Disputes and Deadlock between Shareholders

Business

Recently we have advised a number of companies (in a range of sectors) where shareholders have run into irreconcilable differences and, as a consequence, found themselves going through a messy and costly exit from the company.

For the shareholders involved, the period of disagreement is often stressful, resulting in their spending valuable time at loggerheads with each other. This invariably creates an inharmonious working environment often to the detriment of the goodwill of the business and staff morale.

Ultimately the bickering shareholders may cause the business to run into financial difficulty (if that itself has not been one of the causes of the disagreement).

In most cases where the parties have to resort to their lawyers or even the Courts to resolve their disagreement, we have found that "off the shelf" shareholders agreements (on the occasions when one has been put in place) are often unhelpful in that either the dispute resolution provisions themselves are inadequate and lack teeth (for example, negotiation and mediation can be blunt instruments) or they do not properly address the issues of deadlock between the shareholders. In short they do not facilitate a quick resolution of the issue at hand.

A well prepared shareholders agreement by contrast will usually set out the framework within which a company intends to operate. It ought to include provisions which address matters such as the management and control of the company, funding structure, voting rights, the terms on which shares can be transferred, exit strategy upon the death or incapacitation of a shareholder, dividend policy, dispute resolution and a deadlock resolution provision.

A considered shareholders agreement, with the appropriate dispute resolution and deadlock provisions, can mean the difference between resolving the problem (perhaps by the swift exit of one shareholder) or the untimely demise of the business - usually to all parties’ detriment.

In the absence of these provisions it should be noted that unless one party has acted unlawfully or in breach of contract (or perhaps where a director has breached its duties), the parties may not have effective recourse to the Courts to settle the dispute; indeed the Courts have been increasingly reluctant to appoint a liquidator as a means of addressing issues between shareholders.

In any event litigation is likely to be very expensive and time consuming and, again, it is very likely to have an adverse financial impact on the business.

There are a number of mechanisms that can be adopted to resolve deadlock - the mechanism which should best be adopted for any particular business is dependent on several factors including the type of business, company structure and relative financial strength of the shareholders. The most common deadlock breaking mechanisms include the following (or combinations or variations of these):

  1. “Russian Roulette” – under this procedure, any party can serve a notice either requiring the receiving party to purchase that party’s shares or for the receiving party to sell its shares to the initiating party, at a specified price.  The party receiving the notice then has the option of selling its shares at the price offered or advising the other party that it wishes to buy the other party’s shares at the offered price.  The rationale underpinning this type of provision is to ensure that a fair price is offered as the offeror ultimately does not know whether it will be the seller or the buyer of the shares. 

    This mechanism has its strengths but if a party lacks the financial ability to purchase the shares (and therefore be left with no option but to sell the shares), then it will be at a significant disadvantage. The “weaker” shareholder will run the risk that the stronger party takes advantage of it and buy out the “weaker” party at a low price, knowing that the “weaker” party does not have the capacity to compete.

  2. An “Auction” or “Texan Shoot-Out” - in an auction or so called “shoot out” the initiating party will notify the other(s) that it wishes to acquire their shares. The receiving party will then normally have a certain period within which to decide if it intends to sell its shares or buy the initiating party’s shares.   If the other party also wishes to buy, both parties will then participate in an open auction or “Shoot-Out”.  This mechanism will only work equitably if the parties are of similar financial strength.

  3. “Buy Out” - This involves a mechanism where one shareholder can be quickly bought out by the other parties. While such a mechanism is quite uncommon as a means of breaking deadlock (and is more likely linked to the non-performance by a party if its obligations under a shareholders agreement, which non performance typically gives the “non-defaulting” parties the right to acquire the “defaulters” shares) it can still be effective in certain circumstances. If this mechanism is used it will also be necessary to include an efficient means of establishing the price for the other party’s shares – this is more easily ascertained by reference to a pre determined formula, rather than involving an independent valuation which will be more time consuming.

  4. “Put and Call” Options – A “Put” option enables a shareholder to require another shareholder to purchase its shares at a certain price. A “Call” option on the other hand allows a shareholder to compel the other shareholder(s) to sell their shares

    “Put and Call” Options are probably not such an effective option for a company comprising shareholders of equal stakes. However, “Put” options in particular may be advantageous for a minority shareholder who perceives that the happening of certain events may weaken its position. Conversely a call option may be favoured by a majority shareholder who wants to take a certain course of action which may otherwise be impeded by a minority shareholder.

    The key to “Put” and “Call” option arrangements working well is clearly specifying when and how the option may be exercised, and agreeing on the price at which the option may be exercised at the outset.

  5. Liquidation - For some businesses, the parties may wish to provide for a regime that requires the shareholders to liquidate the company in the event of deadlock and to share the costs and expense of so doing. Liquidation however may not be an attractive option if a large element of the value of the business is “goodwill” and dependent heavily on its continuing as a going concern.

Whatever the mechanism chosen, it is also important to clearly define what constitutes a “deadlock” the occurrence of which will trigger the operation of the relevant provision.

Whilst there are pros and cons with each of the different deadlock provisions (and in particular none may satisfactorily deal with a disparity in the shareholders financial capability), it is imperative to select the mechanism which the shareholders believe is appropriate in the circumstances, questions of “what if…?” can be beneficial at the preparation stage of the shareholders agreement and can provide a useful framework for the parties to understand their respective objectives and how an impasse can be managed going forwards.

In summary, it is by far preferable to invest the time upfront to consider the terms of a shareholder agreement, in particular to select a dispute/ deadlock breaking mechanism to ensure that should circumstances change, a resolution can be reached quickly and to allow the company to move forwards without the distraction of a prolonged dispute which can be both emotionally and financially draining.

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