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:
- a limited liability company;
- a limited liability partnership (under the LLPA 2000);
- a limited partnership (under the LPA 1907);
- a partnership (under the PA 1890);
- a Societas Europea; and
- 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:
- 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;
- 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;
- 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
- 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.