- What is a shareholders’ agreement?
- Why use a shareholders’ agreement?
- Does a shareholders’ agreement override the articles?
- What should a shareholders’ agreement include?
- How do you enforce a shareholders’ agreement?
- How is a shareholders’ agreement terminated?
- What happens with no shareholders’ agreement?
What is a shareholders agreement?
A shareholders agreement is a contract between the members of a company. It can be made by all the members of a company of just a select few. Even parties who are not shareholders can be parties to a shareholders’ agreement, in appropriate circumstances.
There is a common misconception that a shareholders’ agreement can only be made when the company is first formed, however, a shareholders’ agreement can be made at any time during the lifetime of a company.
It is also not uncommon, in particular where all the shareholders are parties to the shareholders’ agreement, for the company to also be a party to the agreement. Where this is the case the legal status of a shareholders’ agreement is very similar to the corporate constitution of the company, namely a contract between the shareholders themselves and the shareholders and the company.
Why use a shareholders’ agreement?
There is a multitude of reasons for why parties elect to use a shareholders’ agreement rather than simply relying on the provisions of the company’s articles of association and/or the Companies Act 2006, these include:
It offers protection for minority shareholders
A shareholders’ agreement should be considered when there is more than one shareholder in a company, as it is often considered an essential safeguard to give protection to minority shareholders.
A common provision inserted in shareholders’ agreements to protect the interests of minority shareholders is a tag-along right, which is the right of a minority shareholder to block the sale of a 50.1% interest unless a like offer has first been made for the 49.9% interest.
Further protection for a minority shareholder is that once a shareholders’ agreement is in place, it can only be amended with the agreement of all of the shareholders to the original agreement whereas the company’s articles of association can be changed by a 75% majority. Accordingly, the former provides better protection.
The resolution of disputes
The absence of a shareholders’ agreement opens up the potential for disputes between the shareholders and a dispute resolution clause is a common feature in the shareholders’ agreements which seeks to pre-empt disagreements and set out appropriate ways for disputes to be addressed.
To regulate the management of the company
Generally, the day-to-day running of the company is left to the board of directors. However, the shareholders may believe that there are certain decisions that should not be left to the discretion of the directors and instead require shareholder approval, this is particularly relevant if there are directors who are not shareholders.
To control the transfer of shares
The shareholders’ agreement can provide a mechanism, which may force the outgoing shareholder to offer a “right of first refusal” over those shares to the remaining members. This can be used as a means to try and restrict who may or may not acquire the shares in the company.
To link to shareholding to employment
It is often the case that shares in a company are held by the directors, officers and/or key employees of the business. If they were to resign or leave for whatever reason, you would more than likely want them to sell their shares, otherwise, they could remain entitled to receive dividends that would be generated by the on-going shareholders’ hard work.
A Shareholders’ Agreement can provide a mechanism whereby a person’s shareholding is linked to their employment so that if they were to leave they must offer their shares up for sale. Otherwise, there is no requirement for them to sell their shares if they cease to be employed by the business.
A Shareholders’ Agreement can go further and include a mechanism that sets different valuation mechanisms depending on the circumstances under which the relationship with the company comes to an end.
As a matter of law, a company’s articles of association and any amendments are open to public inspection at the Companies Registry however members of companies may not always wish for all the agreements which detail how the company is to be run and operated to be so publicly available. In the circumstances, if the members wish to agree on something between themselves then they may enter into a shareholders’ agreement.
It is still very common for sophisticated investors to use a shareholders’ agreement, particularly where the shareholders are several companies entering into a joint venture.
Away from the privacy element, companies with complex decision-making mechanics designed to protect the interests of several shareholders, a potential contracting party who reads the constitution may be able to obtain a negotiating advantage through awareness of the company’s internal power dynamics.
Does a shareholders’ agreement override the articles?
Shareholders’ agreements will frequently have something called a ‘supremacy clause’ which provides that in the event of a conflict between the agreement and the articles of association the provisions of the shareholders’ agreement would prevail. However, in all other cases, the articles of association normally prevail.
It is good practice for a company to adopt new articles of association when a shareholders’ agreement is put in place so that the articles are commensurate with the terms of the shareholders’ agreement. Moreover, matters such as issues and transfers of shares, board meetings and shareholder meetings are often best dealt with in the company’s articles of association rather than the shareholders’ agreement because unlike shareholders’ agreements, which are only binding on the parties to the shareholders’ agreement, the articles of association are automatically binding on all members.
What should a shareholders’ agreement include?
A shareholders’ agreement usually contains a series of mutual promises by the parties to the agreement, which provide the consideration for the contract. Examples include the following.
- An undertaking that the subject company will not alter or modify the provisions of its memorandum or articles of association, or will not do so without the consent of all the parties;
- Similar undertakings regarding changes to the capital or share capital structure;
- Requirement for unanimity for major decisions, for example, the sale of the business;
- Restrictions on borrowing;
- Agreement on dividend policy;
- Any dispute to be referred to arbitration;
- The right for each party or specific parties to be an officer of the company and/or be employed or take part in the management, or right to nominate a specified number of directors;
- Agreements on confidentiality;
- Agreement on intellectual property;
- Duration of the agreement and exit provisions, for example, buy out rights (or against) all particular members; pre-emption rights; option agreements;
- Provisions for the resolution of a deadlock;
- The denial of an intention to create a partnership (in a joint venture company);
- The power to require other members to join in a resolution for the voluntary winding up of the company.
How do you enforce a shareholders’ agreement?
A shareholders’ agreement is a legally enforceable contract and the rules on its enforceability, and the remedies available in the event of a breach, will in many cases be the normal rules of contract law.
The legal effects of a breach will depend principally on the facts of each individual case but the four most likely and common consequences of a breach are as follows:
- The innocent party may elect to terminate or affirm the contract.
- Damages may be recoverable by the innocent party in respect of the loss suffered as a result of the breach.
- The court may order specific performance of the contract or of the provision breached; and
- The innocent party may seek an injunction to prevent a threatened breach.
The starting point of any discussion of damages is that as a general rule, the aim of an award of damages is to put the innocent party in the position he would have been had the breach not occurred, had the contract, in other words, been performed.
In the context of shareholders’ agreements for private limited companies, the question of quantifying the loss can be difficult. Where there is no ready market for the shares the loss suffered by a shareholder as a result of another shareholder’s failure to perform under the agreement may be difficult to calculate, assuming in the first place that loss of share value is the correct way to test lost expectation.
Another method is a specific performance which is a remedy that can only be awarded by court order and it requires the party in breach to perform as specified by the terms of the contract. Specific performance is an equitable remedy that is only awarded at the discretion of the court.
It is generally accepted that certain types of contract, notably for personal service, will not be specifically enforceable but a commercial agreement such as a shareholders’ agreement should in the appropriate circumstances be enforceable. In making an order for a specific performance, the court directs that the defendant honours an unperformed contractual promise. Like all equitable remedies, there are severe limitations to its exercise.
Breach of a negative stipulation in a contract may be restrained by an injunction. Its use is very limited being employed in restraint of trade, where it is often the most effective remedy coupled, even when coupled with a damages claim and in such areas such as breach of copyright and patent contracts. The general rules of equity which apply to the grant or otherwise of specific performance also apply in general to the injunction.
Under the standard rules of contract law, any party to the shareholders’ agreement may, if no provision is made in the agreement to resolve disputes, seek a declaration, damages, an injunction or order for specific performance to stop other parties to the agreement acting contrary to its terms. The effect of an injunction may however indirectly fetter the company’s ability to exercise its statutory right to alter its articles, capital, structure or any other similarly protected provision.
This involves the power of the court to order the putting right and correction of the written terms of a contract so that it accurately reflects the original agreement of the contracting parties. The original or the prior agreement may have been oral, or in writing, but because of some mistake, it has not been properly reproduced in the final document.
This equitable remedy is, like the other equitable remedies, discretionary in nature. When given, it is an order of the court to restore the status quo ante i.e. the position the parties were in before the contract was made, whereas, if a contract is rescinded for breach the effect is not retrospective. This remedy is frequently used in connection with mistake and misrepresentation. It can be a very important remedy in the context of a shareholders’ agreement where the best solution might be for the parties to be able to walk away.
This term means ‘as much as the person deserves’ and is an alternative to damages in some cases. This remedy arises when a person provides benefits in the belief that the contract exists when in law it does not; or where a defendant prevents a claimant from completing the contract. It arises when a person provides benefits in the belief that a contract exists when in law it does not; or where the defendant prevents the claimant from completing the contract. This remedy is often linked to benefits obtained by the defendant, but not paid for. For example:
- A service is rendered with the intention that it should be paid for, but the actual level of payment is unspecified and is subsequently disputed. The Court must fix the amount due;
- A defendant wrongfully repudiates a contract and prevents the claimant from completing it after some performance has already occurred; or
- A contract is upset on the grounds of mistake, but services were rendered in the belief that the contract.
How is a shareholders’ agreement terminated?
In commercial law, the existence of a company is terminated by liquidation, the details of which are beyond the scope of this insight. However, a distinction should be drawn between the termination of a shareholders’ agreement and the liquidation of the company. The most common situations which may lead to termination of a shareholders’ agreement include:
- Breach of the agreement in certain circumstances by a party;
- Expiration of a fixed term;
- The occurrence of an event that indicates either the success or failure of the venture;
- A party ceasing for any reason to be a shareholder in the joint venture company;
- Merger, acquisition or amalgamation with other companies by either party;
- Management deadlock; and
- Insolvency of the venture vehicle or of a party to it.
Where the contract provides for its termination on the occurrence of a certain event or on the expiry of a fixed-term at common law, but subject to any relevant statutory provision the parties are free to enforce such a provision.
The issue becomes more difficult where the contract provides that it is to terminate on a breach by a party of one of its terms but also seeks to exclude a party’s common law right to terminate further performance of the agreement in the event of a breach. Whether an exclusion of the common law right is effective is a matter of construction of the contract.
It appears that a reference in a termination provision to it being “without prejudice to the other rights and remedies” will preserve common law remedies. As the type of damages recoverable may be different depending on whether a party is pursuing an action for breach of contract or relying on a termination clause. The point here is that it should be considered from the outset.
As always, care with the drafting of every provision in a shareholders’ agreement (as in any contract) including the provisions relating to the transfer of shares or termination is essential
We can draft a Shareholders’ Agreement to reflect all of your needs and manage any and all requirements of shareholders. We can do this at the commencement of trading or, if your company has grown or is growing, once it has become established and on an ongoing basis.
What happens with no shareholders’ agreement?
The Articles of Association are not intended to be an exhaustive list of terms that will protect the shareholders in the event of a conflict or other issue. Their purpose is to cover a range of common/generic situations that may impact the shareholders but will not provide protection in a more complicated situation.
For a simple company where you control voting powers sufficiently to change the Articles of Association then this may not be an issue, however, in the event that the company is growing with multiple shareholders meaning no individual has control then this could prove problematic. By failing to have a shareholders’ agreement in place any dispute could create a deadlock hampering progress in the company.
Here are some examples of what could happen without a shareholders’ agreement in place:
- Minority shareholders can block sales of shares: When investing in a company you may have an end goal in mind where you’d like to sell your stake. Not all shareholders may share your view though and would like to continue their investment. Without a shareholders’ agreement, a minority shareholder could have the potential to block a sale. A shareholders’ agreement could provide either a tag along provision which enables minority shareholders to sell on similar terms or drag along provisions that would force minority shareholders to sell.
- Shareholders sell to an unknown third party: Without a shareholders’ agreement a shareholder has the possibility of selling their shares to whomever they please which could result in losing control of the company
- An unresolvable dispute: Relationships in business are unpredictable and no matter how great things seem there’s always the possibility of a falling out. Having a shareholders’ agreement in place can provide an instant solution should these kind of disputes occur.
- Shareholders leave the company to set up a competing business using inside knowledge: The Articles of Association do not provide protection from a shareholders leaving and setting up a competing company. Having a shareholders’ agreement in place can prevent any departing shareholders setting up a competing business or tempting customers, suppliers or staff away.
- A lack of shareholders’ agreement can put off investors: Without a shareholders’ agreement in place any potential investors may be concerned that any dispute could devalue their investment. Having the agreement in place shows a level of professionalism that can give them confidence to invest their cash.
- Some shareholders are not investing equally: In a normal situation dividends, voting rights and shares are divided up equally based on the level of initial investment. However if going forward some shareholders are not investing this can cause contention. With a shareholders’ agreement this can be adjusted if some shareholders are investing more than others.
Please do not hesitate to contact a member of our team to discuss any matters relating to your business. We look forward to speaking to you.
Sources and further reading
- ‘Shareholders’ Rights’ (4th) Robin Hollington Q.C
- ‘The Law and Practice of Shareholders’ Agreements’ K Reece Thomas and C L Ryan
- ‘Goode on Commercial Law’ (5th) Ewan McKendrick
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