Commercial/Employment UPDATE

Issue No.8 May 2005

Shareholders’ Agreements

In the three case studies to date we have highlighted the importance of Shareholders’ Agreements in providing a framework in which the relationship between the shareholders of a company can be governed. In particular we have focused on how things can go terribly wrong where the parties have failed to put in place such an agreement. In this next case study we look in detail at the difficulties such failure can cause where a deadlock subsists.

Case Study – Breaking the Deadlock

Romeo and Juliet each own 50% of Globe Ltd. They appointed themselves as directors upon incorporation of Globe Ltd. There are no other directors and the Articles of Association do not provide a casting vote for the Chairman.

When they first got together, Romeo promised Juliet the earth. Globe Ltd began trading and business flourished. These star crossed lovers couldn’t bear to be parted and working together they spent all their time in each others company. But Romeo had a roving eye………

Before long the game was up. A name, what is in a name? A separation, when that name wasn’t Juliet’s in the poetry she discovered in Romeo’s jacket pocket!

But they were still in business together. Globe Ltd was profitable and the future bright. But each day the relationship deteriorated. Juliet couldn’t stand to be in the same office as Romeo and often she wasn’t! Her absenteeism began to cause problems. Further, when she was in the office most of her time was spent picking fights with Romeo or other employees rather than working for the benefit of the business. Further, management stagnated as Romeo found his proposals being blocked by Juliet at board meetings.

Enough was enough. Juliet’s behaviour was beginning to affect profits and Romeo simply couldn’t allow this to continue. He offered to buy Juliet’s shares in the company at an amount which he considered fair given the damage Juliet had already caused the business. Juliet certainly wasn’t prepared to sell her shares at this price nor indeed did she feel inclined to sell at all given what Romeo had put her through. In fact she herself wanted to continue the business without Romeo and suggested he sell her his shares for the same amount that he had offered her. Romeo had no intention of selling his shares. He pointed out that the offer he had made was based, to a large extent, on the fact that Juliet’s recent behaviour had been a detriment to the business. Accordingly, he explained, he deserved considerably more for his shares.

Shareholders Agreements can contain one of a number of mechanisms to enable Shareholders to resolve deadlocks such as the one described above:-

1. ‘Russian Roulette’

Either party (party ‘A’) may serve notice on the other party (party ‘B’) either offering B the opportunity to sell B’s shares to A or offering B the opportunity purchase A’s shares from A at a price set out in the notice.

B then has a period of time in which to accept the offer made in the notice or reject it. If B rejects the offer then the roles of ‘vendor’ and ‘purchaser’ are reversed and B will be required to buy or sell his shares to A. So, for example, if A were to offer B £10 for his shares and B chose to reject this, B would be required to buy A’s shares for £10. Clearly this encourages A to offer a fair price for B’s shares in A’s original notice.

2. ‘Mexican shoot-out’

A may serve a notice on B stating that A is willing to buy B’s shares at a price set out in the notice. B then has a period of time in which to serve a counter-notice either stating that:-

(a) he will accept that offer; or
(b) he wishes to buy A’s shares for a price that is greater than the price set out in the notice.

If the counter-notice served by B indicates that he wishes to by A’s shares then a sealed bid system is put into operation and the person who bids the highest will be entitled to buy the other out. Alternatively the bidding process can be run as an auction.

3. Winding-up

A simple but effective mechanism simply provides that in the event of deadlock the company will be liquidated and the profits distributed. Of course, if the business is doing well, both parties will lose out and such a provision will of course focus the minds of the parties and encourage compromise where possible.

4. Pre-emption Rights and Drag / Tag along rights

One of the shareholders (party ‘A’) may be able to find a buyer for his shares in the Company. Provided a shareholders agreement contains pre-emption rights A will not be able to sell his shares to that buyer without first offering them to the other party (party ‘B’).

A buyer may well want to purchase 100% of the Company. A shareholders’ agreement may provide that where A finds a buyer for his shares, he may force B to sell his shares to that buyer on the same terms (a ‘Drag’ along right). Similarly, should A find a buyer for his shares only, a shareholders agreement can provide B can require A to procure that the buyer purchases B’s shares too (a ‘Tag’ along right).

BUT Romeo and Juliet didn’t have a shareholders agreement! There was only one way to resolve this impasse, an expensive and time consuming Court application.

Typically the application will be:-

(a) a section 459 petition, on the basis that the company’s affairs are being conducted in an unfairly prejudicial manner; and/or
(b) a section 112 petition, on the basis that it is just and equitable for the company to be wound up.

The Court can make such order as it thinks fit if a s459 application is successful, including requiring one shareholder to sell his shares to the other, at a price determined by the Court. The Courts however have found that while even isolated acts of dishonesty by one shareholder towards the other will constitute unfair prejudice, where both shareholders have behaved dishonestly towards each other, such behaviour, whilst prejudicial, may not be deemed unfair. Further, a breakdown in mutual trust and confidence will not be sufficient for a successful application under s459.

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.