Is this happening to you?

Majority, you’re not running the company the way it should be – it’s just bad management!

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 last 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 the business of the company is to be managed by or under the direction of the directors [5] and the directors may exercise all the powers of the company except any powers that this Corporations Act or the company’s constitution (if any) requires the company to exercise in a general meeting [6].

Management decisions do not often amount to prejudicial conduct against the minority unless there is evidence of other improper behaviour where it would be unfair to leave the affected shareholder locked in.[7]

What makes a good board?

According to Jeffrey Sonnenfeld, Senior Associate Dean for executive programs at the Yale School of Management and the president of Yale’s Executive Leadership Institute, the following matters have traditionally been thought of to make for good boards[8]:

  1. Regular meeting attendance;
  2. Equity involvement, where the directors are vested;
  3. Board member skill, such as financial literacy;
  4. Board member age, boards become less effective as average age of members rises;
  5. Past CEO’s presence;
  6. Having independent directors, as opposed to insiders;
  7. Board size, small rather than large;

However, the author explains, that these standards are in fact present in both good and bad boards.

He explains that good boards occur when board members respect one another, trust one another, challenge one another assumptions, conclusions and beliefs coherently and because a spirited give and take become the norm, they learn to adjust their own interpretations in response to intelligent questions. He says that the highest-performing companies have extremely contentious boards that regard dissent as an obligation and that treat no subject as undiscussable.[9]

He also believes that board “performance evaluations” are beneficial, with the typical lack of feedback as destructive. A performance review can include:

  1. full board evaluation (evaluating its understanding and development of strategy, composition, access to information and level of candour and energy);
  2. individual directors’ self-assessments (evaluating use of time, appropriate use of their skill, knowledge of the company and its industry, awareness of key personnel and general level of participation)
  3. directors’ peer reviews of one another (consideration of constructive and less constructive roles individual directors play in discussion, the value and use of their skill set, interpersonal styles, preparedness and availability, initiative and links to critical stakeholders.

These suggestions are clearly applicable to the big end of town. The article itself only refers to boards of American companies such as Kmart, Enron, Home Depot, PepsiCo and the like. How practical this advice is to a small to medium size company, a closely held proprietary company and what is often called a “quasi-partnership”, is questionable.

However, smaller companies in Australia will still benefit from the core of the message that good culture and accountability is essential to good management.

Protection

With this in mind, a shareholder agreement should have the following obligations reflected:

  1. Regular Board Meetings: regular meeting of board members;
  2. Culture Statement: a statement expressing the desire for the board to have a culture of “respect, trust and challenge”;
  3. Performance Evaluation: An external consultant is engaged to periodically provide a board “performance evaluation”, which should also be provided to the shareholders in smaller companies.

Shareholders agreements could also require:

  1. Education: a requirement for compulsory education for directors on directors duties and other core business management practices;
  2. Business Planning: an obligation to undertake business planning and budgeting for the upcoming financial year;

Of course, there is also the options of having directors agree to service agreements (including the requirement that they achieve certain outcomes / devote certain time to the company) and even a provision in the shareholders agreement that a failure to do so triggers a pre-determined buy / sell procedure of the director’s nominating shareholder’s shares (i.e. the shareholder that nominated that director – usually the controller of the shareholder in smaller companies).

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] s 140 Corporations Act 2001

[5 ] s 198A Corporations Actt

[6] Matters requiring exercise in general meeting are limited and include matters such as varying the constitution and matters concerning changing the company structure or shares, not management decisions.

[7] Cadman, John, Shareholders’ Agreements (Sweet & Maxwell Limited, 4th ed, 2004), 202

[8] Jeffrey A Sonnenfeld. What Makes Great Boards Great. Harvard Business Review. September 2002 Issue

[9] Jeffrey A Sonnenfeld. What Makes Great Boards Great. Harvard Business Review. September 2002 Issue