Shareholder disputes: How to avoid an ugly corporate divorce

What a crazy year it has been! One trend in the business world that has become more evident to us is a sharp rise in shareholder disputes. These disputes have involved issues such as concerns over access to information, dissatisfaction with decisions at the board and management levels of the business and frustrations with certain actions of business partners (including dealings with shares in the company and company assets). Of course, the easiest and cheapest way to resolve these disputes is for the business partners to talk it through with one another and work out a path forward. However, often the people involved are so adamant that their perspective is right and that of their business partner(s) is wrong, therefore, a negotiated outcome proves very difficult to achieve.

It is usually when the discussions between the business partners have failed that the phone rings and the client explains to us that they want to know how to force their business partner to leave the business and sell their shares, or how to force their business partner to buy their shares in the business so our client can move on with their life.

At this point, all too often, there is an awkward silence when we ask whether the shareholders agreement or the constitution of the company provides for a right to compel the sale or purchase of shares simply because the business partners have had a falling out. The silence is commonly the result of the fact that there is no shareholders agreement, or – if there is a shareholders agreement – neither it nor the constitution gives the parties the right to force an exit from the company on acceptable terms.

The importance of smart structuring and decent contracts
Ideally, the investor should seek to have a majority ownership stake in the legal entity and to be able to control the decision-making at the board and management level of the business. That said, it is not uncommon for business people to take a 50:50 stake in a business entity with another partner, or to take a minority ownership stake, frequently alongside other business partners or investors. This means, among other things, that they may not have control of the board of directors of the entity. Sometimes there are strategic, commercial and financial reasons for opting for a 50:50 or even a minority stake. Whatever the reason, the shareholder should ensure that they protect their interests as well as possible from the outset.

Prevention is better than cure

Prevention is usually more effective and certainly cheaper than a cure. Shareholders would do well to seek professional advice on how they can, for instance, buttress the protection of 50:50 owners or minority parties and how they can best structure their investment. If investors do invest in a legal entity (and especially where they do so as 50:50 or minority investors), they would be prudent to do the simple things well, such as:

• ensuring that they negotiate contractual arrangements in their shareholders agreement, subscription agreement and/or constitution which protect their rights and interests
• agreeing upon the operation and governance of the legal entity in constitutional documents, whose binding effect is recognised and enforceable
• negotiating clear and strong safeguards in the relevant documents
• maintaining a copy of the relevant contracts and documents (Australian corporations law does provide a shareholder with the right to obtain a copy of an Australian company’s constitution, but it is always easier if the shareholder protects their own right upfront by keeping a copy in their possession).

To the extent possible, if investors become minority shareholders in an Australian legal entity, they would also be wise to:

• seek representation on the board of directors of the legal entity. Company directors have the power to manage the business of the company. Subject to specific requirements of the entity’s constitution, directors are not required to consult shareholders or obtain shareholders’ consent before making decisions about the company which the directors are empowered to make – including, for instance, the issue of shares in the company or the sale of company assets
• adopt a structure that allows for a degree of disproportionality between decision-making powers and equity involvement or ownership, such as rights to appoint and replace key management personnel, rights to consent to the creation of any security interest over the shares in the legal entity that the other shareholders may wish to put in place, and reserve powers like those described in more detail below
• include in the shareholders agreement and the company’s constitution explicit “information rights” to ensure the investor has unobstructed access to the company’s financial, operational and other important information. Depending on the type of company, applicable corporations law provides shareholders with limited rights to inspect the books and records of the company, but this may require the shareholder to apply to the court for an order authorising the shareholder, or another person on the shareholder’s behalf, to inspect the books of the company
• provide protections in the company’s decision-making procedures as outlined in the shareholders agreement and the constitution (e.g., specify a right to, and proceedings for, summoning regular and interim board and/or shareholders meetings, ensure that the quorum of any board meeting consists of at least one director appointed by the shareholder, and make sure that sufficient notice is given to directors before board meetings, etc.
• provide for anti-dilution controls in the shareholders agreement and the constitution
• specify any particular “reserve powers” of the board or shareholders’ meetings which require unanimous or special majority approval, or include veto rights over reserved matters so that the minority shareholder can block undesirable resolutions in respect of material transactions by the company or material changes to the company
• include in the relevant documents clear and workable exit mechanisms (e.g., put options, call options, tag-along rights, good leaver or bad leaver clauses) or similar arrangements (e.g., redemption rights, buy-out option, Russian roulette) so that the investor has a way out of a bad business or a soured relationship, or a way to squeeze out an uncooperative partner
• include in the relevant documents a termination right which captures deal-specific circumstances in addition to other general law termination rights
• avoid restrictive covenants and non-compete obligations, if possible, or at least ensure that any such restraints are reasonable and don’t serve to make the investor a prisoner of the legal entity when the shareholder relationship has ended
• play an active role in the strategic, operational and financial management of the company or place appropriate limits on the authority of management if it is not possible to play an active role in the management or appointment of management personnel.

Be prepared for the fight

If it becomes clear that there is no way forward for the parties to remain in business and they need to go their separate ways, then having a good quality shareholders agreement and constitution will help. It would also be helpful if the shareholder understands their legal position under Australian law. The law provides mechanisms for upholding the rights and interests of shareholders (and minority shareholders in particular). For instance, the Corporations Act 2001 (Cth) (Act) provides the following, among others, statutory protections of shareholders’ rights:

Knowing how and when these rights can be applied to obtain leverage in respect of negotiated or court-ordered outcomes is crucial for all business owners of private companies.

Parties can use independent facilitators before getting into the deal to help work out what the shareholders arrangements might be. When shareholder disputes arise, it is often best to get legal help sooner rather than later, even during the “negotiation phase” of the dispute resolution process. It often makes sense to involve independent expert mediators to help resolve the more bitter and entrenched shareholder disputes.

Parties should also be aware that they would be best placed speaking with their lawyers before appointing independent expert valuers to value the parties’ shares in the legal entity. This is especially the case where the independent expert valuer’s valuation decision is binding on the parties.

Whilst it is unfortunate for many business owners that these trying times will likely see a further spike in shareholder disputes, having an understanding of the basic legal concepts discussed above can assist business owners to avoid any such disputes spiralling out of control into emotionally and financially destructive legal fights.

For a more in-depth discussion on shareholder disputes, click here to register and watch our presentation which covers how to best approach resolution of shareholders disputes using alternative dispute resolution and/or litigation, key issues to be aware of when acting as a minority shareholder and the protections available for these shareholders.

If you need any assistance on avoiding or resolving a shareholder dispute, please contact us. 

Authors: Carl Hinze & Toby Boys

Disclaimer
The information in this publication is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, we do not guarantee that the information in this newsletter is accurate at the date it is received or that it will continue to be accurate in the future.

Published by:

Toby Boys

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