How To Resolve Shareholder Disputes
Shareholder disputes can arise in a number of ways, with common reasons being a fall out over the management and direction of the company, shareholders not pulling their weight or no longer working with the business, personal problems affecting business relationships, conflicts of interest, (lack of) dividend distributions, breach of a director’s service contract, or concern over possible illegal or fraudulent activities by any or all of the board.
Disputes often escalate because the parties don’t get advice early on about their legal rights and don’t understand the best options and strategies to follow.
Check your shareholders agreement and articles
As a starting point always study the company’s constitutional documents (its articles of association and any shareholders agreement) to understand the main rules that govern the company and the shareholders.
The shareholders agreement or articles should include several provisions that can assist with resolving any disputes which can save a great deal of time, money and aggravation. Commonly there will be an agreed procedure for forcing a shareholder to sell their shares at set valuations in certain circumstances, such as a shareholder having their service contract terminated or leaving the company for any other reason.
If you have only standard articles and no shareholders agreement yet, it may still be worthwhile as part of the process of resolving differences between shareholders to negotiate a relatively comprehensive shareholders agreement.
When there is already a dispute, it may be difficult to get an agreement on anything, but negotiating a shareholders agreement to solve not just the present problem but future problems is worth a try, or at least a mention.
Producing a shareholders agreement is also helpful in working out how the company is to be run and what powers and limits on decision-making ability each shareholder will have.
Even if you don’t have an agreement it is often helpful to discuss in advance how the company is to be run and what each shareholder can do in various situations in the future. This can highlight potential difficulties at an early stage.
Proposing a resolution at a general meeting to redress the situation
Pursuant to sections 303 to 304 of the Companies Act 2006, if requested by those holding at least 5% of a company’s voting shares the board are obliged to call a general meeting of the shareholders.
The written request should clearly state the general nature of the business to be dealt with and could also include the text of any resolutions to be passed at the meeting. If the request is properly made, the board must within 21 days call the meeting for a date not more than 28 days after the date of the notice calling the meeting. If the request included any proposed resolutions, these must be included in the notice, which will then be part of the business that can be conducted at the meeting. The directors must take care to ensure that adequate notice is given of such general meetings in accordance with the statutory provisions.
In general, most shareholder decisions at a general meeting are taken by a simple majority vote (ordinary resolutions). However, the Companies Act designates a few decisions as ‘special resolutions’ that need votes from shareholders holding a majority of 75 per cent of voting shares to be passed.
By calling such a formal meeting the disagreement between shareholders can sometimes be resolved simply by voting power, or through frank, but hopefully amicable, face-to-face discussions about the meeting’s general subject matter.
Appointing directors and other advisors
Companies I’ve been involved with before have made use of a non-executive director, chairman or board advisor not involved in the day-to-day running of the company to dispassionately resolve disputes between shareholders through mediation and attempting to bring the parties together, particularly where there has been somewhat of a communication breakdown.
If the dispute between shareholders is more related to the strategy and management of the company, such decisions being taken by the board directors, then either by an ordinary resolution by the majority of the shareholders, or by a majority of the board, the company can choose to appoint an additional statutory director (or more) who by voting on board decisions will either avoid deadlock occurring or be more favourable to the wishes of certain shareholders over others.
Bringing in another director (or making another appointment such as a board advisor) to resolve conflicts or offer an experienced and fresh perspective may do wonders for team dynamics, especially for companies that only have two major shareholders.
Removal of a director
As mentioned above, shareholders representing at least 5% of the company’s voting rights can require the board to call a general meeting of the shareholders to consider a resolution to dismiss a director. To be effective, the resolution must be passed at the meeting by more than 50% of the votes cast. This removal power is enshrined in the Companies Act, though the director has the right of appeal. The Companies Act also contains strict procedural requirements, including time limits. It is therefore inadvisable to attempt to remove a director without first obtaining legal advice, especially as there may be other consequences if the director is also a shareholder or an employee of the company.
Some of the main procedural points to note are as follows:
- The member who proposes the dismissal must give the company ‘special notice’ of a resolution to remove a director at least 28 days prior to the meeting at which the director may be removed. The director in question should be given a copy of the notice, and he or she will be permitted to attend the meeting and make representations.
- Minutes of the meeting should be taken which must be kept at the company’s registered office address along with a copy of the resolution.
- The company’s statutory register of directors should be updated to reflect the dismissal and Companies House must be notified of a director’s removal by filing a TM01 form within 14 days of the resolution being passed.
Although the threat of removal can sometimes stop a minority shareholder who is on the board from taking things further, note that if you do go ahead and remove the director he/she could have a claim for unfair dismissal that they may choose to pursue.
Irrespective of the above, there may be specific clauses in a company’s articles, shareholders agreement, directors service contract or any other legal document that enable a director to be removed without passing a shareholders’ ordinary resolution (and following the statutory procedure) if any applicable provisions in such documents are triggered or breached.
Negotiation
For the sake of keeping relationships as cordial as possible and reducing the likelihood of getting involved in costly and time consuming legal action, in the first instance aim to negotiate a workable compromise rather than rely on your strict legal rights. It is almost always quicker and cheaper to negotiate a solution (although using your legal rights as bargaining counters) rather than end up in court.
A solicitor with relevant experience can advise you on the practical and commercial context and what you can realistically hope to achieve in your circumstances.
Ideally, a solution can be reached which enables the aggrieved shareholder to stay with the company. If that is impossible the common options are for the other shareholders to buy out the aggrieved shareholder and/or for the company to buy back the aggrieved shareholder’s shares out of the company’s available reserves at an agreed price. The price will usually include an element of deferred consideration.
Parties will often be advised by their own legal representatives in negotiations and lawyers will usually ensure that an appropriate final agreement is produced and completion of any deal takes place securely.
Employment cause of action
If a shareholder is an employee and there is a bona fide employment dispute such as unfair dismissal, redundancy pay, discrimination, whistle blowing etc. then an option to consider in solving the shareholder dispute is to terminate the shareholder’s employment under an employee settlement agreement.
If the company terminates their employment and buys the shares (or some of them) off the shareholder this way then the employee can get a tax free lump sum up to £30,000 – this will also reduce the company’s profits for that year and therefore corporation tax too.
Bear in mind that the £30,000 tax-free amount strictly applies to non-contractual payments only. Therefore share payments are excluded. However a compensation payment for loss of office may be included within the allowance.
Valuation
In order to help agree on what price a shareholder should be bought out at, it is always a good idea to instruct an independent valuation consultant or accountant who specialises in valuing companies in your industry. After setting certain criteria that should be considered, the parties in dispute can agree to adhere to whatever valuation is produced and complete a transaction based on that figure.
Valuation consultants we work with are always willing to conduct initial discussions and review information on a no cost basis to provide a fee quotation. If you get in touch we’d be happy to recommend someone relevant.
Mediation
If direct negotiations between the relevant parties have not worked, it is often worthwhile trying to resolve the dispute through mediation. Note that if things ever become litigious a court will expect the parties to have first attempted mediation.
Mediation, using an independent lawyer or other professional to facilitate consensus in a confidential and without prejudice environment, can help avoid a dispute escalating and do away with the posturing and position taking which can get in the way of a solution that would otherwise protect the business and kill the harmful dispute.
Mediation is invariably quicker and cheaper than the Court process and has a surprising rate of success even where the parties believe that their relationship has broken down irretrievably. It is estimated that over 90% of disputes brought to mediation are resolved. I have been involved with mediations where parties have been involved in fractious deadlocked discussions for months, but within a day or less of mediation the parties have found a way to resolve their issues.
A mediator usually attempts to achieve a consensus through frank discussions in a combination of meetings with all parties present and private meetings with one party or the other. Unlike a trial there is no judge to determine who is right or wrong which gives the parties an opportunity to consider a wider range of possible solutions and be much more flexible in resolving their differences while removing the risk, uncertainty, costs and emotional strain of litigation.
Mediation is not always the answer for some cases, but with the comparative high cost of litigation and the pressure that the courts are putting on parties to have first attempted to settle by mediation (before pursuing a court judgment), it would be unwise to not at least seriously consider the opportunity that mediation offers as a method of alternative dispute resolution.
Buy out by an external buyer
Although there is often little demand for minority shareholdings in private companies, an external buyer can be found to buy the shares held by a disputing party. Such an arrangement may be facilitated and governed by provisions in the company’s articles or a shareholders agreement that can outline how the purchase price is calculated, among other factors.
In order to induce the seller into a deal it is often worthwhile to negotiate part of the price as a form deferred consideration payable over time following completion. Such payments could relate to the future performance of the company. The buyer will be attracted by the cash-flow benefit while the leaver may obtain a higher price than might have otherwise been achieved if there was only a one off and final payment made at completion.
Depending on the type of deferred consideration it might be agreed that the leaver shall remain as a director (if already appointed) until all payments have been made, or that such leaver is granted certain rights to inspect accounting information, attend meetings and influence decisions so that they have some involvement with the company’s on-going performance. The deferred consideration may also need to be structured so that the reduced entrepreneur’s relief tax rate shall apply as opposed to such payments being viewed as employment income and subject to the higher rate of income tax by HMRC.
The leaver may also require security for post completion payments in order to give them an extra degree of comfort. Security arrangements may include personal guarantees, debentures registered at Companies House, charges registered against any property at the Land Registry and contractual mechanisms such as a buy back of shares (for nominal value) reinforced by a power of attorney.
Buy out by one of the parties
A disputing party can buy the shares held by the other(s) shareholder(s) and in most cases an existing shareholder in the company will be the most motivated to buy out another party, although they will often require access to sufficient personal funds in order to make an acceptable offer. A company’s shareholders agreement or articles of association may facilitate such an arrangement by setting out a number of provisions that govern internal buyout scenarios.
In the context of unfair prejudice minority shareholder actions (see further below), the courts are keen to encourage settlement in shareholder disputes. If a reasonable offer has been made to buy out an ‘aggrieved shareholder’ then it will be difficult to successfully bring a claim.
The remaining shareholder(s) may be able to provide further comfort to the leaver by offering a “non-embarrassment clause” in the share purchase agreement. This works to readjust the original sale price of the leaver’s shares in a situation where the remaining shareholder sells on the leaver’s shares, within a specified time period following the original sale. The remaining shareholder would need to share part of any uplift, which is aimed at ensuring that the leaver doesn’t lose out on a higher sale price within an agreed period of time.
Buy out by company
If there are reserves that can be distributed, then company funds may be used to buy some or all of the shares held by a party in dispute. There will often be provisions in a shareholders agreement or articles of association that provide for and facilitate share buy backs by the company in certain situations. The shares being bought back by the company are cancelled (as opposed to being transferred to another party) which serves to increase the percentage shareholdings of the remaining shareholders pro rata.
Finalising a settlement and completing the buy back will also require the parties to agree on a value for the shares, payment terms (often deferred amounts so as to enable the seller to receive more for their shares) and the extent to which and how soon the outgoing party can compete with the company once their shares have been bought back.
Other than distributable profits, the buyback can also be made from capital but this imposes more stringent formalities and can make the process unattractive.
There are also tax implications that the parties need to be aware of. If certain conditions are met the proceeds of the share buyback may be liable for capital gains tax (CGT) which could be beneficial if the parties qualify for CGT relief. HMRC clearance should be sought on such matters and factored into the timescales of any buyback.
Sale of the whole company
A clean way to resolve the dispute and allow all parties to move on without feeling one is getting a better deal than the other is for all of the existing shareholders to align their interests by selling the company to another party, thus allowing everyone to make a clean break.
Although disappointed as he thought the value of the company would be worth more in the future, one client sold his shares along with his co-founder due to their relationship having eventually broken down irretrievably after years of disagreements. The sale proceeds allowed him to quickly move on and start new businesses that have been much more successful and he is no longer stuck working with someone he doesn’t see eye to eye with.
Dilution of shares
Issuance of new shares can reduce the ownership percentage of old shares. When the number of shares outstanding increases, existing shareholders will hold a smaller or diluted percentage of the company. However, unless such right is dis-applied existing shareholders have a pre-emption right, or first option to buy the new shares (section 561(1) of the Companies Act 2006) – therefore this option may not rid the company of all of the disputing parties if pre-emption rights are unable to be disapplied or waived and everyone exercises their pre-emption rights.
Whether or not the shareholders can dis-apply the pre-emption rights, a company can carry out a formal rights issue/pre-emptive offer, following the correct procedure. This could be used to dilute an inactive shareholder where the company requires further investment and the other shareholders subscribe for shares at a certain valuation set out in the offer letter. Of course this is based on the premise that the inactive shareholder does not wish to put more money into the company to maintain their shareholding and will pass on the opportunity to subscribe for their allocation as notified in the offer letter.
A company can usually dis-apply pre-emption rights on the issue of new shares by passing a 75% special resolution and issue the new shares without recourse to the shareholder that the company intends to dilute. However, this will still usually leave the non-subscribing shareholder with a claim for unfair prejudice which would lead to a court ordering that they should be bought out at ‘fair’ value / market price.
Just and Equitable Winding up
Shareholders that meet certain conditions are entitled to present a petition to have the company wound up on the grounds that it would be just and equitable to do so. This right arises from the Insolvency Act 1986 (IA 1986) under section 122(1)(g). More often than not this type of action is brought by a minority shareholder largely due how the grounds giving rise to the petition can arise. Note, however, that the company itself, creditors of the company, the directors of the company (either pursuant to a resolution passed by a majority, or by all directors acting unanimously) and persons liable to contribute to a company’s assets on a winding up per section 124 of the IA 1986 also have the right to present a petition for winding up.
Petitions are usually presented on these bases:
- Deadlock – Where there is a complete breakdown in relations where as a result, decisions relating to the company’s business cannot be reached. A petition on this ground will fail if the fault of the deadlock lies with the petitioner or the deadlock is justified through the proper operation of the company’s articles of association and/or shareholders agreement to protect the interests of one or more shareholders.
- Mismanagement – When the director’s conduct results in a justifiable loss of confidence on the part of the shareholders. The conduct must be serious to be justifiable (for example fraud). Generally, in this situation the company is the proper entity to bring the claim, although where the company is a quasi-partnership a shareholder can petition on this ground.
- Exclusion from management – Where a quasi-partnership exists or the court finds that a shareholder forms part of the senior management of the company, the exclusion of the shareholder from management may constitute grounds for a just and equitable winding up.
- Loss of substratum – Where the original purposes of the company have been met in full or can no longer be achieved. A failure to meet a commercial purpose when another avenue may be pursued will not amount to a loss of substratum. The petitioner must demonstrate that there is nothing more to do than wind up the company.
In addition to the above, unfairly prejudicial conduct will almost always constitute grounds for petitioning for a just and equitable winding up. As a result, it is common for a claim for unfair prejudice to include a petition to wind up on just and equitable grounds. You can read more about unfair prejudice here.
Derivative claims
A derivative claim may be brought by a company (through its members) for wrong doing by a company’s directors or by third parties. For specific wrong doings by directors and where the court permits, a shareholder can bring an action in their own name on behalf of the company.
The grounds for a derivative claim arise only in relation a cause of action arising from an actual or proposed act or omission (as stipulated in section 260(3) of the Companies Act 2006), specifically in connection with:
- negligence;
- default;
- breach of duty; and
- breach of trust,
by a director of the company.
Note that shadow directors and de facto directors also fall under the definition of director for the purpose of a derivative claim. A shadow director being “a person in accordance with whose directions or instructions the directors of the company are accustomed to act”. A de facto director being a person who acts as a director but has not been legally appointed.
Whilst the cause of action must relate to conduct by a director involving the above, claims may be brought against the director, a third party or both (for example where a third party is accessory to the breach).
The definition of “member” in relation to derivative claims encompasses persons whose shares have been transferred, but are not currently registered members or if the person acquires the shares by another operation of law (for example inheritance). It also includes shares transmitted by operation of law (for example a personal representative of a deceased member). There is no minimum number of shares which need to be held by a member in order to bring a derivative claim.
Whilst any member is permitted to bring a derivative claim, whether such claim continues is at the full discretion of the court. The court’s aim is to avoid concerning itself with the internal politics of the company and allows the court to consider where the claim meets the statutory preconditions and should be continued on the basis of these criteria.
The court may also grant permission for a member to continue a claim in circumstances where the claim has been brought in a manner which amounts to abuse of process, where the company or member fails to prosecute the claim diligently and where it is appropriate for the member to seek permission to continue the claim.
As mentioned above, the court must refuse any claim where it does not meet these preconditions:
- the act, proposed act or omission was done so in accordance with the articles of the company or was duly authorised by the company; or
- a person adhering to the duty to promote the success of the company in accordance with section 172 of the Companies Act 2006, would not seek such action.
If a claim satisfies the statutory preconditions for continuing a derivative claim, the court then has discretion whether or not to permit the member to continue the claim. In exercising its discretion the courts must have regard to all of the relevant matters in section 263(3) to (4) of the Companies Act 2006, including (but not limited to) whether the member is acting in good faith, whether the company has decided not to pursue the claim, or whether a proposed act or omission would likely be authorised or ratified.
Further reading:
How To Sell Or Buy A Private Company Minority Shareholding
Dissolving Discord: shareholder dispute resolution in the UK
