What happens when shareholders running a business are in dispute?

February 2020

What happens when shareholders running a business are in dispute?

 Overview

Shareholder disputes between partners running a business are common.  Statistics show that financial pressure on business often leads to shareholder disputes.  The COVID-19 pandemic has caused major stresses upon businesses.

What should you do if you’re a shareholder and you’re in dispute with your business partner?

This article provides an overview of your rights as a shareholder in a dispute with your business partners and the available remedies under common law and the Corporations Act 2001 (Cth) (Corporations Act).

Key Takeaways

  • Alternative dispute resolution may be able to resolve a dispute, without the need for Court proceedings. However, the threat of Court proceedings is often a powerful tool to encourage resolution.
  • A shareholder may enforce his/her personal rights by compelling the company to observe and perform its contractual requirements under the Constitution or Shareholders Agreement.
  • The Corporations Act allows a shareholder to bring proceedings in the company’s name against the directors if the Court grants permission.
  • Flexible remedies are available to shareholders who have been oppressed by the majority shareholders.
  • If business owners can not reconcile their disputes, the Court can make a compulsory buy-out order. Alternatively, the Court can order the winding-up of the company as a last resort.

Shareholder rights at Common Law and under the Corporations Act

The minority shareholders are generally susceptible to exploitation through a number of techniques directed at either diminishing the value of their investments, or buying their shares at lower than the fair market value.  These techniques are typically seeking a discriminatory advantage for majority shareholders at the expense of the minority shareholders.  For example:

  • distributing profits among the majority shareholders in the form of salaries, bonuses and other emoluments;
  • excluding minority shareholders from management participation;
  • diverting corporate assets to entities associated with the majority shareholders;
  • allotting shares disproportionately among shareholders;
  • withholding information concerning company affairs; and
  • making fundamental changes affecting the value of minority interests.

The law has imposed restrictions on the voting power of majority shareholders in general meetings, as a mechanism for legal protection of the minority shareholders.  This is to prevent the majority shareholders from acting oppressively towards the minority shareholders at a general meeting, by voting for an improper purpose, notwithstanding that the majority are acting within the scope of their powers.

Traditionally, the law has prevented shareholders from suing a company’s directors for breach of their duties.  This is because the directors’ duties are owed to the company and not to individual shareholders.  Accordingly, if a shareholder wishes to sue the company directors, he/she must do so in the company’s name.  The difficulty with this rule is that the directors of a company have the power to decide whether the company should commence Court proceedings.  Additionally, a majority vote by shareholders at a general meeting can ratify past actions of directors that would otherwise be a breach of their duties.  Particularly in small businesses, directors usually hold and control the majority of the voting shares.  This effectively means that the company would not commence Court proceedings against the directors, as the directors themselves control whether the company commences proceedings or not.  This difficulty has now been addressed by certain amendments to the Corporations Act, which are discussed below.

A Company’s Constitution and Shareholders Agreement

The Corporations Act requires a company to have a constitution upon its registration with the Australian Securities and Investment Commission (ASIC).  The Constitution of the company and any replaceable rules is a statutory contract:

  • between the company and each shareholder;
  • between the company and each director and company secretary; and
  • between a member and each other member.

A Shareholders Agreement is a binding contract that sets out the rights and obligations of the company’s shareholders.  It can be a powerful tool to manage expectations of how directors will run the company and make critical decisions.  A robust Shareholders Agreement will include a mechanism for resolving and settling disputes, such as options for alternative dispute resolutions and mediation at first instance, before commencing litigation.

We always recommend our clients have a Shareholders Agreement in place, because the agreement can set out with certainty how the business is to run and how decisions are to be made, so as to avoid disputes.  If a dispute arises, a Shareholders Agreement is useful to establish the ground rules that were agreed.  A Shareholders Agreement can also include a dispute resolution process, which can avoid Court proceedings.

Derivative Action

Currently, the Corporations Act permits a person to bring proceedings on behalf of a company if that person:

  • is a member or former member of the company (or of a related body corporate);
  • is entitled to be registered as a member of the company (or of a related body corporate); or
  • is an officer of the company; and
  • has been granted leave under section 237 of the Corporation Act.

In order to obtain the Court’s permission (also known as ‘leave of the Court’) to litigate on behalf of a company, the applicant must satisfy the Court that:

  • it is probable that the company will not itself bring the proceedings;
  • the applicant is acting in good faith;
  • it is in the best interests of the company that the applicant be granted leave;
  • if the applicant is applying for leave to bring proceedings – there is a serious question to be tried; and
  • either:
    • at least 14 days before making the application, the applicant gave written notice to the company of the intention to apply for leave and of the reasons for applying; or
    • it is appropriate to grant leave even without such notice.

It is important to note that the proceedings cannot be discontinued or settled without the Court’s permission once the Court grants leave.  This is to prevent collusive settlements in the applicant’s interests, but not of the company’s.

Shareholder’s Personal Action

Section 232 of the Corporations Act provides that a shareholder can bring an action on his/her behalf and apply for a remedy if he/she has been effectively squeezed out from the company by unfair or illegal conduct of the majority shareholders (who are usually connected with the company’s director).  This is often called ‘oppression remedy’.  The benefit of bringing an action under this section is that it can apply to a wide range of circumstances and provides a range of flexible remedies.

The following persons can apply for an oppression remedy:

  • a member of the company;
  • a person who has been removed from the register of members because of a selective reduction; or
  • a person who has ceased to be a member of the company if the application relates to the circumstances in which they ceased to be a member; or
  • a person to whom a share in the company has been transmitted by will or by operation of law; or
  • a person whom ASIC thinks appropriate, having regard to investigations it is conducting or has conducted into:
    • the company’s affairs; or
    • matters connected with the company’s affairs.

Shareholder Remedies 

The Court may make one or more of the wide range of remedial orders under section 233 of the Corporations Act, if it is satisfied that the conduct of the company affairs (actual or proposed) is either:

  • contrary to the interests of the shareholders as a whole; or
  • oppressive to, unfairly prejudicial to, or unfairly discriminatory against, a shareholder or shareholders, whether in that capacity or any other capacity.

The remedies available include:

  • altering the company’s constitution;
  • ordering the company to purchase the minority’s shares;
  • ordering the company to undertake or to defend or discontinue legal proceedings;
  • restraining a person from doing a specified act; and
  • appointing a receiver over the company.

If the business owners can not reconcile their differences and can no longer work together, the Court can make a compulsory buy-out order.  It means that the shareholder must purchase the other shareholder’s interests at fair value.  The parties can agree on the fair value of the shares.  However, if not agreed, the fair value will be determined by a valuer as an expert and not as an arbitrator.  Both parties will have the opportunity to make submissions to the valuer.

Alternatively, the Court can also order the winding up of the company.   However, the Court is generally reluctant to wind up a solvent company.  It is important to note that the Court also has the power to wind up a company on a just and equitable ground under section 461(1)(k) of the Corporations Act.  The following principles and criteria are relevant to the Court when deciding to wind up a company:

  • lack of confidence in the conduct and management of the company’s affairs;
  • the Court is able to consider a wide variety of circumstances and actions that would justify winding up order
  • there must be a direct relationship between the facts or conduct and the administration of the company’s affairs (“a sufficient nexus”);
  • it is fair when considering the legal rights of the parties;
  • it is in the public interest, including the protection of investors and the prevention or condemnation of repeated breaches of the law;
  • the company is at least solvent and an established business.

It is important to note that the winding-up of a solvent company is a drastic action, and the Court will only make this order if it is absolutely necessary.

Contact Us

If you are a company director and need assistance in preparing a Shareholders Agreement, or are a shareholder and require help resolving a dispute with the company directors and officers, contact us today.  We would be happy to assist you with specific advice on the best course of action available.

Call us by phone on (02) 8920 0475 or send us an email at mail@teneolaw.com.au.

Craig Higginbotham and Richen Mojica
15 February 2021

 

 

 

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