A stark illustration of the need for a Shareholders’ Agreement

Introduction

A recent High Court decision concerning an unsuccessful prejudiced shareholder claim under section 174(2) of the Companies Act highlights the need for SMEs (and especially family businesses) to think carefully about (and plan for) the changing needs of stakeholders over time.

The case concerned a well-known retail business started by two brothers in 1983. Because the business also owned the premises – two companies were formed (one to operate the business and the second to own the premises). The shareholdings in both companies reflected the brothers’ initial capital contributions – with the older brother holding just over 50% and the younger brother just under 50%.

More than three decades after the business was started, the younger brother brought a claim, under section 174 of the Companies Act, that his older brother is conducting the companies’ affairs in a manner unfairly prejudicial to him as a shareholder. Consequently, he sought relief under section 174(2) by way of acquisition of his shares, or payment of compensation, or the companies’ liquidation.

Background

Both brothers were directors and initial both worked fulltime in the business. For many years their respective families also worked in the business (the older brother’s family mostly full-time – and the younger mostly worked as casual employees when required).

The brothers were paid at agreed hourly rates in a manner designed to reflect their input into the business – with their hourly earnings being topped (paid as a bonus) up from operating surpluses, plus a profit share which were paid in proportion to the shareholdings. Both wives initially were paid salaries, but that reverted to hourly rates in later years as the business became less profitable.

In 2003, as a result of ill health, the younger brother substantially reduced his day-to-day input into the business (and his remuneration dropped accordingly). The older brother’s remuneration increased – because of his extra hours in his brother’s absence.

In keeping with many retail businesses, the combined impact of increased competition (traditional and online) meant that the business suffered a decline in turnover and profitability – and had largely declared losses in the first half of the present decade. In 2012 additional capital was required to be injected into the business. At this stage, the older brother contributed in proportion to his shareholding (and the younger brother contributed a much lower proportion because he was earning les from the business). The brothers also agreed to halve their hourly rates. At this stage the business was no longer paying rent to the property-owning company.

By March 2013, the brothers were at loggerheads and the rift continued until late 2015, when the younger brother resigned as a director.

Prejudiced shareholders

Section 174 of the Companies Act enables a shareholder (or former shareholder) or any other ‘entitled person’, who considers that the affairs of a company have been, or are being, or are likely to be, conducted in a manner that is oppressive, unfairly discriminatory, or unfairly prejudicial to them – to apply to the Court for a range of orders.

Although failure to comply with specified sections of the Companies Act constitutes “unfairly prejudicial conduct” for the purposes of section 174, the Courts have held qualifying conduct does not need to be unlawful or exercised in bad faith. Instead, section 174 is described as a remedial provision designed to allow the Court to intervene where there is a clear departure from the standards of fair dealing and, in the light of the history and structure of the particular company and the reasonable expectations of the shareholders, to determine whether the detriment caused to the complaining shareholder’s interests is justifiable.

Section 174 is said to be directed to respond to “an unjust detriment to the interests of a [shareholder]”, where it is just and equitable to do so. It is designed to provide a remedy (not punishment) and because the Court must undertake a sort of balancing act. And (because the remedies available are drastic) the Courts have held that:

• errors of judgment, inefficiencies, and poor business management without (clear evidence) of bad faith or self-interest cannot amount to oppression;

• judges are ill-equipped to evaluate business strategies – but do have training and expertise in dealing, for instance, with fraud, illegality, or conflicts of interest; and

• section 174 is not a(n easy) means of providing an exit – where there are straight-out disagreements over company strategy. This point was reinforced by the High Court in Yovich (2001).

Complaints

A brief summary of the manner in which the Court dealt with the younger brother’s complaints is:

• Refusal to buy him out
  • In late 2003 (after younger brother’s ill health), older brother commissioned an informal valuation of the business – for the purposes of its sale, or sale of younger brother’s shareholding.
  • Younger brother said the older refused to sell the business but had offered a price that was unacceptable. The judge did not see anything in the (skeletal) evidence of the proposed transaction to point to any unjust detriment under this heading alone.
  • The judge also found nothing in the company’s history or structure, or in the brothers’ reasonable expectations as to its operation, to suggest one shareholder could require the other to buy them out.
  • Given younger brother’s resignation as director, the judge did not see the cases on ‘irretrievable breakdowns’ to be particularly relevant. There was no inability to operate effectively – despite difficult trading circumstances the business continued to operate effectively and the relationship breakdown did not stymie its operation.
• Management of the business
  • The judge found no evidence that the brothers’ joint expectations (for remuneration in proportion to the level of participation – plus a top from surpluses in proportion to shareholdings) were not readdressed when younger brother reduced active participation, or (more significantly) when the business suffered a downturn.
  • The judge noted that, in seeking something as significant as the forced liquidation of a functioning business – the ‘unjust detriment’ must be something in the nature of fraud, illegality, or conflicts of interest. Evidence is required of diversion from the company’s reasonable and accepted remuneration practices, and/or of a sham to divert shareholder entitlements elsewhere. Here, the level of remuneration was not seen by the judge as disproportionate in management of a 7-day a week retail business.
  • The judge could see nothing unjustly detrimental in older brother’s management of the business. In particular, younger brother’s concerns about the business’ efficiency, statutory compliance, premises and other prospects (even if proven) – simply arose from his and the business’ changed circumstances. And the continuing conduct of the business in accordance with the shareholders’ original expectations – was not (of itself) unjustly detrimental to him.
  • By contrast with Yovich, there is nothing in the companies’ present circumstances to make the original expectations now unjustly detrimental to younger brother’s interests. Instead, the business’ present circumstances reinforce the shareholders’ original expectations, to reward participants’ (based on input) over any determined return on shareholders’ investment.
• Access to company records
  • The complaints about lack of access to business’ records were unclear (and in any event the judge was satisfied that the records were made available at the business’ premises and during the proceedings).
• The property company
  • The younger brother argued that his interests in the property-owning company should be addressed on a standalone basis.
  • The judge did not agree – noting that the companies’ history and structure pointed to the brothers’ reasonable expectations that both companies were to be operated jointly for the good of the overall business. He found that there is nothing in that original intention that makes it now unjustly detrimental to the younger brother.

Concluding comments

One of the difficulties evident in this case was that, not only did the operating company not have a constitution (having been compulsorily re-registered under the Companies Act) but also there was no Shareholders’ Agreement in place between the brothers. Sadly, the evidence in this case points to a number of inflexion points where the brothers might have considered their changing needs and those of the business – including the period of ill health and the need for a capital injection. These were opportunities missed.

A Shareholders’ Agreement is a common means of bridging the gap between the Companies Act 1993 and a company’s constitution (if it has one) and the key arrangements between shareholders governing the birth, life and orderly burial of a company that is the vehicle for their joint business.

A Shareholders’ Agreement should provide a series of clear rules governing the major events in the lifecycle of the business and its stakeholders, including the introduction of new investors, and the exit or death of a shareholder (particularly a working shareholder).

Increasingly, the exit mechanisms in a Shareholders’ Agreement are being paired with key person insurance cover and ‘Buy-Sell’ arrangements which ensure that there is both a compulsory sale upon the occurrence of a trigger event (typically death or disability) and a pool of money with which to fund the buy-out.

Particularly in the context of a family business, with arrangements for future generations to take over the reins, a failure to plan for the consequences of developments such as ill health can risk the shareholders becoming embroiled in time-consuming, stressful and expensive arguments. As this most recent case has demonstrated, the Courts will be reluctant to force a buyout or even a liquidation where the stakeholders had not planned for this eventuality and there was no unjust detriment by continuing to operate the business in the manner the founders’ planned.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.