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Minority shareholders and their rights

Briefing note Author: John Sykes Date: January 2009

Contents Unfair Prejudice Derivative Claims Personal Claims Just and Equitable WindingUp In Practice

A Ltd is small owner managed business with an annual turnover of 15 20 million. It is owned and controlled by 3 old friends, business partners of longstanding who decided 10 years ago to give up their day jobs and go into business together. All 3 are directors. They agreed from the outset to take broadly equal amounts out of the company. The shareholding however is not split equally between them. One member has 58% of the issued share capital, the other two have 21% each. All 3 directors play a full role in the management of A Ltd. They operate by consensus and formal board meetings are rare. Sounds familiar? This is how many owner managed businesses and family companies are run. All is well whilst the members get on with each other and are happy with the direction the business is going. But what happens when clouds appear on the horizon, when the majority shareholder sees the company as his own to do with as he likes, or when he wants to eject a director who is also a shareholder? Surely, subject to having sufficient voting power to carry an ordinary or special resolution, the majority rules? A minority shareholder is not entirely impotent. The Companies Acts have always contained provisions giving a minority shareholder leverage to curb the excesses of the majority. However, generally they are little use against a majority shareholder determined to execute his plans. In these circumstances, the minority shareholder will need to apply to the Court for protection and relief. Unfair Prejudice The most important protection that a minority shareholder has is the right to petition the Court for an order under s994 of the Companies Act 2006 (formerly s459 of the Companies Act 1985). This action is founded on an allegation that the affairs of the company are being conducted by the majority in a manner unfairly prejudicial to the interests of members generally, or to some part of its members (including the applicant). This could include breach of a legal bargain between the shareholders (e.g. a Shareholders Agreement or Articles of Association); breach of fiduciary duty; breach of an equitable agreement or understanding; or breach of quasi-partnership principles. The relief sought is normally an order that the other shareholders (or the company itself) purchase the minority shareholding at fair value. An Order providing for a clean break will be preferable. However, the Court has complete discretion and if the circumstances warrant can even order the minority shareholder to purchase the shares of the majority. The Court can, and will, make orders to adjust the unfair prejudice that the minority shareholder has suffered. For example, the Court may order the company to be valued on the basis that the benefits taken by director/shareholders in breach of fiduciary duty be repaid. The Court will also decide at what date the company should be valued and whether there should be any discount to reflect the minority shareholding. The Court can also make an Order regulating the conduct of the companys affairs in the
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Charles Russell LLP is a limited liability partnership registered in England and Wales, registered number OC311850, and is regulated by the Solicitors Regulation Authority. Any reference to a partner in relation to Charles Russell LLP is to a member of Charles Russell LLP or an employee with equivalent standing and qualifications. A list of members and of non-members who are described as partners, is available for inspection at the registered office, 5 Fleet Place, London EC4M 7RD.

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future; require the company to do or refrain from any act and authorise civil proceedings to be brought in the name of the company. Derivative Claims In many circumstances, a minority shareholder may be affected by a wrong done, not to him personally but to the company by the majority. For example, diversion of contracts from the company to the directors personally. The minority shareholder faces an impossible task in attempting to force directors into bringing an action against themselves. In certain circumstances, however, the Courts will allow a minority shareholder to bring a claim in the companys name. Such derivative claims were formerly governed by the common law and were rarely brought. However, they have now been given statutory force through ss260-264 of the Companies Act 2006. The Act permits derivative claims arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director. This is wider than the old common law test where the act had to amount to a fraud on the minority. Further, under the old rules a director who was also a majority shareholder could ratify the disputed act. However, under s239 of the 2006 Act, a shareholder-director responsible for the negligent act will not be able to vote at a meeting of members called to ratify the act or omission. It should be noted, however, that the claim is brought by a shareholder on behalf of the company. Any financial award accrues to the company itself (unlike the unfair prejudice petition described above). Personal Claims 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 objection to 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. The Memorandum and Articles of Association represent a statutory agreement between the shareholders and the company as to how the company is to be run. The court will enforce a breach of that agreement. An otherwise proper attempt to vary the articles can be actionable if it affects rights already in existence or the majority have not acted in good faith. Just and Equitable Winding-Up s122(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 meaning that if the applicant can be blamed for some of the matters he complains of then the Court may not grant his application.

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Charles Russell LLP is a limited liability partnership registered in England and Wales, registered number OC311850, and is regulated by the Solicitors Regulation Authority. Any reference to a partner in relation to Charles Russell LLP is to a member of Charles Russell LLP or an employee with equivalent standing and qualifications. A list of members and of non-members who are described as partners, is available for inspection at the registered office, 5 Fleet Place, London EC4M 7RD.

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An application for just and equitable winding up can be used by the Court as an opportunity to look into the companys 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 companys actions. The type of situations that might merit a just and equitable winding-up include the exclusion of a minority shareholder from management or the breakdown of confidence in the management of the company. In Practice A Ltds members have a falling out. The majority shareholder is advised that he has sufficient voting power to exclude the others from management of the company under s303 of the Companies Act. He calls an EGM and passes the resolution. He decides to take advantage of pre-emption rights in the articles and makes a number of low offers reflecting a high discount for the fact that the shareholdings are minority holdings. These are rejected. The minority shareholders say that they have an expectation of being involved in the management of the company; that the company was a quasi-partnership. This means that 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 say it is unfair to exclude them. They also say that this means that their shares should be purchased by the majority without a discount. Who is right depends very much on the facts. It is not safe to advise the majority shareholder that a minority discount applies in every case. Nor is it safe to advise the minority shareholder that if trust and confidence between shareholders has broken down that their shares should be bought at fair value. There certainly is no such thing as a nofault divorce in company law.

More information John Sykes, Partner +44 (0)20 7203 5131

john.sykes@charlesrussell.co.uk

This information has been prepared by Charles Russell LLP as a general guide only and does not constitute advice on any specific matter. We recommend that you seek professional advice before taking action. No liability can be accepted by us for any action taken or not taken as a result of this information. Charles Russell LLP is not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of the Law Society. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide.

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Charles Russell LLP is a limited liability partnership registered in England and Wales, registered number OC311850, and is regulated by the Solicitors Regulation Authority. Any reference to a partner in relation to Charles Russell LLP is to a member of Charles Russell LLP or an employee with equivalent standing and qualifications. A list of members and of non-members who are described as partners, is available for inspection at the registered office, 5 Fleet Place, London EC4M 7RD.