Shareholder Disputes Series (Part 3 of 10): Little or no participation in profits

Is this happening to you?

Majority, the company is profitable and we’ve got more money in reserve. You should be paying me a dividend but you’re not!

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 second 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 will provide that, subject to the terms on which shares in a proprietary company are on issue, the directors may pay dividends as they see fit.[5].

Therefore, minority shareholders can find themselves without any dividends (or income) if the directors decide not to pay any. Instead, they may eventually overpay themselves, others or use the money to benefit their self-interest to the detriment of the minority.

Protection

With this in mind, the shareholders agreement can incorporate the following provisions to protect the minority:

Dividend policy

: a dividend policy setting out when and what dividends shall be declared by the company. This is typically a proportion of its distributable profits to be paid or be retained (with the balance paid out).

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 shareholders in your company as a result of any of these complaints, please call me on (07) 3103 3199 to discuss how I can help.

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, 4^th 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 254W(2) Corporations Act 2001