When a company is incorporated, it is governed by the Corporations Act 2001 (Cth) (the Act) and the terms of its constitution. However, there are a number of items that the Act and the constitution will not address. This is where a shareholder agreement comes in handy.
Often, people enter business partnerships without turning their minds to crucial questions about their future, such as "Who will buy my shares when I leave, and at what price?"
Unfortunately, for many businesses, these questions arise when it is too late, and the parties must be dragged into costly legal proceedings in order to determine the answers.
The purpose of shareholder agreements
A shareholder agreement is a contract between the shareholders of a company. It includes mechanisms to deal with a range of events that might occur over the life of the business.
A well-drafted shareholder agreement will also put in place strong corporate governance, including the requirement for regular board meetings and majority decisions.
There are a number of benefits to a shareholder agreement, including:
- putting in place mechanisms to deal with the unexpected (such as the resignation or death of a shareholder or director);
- forcing the parties to enter an agreement whilst they are on good terms and enabling proper dispute resolution procedures to be established at the outset, to avoid costs down the track;
- helping business partners turn their minds to their commercial and personal objectives (otherwise, they may be too busy with the day-to-day business challenges to consider these);
- determining the types of decisions that must be unanimous between shareholders (such as a sale of the business or a change of control);
- creating a procedure for removing directors (i.e. because of poor performance or bankruptcy);
- restraining shareholders from competing with the company when they leave; and
- establishing exit strategies if one shareholder wants to sell their shares (i.e. pre-emptive rights to other shareholders).
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The differences between shareholder agreements and company constitutions
The main differences between these establishing documents include the following:
|Governed by the Act.||Governed by the laws of contract and the constitution.|
|Can be amended if 75% or more of shareholders vote in favour of the amendment.||Can generally only be amended by agreement between all the parties.
(A shareholder agreement would, therefore, be a preferable option for minority shareholders wishing to protect their rights).
|Confirms the terms and conditions relating to corporate governance, generally.||A much more specialised document that is tailored to the parties’ specific business and personal objectives.
(For example, the constitution might include pre-emptive rights; however, it will not specify how the departing shareholder’s shares are to be valued or what insurance needs to be in place to cover death or incapacity).
A shareholder agreement will typically formalise the following critical considerations:
Who are the shareholders? What are their shareholdings? Will shareholders have pre-emptive rights on any future issue of shares by the company?
Who are the directors? How many directors must be on the board at any given time? How are directors appointed and removed?
How is the company funded? For example, will this occur by way of shareholder loans, issue of partly paid shares or provision of guarantees and/or security by shareholders? How will additional funding be raised to ensure the company has sufficient funds to operate and expand?
Will any new shares be issued in proportion to the amount of the existing shares to which a party is currently entitled? If new shares are not taken up, can the directors allot shares as they see fit? Are there any prohibitions on shareholders against encumbering their shares?
How often must board meetings take place? What is the quorum (minimum attendance) for board meetings? What is the voting process? Should certain decisions be made unanimously?
How will voting be carried out? For example, will each shareholder have one vote per share, and will decisions be voted on by way of show of hands or by poll? The agreement will also list the decisions that require the unanimous vote of shareholders, such as the sale of the business, an increase or decrease in the authorised or issued share capital of the company, and the winding up of the company.
Voluntary Exit and Transfer of Shares
What rights does a shareholder have to transfer shares (whether to third parties or existing shareholders)? Will existing shareholders have pre-emptive rights to buy the shares being sold, and how will those shares be valued (i.e. through an independent or pre-agreed valuation mechanism)?
The shareholder agreement will also include drag-along and tag-along rights. Drag-along rights refer to a situation where a majority of shareholders receive an offer from a third party to buy all of the company. Under the drag-along rights, those shareholders can require the minority shareholders to sell at the same price.
Tag-along rights operate where a shareholder receives an offer from a third party to buy some of their shares. The remaining shareholders can opt in and require the third party to buy their shares also at the same price.
What is the mechanism in place for the transfer of shares of a deceased or permanently disabled shareholder? What insurance policies must be in place to cover the unexpected and to enable remaining shareholders to purchase the departing shareholders’ shares?
What are the dispute resolution procedures? Will parties be required to negotiate before proceeding to mediation? Who will mediate any dispute? How long will the parties have to mediate before any dispute can proceed to court?
The agreement will seek to prevent shareholders from competing with the business during the term of the agreement and after termination. It will also specify the geographical area to which the restraint applies.
What if there is an inconsistency between the constitution and the shareholder agreement?
Typically, shareholder agreements will contain a clause stating that, in the event of any inconsistency, the shareholder agreement prevails (inconsistency clause).
A recent case has demonstrated that this inconsistency clause may not always have its desired effect.
In Cody v Live Board Holdings Limited  NSWSC 78, the directors sought to cause the company to issue particular shares, which had the effect of varying the rights of a particular class of shares.
The company’s constitution provided that directors had the power to issue or allot securities with such preferred, deferred or other special rights as the directors determined. However, if the share issue directly or indirectly varied the rights of a class of shares, at least 75% of shareholders of that class needed to approve.
The directors did not obtain the vote of at least 75% of shareholders because they sought to rely on the shareholder agreement, which provided that certain powers of the company were reserved for decisions by shareholders and these reserved powers (to be approved by 51% or more of shareholders) included the issue of shares or other securities of the company or the grant of rights over any shares or other securities in the company.
The court held that the inconsistent clauses were not actually inconsistent because they had different purposes. It was held that the purpose of the constitutional provision was to protect the interests of holders of a class of shares being varied, whilst the purpose of the shareholder agreement was to grant shareholders the power to issue shares.
As these purposes were aligned, the judge found there was no conflict between the two provisions, and therefore both requirements had to be complied with. So effectively, the directors should have obtained 75% of the shareholder votes.
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Take home points
The key messages from this case are:
- Do not assume that the shareholder agreement will always prevail over a similar clause in the constitution.
- Review the inconsistency clauses in the constitution and shareholder agreement to ensure they expressly provide that an inconsistency will be considered to exist where two conflicting clauses deal with the same subject matter.
- Consider amending the constitution so that the clauses in the constitution are the same as the corresponding clauses in the shareholder agreement.
- When issuing preference shares that vary the rights of existing shareholders, pay attention to the protections afforded to shareholders in the constitution and the Act, which may require a special resolution to vary existing class rights.