Shareholders Agreement


Shareholders' Agreement 

 

A company is the most common form of joint venture to carry on an ongoing business. Corporate entities exist in most countries. A corporate structure generally offers advantages such as: identity; limited liability; more opportunities for financing; continuity in the event of transfers; flexibility of share rights; established laws. Against that, there will be certain additional publicity, formality and compliance requirements.

 

The most common form will be a company limited by shares (usually a private company, or its equivalent in the relevant jurisdiction, unless a subsequent public offering of shares is contemplated).

 

Shareholders’ disputes are one of the most common causes of business failures. Shareholders' Agreement is the best way to avoid disputes and offer legal protection for shareholders. It is concluded between the shareholders of the company to (i) define their respective rights and responsibilities, and (ii) organise the management of the said company. It allows shareholders to incorporate express contractual provisions addressing key management issues above and beyond those afforded by statute and corporate law but is not intended to govern the day-to-day operations of a business.

 

The following table is a quick reference guide to the documents available on DocPro:

 

Documents

When to Use

Shareholders Agreement - Equal Shareholdings

A Shareholders' Agreement suitable for the set up of a relatively simple joint venture - a company with equal shareholding. This agreement is drafted for 2-5 parties and can be in Neutral, Strict or Loose Form.

Shareholders Agreement - Unequal Shareholdings

A Shareholders' Agreement to be entered into upon completion or establishment of the Joint Venture Company with standard clauses for minority protection. This agreement is drafted for 2-5 parties and can be in Neutral Form, or in favour of the Majority / Minority Shareholder.

Parental Guarantee to other parties in relation to Shareholders Agreement

In relation to a Joint Venture / Shareholders Agreement, a guarantee is given by a party's parent to the other shareholders for the party's obligations. 

 

A well drafted Shareholders Agreement should allow the minority shareholder to: 

  • participate in management through board representation;
  • involve in any event in major decisions (including, where feasible, a right of veto);
  • protect against its equity stake being improperly diluted;
  • fair and proper distribution of profits;
  • access to information regarding the Company's affairs;
  • protection itself and the Company against the majority shareholder;
  • exit the joint venture.
  1. Board of Directors

A minority shareholder will often seek a right to appoint a director to the board of the Company. This should ensure that, although the board may not be involved in day-to-day operations, the minority shareholder is kept fully informed about the Company's business through its appointed director and that it has a voice at board discussions. In the case of a multi-party joint venture, the formula may be that a number of minority shareholders (perhaps aggregating not less than a certain percent of the voting share capital) should, collectively, be entitled to appoint a director. A minority shareholder should consider whether certain additional protections are appropriate in order to ensure that its right to participate in management is not circumvented:

  • the presence of its appointees should be necessary for a quorum of the board;
  • prevent the delegation of key powers of the board (for instance, to an executive director or a committee) or, if delegation to a committee takes place, a right of representation on that committee;
  • reasonable notice is given of all board meetings and of the agenda items for discussion (including advance circulation of relevant board papers) and that no decisions can be taken (unless all agree) outside the matters on the agenda;
  • written resolutions need the approval of all directors.

In practice, much will continue to depend in practice on the spirit of the joint venture relationship to ensure appropriate participation by a minority shareholder.

 

  1. Veto Right

A minority shareholder may wish to have a right of veto over certain major decisions by the Company, such as:

  • changes in the Company's articles of association;
  • changes in the share capital of the Company (including the grant by the Company of any share options or convertible securities);
  • any significant change in the nature of the Company's business;
  • the Company incurring capital expenditure or contract commitments in excess of pre-agreed financial limits or not specifically contemplated by an agreed budget;
  • any borrowing by the Company which would cause a pre-agreed borrowing limit to be exceeded;
  • major business acquisitions or disposals by the Company;
  • dividend distribution below an agreed minimum level;
  • appointment and dismissal of executive directors or other key personnel and directors (including approval of long-term service contracts or material variations to their remuneration or benefits);
  • material dealings by the Company with its intellectual property;
  • dealings between the Company and any of its shareholders (except, perhaps, arm's length dealings in the ordinary course of business);
  • voluntary winding-up.

It is necessary to decide whether these matters should be entrenched at the board or shareholder level. Should the unanimous approval or super-majority vote be required of the directors or of the shareholders of the Company? It may be appropriate that decisions on these major matters should be reserved to the parties at the shareholder level with more operational matters being left to the board level. In smaller ventures, decisions at board level will often amount to the same thing and be sufficient. It may not be appropriate for each minority shareholder to have a separate right of veto. In joint ventures where there are a number of joint venture parties, for certain matters to require the approval of a "super majority" of the shareholders (normally 75% to 90% rather than unanimity). 

 

  1. Protection against Dilution

A minority shareholder will wish to ensure that its equity stake in the Company will not be diluted by alterations to the share capital of the Company, including:

  • an issue of shares which is not made pro rata to existing shareholders;
  • an issue of shares to the other shareholders (and/or to a third party) at less than a fair price;
  • a "rights" offer of shares to existing shareholders where the majority knows that the offer cannot in practice be taken up by the minority;
  • a purchase by the Company of its own shares at a price in excess of their fair value; and
  • certain other reorganisations of share capital - such as a sub-division of share capital which alters the voting balance or an alteration in the rights attaching to certain shares and not others.

Some of the common protections against dilution are:

  • a requirement that new issues of shares in the Company must be offered pro rata to existing shareholders;
  • a requirement that any issue of shares should require the consent of the minority shareholder - such requirement for such approval will obviously be inappropriate in those joint ventures where it is always envisaged that substantial further funding will be required up, perhaps, to a certain limit;
  • a requirement that shares must be offered to shareholders at a fair value - with a right for a party to require certification by the company's auditors or an independent valuer that the offer price is fair; or
  • a requirement that the minority shareholder's consent is needed if the Company wishes to issue, allot, redeem, purchase or grant options over any of its shares or other securities or reorganise its share capital in any way.

An alternate protection is to preserve a minority shareholder's equity stake is for it to retain an option to ensure - possibly for a specified period - that it can buy back its full equity stake by subsequently acquiring from the majority shareholder sufficient shares, at current full market or fair value, to take it back to an agreed percentage level. 

 

  1. Right to Distributions

The board of directors of the Company will declare dividends, and the amount of each dividend distribution. A minority shareholder may wish to ensure that an agreed distribution policy is established at the outset - and, in some ventures, to ensure that profits cannot be diverted in a discriminatory manner to the majority shareholder:

  • the parties agreeing that the Company shall distribute not less than a stated percentage (or such other percentage as may from time to time be agreed) of its available distributable profits for any year - subject usually to the retention of such profits as the board considers reasonable or desirable to meet the working capital or other financial requirements of the Company;
  • in cases where the minority is afraid that sums may not be retained to assist the development of the Company, the formula might provide for a certain proportion of profits to be retained in the business of the Company to fund future growth before there can be any distribution to shareholders;
  • where a minimum dividend policy is established, provision for the auditors to certify the amount of distributable profits available for that year;
  • a requirement that the consent of the minority shareholder is necessary for any management or service agreement to be entered into between the Company and the majority shareholder (or connected parties) or any variation in the payment terms under any such agreements; and/or
  • ensuring that any remuneration paid to directors appointed by the majority shareholder is also subject to approval by the minority shareholder.

Another approach is to require that the dividend policy should be dealt with in the annual business plan if the minority shareholder has rights of approval over the annual adoption of that plan.

 

  1. Right of Inspection

A minority shareholder's rights to information regarding the Company's affairs is limited under Common law. Apart from the right to receive the annual audited accounts, a shareholder has no statutory right to inspect the accounting records of the company nor, as a shareholder, a right to inspect the minutes of board meetings. A minority shareholder should consider seeking the following:

  • right of access to inspect (and take copies of) accounting records and the other documents of the Company and, if thought appropriate, to visit the Company's premises and interview its directors and senior staff (sometimes termed "visitation rights");
  • right for a director nominated by a particular shareholder to give his appointing shareholder such information regarding the Company's affairs as he thinks fit. It should be remembered that information regarding the Company will invariably be confidential and there is no automatic right for a director to disclose that information within his parent organisation. A right to such disclosure, subject to due confidentiality restraints, should generally be made clear in the joint venture documentation;
  • obligation on the majority shareholder and/or the Company to keep the minority shareholder informed of material developments regarding the Company's business;
  • obligation for the board of the Company to circulate monthly or quarterly audited management accounts and other financial information (budgets, cashflow forecasts, etc) to the shareholders, including the minority shareholder, in such form as may be agreed;
  • draft of annual budgets or business plans relating to the Company for approval and/or comment of the minority shareholder.

  1. Exit

A minority shareholder can find itself locked in the Company without any effective exit route. The following are possible protective provisions to enable an exit for a minority shareholder:

  • Transfer Although a minority stake will rarely be marketable to a third party, a right to sell will normally be preserved. This will usually include:
    • ensuring that the minority shareholder is free to transfer its shares, albeit after the other members have been able to exercise a pre-emption right;
    • removing any right of the directors to refuse to register a transfer to a third party if the other members do not purchase the shares and a third party purchaser is found; and
    • ensuring that, where the pre-emption right is exercisable at a fair value, it is made clear that there will be no discount in determining the value of the minority shareholding being sold (i.e. its value will be on a per share basis pro rata to the value of the Company as a whole).
  • Redeemable Shares In some cases, one method of establishing a pre-determined exit route for a minority shareholder is to issue shares to the minority shareholder which are redeemable at the option of the shareholder (or the Company), usually at a stated price. Factors affecting the issue of redeemable shares under Common law include:
    • redeemable shares must be issued at the outset since rights of existing shares cannot be altered so as to become redeemable;
    • shares can only be redeemed out of distributable profits or a fresh issue of shares for that purpose although a private company can, subject to certain conditions, also redeem shares out of capital;
    • the shareholder may wish to have a veto over transactions which could reduce the level of distributable reserves and therefore make redemption more difficult (such as bonus issues or dividends beyond a certain fixed maximum level).
  • Put Option One safeguard (particularly if limited voting rights are granted to the minority) is for a minority shareholder to negotiate a put option, whereby it can oblige the majority shareholder to buy out its investment in the Company, usually in accordance with a pre-determined price formula and at a defined time or times. Such an option will provide the surest protection against the risk of a minority shareholder being "locked in" if the joint venture is unsuccessful from its viewpoint or it wishes to exit. 
  • Tag along Right A minority shareholder should also consider establishing a "tag along" right whereby it can oblige the majority shareholder to include the minority's stake, at the same price per share, in any sale which the majority shareholder may make of its controlling interest to a third party. This right ensures that the minority shareholder cannot be left unwillingly as a minority shareholder in a joint venture with a new majority partner. The same principle, in appropriate cases, should apply to enable the minority shareholder to "piggy back" and participate proportionately in any public offering or private placement of shares in the Company (including, where applicable, participation in the US in any registration by the Company of securities prior to any such offering).

  1. Tax Structure

The structure of the Company may lead, and indeed be designed to lead, to the ability of the majority shareholder to exercise rights which assist its own tax planning. Examples could include arrangements (between the Company and its shareholders concerning use of group relief or consortium relief. In most cases, the co-operation of the Company itself will be required before any of these rights can be exercised. The minority shareholder should ensure that these rights cannot be exercised to the prejudice of the Company (and indirectly the minority shareholder) and that provision is made for proper payment to the Company by the majority shareholder for any benefit obtained by it.

 

  1. Claims Against Majority Shareholder

If the minority shareholder considers that the majority shareholder or any of its directors is in breach of any obligation to the Company (including, for example, breach of other ancillary contracts or breach of warranty under any asset transfer agreement at the time of forming the Company), the minority shareholder needs to ensure that the Company's right of claim cannot simply be blocked by the majority. Common solutions are:

  • to provide that responsibility for pursuing any such claim against the majority shareholder should be delegated to a committee of the Company board excluding the appointees of the majority shareholder - or delegated to the minority shareholder as an agent of the Company; or
  • to provide, generally, that the majority shareholder (and/or its appointed directors) shall not vote on or interfere with or obstruct any such claim - but without prejudice to its right to defend or resist any such claims.

  1. Other Minority Rights

Other possible protections which a minority shareholder may seek in any particular case include undertakings that the majority shareholder will ensure that:

  • the Company maintains proper insurance (particularly product liability insurance), prepares and maintains proper books of account and conducts the business in accordance with all applicable laws;
  • key employees enter into appropriate non-competition covenants, confidentiality agreements and employment contracts - including, in technology ventures, employment contracts which provide (so far as possible) that intellectual property devised by employees belongs to the Company.

  1. Shareholders Agreement or Articles?

Once the protections for the minority shareholder have been agreed, the next question is whether they should be set out in the Joint Venture Agreement or in the Company's Articles of Association or both. This issue will depend on a mixture of practice, drafting style, practitioner preference and legal considerations. There following are some of the implications from case law, Russell v Northern Bank Development Corporation Limited  [1992] 1 WLR 588 (HL):

(a) If the Company is a party to a shareholders' agreement which contains terms which fetter the Company's exercise of its statutory powers (e.g. a term requiring more than a special resolution to change the company's name or alter its articles of association), these terms will be void as against the Company but enforceable as a voting agreement between the other parties if the terms which restrict the Company can be severed. If the terms cannot be severed then the provisions may be ineffective, even between the shareholders.

(b) In relation to a shareholders' agreement, provisions which would otherwise "offend" could be included if the Company is not a party to the agreement (or, at least, not a party to the "offending" provisions).

(c) Provisions in the articles relating to the same matters (e.g. any attempt to require a super-majority for a shareholders' resolution on a particular matter, being a majority higher than that required under statutory corporate law for that resolution) can no longer be regarded as enforceable against the Company or valid if contained in the articles of association. The preferred legal course is that minority veto rights should be established either (i) in the articles of association on the basis that they are established as class rights or (ii) by including them in the shareholders' agreement (taking account of the effect of the Russell decision). 

(d) Rights normally attaching to shares (such as rights to appoint directors, dividend and voting rights) should be in the articles of association.

(e) Positive obligations on a majority shareholder (e.g. undertakings by the majority shareholder to provide information or access rights to the minority) usually appear solely in the shareholders' agreement.

(f) Whether minority veto rights should appear in the articles and be established as "class rights" or be dealt with solely in the shareholders' agreement (taking account of the Russell decision) is debated between practitioners. There is a balance of considerations. Minority veto rights will usually take the form of an undertaking by the other party(ies) to use all respective votes and powers (including to procure that its appointed directors exercise their respective rights and powers) to ensure that the requisite action does not take place without the relevant minority shareholder's consent. Where the party giving the undertaking does not have a majority shareholding, the undertaking will usually be given only "so far as it is able" or on a "best endeavours" basis. Therefore, in the case of a multi-party joint venture where no single shareholder has a majority position, there is a stronger argument that veto rights should be established as class rights in the articles.

 

10.1   'Contracting out' of the statutory right to petition for unfair prejudice 

Fulham Football Club [2011] EWCA Civ 855 (CA)

The question of whether shareholders can, by contract, restrict their statutory rights to petition for unfair prejudice has been a matter of controversy. The difficult question is: how far would an agreement to arbitrate restrict a member’s statutory right to seek relief for unfair prejudice? The Court of Appeal decision in Fulham Football Club (1987) Ltd v Richards [2011] EWCA Civ 855 (CA) sheds some light on the subject.

 The Football Association took a non-voting share and the 20 football clubs one share each in a company formed at the instigation of Premier League (consisting of 20 football clubs). Its business was managed by Sir David. The 20 football clubs were bound by the rules of the company as well as the Football Association, which contained widely drawn arbitration clauses.

The dispute arose out of a battle between Fulham Football Club Ltd and Tottenham Football Club Ltd for securing the transfer of striker Peter Crouch. Fulham Football petitioned for unfair prejudice, complaining that the chairman Sir David, had acted unfairly in facilitating a player’s move to Tottenham, in preference to a bid put forward by Fulham. It sought an injunction restraining Sir David from participating in future player transfer negotiations, or an order removing him as the director.

The Court of Appeal upheld the shareholders’ agreement to arbitrate, and stayed the unfair prejudice petition.

Patter LJ held, first, that the statute did not exclude unfair prejudice disputes from arbitration. More important is his conclusion that, the dispute relating to alleged breaches of the company’s articles or a shareholders’ agreement was generally arbitrable (at [77]). This is because it was an essentially contractual (internal) dispute which did not ‘engage third party rights’ (at [41]), or affect ‘public interest’ (at [50]).

Longmore LJ agreed, adding that there was no public policy reason to strike down an arbitration agreement in relation to disputes about ‘the internal management of a company’ (at [98], [99]).  Here, Fulham did not seek a winding up order. The agreement would not affect the interests of third parties or the general public. On this view, the Court of Appeal concluded that the agreement was valid.

 

10.2   'Contracting out' of the statutory right to petition for winding up

Can a shareholders’ agreement remove or restrict the statutory right to petition for a winding up? 

Fulham Football Club (1987) Ltd v Richards [2011] EWCA Civ 855 (CA) gives some comfort for the view that shareholders’ agreements to arbitrate corporate disputes are generally enforceable so long as they do not affect third parties or go against public policy. What about an agreement not to petition for winding up? In Fulham Football, Patten LJ had opined, obiter, that the same principle would probably apply (at [86]). The arbitration agreement would, in his Lordship’s view, operate as ‘an agreement not to present a winding-up petition unless and until the underlying dispute had been determined in the arbitration’ (at [86]).

This dictum was endorsed by the Hong Kong court in Re Quiksilver Glorious Sun Licensing Limited [2014] 2 HKLRD 759. Quiksilver (a subsidiary of a US listed company) and Glorious Sun (a Hong Kong listed company) were two equal shareholders in two joint venture companies. They entered into a joint venture agreement providing for arbitration of ‘any controversy arising under or relating to this Agreement’ (Cl. 14.4). The joint venture was not developing. Quiksilver offered to buy Glorious’s shares, or sell its shares to Glorious Sun to which Glorious agreed but the parties could not agree on the terms. Arbitration had been underway in California. When Quiksilver sought to wind up the companies on just and equitable ground in Hong Kong, Glorious applied to stay the proceedings. 

Harris J upheld the arbitration agreement and stayed the winding up petitions. He held that the substance of the dispute was essentially shareholders’ disputes which did not affect third party rights, and therefore the case was arbitrable. Three main points emerged.

(1) Insolvent and solvent winding up of companies. First, Harris J drew an important distinction between winding up on ‘insolvency’ ground and winding up on ‘just and equitable’ ground: the former invokes a class right that engages the statutory regime for the liquidation of companies for the benefit of all creditors, whilst the latter would normally involve solvent company in that a shareholder must demonstrate a ‘sufficient interest’ in the winding up (see Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap 32), section 179(1)), and that it would normally involve shareholder disputes that did not affect third parties. Therefore, a just and equitable winding up, he insisted, did not involve a class right that could only be determined by the court.

In more general terms, the judge clearly reinforced the broad rule that an arbitration agreement which restricts members’ statutory rights to petition for winding up is enforceable, so long as it does not affect third parties. This was the uncertain principle in Best Floor [1999] VSC 170 where the Australian court, without drawing a line between solvent and insolvent winding up, refused to stay a winding up petition on the ground that it would have the effect of ‘obviating the statutory regime for the winding up of a company’ (at [18]).

(2) Arbitration Ordinance. Putting aside the ‘class right’ point, question arose as to the applicability of section 20 of the Arbitration Ordinance which requires ‘a court before which an action is brought’ to refer the parties to arbitration. It is clear that winding up proceedings were not an ‘action’. Harris J relied heavily on Fulham where the Court of Appeal stayed an unfair prejudice petition notwithstanding that the provision of UK Arbitration Act left open the possibility of a challenge to a stay on the ground of arbitrability. He agreed with Pattern J in Fulham that ‘action’ (‘legal proceedings’ in the equivalent UK provisions) included a petition, adding that the difference in wording between the Arbitration Ordinance and the equivalent UK provisions were immaterial (at [21]).

(3) Subject matter and the relief granted. Even though an arbitrator cannot make a winding-up order, nevertheless Harris J held that the question of whether a shareholder’s conduct was consistent with the terms of a shareholders’ agreement and the determination of the facts and matters which found a petition to wind up a company were clearly arbitrable (at [14]).

 

  1. Class and Voting Rights

Class rights include any rights conferred on a particular class of shares in contrast to one or more other classes. They may also, importantly in the joint venture context, include rights conferred on a shareholder by name under the company's articles even though they are not attached to a particular class of shares identified as such. Company law generally includes certain protections for the members of a class against any change in the rights attaching to shares of that class. 

An alternative approach, in circumstances where it is considered not appropriate to establish class rights, is for a minority shareholder to protect its position by having "weighted voting rights" on particular matters. This method has been used to ensure that a minority shareholder's appointee as director cannot be removed by the majority shareholders. This appears to be a technique capable of general application to entrench rights of a shareholder under Common law.

 

Keywords:

Shareholders Agreement

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Documents
Shareholders Agreement
2 Parties - Majority Shareholder
Shareholders Agreement
2 Parties - Minority Shareholder
Shareholders Agreement
2 Parties - Neutral
Shareholders Agreement
3 Parties - Majority Shareholder
Shareholders Agreement
3 Parties - Minority Shareholder
Shareholders Agreement
3 Parties - Neutral
Shareholders Agreement
4 Parties - Majority Shareholder
Shareholders Agreement
4 Parties - Minority Shareholder
Shareholders Agreement
4 Parties - Neutral
Shareholders Agreement
5 Parties - Majority Shareholder
Shareholders Agreement
5 Parties - Minority Shareholder
Shareholders Agreement
5 Parties - Neutral
Shareholders Agreement - Equal Shares in Company
2 Parties - Neutral
Shareholders Agreement - Equal Shares in Company
Loose / Light - 2 Parties
Shareholders Agreement - Equal Shares in Company
Loose / Light - 3 Parties
Shareholders Agreement - Equal Shares in Company
Loose / Light - 4 Parties
Shareholders Agreement - Equal Shares in Company
Loose / Light - 5 Parties
Shareholders Agreement - Equal Shares in Company
Neutral - 3 Parties
Shareholders Agreement - Equal Shares in Company
Neutral - 4 Parties
Shareholders Agreement - Equal Shares in Company
Neutral - 5 Parties
Shareholders Agreement - Equal Shares in Company
Strict / Tight - 2 Parties
Shareholders Agreement - Equal Shares in Company
Strict / Tight - 3 Parties
Shareholders Agreement - Equal Shares in Company
Strict / Tight - 4 Parties
Shareholders Agreement - Equal Shares in Company
Strict / Tight - 5 Parties
Parental Guarantee to other parties in relation to Shareholders Agreement
Guaranteed Shareholders
Parental Guarantee to other parties in relation to Shareholders Agreement
Guarantor
Parental Guarantee to other parties in relation to Shareholders Agreement
Neutral