When multiple parties hold shares in a business in which they are actively involved, it’s inevitable that differing views about the best way to run the company can arise throughout the course of the business relationship, which can sometimes lead to a breach of the shareholder agreement that’s in place.
In this guide our shareholder dispute solicitors cover some key aspects of the nature of shareholder agreements, including what constitutes a breach, the consequences of a breach, available remedies and termination of a shareholder agreement.
- What is a shareholder agreement?
- What will a shareholder agreement contain?
- When might you have a shareholder agreement?
- The benefits of having a shareholder agreement in place
- What constitutes a breach of a shareholder agreement?
- Consequences of breaching a shareholder agreement
- Remedies for breach of shareholder agreements
- Terminating a shareholder agreement
What is a shareholder agreement?
A shareholder agreement is a form of agreement between some or all of the shareholders in a company, and it sits alongside the company’s Articles of Association. A shareholder agreement protects the shareholders’ investment in the company, act as a governance mechanism and will set out the finer details of the working relationship between the shareholders.
What will a shareholder agreement contain?
A shareholder agreement will contain rules which regulate the relationship between the shareholders and it will usually include protections for both majority and minority shareholders, along with providing the added advantage that it will require little or no ongoing administration. The agreement will also:
- Outline how the company will be run;
- Define the shareholders’ rights and obligations;
- Define how key decisions will be made and by who;
- Regulate the sale of shares in the company (including the sale of material assets);
- Outline the appointment and dismissal procedures in relation to directors;
- Act as a record of agreement as to what can and can’t be done and prevent claims that something was agreed when it was not.
When might you have a shareholder agreement?
Whilst one can be put in place at any time and there is no legal requirement to compel a business to have one, it’s strongly advised that a shareholder agreement is drawn up as soon as possible in the early stages of the formation of a company. A new agreement is also crucial when:
- The company’s business model changes
- A director-shareholder is newly appointed, resigns or exits the business
- A shareholder passes away
- A shareholder wishes to sell their shares
- Shares are issued to a new shareholder
- The company borrows money from a shareholder
- One shareholder’s holding is divided amongst several others (for example, their children in the event of their passing)
The benefits of having a shareholder agreement in place
The benefits of having a shareholder agreement in place are multiple in number, and the below are just a few key examples to highlight:
- Aids dispute resolution - If a situation gives rise to conflict between the shareholders, an agreement will set out the procedure as to how that will be resolved and the positions of both the majority and minority shareholders will be considered and defined within the agreement.
- Provides guidance in situations of deadlock - In addition to the above, a shareholder agreement will outline what course of action should be taken if a deadlock situation occurs, e.g., through meetings and voting systems.
- Assists with overall company management - Details on how the management of the company should be undertaken can be outlined in a shareholder agreement (along with the company’s Articles of Association). This detail can include what the structure of the company should look like, the nature of the business, how transactions and clients are to be dealt with, the aims of the business and its obligations and which actions require unanimous or majority shareholder consent.
- Can outline competition restrictions - A shareholder agreement can outline protective measures for the shareholders and the company itself in terms of non-competition. (N.B. It’s recommended that you take legal advice on any competition restrictions before including them in the agreement, due to the fact that such issues can quickly become contentious.)
- Provides a mechanism for issuing and transferring shares - An agreement can include provisions governing the issue of and transfer of shares to another party by way of outlining the rights and powers as to the transfer, along with providing structure for the procedure involved in the valuation of the worth of the shares.
- Brings clarification in relation to profits and losses - A shareholder agreement can be useful (in tandem with the Articles of Association) in determining how and when profits are distributed and can cover the liability for losses between shareholders/how the need for further investment is dealt with if required.
- Establishes shareholders’ rights, powers and restrictions - Importantly, an agreement will bring clarification as to the rights, powers and restrictions of both the majority and minority shareholders. It will also set out the process that needs to be adhered to as to how a new shareholder can purchase shares.
What constitutes a breach of a shareholder agreement?
Put simply, when an action is taken which violates the terms of a shareholder agreement, this constitutes a breach. There are various ways in which an agreement can be breached, and a few examples include:
- A decision being made by the company without the required majority of shareholders
- Shares are sold or transferred in a manner that contravenes the rules outlined in the shareholder agreement
- A breach of the confidentiality obligations set out in the agreement
- Breach of restrictive covenants by one or more shareholders
Consequences of breaching a shareholder agreement
Whilst it may be determined that the above actions are found to be valid, in circumstances where a breach has caused loss to the other shareholders, those shareholders may have a claim for breach of contract against the offending shareholder(s), along with their shareholder voting rights potentially being be suspended (in cases where the shareholder agreement specifically states that this should happen).
Remedies for breach of shareholder agreements
The most common remedies for the breach of a shareholder agreement can be summarised in the following categories:
Where the shareholder loss can be quantified, monetary damages are one of the main possible remedies for the breach of a shareholder agreement. The aim of an award of damages is to put the innocent party in the position they would have been had the breach not occurred. When assessing the level of damages to be awarded, the court will consider the elements of loss of profit, restitutionary interest and reliance interest.
Specific performance is a type of remedy that can only be awarded by way of a court order and is subject to the court’s discretion. Because the nature of the remedy is that the court would direct the offending shareholder to honour an unperformed contractual promise, it doesn’t necessarily lend itself to being a suitable type of remedy for all businesses or all types of shareholder disputes.
Breach of fiduciary duty where the offending shareholder is also a director
In circumstances where the offending shareholder is also a director (often the case with small and medium-sized businesses), the lines between the two roles can become blurred and this can give rise to problems within the business. A claim might arise against a director/shareholder in this scenario if, for example, the person in question was diverting business away from the company to their own business, or taking a commercial opportunity for themselves/simply failing to act in the best interests of the company for their own or other people’s benefit. This would almost certainly constitute a breach of the shareholder agreement, however, any claim for a breach of fiduciary duty would be a claim brought by the company against the individual in question rather than by other shareholder(s) party to the agreement.
It may also be possible for the claimant shareholder(s) to take action on behalf of the company, but this is dependent upon several variable factors that would turn on the specific facts of the case.
In certain cases, an injunction can be a suitable remedy for a threatened breach of a shareholder agreement. This could, for example, be to stop another shareholder being voted off the Board, or to force a shareholder who is guilty of wrongdoing to transfer their shares. (It’s worth bearing in mind here that seeking injunctive relief can unfortunately be a costly process.)
Claim for unfair prejudice under the Companies Act 2006
If grounds are successfully made out for a claim of unfair prejudice (claims which typically arise when majority shareholders, who are often also directors, use or abuse their powers to the detriment of the minority shareholders), the court can make any order it sees fit to remedy the position. This might include requiring/preventing the company to perform an act, ordering one party to buy another party’s shares or regulating the future conduct of the company.
Without prejudice discussions as a remedy for breach
In some cases, it might be appropriate for a breach of the shareholder agreement to be remedied efficiently by way of a ‘without prejudice’ discussion between the shareholders. The purpose of this could be to agree exit terms where the nature of the breach is such that the shareholders can no longer continue working together. (N.B. The nature of a without prejudice discussion would mean that if, following a free-flowing, “all cards on the table” conversation, the parties cannot come to a mutually agreeable solution, anything said during the discussion cannot be legally used to “prejudice” any party’s position in subsequent formal legal proceedings.)
Terminating a shareholder agreement
There are certain factors to consider when it comes to the termination of a shareholder agreement. There will usually be a clause in the agreement itself which stipulates the reasons why the agreement might need to be terminated as the starting point to this process, and it should include provisions relating to the transfer of shares, for example, upon termination (including such clauses is advisable at the outset when the agreement is drawn up in order to make the process as efficient as possible).
Termination of a shareholder agreement usually requires the consent of all shareholders who are party to the agreement, and it’s worth bearing in mind that the agreement may contain post-termination restrictive covenants, for example, to prevent a former shareholder from setting up a competing business within a defined timeframe post-termination.
Any post-termination restrictive covenant must seek to protect a legitimate business interest and go no further than is reasonably necessary to protect that interest. Again, careful drafting at the outset of any covenants of this nature is imperative to maximise their chances of being successfully upheld as enforceable by the courts if necessary. Case law suggests that such provisions in a shareholder agreement will be subject to more forgiving scrutiny by the courts (than in an employment contract scenario) and are more likely to be interpreted as reasonable and therefore enforceable on the basis that they were freely negotiated between the shareholders at the outset.
Change of control
One other example of what might lead to the termination of a shareholder agreement in accordance with the terms of it would be a situation where a change of control is triggered, i.e. in relation to the structure or the ownership of the company. Again, this is likely to warrant legal advice to ensure that such a change is handled correctly and in accordance with any terms in the agreement.
It’s clear that having a shareholder agreement in place is sensible for entrepreneurs starting a new business, and that any such agreement ought to be reviewed when there are any structural changes within the framework of the company. The cost of resolving disputes between shareholders in the absence of a well-drafted agreement will far outweigh the cost of engaging a lawyer to draw one up at the outset. This article demonstrates that there a multitude of ways in which such agreements can be breached and that the appropriate remedies for the corresponding breach often turn upon the facts of each particular case.
If you believe another shareholder has breached a shareholder agreement and you would like some practical legal advice, call our business dispute solicitors on 0808 501 5117, email us at email@example.com, or fill out the short form below with your enquiry.