This article will seek to asses if the rules governing shareholder remedies in English company law are seriously convoluted. It will do this by critically discussing what remedies minority shareholders have and the problems they may encounter. First this article will set the issue in context by using an example to demonstrate why shareholder remedies are important. Second this article will discuss the different options available to the shareholder i.e. derivative claims; personal claims; unfair prejudice claims; the ‘Just and Equitable’ Winding-Up and shareholder agreements. The article will then offer some practical advice and conclude its findings.
Setting the Context
Consider this example: ABC Ltd is a small to medium enterprise with an annual turnover of £5 million. There are 2 director shareholders each holding 40% of the issued share capital. There are 4 further shareholders of which you are one each holding 5%. The director shareholders then decide to increase the company’s share capital and issue non-voting preference shares to raise finance for a scheme which the minority believe will be unsuccessful and will result in the company’s reputation and profitability being damaged. Provided there are no shareholders agreements to the contrary, the directors are within their powers to carry out the above scheme. Although increasing the issued share capital of the company and issuing shares of a different class would require a resolution of the shareholders, the directors have a sufficient shareholding to enable them to force the resolution through. As a minority shareholder they have limited powers to prevent the scheme proceeding unless they go to court or negotiate an acceptable outcome with the directors.
The Derivative Claim
The law provides a number of remedies to disgruntled shareholders. One of the oldest remedies was the derivative action which was created as an exception to the rule established in the landmark case of Foss v Harbottle. However, the rules relating to the derivative action have been heavily criticized. Accordingly, the Companies Act 2006 abolished the derivative action and created a new statutory derivative claim. It is important to note that Part 11 of the 2006 Act does not abolish the Rule in Foss v Harbottle and the Rule itself and its justifications retain much of their force. The rules relating to the derivative action can be found in a mass of common law, which adversely affected the accessibility and clarity of derivative actions. The derivative claim is now on a statutory footing, which provides a number of advantages. For example having the derivative claim remedy in a single statute means that the 2006 Act provides a more complete source of shareholders’ remedies. It will better alert shareholders, directors and other interested parties to the existence of the remedy. The disadvantage of placing the remedy in statute is that alteration of the remedy will require amending the 2006 Act, and amending legislation is rarely a quick and simple process.
Under the common law, negligence could only form the basis of a derivative action if the wrongdoer gained some form of benefit from the negligent act. This limitation has not been preserved in the 2006 Act and derivative claims can be brought for any negligent act. This reform has caused fears that derivative claims will increase sharply. A common law derivative action could be based on an act/omission by a director or a member. A statutory derivative claim can only be based on the acts/omissions of a director (including former directors and shadow directors). Permission from the court was required to continue a derivative action, and this requirement is preserved for derivative claims. However, the 2006 Act provides guidance on what factors are relevant when determining whether or not to grant permission. Such guidance did not exist under the common law. One final point is worth noting. With the creation of the unfair prejudice remedy, derivative actions/claims are much less common and it could be argued that the shareholder remedy is of little significance in practice.
All shareholders have rights that they can enforce against the company and other shareholders whether or not a formal shareholders’ agreement has been reached. These include such claims as a decision to enter into a transaction beyond the company’s objects, a decision by directors to allot shares for an improper purpose, alteration to the Memorandum and Articles of Association, the variation of class rights, the giving of financial assistance and the enforcement of directors’ duties, prevention of ultra vires transactions and in relation to certain take-over offers. This concern the legal right of a member as opposed to a claim brought in respect of the company’s rights. The enforcement of such a personal right so as to give rise to a claim for damages or other compensation is not prevented by reason of the claimant holding or having held shares in the company.
Unfair prejudice claims
S.994 allows a member to bring an action on the grounds that the company is being run in such a way that he or she has suffered unfair prejudice. This is a long established provision which is preserved under CA 2006. Examples of conduct that may be held to be unfairly prejudicial to the interests of members are: the granting of excessive remuneration to directors, directors’ dealing with associated persons, or non-payment of dividends. According to Judge Perle QC in the recent case of Sunrise Radio Limited:
“There must be both prejudice and unfairness. Prejudice will most often be established by reference to conduct having a depressive effect (actual or threatened) on the value of the petitioner’s shareholding, which will in most cases be a minority holding, typically in a private company with restrictions on transfer. Unfairness, in turn, most often connotes some breach of the articles, statute, or general principles of company law.”
Note that under s.260 CA 2006 the shareholder sues on behalf of the company in respect of the company’s loss, whereas under s.994 the shareholder sues for himself. S.994 petitions are likely to be expensive, time-consuming and complicated to bring. Since the Court has discretion to make such order as it thinks fit, such petitions also bring with them a great deal of uncertainty for the petitioner. Generally, a negotiated settlement will therefore be the preferred option.
Under s. 996(1) CA 2006, the Court has the power to grant such order as it thinks fit to provide relief and, subject to this general power, s. 996(2) sets out a list of particular types of order that may be made. These include orders regulating the future conduct of the company’s affairs and requiring the company to do or refrain from doing certain acts. The most commonly made order is to provide for the purchase of the petitioner’s shares by the wrongdoer(s). The value at which such shares are to be purchased is a fundamental issue and usually a matter which is argued. The Court has a wide discretion in relation to valuation matters. In practice where one side is willing to buy out the shares held by the other and the dispute centres on the valuation of those shares, the Court will encourage the parties to settle out of court by means of a binding third-party valuation of the shares. If the petitioner objects to such an out of court settlement, the Court will usually require them to give reasons for their objection.
The ‘Buyout’ process
If the parties agree on a mechanism for valuing shares, the court will usually uphold this. Otherwise the court will usually order that an expert is to determine the value of the shares. The court can specify what the expert should and should not take into consideration. The court can order that the valuation of the shares be backdated and include assets which had since been stripped out of the company, Ordering such measures will usually only be considered where there is a suggestion of bad faith on the part of one or more of the parties. Generally the threat of section 994 petitions can be a very useful tool in relation to shareholder disputes. They should only really be considered as a last resort though as it is likely that relationship within the company will be soured through the process of litigation.
‘Just and Equitable’ Winding-Up
Section 122(1)(g) Insolvency Act 1986 grants power to the court to wind up the company on ‘just and equitable grounds’. The applicant must satisfy the court that there is an adequate surplus for distribution to the members after a winding up. He must also satisfy the court that he has “clean hands” i.e. if the applicant can be blamed for some of the matters he complains of then the court may not grant his application.
An application for just and equitable winding up can be used by the court as an opportunity to look into the company’s internal affairs. Although, the burden rests on the applicant to demonstrate that the circumstances warrant intervention, the courts are willing to consider the motivation driving a company’s actions. The type of situations that might merit a `just and equitable’ winding-up includes the exclusion of a minority shareholder from management or the breakdown of confidence in the management of the company.
The minority shareholders will say that they have an expectation of being involved in the management of the company; that the company was a quasi-partnership (i.e. the way that they joined together to form the company and the way that it has been run since has given rise to an understanding that each of the shareholders would participate in management). They will argue that it is unfair to exclude them. They will also say that this means that their shares should be purchased by the majority without a discount. The outcome will depend on the facts of each individual case. What is certain is that shareholder disputes are expensive pieces of litigation.
A shareholders’ agreement provides a right of action which enables one member to enforce the provisions of the shareholders’ agreement directly against another, whereas under the articles this right of action may not arise. Because of the difficulties shareholders can encounter in enforcing the provisions of the articles under s. 33 CA 2006, a shareholders’ agreement can be used in order to ensure the enforceability of provisions that would not be regarded as membership rights, such as the right to be appointed as the company’s solicitor or the right to approve certain transactions.
If a term of a shareholders’ agreement is breached it can be enforced in the usual way under general contract law principles. A shareholder will be able to claim for breach of contract or alternatively could apply to the Court for an injunction to prevent a breach of the terms of the agreement. A shareholders’ agreement can also prevent the need for s. 994 petitions although it obviously cannot stop a disgruntled shareholder from bringing such a petition.
Funding the fight
At first glance it would appear that majority shareholders have a distinct advantage in that company funds can be used to fight the majority shareholder’s battle. Conversely a minority shareholder even with a case of considerable merit will have limited funds to fight the case. The courts have shown however that in genuine shareholder disputes they will not allow this inequality to prevail and will grant injunctions to prevent company monies to be used to fund the majority shareholder’s battle. Shareholder disputes are expensive, emotionally exhausting and should be avoided at all costs. Consideration should be given to entering into a formal shareholders agreement when the company is formed. Whilst complex these agreements can save considerable headaches and money in the long run.
It is important to appreciate that the remedies open to minority shareholders are far from ideal even when the provisions of s. 260 are considered. Consequently minority shareholders may benefit from the protections offered by a shareholders’ agreement. However, protection of minority shareholders is only one use to which shareholders’ agreements can be put. Moreover, s. 994 may be invoked by a party to such an agreement.