Shareholders Disputes Series (Part 4 of 10): The majority are diverting corporate opportunity / are operating a competing business

Is this happening to you?

Majority, you came across that business opportunity in your position with the company. It’s the company’s, not yours to take to your own separate private company!

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 third of these complaints with recommendations on how a shareholders agreement could assist to prevent them.

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

These powers are very wide!

Protection

With this in mind, the shareholders agreement can include the following provisions that may assist:

1. Non-compete: a non-compete clause prohibiting shareholders from having an interest in a competing or complimentary business;
2. Full disclosure / consent: an obligation on shareholders (and therefore an agreed expectation of them) that any opportunity presented that may further the objectives of the company, is in any way related to the business of the company, the industry of the business of the company to the customers, the workers or the suppliers of the company, are to be presented to the company. Only if the company decided not to pursue it may the shareholders do so with the others consent.
3. Devotion requirement: a commitment by the shareholder that they will devote all or a substantial part of their time and energy to the company.
4. Confidentiality undertakings: a commitment from the shareholders to keep all company information confidential.

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 to you 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 198A Corporations Act 2001