure and Transparency Rules (‘LPDT Rules’) and the LSE’s Admission and Disclosure Standards. In April 2019 there were 936 UK companies and 221 international companies traded on the Main Market.

The process of obtaining a listing is known as a flotation. Larger companies apply to have their shares listed and traded on the Main Market of the LSE. To have its shares listed and traded on the Main Market, a company must apply to have its shares admitted to listing on the Official List and to have its shares admitted to trading on the Main Market of the LSE.

When companies float, they often take the opportunity to raise equity finance at the same time by making a primary issue of shares. A primary issue is the first time a company offers its shares into the market and is more commonly known as an IPO or an Initial Public Offering. The term IPO is often used interchangeably with the term flotation although, in fact, not all flotations involve a public offering. Obtaining a listing gives companies access to institutional investors such as pension funds and banks.

AIM

The LSE also operates a secondary market for smaller, growing companies, called AIM. AIM is the most successful growth market in the world. AIM originally stood for ‘Alternative Investment Market’.

AIM was developed and launched in 1995 to meet the needs of smaller, growing companies which could not meet the full criteria for a listing on the Main Market (for example, a three year trading record) or those that preferred to be subject to a more flexible regulatory regime.

Over the years, AIM has been popular for new issues. In May 2020, there were 721 UK companies and 119 international companies on AIM. The majority of AIM companies are small in comparison to the Official List, with many valued at between £20 million – £50 million. Most are unknown to the general population. However, there are some household names, such as the Mulberry Group and a handful of other AIM companies that have values that exceed £1 billion.

The Takeover Panel

The Takeover Panel (the ‘Panel’) is a committee that regulates the takeover of public companies in the UK (and also in the Channel Islands and Isle of Man). (Only exceptionally will takeovers of private companies be so regulated.) The Panel is made up of representatives from financial institutions and other professional bodies, including some solicitors seconded from law firms in the City. The Panel has drawn up a series of principles and rules in relation to the conduct of public company takeovers. These rules are contained in the City Code on Takeovers and Mergers (the ‘City Code’).

Until May 2006, the City Code did not have the force of law but worked very effectively as a system of self-regulation. In May 2006, as a result of the Takeovers Directive, the City Code was revised. The Code is now legally binding under Part 28 CA 2006. The Panel is still able to rely on the enforcement powers which it had before the City Code became statutory. It may, if it finds that there has been a breach of the City Code, privately or publicly censure the individual or organisation or report the offender’s conduct to another regulatory authority. In addition, the Panel now has formal statutory powers to order compensation to be paid and may apply to the courts to enforce its rulings. It also has statutory powers to require parties to provide information in some circumstances.

Other regulatory bodies

Depending on the market in which the listed company operates, the listed company may be subject to the rules of an industry regulator. By way of example, easyJet plc is regulated by the Civil Aviation Authority, Severn Trent plc is regulated by Ofwat and BT plc is regulated by Ofcom.

Introduction

Most companies are private limited companies. A smaller number are public limited companies. Only a small sub-set of public companies are listed on the Official List and traded on the Main Market of the London Stock Exchange.

The BLP module of the LPC focuses for the most part on private companies.

It is important for you to be aware from the outset, however, of the concept of public companies and, in particular, listed companies. Listed companies are run very differently to private companies since they may have thousands of shareholders, only a few of whom will have any managerial role at all. They therefore require far more regulation than private companies and even public unlisted companies.

In a listed company, an individual shareholder will not normally have any access to the board and additional regulation is needed to ensure the accountability of the directors.

Companies Act 2006 – Different levels of regulation

There is a significant degree of similarity between the way in which the Companies Act 2006 (CA 2006) applies to the smallest private company and the largest public listed company. Essentially the same legislation governs both types of companies, though with refinements to cater for the differences between the one-person private company, for example, and Vodafone (one of the largest listed companies).

While there are similarities, there are also important differences. Generally speaking, private companies enjoy lighter regulation under CA 2006 than public companies. One of the aims of the CA 2006 reforms was to make it easier to set up and run a private company.

A straightforward example is the fact that private companies do not need to hold an annual general meeting. Two other important differences are set out below, concerning offering shares to the public and written resolutions.

Offering shares to the public

Private companies

Private companies are generally prohibited from offering their shares to the public at large (s.755 CA 2006). An ‘offer to the public’ for these purposes is defined in s.756 CA 2006. The prohibition applies to shares or bonds (i.e. debt securities).

Public companies

As the business of a private company gets larger and more successful, its shareholders may decide that the company requires further equity and debt finance. If the company re-registers as a public company it will then be able to apply for a listing (for example via a flotation on the London Stock Exchange) in order to access a much wider investor base. A listed public company also has greater access to the international debt capital markets for the issuing of debt securities.

However, the fact that a company is registered as a public company and has ‘plc’ after its name does not indicate that the company is listed. Most public companies are not listed.

Written resolutions

One important administrative benefit enjoyed by private companies (but not public companies) is that their shareholders can pass shareholder resolutions using the written resolution procedure under s.288 CA 2006. Public companies cannot use this procedure. The written resolution procedure can be a very convenient, and sometimes time saving, method of passing shareholder resolutions and avoids the need for a general meeting.

The CA 2006 made the written resolution procedure easier to use for private companies. Under the Companies Act 1985 (CA 1985) any shareholder resolution passed as a written resolution had to be agreed to by all the shareholders (unanimous consent). Under the CA 2006, there is no such requirement and therefore an ordinary resolution can be passed by a simple majority of the total voting rights of eligible members (s.282(2) CA 2006) and a special resolution can be passed by a majority of not less than 75% of the total voting rights of eligible members (s.283(2) CA 2006).

Note, however, that the relevant percentages for passing shareholder resolutions as written resolutions are percentages of all the eligible members (i.e. all those shareholders entitled to vote), whereas when a vote takes place at a general meeting, it is only necessary to take into account the votes of those shareholders who actually vote.

This change has resulted in considerable cost, time and administration savings for many private companies although such companies can still call general meetings if they prefer.

The directors manage the company on behalf of its shareholders on a day-today basis. As directors, they run the company by making decisions as a board, or by delegating specific functions to individual directors.

Directors owe general duties to their company. These duties were codified by the Companies Act 1985 (CA 2006). If a director exceeds his powers or breaches his duties, he can be liable to the company for the loss he has caused. Any liability for breach can be avoided if the director’s conduct is capable of subsequent approval or ratification by the shareholders.

In addition the CA 2006 requires the directors to obtain prior shareholder approval for certain decisions and directors’ powers can be further regulated, and limited, by the Articles.

As already mentioned, ultimately, if shareholders do not approve of the way the directors are managing the company, they can change the composition of the board by removing directors and/or appointing new directors.

Financial reward of directors

The financial reward for the director will be in the form of payment for services rendered. If the director is also an employee of the company (an executive director) then his payment will be in the form of a salary. If the director is not an employee (a non-executive director) then he will receive directors’ fees. Either way the entitlement is purely contractual and is based on whatever the company decides is appropriate.

The company acting through the directors – agency

The company is a separate legal person but it is not animate. It has no mind and no body and cannot do anything on its own. The directors therefore need to act as the agents of the company. The concept of agency means that, while a director is acting with the authority of the company (the principal), any act of the director is seen, in law, to be an act of the company.

There are situations where it can be hard to determine whether the agent (the director) has acted with the actual authority of the company and thus whether the company should be bound. Where it is not clear, the common law rules of agency need to be applied.

Directors’ decision making

When exercising powers and functions, the directors act as a board and make decisions by passing board resolutions. The Articles will regulate the procedure for passing board resolutions. In most cases this means that the directors make decisions by passing board resolutions at a board meeting and board resolutions are usually passed by a simple majority of those who are present at the meeting, and voting. As an alternative the Articles usually allow directors to take decisions unanimously by some other means that allows all the directors to indicate common consent (as an example see Model Articles paragraph 8).

As mentioned above, the directors can also delegate their powers and functions. They often delegate their powers and functions to:

• committees;
• individual directors (such as a managing director); and/or
• officers of the company who are not directors.

Any such delegation is done by means of a board resolution so that, in essence, the delegatee acts with full board authority.

Directors’ duties

Directors are usually empowered to exercise all the powers of a company in order to manage the company’s business on a day-to-day basis (see Model Articles paragraph 3). Directors must exercise these powers in accordance with their statutory duties.

Whenever a director is making a decision, they must always consider the duties to which they are subject. Before the enactment of the CA 2006, directors’ duties derived for the most part from common law and equity. The former regime still operates to the extent not expressly provided for in the CA 2006 and the CA 2006 provides that the new duties shall be interpreted and applied in the same way as the common law rules and equitable principles.

Statutory duties under CA 2006

The statutory duties under CA 2006 are as follows:

• duty to act within powers (s.171);
• duty to promote the success of the company for the benefit of its members as a whole (s.172);
• duty to exercise independent judgment (s.173);
• duty to exercise reasonable care, skill and diligence (s.174);
• duty to avoid conflicts of interest (s.175);
• duty not to accept benefits from third parties (s.176); and
• duty to declare any interest in a proposed transaction (s.177).

Directors who are also shareholders

It is not unusual for a director to hold shares in their company and in some smaller private companies most, or all, of the directors will also be shareholders. It is important to remember that where a person is both a director and a shareholder then he has two separate roles. The person’s actions need to be divided into those taken as a director and those as a shareholder, and analysed separately, in the relevant capacity.

The shareholders own the company and it is their investment that is at risk in the venture.

There are two important consequences of this:

1. shareholders exercise ultimate control over the company; and
2. shareholders hope to receive a financial return on their investment.

Control by shareholders

The shareholders exercise their control in two key ways:

1. by determining the company’s constitution; and
2. by voting on shareholder resolutions.

Although the directors manage the company on a day-to-day basis, a key element of shareholders’ control is their power to vote on a resolution to remove directors from the board and/or to appoint new directors whose approach to managing the company the shareholders prefer.

Constitution

The Companies Act 2006 (CA 2006) sets out fundamental rules which a company has to follow. The constitution of a company can then set out and apply more rigid or detailed systems of management to the extent this does not conflict with the CA 2006.

In theory the shareholders exert control over the company they created, own and have invested in, by overseeing the company’s management through providing a series of rules.

Articles of association

The articles of association (Articles) form the company’s constitution. The Articles form the basis of a ‘contract of membership’ between the company and the shareholders and between the shareholders themselves. This contract governs the principal rules of their relationship. The nature of this contract will be examined in more detail later in the BLP module.

The Articles determine the company’s internal management. The Articles also give control to the shareholders, enabling them to prescribe how their company can be run. Two key points need to be understood:

1. the Articles set out the rules that any shareholder of the company has to comply with and include all the procedures which govern the relationship between the shareholders, such as the procedures for general meetings, voting and transferring shares; and
2. the Articles set out the rules that the directors have to comply with, and these rules determine how the directors should conduct board meetings, make decisions and delegate their functions.

The Articles form a contract between the company and its shareholders. The directors are not a party to that contract, so if a director breaches a provision in the Articles, they will not be in breach of contract. However, directors have a duty to act in accordance with their company’s constitution under s.171 CA 2006.

The Articles can be changed by a special resolution of the shareholders under s.21(1) CA 2006. It is important to understand the interaction between a company’s Articles and the CA 2006. Sometimes the CA 2006 will override any provisions in a company’s Articles. For example, s.307(1) CA 2006 provides that a general meeting of a private company must be called by notice of at least 14 days. Section 307(3) CA 2006 provides that the company’s Articles may require a longer period of notice than that specified in s.307(1) CA 2006. The effect of these provisions is that a term in a company’s Articles stipulating that the notice period for general meetings must be at least 28 days would be valid, whereas a term in the Articles stipulating a notice period for general meetings of seven days would not be valid.

Model articles and Table A

A company is free to choose its Articles, as long as they do not contravene the CA 2006.

A private company incorporated under the CA 2006 will have the model articles by default unless it chooses otherwise (s.9(5)(b) and s.20 CA 2006).

Under the Companies Act 1985 (CA 1985), the default Articles for private companies were contained in Table A. A number of private companies still have Articles based on Table A and this is likely to continue to be the case for some time.

Most companies use the default articles (model articles or Table A, as the case may be) as a starting point and then make certain amendments to tailor their Articles to their specific needs.

Memorandum of association

Before the enactment of the CA 2006, companies had a second constitutional document, the memorandum of association (‘Memorandum’), which governed the relationship between the company and the outside world. One part of the Memorandum, known as the objects clause, enabled shareholders to restrict the company’s powers in dealing with third parties. Another part of the Memorandum, the statement of the company’s authorised share capital, effectively put a limit on the number of shares the company could issue.

A series of reforms over the years diluted the importance of the objects clause. For companies incorporated under the CA 2006, the Memorandum does little more than record the agreement of the founding shareholders to form the company. There is no objects clause. Any restrictions that the shareholders want to impose on the company’s activities need to be contained in the Articles instead. Any such restrictions would be rare.

Under the CA 2006, any restrictions contained in the objects clause of any company incorporated before the CA 2006 came into force are treated as provisions of that company’s Articles. The objects clause will therefore continue to restrict such a company, unless the company changes its Articles.

The statement of such a company’s authorised share capital is also now deemed to be a provision in the company’s Articles and effectively operates as a cap on the number of shares that the company may issue. However, it is possible to remove this cap.

Voting

Shareholder resolutions may be ordinary resolutions (s.282 CA 2006) or special resolutions (s.283 CA 2006). A shareholder resolution will be valid and binding on the company, provided the correct procedure is followed and the vote on the resolution is carried by a sufficient majority, as determined by the CA 2006 and the company’s constitution.

Financial return

In addition to control, shareholders hope to receive a financial return on their investment. This may be achieved in a number of ways.

A dividend (a distribution of the profits of the company to the shareholders) can be recommended by the directors if they are satisfied that the company has generated sufficient distributable profits (as defined in the CA 2006) in a given year. ‘Final dividends’ (those recommended by the directors after the end of the financial year) must then be approved by the shareholders before they can be paid. Directors can also declare ‘interim dividends’ during the financial year. These do not require shareholder approval.

A shareholder may sell their shares, receiving cash from a third party who becomes the new shareholder. In certain circumstances and if certain conditions are satisfied, the company itself can purchase shares from a shareholder.

Lastly, the shareholder could have their investment returned at the end of the company’s life, when the company is wound up. If the company is solvent (i.e. still has money once all the creditors are paid off), the shareholders will be able to recover the money they invested and will share any surplus between them, in accordance with the provisions in the company’s Articles.

Note that a company can create different classes of shares, giving the shareholders in each class specific rights. For instance, one category of shareholders may be given a preferential right to dividends and/or to share in the surplus assets of the company on a winding-up. The rights attaching to different classes of shares will be set out in the company’s Articles.

Transferability of shares

It is worth appreciating at this stage that, generally, only public companies can issue shares to the public. There may also be provisions placed in a private company’s Articles (by existing shareholders) restricting the ability of shareholders to sell shares to persons who are not already shareholders in the company.

As there is no public market for shares of private companies, it can be difficult for a shareholder in a private company to find a buyer for his shares in any event. This means that there are both practical and legal barriers to shareholders being able to exit their investment in small private companies. This, in turn, restricts their ability to obtain a return on their investment.

Having established that a company is distinct from its shareholders, the next fundamental distinction is between the shareholders and the directors.

We will consider this in the next posts where we first look at shareholders and then directors.