Commercial/Employment UPDATE

Issue No.5 December 2004

Shareholders’ Agreements

In the first of our case studies last month we looked at some of the issues surrounding a 50 : 50 joint venture and how a Shareholders’ Agreement can be used to address those issues. In the second in our series of case studies we look at some of the difficulties that can arise where three parties set up in business together, one of whom holds less than 50% of the issued share capital, but more than 25%, with the other two together holding the balance, being of course more than 50%.

Case Study 2 – Minority Shareholder holding less than 50% but more than 25%

Where a shareholder holds less than 50% of the shares in a company, but more than 25% he can block special resolutions but not ordinary resolutions. The most important special resolution he can block is a resolution to amend the Articles of Association, which, without the benefit of a shareholders’ agreement, at least provides him with a certain level of protection in respect of the rights attaching to his shares. The remaining shares in the company may of course be held by more than one person though if more than one, there is nothing to stop them acting in concert.

Mr Vierzig and Mr and Mrs Trente all decide to set up in business together and incorporate ‘Three’s A Crowd Ltd’ (the ‘Company’). Mr Vierzig contributes £40,000 of capital to business and is issued 400 ordinary shares, Mr and Mrs Trente each contribute £30,000 of capital to the business and are each issued with 300 ordinary shares. The parties agree that they will all be appointed to the board as directors of the Company.

The Company is a great success and makes good profits in the first few years of trading. In year four Mr and Mrs Trente put to the board a resolution approving payment of an interim dividend. Their son Terence wants to do an MBA at the University of Derby and they want to help him financially. Mr Vierzig however predicts tough times ahead for the Company and believes it would be folly to distribute the Company’s distributable reserves at this stage. However, given the Trente’s majority on the board the resolution is passed and the interim dividend is paid.

Shareholders’ agreements can set out a dividend policy. The parties will be bound to procure that the company gives effect to that policy.

Mr Vierzig’s business senses were correct. There is a down turn in the market and the Company starts to lose money. Further working capital is required and Mr Vierzig proposes to subscribe for further shares in the Company thereby injecting share capital. However, the Company has issued all its shares and an ordinary resolution of the Company is required to increase its authorised share capital before such a subscription is possible. Mr and Mrs Trente, as directors of the Company, have a duty to act in its best interests and the terms upon which Mr Vierzig is prepared to subscribe are certainly favourable. However the number of shares for which Mr Vierzig wishes to subscribe would give him more than 50% of the Company and effective control. Mr and Mrs Trente are unwilling to surrender the control they currently have while they act together and would rather borrow money from the bank despite the high interest rates the banks are currently charging. So, while they approve the board resolution to call an EGM for the passing of the ordinary resolution, thereby fulfilling their fiduciary duties as directors, they vote against the resolution at the EGM in their capacity as shareholders, which they are quite within their rights to do. The only alternative is to go to the bank, which Mr Vierzig reluctantly agrees to do.

A shareholders’ agreement can set out how future finance will be raised.

The Company survives, but it has not been an easy ride. Mr Vierzig believes that a number of mistakes have been made by the board. On many occasions the board have resolved to undertake to do certain things despite Mr Vierzig’s vociferous objections. In each instance he has been out voted though time has proved his objections well founded.

A shareholders’ agreement can incorporate any number of management restrictions preventing the company from undertaking certain matters without the consent of all the shareholders.

Despite Mr Vierzig’s clear business acumen the Trente’s have found dealing with him difficult. They find his manner abrupt and whilst they concede that on a number of occasions his warnings have proven well founded, they do not attribute this to a better knowledge of the market but rather to luck. Terrence has finished his MBA and is keen to make his mark in the world of business. His ideas are modern and in contrast to Mr Vierzig’s more traditional approach to business. Mr and Mrs Trente dote on their only son and want to give him first hand experience of running a company. They pass an ordinary resolution electing him to the board of the Company and the board resolves that the Company will enter into a service agreement with him.

Shareholders’ agreements can not only determine the composition of the board, but can set out what the quorum for a board meeting will be, how the chairman will be elected and whether the chairman will have a casting vote.

Another tough year for the Company passes, not helped by the almost daily conflict between Mr Vierzig and Terence. Not only do they have differences of opinion on how to run a business, but hardly seem able to see eye to eye on anything. Mr Vierzig who has made his way in the world with no help from anyone resents the mollycoddled Terence. Terrence in turn sees Mr Vierzig as stuck in his ways, an anachronism. Tensions get to the point where Mr and Mrs Trente suggest that Mr Vierzig steps down from the board, though this only adds fuel to the fire and relations between the Trentes and Mr Vierzig reach an all time low. Finally Mr and Mrs Trente see no alternative but to pass an ordinary resolution resolving to remove Mr Vierzig from the board and Mr Vierzig is forced to step down.

A shareholders’ agreement can enshrine a shareholders’ right to appoint one, sometimes more than one, individual to the board, while he retains shares in the company.

Mr and Mrs Trente believe that Terence needs a stake in the Company in order to properly motivate him. They call an EGM and resolve to increase the authorised share capital of the Company so that Terence can subscribe for shares at a price determined by the board. The board determine a price for the shares which puts a price on the Company as a whole much lower than the value which Mr Vierzig believes it to be worth. Mr Vierzig has a pre-emption right granted to him by virtue of the Companies Act, but his cash is tied up in other investments and he is unable to exercise this right. He is advised that he may have a claim that he has been unfairly prejudiced by the other shareholders on account of shares being issued at an undervalue though it will be difficult to prove given that he had a pre-emption right and that the shares were issued at an undervalue only to motivate an employee.

Over the next few years further subscriptions for shares are made, each time Mr Vierzig is unable to exercise his pre-emption right for one reason or another and gradually his shareholding is reduced from 40% to less than 25%. The trials and tribulations of Mr Vierzig continue after his shareholding was reduced to below that level, but that’s a whole other case study!

Shareholders’ agreements can prohibit any new issue of shares or options to subscribe for new shares without the consent of all parties.

Note:

Please note that this newsletter is not intended to be a comprehensive statement of the law and should be used for guidance purposes only. If you require specific legal advice please contact Mark Machray or Edward Bond or by telephone 020 7493 2903.