UPDATED February 2021 – Please click here to read the latest version of this article
In our last article on shareholder disputes, which focussed on our top ten tips for consensual ways of “breaking the deadlock”, we introduced the following scenario:
- Two friends who have known each other since university leave their current jobs to set up a new business.
- They agree that they will both be employees and directors of the new company and will each hold half of the shares.
- The business is successful but there are mounting tensions over the future direction of the company.
- Events come to a head and one of the founders (the “Leaver”) storms out saying he will never again work with the other one (the “Remaining Shareholder”).
- Not having foreseen any problems arising down the line, they did not take legal advice when setting up the company. They do not have a shareholders’ agreement or bespoke articles in place imposing an obligation on the Leaver to offer up his shares for sale to the Remaining Shareholder.
- The Leaver says he has been forced out by the Remaining Shareholder as an employee/director. He is willing to sell his shares, but he wants to sell them for £1 million. The Remaining Shareholder is keen to purchase them but he/the company only have access to £500,000 available cash.
Continuing on with this scenario, in this article we outline ways to “break the deadlock” using less favoured but effective non-consensual strategies.
Applying Pressure on Leaver to Sell
The first possible strategy, and probably the simplest of the following strategies, is for the Remaining Shareholder to try and apply pressure on the Leaver so that he eventually agrees to sell his shares. Assuming that the Leaver has resigned as a director of the company, the Remaining Shareholder could take certain actions, such as increasing his own salary and/or awarding himself a bonus to reflect the increased work he has taken on. The Remaining Shareholder does, however, need to proceed with caution if going down this route, as he may be giving the Leaver grounds on which he could bring an unfair prejudice claim.
Unfair Prejudice and Purchase Orders
Although it is usually considered a remedy for a minority shareholder, unfair prejudice petitions under section 994 of the Companies Act 2006 may be used to resolve a deadlock where the shareholders are no longer able to work together. The commercial reality of the business relationship as described above is a form of quasi-partnership. Consequently, the Courts may intervene not only where, for example there is a breach of the company’s articles of association, but also where there is a breach of expectation or obligation owed by one shareholder to the other.
Either shareholder may be able to bring an action under section 994. However, the shareholder bringing the petition must be able to show that the other shareholder is at fault. Although the trust and confidence may have broken down between them completely, the Court will generally not assist where both shareholders are equally at fault; the petitioner must be able to show unfairly prejudicial conduct on the part of the respondent shareholder.
Where a Court determines that there has been unfair prejudice, it has general powers to make such an order as it thinks fit. The most common order made is a buy-out order, i.e. for the petitioning shareholder’s shares to be purchased by the respondent shareholder at a “fair value”.
Compulsory Winding Up
The parties may decide that they cannot see the business moving forwards at all, and their only option is to discontinue the business and wind up the company. The company or a shareholder(s) may petition the Court for the winding up of a company under section 122 of the Insolvency Act 1986, on the grounds that it would be just and equitable to do so.
It is fairly common for petitions of this nature to cite a deadlock as their basis. Where the relationship between the parties has broken down so that decisions concerning the business are not able to be reached and such a deadlock had not been contemplated by either party, this may justify winding up. However, such a petition is likely to fail if the deadlock is attributable to the petitioner’s fault or if the deadlock has arisen from the proper operation of the company’s articles of association, the purpose of which was to prevent a decision being taken without the agreement of one or more shareholders. It is also likely to fail if the Court is of the opinion that there is another available remedy to the petitioner and that he is acting unreasonably in seeking to have the company wound up instead.
Sale of Assets
Another option is for the Remaining Shareholder to sell the company’s assets to a third party company or a newly incorporated company, e.g. one set up by the Remaining Shareholder and a new business partner. This would enable the Remaining Shareholder to carry on in business without the Leaver getting in the way. Once the assets have been transferred from the company to the third party or newly incorporated company, the Leaver will own shares in an empty shell company.
In order to execute this option, the Remaining Shareholder would need to carry out an independent valuation of the company and then sell the assets at the valuation price, avoiding any potential argument from the Leaver that a proper price was not paid.
However, this option does present a couple of legal challenges. The Remaining Shareholder in his capacity as a director of the company is still required to observe his duties as a director. It may be difficult to show that he has complied with these duties should he wish to go down this route.
The second issue is that under the rules relating to substantial property transactions, if the Remaining Shareholder owns at least 20% of the share capital or is entitled to exercise more than 20% of the voting power at a general meeting of the third party company or newly incorporated company which is to purchase the company’s assets, then the transaction will require shareholder approval. The Leaver, owning 50% of the shares in the company, would be able to block such approval.
Rather than a solvent sale of the company’s assets, as described above, it may be possible to place the company into administration and then immediately sell the company’s business under a sale to a third party company or newly incorporated company which would be arranged before the administrator is appointed.
The advantage of this is that it is less easy for the Leaver to challenge than a solvent sale, as it would be sanctioned by an insolvency practitioner. However, there are several disadvantages of pursuing this option, namely that it is expensive, there could be a deemed loss of value, and if the company is solvent, you may not be able to put it into administration into the first place.
The Threat of Action
Lastly, the mere threat of doing any one or a combination of these things in order to break the deadlock may be enough to bring the Leaver to his senses. When faced with a more aggressive strategy as outlined above, he may come to see that the ways forward offered up under our first article on Shareholder Disputes are not so bad after all and could actually be the best way to resolve the issues for everyone involved.
A consensual exit remains the preferable route by far, where such an exit can be negotiated. However, in shareholder disputes such as these where emotions run high, this may not always be possible. As can be seen, non-consensual strategies are on the whole somewhat trickier to implement and can present more legal challenges than consensual strategies. As such, where the Remaining Shareholder has exhausted all other options and is turning to non-consensual strategies to resolve the dispute or where the Leaver is being confronted with such strategies, the one thing they will have in common is that both parties should take legal and tax advice as soon as they can in order to place themselves in the best position possible.
Fox Williams has extensive experience in this area and has been involved in “breaking the deadlock” on numerous occasions in differing sectors.