Hell hath no fury like a business partner spurned

Whilst we focus on business conducted through a private company.  Similar ideas apply for other business structures such as partnerships and limited liability partnerships.

The pre-nup
The first opportunity for the shareholders in a new company to regulate their relationship is through the company’s articles of association.  The articles are an agreement between each of the  shareholders and the company which regulates the structure and management of the company.  There are a number of very commonly used standard forms – examples have been included in the Companies Acts going back many years.  However, the shareholders can agree at the outset to utilise bespoke rather than off-the-shelf articles.

The articles are a public document − anyone interested in the company can obtain a copy from Companies House.  For this reason, many business people prefer to use standard form articles while recording their specific agreements in a private shareholders’ agreement.

In either case, some of the areas that are very commonly tailor‑made are: (i) the mechanisms for shareholders to exit their investments, including pre-emption rights and processes to determine fair value, (ii) rights to nominate directors to the board, (iii) areas of particular strategic importance and the nature of the resolutions required to enact decisions in those areas, (iv) dividend policy and (v)  events that give rise to a right to terminate the agreement and the consequences of termination.

The intention, in tailoring the articles or entering into a shareholders’ agreement, is to anticipate the types of issues that are fertile grounds for disagreement, and agree in advance the investors’ rights and obligations.

The rocky patch
The following simple example contains some classic ingredients that appear time and again in shareholder disputes.  Five investors take equal stakes in a new company.

Each has a seat on the board from the outset.  As soon as the company turns to profit, the board votes regular dividends.  Following a strategic dispute, one investor falls out with the other four.

The majority votes to remove the minority from the board.  The majority then votes to start paying the directors large salaries, and refuses any further dividends.  What can the minority do to remedy this?

The divorce
If the actions of the majority are in breach of the articles or any shareholders’ agreement, the minority can bring a breach of contract claim seeking damages and/or an injunction compelling the majority to manage the company in accordance with those agreements.  If the minority wants to exit his investment, he can exercise his agreed exit rights to obtain fair value for his share from either a third party or the majority.

But what if the shareholders’ agreement doesn’t seem to reflect the long-standing agreement about the management of the company, or there is no shareholders’ agreement and the majority appears to have acted within the terms of the articles?

All is not lost for the minority.  The law recognises that obligations between investors may exist outside the terms of their written agreements.  The minority may have a ‘legitimate expectation’ that the company will be managed in a particular way, even if the strict wording of relevant agreements allows for something different.

For example, where all the investors participate in the management of the company from the outset, a legitimate expectation is likely to arise that each investor is entitled to a seat on the board so long as he retains his investment.

In these circumstances the minority may petition the court for a declaration that the company’s affairs are being conducted in a manner that is unfairly prejudicial to the minority’s interests as a shareholder.

If unfairly prejudicial conduct is established, the remedies available include orders regulating the future conduct of the company’s affairs and/or that one side buy out the interest of the other.  A shareholder may also petition that it is ‘just and equitable’ that the company should be wound up.  However, a court typically will not wind up a going concern if the petitioner does not first offer the opportunity to buy out his share at a fair value.

Where trust and confidence between the investors in a private company irretrievably breaks down, it is usually sensible for one party to exit the investment. The argument is then limited to determining the fair price of the shareholding. Sadly it is often difficult to arrive at that point, particularly if the company appears to be thriving and neither side wants to give up its interest.

A well drafted shareholders’ agreement may save a lot of anguish down the line.

[box]Stephen Hayes is a Senior Associate in the Litigation department of Fladgate LLP.  He advises clients on commercial disputes including shareholder and partnership disputes. [/box]