Is this happening to you?

Majority, you’re issuing shares that I can’t afford to buy so that my interest and rights in the company are reduced!

Introduction

Proprietary companies are often controlled by a single shareholder or a group. The majority’s nominated directors will control the board and therefore the activities of the company. If the majority (whether as shareholders or with their nominated directors) run the company in their own interests, the detriment to the minority can be serious. The minority shareholders have limited options because they cannot vote the directors out, in a general meeting, without the majority’s support. Getting out is difficult because they cannot force the majority to buy them out. As it’s not a listed company, they are also likely to find it hard to find a buyer of their minority stake. They are locked in with no control of their investment. It’s a difficult position to be in.[1]

The following are the most common complaints made by minority shareholders[2]:

  1. The majority are paying themselves excessive remuneration;
  2. Little or no participation in profits;
  3. The majority are diverting corporate opportunity / are operating a competing business;
  4. Exclusion from management;
  5. No involvement in important decisions;
  6. Limited access to information about the company’s affairs;
  7. Inability to prevent dilution of their equity stake;
  8. No freedom to transfer shares;
  9. No market for their shares;
  10. Bad management by the majority.

The following is a consideration of the seventh of these complaints, with recommendations on how a shareholders agreement will assist to prevent it.

Shareholders Agreement – What is it?                                                                                                        

Shareholders agreements are a fundamental tool to help a company’s shareholders establish expectations and manage their risk. They are particularly useful to establish rights for minority shareholders and arguably, its primary purpose is “to eliminate the tyranny of the majority”[3].

Starting Point – The Company’s Constitution

To properly appreciate how to address a risk in shareholders agreement, you first need to understand what the legal position would be without a shareholders agreement. To do so, the first point of call is the company’s constitution. This is because the company’s constitution contains provisions relating to the day-to-day internal management and proceedings of the company – the rules.

Legally, a company’s constitution has effect as a contract:

  • between the company and each shareholder; and
  • between the company and each director and company secretary; and
  • between a shareholder and each other shareholder;

under which each person agrees to observe and perform the constitution and rules so far as they apply to that person[4].

Every company’s constitution will be different, depending on who originally helped the company founders establish the company. Typically, however, the constitution provides that before issuing shares of a particular class, the directors of the company must offer them to the existing holders of the shares of that class. As far as practicable, the number of shares offered to each shareholder must be in proportion to the number of shares of that class that they already hold. The directors may issue any shares not taken up under the offer as they see fit. The company may by resolution passed at a general meeting authorise the directors to make a particular issue of shares without complying with the requirement of offering them to existing shareholders section[5].

The following are examples of ways in which the value of a minority shareholders interest in a company can be diminished by alterations of share capital[6]:

  1. an issue of shares to other shareholders or to an outsider, and perhaps at a low price;
  2. an issue of shares otherwise than pro rata to the existing shareholders;
  3. an offer of shares pro rata to all shareholders but where the majority know that the minority shareholders will not be able to take up their rights in full or at all;
  4. a reorganisation of share capital not amounting to a variation of class rights;
  5. a purchase of the company of its own shares as a price in excess of the real value.

A value of a minority shareholders stake can be diminished in a monetary sense and a strategic sense e.g. shifting the shareholders stake to a point where they cannot, say, affect a special resolution.

Also, some reorganisations of share capital which do not amount to a variation of class rights can nevertheless have a serious adverse effect on a minority shareholder. For example, the subdivision of shares of another class.[7]

Protection

With that in mind, the shareholders agreement can incorporate:

Veto: a power to veto matters concerning shares. This is usually achieved by requiring unanimity or concurrence of a higher percentage of voting units for a resolution. In this context, it would include:

  1. Issue, or grant any right to issue, any securities.
  2. Vary any rights attaching to any securities.
  3. Vary the share capital of the company including:
  4. by way of buyback;
  5. a capital reduction;
  6. the conversion of shares of one class into shares of another class; or
  7. the conversion of shares into a larger or smaller number of shares.

Non-dilution right: where the shareholders agree that the shareholding of a particular shareholder will not be diluted after any share issue etc. So that after any share issue, the shareholders shares will be topped up to the correct percentage.

Shareholder Disputes Rights and Remedies

This post is not a consideration of the legal duties and remedies that may prohibit the conduct or the remedies available when such conduct occurs. If you have, or anticipate, a dispute between shareholder in your company as a result of any of these complaints, please call Joe Kafrouni to discuss how we can help.

Author

Joe Kafrouni, Legal Practitioner Director, Kafrouni Lawyers

Disclaimer

The information provided by Kafrouni Lawyers is intended to provide general information and is not legal advice or a substitute for it. Business people should always consult their own legal advisors to discuss their particular circumstances. Kafrouni Lawyers makes no warranties or representations regarding the information and exclude any liability which may arise as a result of the use of this information. This information is the copyright of Kafrouni Lawyers.

 

References

[1] Lipton, Phillip; Herzberg, Abe; Welsh, Michelle, Understanding Company Law (Law Book Co, 17th ed, 2014 ), 629

[2] Cadman, John, Shareholders’ Agreements (Sweet & Maxwell Limited, 4th ed, 2004), 190

[3] Duffy, Michael J. (2008) “Shareholders Agreements and Shareholders’ Remedies Contract Versus Statute?” Bond Law Review: Vol. 20: Iss. 2, Article 1 at 5 citing A Elson, ‘Shareholders Agreements: A Shield for Minority Shareholders of Close Corporations’ (1967) 22 Business Lawyer 449

[4] Section 140 Corporations Act 2001

[5] This is a Replaceable Rule – s 254D Corporations Act Corporations Act 2001

[6] Cadman, John, Shareholders’ Agreements (Sweet & Maxwell Limited, 4th ed, 2004), 198

[7] Cadman, John, Shareholders’ Agreements (Sweet & Maxwell Limited, 4th ed, 2004), 198

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