Business Law and Practice

Nominal or par value

Section 542(1) CA 2006 provides that the shares in a limited company having a share capital must have a fixed nominal value. Section 542(2) CA 2006 provides that any allotment of a share that does not have a fixed nominal value is void. The nominal or par value of a share is the minimum subscription price for that share. It represents a unit of ownership rather than the actual value of the share. Common nominal values for ordinary shares are 1p, 5p or £1.

Section 580 CA 2006 provides that a share may not be allotted/issued by a company at a discount to its nominal value. However, it may be allotted/issued for more than its nominal value, and the excess over nominal value is known as the ‘premium’. The market value will often be much higher than the nominal value of the share.

Issued, allotted, paid-up and called-up shares

The amount of shares in issue at any time is known as the issued share capital (ISC). This is the amount of share capital that will be shown in the company’s balance sheet in its accounts. This was the same under CA 1985.

A company’s ISC is made up of:

• shares purchased by the first members of the company, known as the ‘subscriber shares’; and
• further shares issued after the company has been incorporated, to new or existing shareholders. New shares can be issued at any time provided that the correct procedures are followed.

Allotment is defined in s.558 CA 2006. Shares are said to be allotted when a person acquires the unconditional right to be included in the company’s register of members in respect of those shares. This term is often used interchangeably with the issue of shares but the terms have different meanings. There is no statutory definition of ‘issue’ but it has been held that shares are only issued and form part of a company’s issued share capital once the shareholder has actually been registered as such in the company’s register of members, and his title has become complete (s.112(2) CA 2006 confirms that full legal title to shares is only achieved once a person’s name is entered in the company’s register of members).

It is not necessary for shareholders to pay the full amount due on their shares immediately. The amount of nominal capital paid is known as the ‘paid-up share capital’. The amount outstanding can be demanded by the company at any time. Once demanded, the payment has been ‘called’. It is increasingly rare for shareholders not to pay the full nominal value of their shares on issue.

The definition of ‘called-up share capital’ in s.547 CA 2006 is the aggregate amount of the calls made on a company’s shares and the existing paid-up share capital. Given that shares are rarely not fully paid up, this term is not regularly used.

What is the difference between allotting and transferring shares?

An allotment of shares is a contract between the company and a new/existing shareholder under which the company agrees to issue new shares in return for the purchaser paying the subscription price.

A transfer is a contract to sell existing shares in the company between an existing shareholder and the purchaser. The company is not a party to the contract on a transfer of shares.

It is crucial to remember the difference between an allotment and a transfer of shares as the procedure to effect an allotment and a transfer of shares is different.

Treasury shares

These are shares that have been bought back by the company itself and are held by the company ‘in treasury’. Treasury shares are issued shares being held by the company in its own name, and the company can subsequently sell those shares out of treasury. Note that although such a sale of shares is a transfer, not an issue, of shares, s.561 CA 2006 pre-emption rights (see s.560(3)) and s.573 CA 2006 disapplication of pre-emption rights will apply. The company can also choose to cancel treasury shares at any time or transfer them to an employee share scheme.

What is capital?

The general term ‘capital’ is used to refer to the funds available to run the business of a company. For example, you may hear in the media, professionals advising that a business needs an ‘injection of capital’. All it means is that the company requires more finance or funding to run its business.

In company law, the term ‘share capital’ relates to the money raised by the issue of shares. The share capital is contributed by investors in the company and is represented by shares that are issued to such investors.

Why does a company need funds?

When a company is set up, funds are needed to get the business started, e.g. to pay rent, buy stock and machinery, etc.

Funds are also needed to keep the business going – this is commonly known as ‘working capital’.

Funds are also needed for expansion and growth, e.g. by taking on new premises or buying other businesses.

How does a company fund its business?

There are various ways in which a company can raise funds, including by:

• issuing shares, i.e. ‘equity finance’;
• borrowing, i.e. ‘debt finance’;
• issuing a ‘hybrid’ investment which has the characteristics of both debt and equity (for example a convertible bond or a preference share); and/or
• retaining its profits for use in the business (rather than paying the profits to the shareholders).

Equity finance: what are shares?

A share is often described as a ‘bundle of rights’. By investing in the share capital of any company, the investor becomes a part owner of the company and will often have voting rights in shareholder meetings. In the case of a private company, most investors make a long-term investment and will only usually get their investment back on a sale of their stake, a sale of the company itself, on a flotation, or when the company is wound up (provided sufficient funds are available). The incentives for investing would be the receipt of income (by way of dividend) and a capital gain (by way of the growth in the value of the company, and therefore the individual shares), although neither are guaranteed.
Different classes of shares may carry different rights and entitlements. All rights and entitlements in relation to shares of all classes are set out in the articles of association. It is imperative to check these.

Equity finance: effect on the Balance Sheet

Blue Moon Limited, a new company, issues 100 ordinary shares of £1 each for cash on incorporation. The effect on the Balance Sheet of the company is set out below.

 

As you can see, the entry for the issue of the shares is as follows:

1. increase share capital to show the nominal value of the shares issued; and
2. increase the cash (current assets) to show the cash received for the shares.

i.e. the top half of the balance sheet shows you what the company owns and the bottom half shows you where it came from.

Debt finance

Companies will often borrow funds for their business. Money can be borrowed in a variety of different ways, for example by way of overdraft, term loan and bonds.

On a transaction involving a Shareholders’ Agreement, alongside the Shareholders’ Agreement and the Articles, lawyers may be involved in drafting various additional documents as discussed below. This is not an exhaustive list and neither are they all required in all circumstances.

Please also note that some of these documents may also be required even when there is only one shareholder, but they are most common in the context of companies with two or more shareholders.

Management Agreement

These are sometimes used in companies where one of the shareholders agrees to be responsible for the day to day management of the business. Such an agreement would be likely to cover the following issues:

1. the manager’s role;
2. limits on the manager’s powers;
3. any fee payable to the manager; and
4. provisions for terminating the manager’s role.

Asset/Business Purchase Agreement

The parties may be contributing parts of their existing business to the company or the company may be acquiring a business or assets from a third party. In either instance the transaction will be documented by a purchase agreement.

Such an agreement may include warranties in relation to the business or assets to be acquired. If there are, this might allow the company a right of recovery if the business or assets turn out to be less valuable than warranted or subject to an undisclosed liability. We will look at warranties in more detail in the Acquisitions zone later in the module.

Secondment Agreement/Employment Agreements

If directors and senior management are seconded from the shareholders (if they are themselves businesses or companies), it is important to decide whether the company or the shareholders will be responsible for their remuneration. A Secondment Agreement would cover these issues.
Any employees of the company would require employment contracts.

Intellectual property licences

As part of their contribution, the shareholders may license intellectual property rights to the company and/or it is possible that the company will agree to license back to the shareholders any intellectual property which it develops.

Contracts for the supply of goods and services

It may well be that the shareholders are to supply goods and/or services (other than those already mentioned above) to the company, in which case issues such as the price and other terms of such goods/services will need to be determined and documented.

Guarantees

Third parties such as banks may require the shareholders to provide guarantees in relation to the company’s obligations.

The provisions of a Shareholders’ Agreement will always be subject to negotiation and the outcome of those negotiations is likely to be governed by the parties’ relative bargaining power. However, Shareholders’ Agreements will commonly include the following provisions.

Veto rights

It is common for a Shareholders’ Agreement to include a list of matters that require the consent of all (or a certain number or a majority) of the shareholders. Such provisions may also reserve particular matters concerning the day to day running of the business to the shareholders (i.e. matters that would usually be decided by the board of directors).

Examples of matters which commonly require the consent of all shareholders include:

• increases in authorised share capital (if relevant);
• change of the company’s name;
• changes to the Articles;
• variation of any rights attaching to the shares in the company;
• entering into any borrowing or entering into any borrowing over a certain threshold;
• acquiring shares in, or other property from, any other company – sometimes this has a de minimis amount set such as £20,000 (i.e. acquisitions costing more than £20,000 require the consent of all shareholders);
• change of registered office;
• change of auditors;
• change of accounting reference date;
• matters of policy (i.e. the commercial direction of the business); and
• appointments or changes of bankers.

Where some formal procedure for decision-making is set out in a Shareholders’ Agreement but the shareholders fail to follow that procedure, provided that all the shareholders agree, their decision will be binding, notwithstanding the failure to follow the stipulated procedure.

Provisions relating to directors

These provisions deal with the appointment and removal of directors and also procedural issues relating to the day to day management of the company by the directors.

Such provisions may include quorum, notice and voting provisions (these provisions may also be repeated in the Articles). For example, above a certain percentage of shareholding, each shareholder is likely to be entitled to appoint a representative or representatives to the board or it may be provided that no director shall be appointed to the board or removed from the board except with the consent of all of the shareholders.
If the company is deadlocked, each shareholder will normally be entitled to appoint the same number of directors or representatives. They will also have the right to appoint the chairman of the board without a casting vote but probably on a rotational basis for a fixed period.

Quorum requirements for shareholder meetings

Though the Model Articles do set out quorum requirements for company meetings, it is common in a Shareholders’ Agreement, especially in joint venture arrangements, to set overriding quorum requirements that provide that certain persons (or their representatives) from each party to the Shareholders’ Agreement must be present in order for a quorum to be reached.

A deadlocked company often provides that no decision of a meeting can be taken unless a representative of each shareholder is present throughout the meeting. If the company is not deadlocked, it may be the case that a representative of the minority shareholder will be required to be present for the meeting to be quorate or have the right to receive notice of the meeting and decide whether to attend or not. If the minority shareholder’s representative is required to be present before the meeting is quorate, this can effectively give it a right of veto over decisions. This position is naturally resisted by a majority shareholder.

Financing the Company

Provisions may be included which set out how the company is going to be financed. In an investment arrangement or a joint venture arrangement, the Shareholders’ Agreement is often made conditional upon receipt of the financing. The types of provisions will depend upon the reason for which the Shareholders’ Agreement is being entered into.

If the parties are entering into a joint venture arrangement, the parties often contribute different assets, equipment and property to the venture as well as capital in return for shares. The Shareholders’ Agreement will need to describe who is contributing which assets, equipment and property and what will happen to these items (if anything) when the joint venture terminates or any of the parties exit the joint venture.

If on the other hand the Shareholders’ Agreement is being entered into in connection with an investment or as a result of a private equity buy-out, the Shareholders’ Agreement will detail the precise share subscriptions of the parties and the rights attaching to the shares as well as any loan financing that is being provided by the parties.

These provisions should also include what is to happen if a shareholder leaves and, for example, a loan is still outstanding.

As mentioned above, Shareholders’ Agreements also have the advantage of confidentiality. Unlike a company’s Articles, they do not have to be filed at Companies House and are therefore not open to public inspection. Nor are Shareholders’ Agreements open to inspection by a company’s creditors or employees. Shareholders may feel that they do not want provisions dealing with funding to be public. The same issue is also likely to arise with other provisions such as those relating to directors’ remuneration which the parties will want to keep confidential (subject to any company law or accounting regulatory requirements).

Pre-emption rights on transfer

S.561 CA 2006 gives statutory pre-emption rights on the allotment and issue of new shares in a company, whereby statute gives existing shareholders a statutory right of first refusal to take up new shares that are being issued by a company. I will cover this in more depth in a later post.

One important clause for all shareholders in a Shareholders’ Agreement will be the clause relating to pre-emption rights on the transfer of existing shares in the company. This is because there is no statutory provision giving existing shareholders a right of pre-emption on a transfer of shares from an existing shareholder to a new or another existing shareholder. A Shareholders’ Agreement provides for contractual pre-emption rights. Contractual pre-emption rights in a Shareholders’ Agreement give existing shareholders a right of first refusal to accept a transfer of shares from a departing shareholder. In a joint venture or private equity buy-out scenario, the nature of the business depends on the expertise of the joint venture parties or (in the buy-out scenario) the management team (who will also be shareholders), so shareholders will very often not want shares in the company to fall into the hands of people other than the original shareholders to protect their investment.

A Shareholders’ Agreement will therefore often provide that the shares belonging to the exiting shareholder must be offered to the remaining shareholders pro rata and that the consent of all shareholders will be required in order for the transfer of existing shares to be registered by the directors. It is also common for these provisions to be repeated in the Articles of the company. On a major investment or private equity buy-out where the majority shareholders are an institutional investor or private equity house, the transfer provisions may provide that the departing shareholders’ shares must first be offered to the majority shareholders before they are offered to other shareholders.

If there is a majority shareholder there may be so-called drag-along provisions which require the minority shareholders to sell their shares in the event that the majority shareholder wants to sell to a third party. The majority shareholder can force the minorities to sell.
You may also find so called tag-along provisions which state that a majority shareholder wishing to sell to a third party cannot do so unless he procures an offer by the third party to purchase the minority shareholders’ shares on matching terms – the smaller shareholder can tag along with the sale.
Whatever is agreed, it is often the case that there will be exceptions for certain transfers, the most common being intra-group and intra-family transfers. For clarity, and to avoid conflict in the future, the permitted transferees are often specifically defined in the Shareholders’ Agreement.

Anti-dilution provisions/Rights on allotment of new shares

Shareholders may also not want their current shareholdings to be diluted by the issue of new shares. Although the CA 2006 provides for pre-emption rights on the allotment of certain types of shares (“equity securities” defined in s.560 CA 2006), this only protects shareholders from the dilution of their shareholding in respect of these types of shares, if they can all afford to and wish to take up those new shares. A Shareholders’ Agreement may therefore provide that the consent of all shareholders will be required in order for any new shares to be allotted at all.

Dividend policy

A Shareholders’ Agreement will almost always set out some kind of policy on whether to declare dividends or not and in what proportions those dividends will be paid. The Shareholders’ Agreement may for example state that a dividend is not to be declared for a certain period of time and/or that a dividend is not to be declared until such time as certain financial milestones have been reached by the company (e.g. the repayment of all loans).

Pre-completion obligations

It may be the case that certain arrangements need to be entered into before the parties agree to set up the company or subscribe for shares in the company. The idea behind this is that all parties’ initial obligations will be subject to each other so that the company will only be established once all initial obligations have been fulfilled. Such matters are often set out in a Shareholders’ Agreement. For instance, prior to completion each party would be obliged to subscribe for a certain number of shares in the company at a certain price or to transfer certain property into the name of the company.

Restrictive covenants

Restrictive covenants exist to protect legitimate business interests which include trade secrets, confidential information, etc. It is common to have restrictive covenants dealing with the period during which a party is a shareholder and also for a period following the shareholder’s departure to protect a company’s legitimate business interests.
Such covenants often prevent former shareholders from competing with the business of the company or from soliciting customers, suppliers and employees from the company. As such these covenants can be regarded as a critical issue to negotiate (from the outset) where, on departure of a shareholder, the company is intended to continue as an ongoing business.

Deadlock

Deadlock provisions will always be included in a Shareholders’ Agreement to provide for what is to happen in the event of the company becoming deadlocked either at board or shareholder level – although it is usually the case that if the company is deadlocked at board level it will be referred up to shareholder level.

Deadlock occurs when, for whatever reason, it is not possible for the board or a meeting of the shareholders to pass resolutions (e.g. because certain directors or shareholders refuse to attend meetings so that they cannot become quorate).

Deadlock may also occur if a party wants to sell its shares and leave the company and the other shareholders are not willing to buy its shares but it is not permitted to sell the shares to a third party as mentioned above.

In practice you may come across deadlock resolution procedures referred to as Russian Roulette or Mexican/Texas Shootouts, where the end result is that certain shareholders buy the shares of others.

A “Russian Roulette” mechanism typically provides that a shareholder (A) can serve notice on another shareholder (B) offering to buy all of B’s shares in the company at a price specified by A (or to sell its shares to B at the stated price). B must accept A’s offer and sell its shares to A at the stated price or must buy A’s shares at the same price per share.

A “Mexican/Texas shoot-out” is a variation of the Russian Roulette provision in that either party can serve notice on the other party to buy the other’s shares or to sell its own shares to the other party at a specified price. This type of mechanism generally occurs where both parties are interested in buying the company, and provides that in this case they both submit sealed bids to an ‘auctioneer’ and the party who makes the higher bid is entitled to buy the company at that price.

These procedures are not the only remedy in all deadlock situations. It may not be appropriate or workable in certain circumstances to follow these procedures. As such, a deadlock provision can also provide for the company to be wound up. Whilst liquidation may appear to be an obviously drastic result for a deadlock situation, the clear benefit is to focus the shareholders’ minds as to whether the deadlock is irretrievable or whether they wish to continue with the company.

Deadlock provisions may also provide for a period of arbitration, mediation or other form of alternative dispute resolution in order to settle the dispute before any of the more serious steps, as identified above, are taken. In any event, when drafting deadlock procedures it is important to ensure that they clearly provide for what circumstances will constitute a deadlock and for the procedure to be followed once the deadlock situation has arisen.

Termination other than by Deadlock

As well as providing for termination in the event of deadlock, it is usual for Shareholders’ Agreements to be terminable on the happening of any of the following events:

1. a shareholder committing a material breach of the agreement which it has failed to remedy within a specified time;
2. the company or a shareholder becoming insolvent;
3. change of control of a shareholder (if it is itself a company);
4. the expiry of a definite term or completion of or failure of a particular project undertaken by the company; or
5. service of notice by a shareholder or shareholders.

The above ‘termination situations’ can be categorised into two categories: termination by default (points 1-3) and termination by consent of the parties (points 4 and 5).

Where termination by default occurs, the Shareholders’ Agreement will usually specify a mechanism by which (1) the other party is put on notice that such a breach has occurred; (2) the breach is verified by a third party; (3) the infringing party has had an opportunity to remedy the breach; and (4) the infringing party’s shares are purchased by the other innocent party. Termination by consent is, of course, the more straightforward scenario.

Provisions dealing with termination (including termination by deadlock) must provide for how the company assets are to be allocated. Such assets will include any intellectual property rights generated by the company.

Where there is termination other than as a result of deadlock, termination provisions can be drafted to provide that the shareholder who has not defaulted is then able to force the sale to itself of the defaulting shareholder’s shares in the company. These are known as compulsory transfer provisions. Similarly, options can be put in place for a non-defaulting party to exercise (put or call options). These allow the non-defaulting party to buy the defaulting party’s shares, or to sell its shares to the defaulting party. The price at which the shares will be purchased will either be expressed as being a fair value or will be ascertained by reference to a pre-agreed formula.

New shareholders

It must be remembered that the only parties to a Shareholders’ Agreement are those shareholders who have signed up to its provisions (and perhaps also the company itself). Unlike the Articles where every person is automatically bound upon becoming a shareholder, with a Shareholders’ Agreement shareholders must actively enter into the Shareholders’ Agreement in order to be bound. New shareholders are often signed up to the provisions of Shareholders’ Agreements by entering into a Deed of Adherence. A proforma Deed of Adherence is usually appended to the Shareholders’ Agreement.

Note that the provisions of a Shareholders’ Agreement dealing with pre-emption rights on allotment and/or transfer may make new or additional shareholders an unlikely proposition. In any event no person is likely to be permitted to become a shareholder unless they enter into a Deed of Adherence.

Departing shareholders

As stated earlier, it is often the case that restrictive covenants are entered into between the parties to a Shareholders’ Agreement. Restrictive covenants require careful drafting as they must be drafted no more widely than is reasonably necessary to protect the legitimate business interest of the company concerned. A restrictive covenant which is unreasonable in its scope will be held to be void and unenforceable.

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.