In addition to seeking contractual protections under the terms of a shareholders’ agreement and the articles of association of the company, a prospective minority shareholder of a joint venture company would be well advised to understand the statutory rights and protections available to it under English law.
The principal protections are to be found in the Companies Act 2006 (CA 2006) and the Insolvency Act 1986 (IA 1996) and in this briefing we discuss how they may operate in the context of a minority shareholding in a joint venture.
Under s.994 CA 2006, a shareholder or shareholders may apply to court where:
- the affairs of the company are being, or have been, conducted in a manner that is unfairly prejudicial to the interests of members generally, or some part of its members, in their capacity as such (including the petitioning member); or
- an actual or proposed act or omission of the company is or would be so prejudicial.
It is worth noting that, whilst the members of a limited liability partnership may, by unanimous written agreement, exclude the right to apply to the court for relief on the grounds of unfair prejudice, no such ‘opt out’ right exists for shareholders of a private limited company.
Establishing unfair prejudice
The shareholder must prove that the conduct or proposed conduct amounts to unfair prejudice (in relation to its interest as a shareholder). Both ‘unfairness’ and ‘prejudice’ must be proven, without which the petition will fail. Prejudice will generally be financial loss, but this is not a strict requirement. As far as the ‘unfairness’ element is concerned, this may arise where there has been a breach of the express terms on which the parties have agreed the company’s affairs will be conducted (for example, a breach of a shareholders’ agreement), or where there are wider considerations that make it unfair to rely on a party’s strict legal rights.
Because of these requirements, an unfair prejudice petition cannot be used to seek a ‘no fault divorce’ and, whilst it is not necessary for a claimant to seek relief with ‘clean hands’, it may influence the court in determining what, if any, remedy may be appropriate, where the petitioner is ‘part of the problem’.
A broad range of circumstances can amount to unfair prejudice, such as the misuse of company assets, serious mismanagement, exclusion from management5 and the improper dilution of minority shareholdings. However, considering some of the cases where unfairly prejudicial conduct has been alleged, reveals why it is advisable to underpin the position of the minority shareholder in a joint venture with appropriate contractual protections. Whilst conduct might satisfy the ‘unfairly prejudicial’ test in the circumstances of one case, such conduct will not necessarily meet that test in the circumstances of a different company. Against this backdrop, the review below also highlights some of the contractual positions commonly adopted to protect minority shareholders:
- Bad management decisions. Although mismanagement of sufficient magnitude may amount to unfairly prejudicial conduct, a difference in opinion as to commercial decisions is unlikely to do so. Similarly, a breakdown in trust and confidence leading to a deadlock situation, may not amount to unfairly prejudicial conduct. Achieving involvement in the company’s commercial strategy is often addressed in a shareholders’ agreement by identifying a business plan and associated supporting budget to set the commercial parameters of the company’s business strategy. A minority shareholder may also appoint one or more directors to the board of directors of the company or be entitled to have an observer present at board meetings to enhance transparency of decision-making even though the minority does not control the board.
- Lack of transparency and denial of information. A majority shareholder’s refusal to provide financial information and revisions made to the company’s articles to remove the right to receive such information, have been found to be unfairly prejudicial. However, by law, a shareholder may only be entitled to limited information about the financial position of the company and so may find it difficult to establish that a line has been crossed between poor shareholder communication and conduct intended to undermine the minority shareholder’s position. With this in mind, a shareholders’ agreement will typically detail the financial and other business information that the company must provide to each shareholder within stipulated timescales.
- Failing to pay out profits. There have been cases in which shareholders have successfully established an unfair prejudice claim based on conduct designed to block or reduce the payment of dividends. However, a court may be reluctant to interfere with a commercial and financial decision not to pay a dividend. This topic is commonly addressed in a shareholders’ agreement by prescribing a detailed dividend policy and often with an overarching commitment that the company will pay the maximum dividend possible, subject only to the maintenance of reasonable reserves.
- Excessive remuneration for directors. Similar to the position with respect to the payment of dividends, this issue has been considered in a number of cases where unfair prejudice has been established. However, a court may generally be reluctant to substitute its own opinion on the question of whether payments made to directors, or others connected with shareholders, are so excessive as to constitute unfair prejudice. To pre-empt conflict on this topic, the minority shareholder’s agreement may be required to the terms of employment of key individuals. Similarly, where a conflict of interest arises (for example where a shareholder is the provider of goods or services to the company), a minority shareholder may have weighted voting rights and so decisive influence on such matters.
- Dilution of a minority’s shareholding. Allotting further shares for the improper purpose of diluting a minority shareholder’s shareholding may constitute unfair prejudice. Given the serious economic consequences of dilution, a minority shareholder will commonly seek a range of contractual protections. These may include, firstly, the right to participate in a further share issue pro rata its existing shareholding. Secondly, a right to call for an independent valuation of the number of shares to be issued to ensure that the shares are not issued below their true value and thirdly, contractual restrictions on the issue of shares except in defined circumstances, for example where there is a need for emergency equity funding.
- Amendment of the Company’s articles of association. Where a minority shareholder does not have a sufficient interest in the company’s share capital to block a special resolution (required to change its articles of association), a number of cases have considered whether changes to the articles may nevertheless constitute unfair prejudice to the minority shareholder. In one case, an interim injunction was granted to prevent changes being made to articles to include a compulsory transfer provision (a so-called “drag right”) but in another case, revisions made to existing drag provisions were not considered to be unfair prejudice. This was, in part, because the revisions were made in good faith and in the interests of the company. There may not be bright lines to indicate where changes to the company’s constitution could be unfairly prejudicial to a minority shareholder, so this point may be addressed explicitly in a shareholders’ agreement making changes to the company’s constitution a matter requiring a minority shareholder’s consent.
Remedies for unfair prejudice
Under s.996 CA 2006 the court can “make such order as it thinks fit for giving relief in respect of the matters complained of” and s.996(2) CA 2006 sets out various non-exclusive categories of relief, including regulating the conduct of the company’s affairs or requiring the company to do or refrain from doing a specific act. The court does not have power under s.996 CA 2006 to make an order for the winding up of the company and so, to seek this remedy, an application under IA 1986 would be needed.
In most cases, the behaviour complained of is part of a pattern of behaviour representing an irretrievable breakdown in relations, especially since the court cannot regulate the affairs of the company on an ongoing basis. In practice, therefore, the most common remedy is that the members (or, occasionally, the company itself) must buy out the shares of the minority shareholder.
Approach to valuation
If the relief sought or ordered by the court is a buy out of the minority shareholder’s shares, contested valuation issues may arise.
Such issues may include the effective date of the valuation because the breakdown in relations between the shareholders may result in a deterioration in the company’s value. The basis of the valuation, and whether the shares should be valued on a pro rata basis without a discount to reflect the fact that the shares represent a minority holding, may also be contentious. The valuation will typically be referred for expert valuation with a direction from the court on such critical matters. The question of whether a discount should be applied has seen a variable judicial approach. Of course, for a minority shareholder, there can be a significant disparity in value according to whether the shareholding is valued as a minority shareholding or as a pro rata share of the company’s overall value. Recent authority suggests that a minority discount should be applied in the absence of express provision to the contrary.
Having regard to some of these uncertainties, a shareholders’ agreement will often address the detailed circumstances in which one shareholder may be entitled (or obliged) to buy out the shares of the minority shareholder. Detailed valuation mechanisms and bases would be set out with the appointment of a mutually acceptable expert to determine any dispute which arises.
Arbitration of joint venture disputes
Claims under s.944 CA 2006 may be determined by an arbitrator if the parties have agreed that any disputes will be subject to arbitration rather than being subject to the jurisdiction of the courts. However, there may be constraints on the relief to be granted by an arbitrator, particularly where third parties (such as creditors) are affected since they are not parties to the arbitration.
Just and equitable winding up of the company
Under s.122 (1) (g) IA 1986, the court may order a company to be wound up if “the court is of the opinion that it is just and equitable” to do so.
The court’s power to order that a company be wound up
The court has a wide discretionary power and can take into account all the circumstances when deciding whether to make a winding up order. For example, if there is a practical deadlock in the management of the company or where the management and conduct of the company make it unjust and inequitable for the petitioner to remain a member of it. A recent Privy Council case identified two categories of deadlock: firstly a ‘functional deadlock’, i.e. a complete impasse at board or shareholder level in relation to corporate decision-making; and secondly an irretrievable breakdown in trust and confidence between the members of a corporate quasi-partnership. Where there is a shareholders’ agreement in place, a ‘functional deadlock’ may arise by virtue of the inclusion of certain matters (‘reserved matters’) that the minority may veto or requiring unanimity. For both categories of ‘deadlock’, the court will examine all of the circumstances to determine whether the deadlock is such that a winding up order is appropriate.
Parties wishing to enter into a shareholders’ agreement typically consider at length those matters which are considered so fundamental as to justify inclusion on a list of reserved matters. Further, a shareholders’ agreement may stipulate the remedies or actions that will follow if there is deadlock on such matters. At one end of the spectrum, the shareholders’ agreement may simply state that a failure to agree on a reserved matter will result in no action being taken. In other words, the proposed matter will not be effected. At the other end of the spectrum, structural remedies may be activated, for example, entitling one party to buy out the other. The commonly identified danger for a minority shareholder in accepting such structural mechanisms, is that they may favour the party with the greatest financial resources. Although the court’s jurisdiction to order a winding up cannot be excluded, a court may be reluctant to order a winding up where a shareholders’ agreement prescribes contractual outcomes in the event of a deadlock.
Disadvantages of a winding up order
A winding up order will generally lead to a shareholder receiving only his pro rata share of the net assets of the company, which will often be below the ‘fair value’ of its shares in the company Further, putting the company into liquidation is a far-reaching and draconian step.
Availability of winding up in an arbitration
An arbitrator cannot order a winding up because this is within the exclusive jurisdiction of the court.
An important principle of English company law is that the company is the proper person to bring an action for wrongs done to the company. Derivative claims are an exception to this principle. A derivative claim is an action brought by one or more shareholders of the company against a director or a third party, for and on behalf of the company for wrongs done to the company. In this way, a derivative claim allows minority shareholders to bring an action on behalf of the company that the company’s management has not pursued.
Statutory derivative claims are governed by Part 11 CA 2006 and are brought by a member of a company under s.260 (1) CA 2006 in respect of a cause of action vested in the company seeking relief on its behalf.
Requirement for the court’s permission
It is important to note that there are certain hurdles associated with statutory derivative claims which do not apply to other claims due to the requirement for the court’s permission to proceed (s.261 CA 2006). For instance, permission will be refused if the conduct has been authorised/ratified by the company or where a person acting in accordance with the statutory duty to promote the success of the company would not seek to continue the claim.
Shortcomings of a derivative claim
A fundamental shortcoming for a minority shareholder is that any remedy or compensation is for the benefit of the company rather than for that shareholder. In addition, success in such a claim may not address the breakdown in relations between the shareholders or directly put the minority in a better position, for example by requiring a buy out of the minority shareholder’s shares. Accordingly, minority shareholders will often prefer to pursue an unfair prejudice petition rather than a statutory derivative claim against the majority shareholder.
It is important for a minority shareholder to understand the benefits and constraints of the statutory framework. This will inform how it should protect itself contractually, ensure fair treatment by the other shareholders and optimise its position should a dispute arise.