Commercial/Employment UPDATE

Issue No.9 June 2005

Shareholders’ Agreements

In the last of our case studies highlighting the importance of Shareholders’ Agreements we look at what might happen if an individual shareholder dies or becomes bankrupt without a Shareholders’ Agreement being in place and the problems it may cause surviving or continuing shareholders.

Case Study 5 – There are two things certain in life death and taxes

Nelson and Hardy, the closest of friends, owned respectively 55% and 45% of the issued share capital of Southern Spain Cruises Ltd, a successful company, which, having sunk the competition and buoyed by recent profits, they were considering floating.

It was then that tragedy struck. Nelson’s life was cruelly cut short. Upon a famous victory in the amateur international squash championship over his deflated rival Monsieur Villeneuve, Nelson turned a blind eye to those tell tale chest pains and suffered a massive heart attack.

In his Will Nelson left all his worldly possessions, which of course included his shares in Southern Spain Cruises Limited (the ‘Company’), to the love of his life Miss Hamilton, a lady famed for her extravagance. Miss Hamilton and Hardy had never been close. Each thought the other a poor influence on Nelson, though now they found themselves in business with one another. Hardy offered to buy the shares in the Company now held by Miss Hamilton, but Miss Hamilton had no intention of selling. With a majority stake in the Company and with the advice of her lawyers she wasted no time in appointing herself and others close to her, to the board of the Company and removing Hardy as a director.

Shareholders’ Agreements can contain provisions whereby if a shareholder dies, the shares held by that shareholder are automatically offered to the surviving shareholders. The Shareholders’ Agreement can provide that the surviving shareholders and the Personnel Representatives of the deceased agree a price between them, failing which a price will be determined by a third party.

Life Assurance policies are often taken out on the lives of key men within a business, such policies providing that the proceeds of any claim be paid to the surviving shareholders to enable them to fund the acquisition of the deceased’s shares. Alternatively the proceeds may be paid to the company to fund a buy back of the shares. Clearly, in such circumstances the Shareholders’ Agreement would need to provide the deemed offer is made to the company rather than the surviving shareholders, though upon receipt of such funds the company may still not have adequate distributable reserves to lawfully buy back such shares. A Shareholders’ Agreement can of course provide that the shares be offered to the Company for buy back in the first instance failing which they are offered to the surviving shareholders.

Upon taking over the reigns she decided to use some of the cash she had received under Nelson’s Will to inject as capital into the Company, and arranged for new Shares to be issued to herself. As a result her shareholding in the Company increased to more that 75%, diluting Hardy’s shareholding accordingly. The Company’s Articles of Association did not contain pre-emption rights on the new issue of shares.

As we have highlighted in previous case studies Shareholders’ Agreements can place restrictions on majority shareholders, such as preventing the new issue of shares without the consent of the minority, and can also enshrine the right of a shareholder to have board representation.

It wasn’t long before Miss Hamilton’s extravagance caught up with her. Whilst she was busy spending, the business of the Company declined without the leadership of Nelson and the support of Hardy. Miss Hamilton’s debts began to accumulate and upon a petition by the Inland Revenue for unpaid income tax, Miss Hamilton was declared bankrupt. All her assets, including her Shares in the Company passed to her Trustee in Bankruptcy. Miss Hamilton’s debts were considerable and the Trustee in Bankruptcy saw only one solution. As the holder of more than 75% of the Shares in the Company he passed a Special Resolution to put the Company into solvent liquidation in order to realise the asset. The Company was wound up and poor Hardy received a paltry sum for his shareholding.

As with death a Shareholders Agreement can provide that upon the bankruptcy of a shareholder, that shareholder is automatically deemed to have offered his shares to the continuing shareholders. The price for such shares can either be agreed between the Trustee in Bankruptcy and the continuing shareholders or determined by a third party.

A Shareholders’ Agreement can provide for other circumstances, in addition to the death and bankruptcy of an individual shareholder, in which an offer will be deemed to have been made by the ‘leaving’ shareholder to the remaining shareholders. For example, a shareholder leaving the employment of the company or ceasing to be a director of the company, or a shareholder being in breach of the Shareholders’ Agreement. The price of the ‘leaving’ shareholder’s shares might be calculated differently depending on whether he is a ‘good leaver’ or a ‘bad’ leaver. The Shareholders’ Agreement will set out ‘good’ leaver events and ‘bad’ leaver events and will dictate how the price for the leaver’s shares will be calculated in either circumstance.

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.