The shareholders own the company and it is their investment that is at risk in the venture.
There are two important consequences of this:
- shareholders exercise ultimate control over the company; and
- shareholders hope to receive a financial return on their investment.
Control by shareholders
The shareholders exercise their control in two key ways:
- by determining the company’s constitution; and
- 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:
- 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
- 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.