\'You will never walk alone\' if you are aware of your shareholder rights

October 14, 2010

The drama being played out at Anfield (and the High Court) shows what happens if the relationship between a company's board of directors and its shareholders breaks down. The case at Anfield is actually the exception, rather than the rule, as most shareholder disputes involve a minority shareholder (rather than 100% of the ownership as with Messrs Hicks and Gillett).

Although the directors are responsible for the day to day running of a company, a number of important decisions regarding a company, are reserved to shareholders (as they require the passing of a shareholder resolution). These decisions tend to be taken based on the principle of 'majority rules' (i.e. an ordinary resolution needs over 50%, a special resolution needs no less than 75%).

Minority shareholders have various options when seeking to protect their interests in a company following board or majority shareholder misconduct of the company’s affairs.

i) Membership rights

The articles of association ("articles") of a company mainly regulate the relationship between the shareholders and the company. Section 33 of the Companies Act 2006 ('CA 2006') provides that the articles act as a contract. Therefore, under this section, a shareholder can sue the Company if their membership rights are infringed.

It is far from clear as to what constitutes a "membership right". Examples which have been enforced include the right to a dividend once it has been lawfully declared and the right to vote at meetings.

The case of Eley v Positive Government Security Life Assurance Co Ltd (1876) 1 Ex D 88, highlights the impracticality of relying on this approach. In this case, although the company's articles contained a provision that the plaintiff would be appointed as the company's solicitor, he was never appointed to such a position. It was held that the plaintiff could not sue as the right to be appointed as a company's solicitor was not a "membership right". It is important, therefore, to protect any shareholder rights in a separate contract such as a shareholders' agreement.

ii) Shareholders' agreement

A shareholders' agreement is typically entered into by the shareholders, key directors and the company. It may, for example, contain reserved matters (where certain key decisions require the consent of all, or a certain percentage, of shareholders) e.g. amendments to the articles of the company, the issue of new shares or the appointment or removal of a director.

Whereas articles provide rights attached to shares, a shareholders' agreement creates personal contractual rights. Such an agreement provides a right of action which enables one shareholder to enforce provisions of the agreement directly against another shareholder, the company and/or the contracting director. If a term of the agreement is breached, it can be enforced under general contract law principles; a shareholder would be able to claim damages for breach of contract. It could also apply to the court for an injunction to prevent a breach.

iii) Foss v Harbottle and derivative actions

The above case has long provided the general rule that where a wrong has been done to a company, the company is the proper claimant. However, over the years the courts have recognised that there needs to be some circumstances in which a shareholder could bring a claim on the company’s behalf. There are now a number of exceptions to the rule in Foss v Harbottle. An action brought under one of the exceptions would be a derivative action because the shareholder's right to sue is not a personal right to that shareholder (but has derived from the company's right to sue).

A derivative claim is defined in s.260(1) CA 2006 as one initiated by a shareholder of a company in respect of a cause of action vested in the company and seeking relief on behalf of the company. A claim may be brought where there has been, i) an act or omission by a director, ii) involving negligence, default, breach of duty (i.e. director’s statutory duties) or breach of trust (s.260(3) CA 2006). There is no requirement that the director received some personal benefit. The claim may be brought against a director, third parties who are aware of the breach or even shadow directors. The claim must be brought by a shareholder of the company. Section 260(4) CA 2006 also provides that a shareholder my bring a claim in respect of events which occurred before he became a shareholder of the company.

The shareholder bringing the claim, must obtain permission from the court to continue his claim (s.261(1) CA 2006). He must make out a prima facie case in order to obtain permission. When deciding whether to grant permission, the court must consider the factors listed in s.263(3) CA 2006, for example, whether the shareholder is acting in good faith. This procedure is potentially time consuming and arduous.

If permission is given for the claim to continue, Civil Procedure Rule 19.9 and its Practice Direction sets out the procedures with regard to the conduct of a derivative claim.

iv) Unfair prejudice

Section 994 CA 2006 allows a shareholder to bring an action on the grounds that the company is being run in a way that he has suffered unfair prejudice. Examples of behaviour that may be held to be unfairly prejudicial to the interests of shareholders include the granting of excessive remuneration to directors or non-payment of dividends. Unlike with a derivative action, a claim for unfair prejudice is brought by a shareholder in his personal capacity.

There are two grounds for such a claim:

  1. the company’s affairs having been conducted in an unfairly prejudicial manner, or
  2. an unfairly prejudicial act or omission has occurred

So what constitutes unfairly prejudicial conduct? Negligent or inept management will not, unless such conduct amounts to serious and/or repeated mismanagement which puts at risk the value of the shareholders' interests. A disagreement as to company policy will not afford grounds for a petition under s.994 CA 2006. There is no need to show bad faith for the conduct to be unfair. A shareholder may have a legitimate expectation that he be involved in the management of the company and prevention of such involvement may be considered to be unfairly prejudicial conduct (Re a Company No 00477 of 1986 (1986) 2 BCC 99, 171).

The court has power to grant such an order as it thinks fit to provide relief (s.996(1) CA 2006). Section 996(2) CA 2006 sets out a list of orders that may be made. A client should be advised that the most common order is for the purchase of the petitioner’s shares by the wrongdoer.

v) Insolvency Act 1986 ('IA 1986')

Section 122(1)(g) IA 1986 provides the right for a disgruntled shareholder to apply for the company to be wound up on the grounds that it is just and equitable to do so. This would be drastic as the corporate life of the company would effectively be brought to an end. The expression, cutting off your nose, to spite your face often comes to mind when reviewing such cases.

A winding up order is less frequently invoked as it is a remedy of the last resort. Note that s.125(2) IA 1986 states that a winding up petition may be struck out if the court considers that it was unreasonable for the petitioner not to have pursued an alternative course of action. It is likely that a remedy which a court has wide discretion to order under s.994 CA 2006 would be more attractive to a shareholder.

vi) Removal of director by shareholders

Another sanction that a shareholder has against a director is the ability to remove a director from his office. This can be done by ordinary resolution (s.168(1) CA 2006), i.e. majority rule. This right overrides any contractual arrangements in place between the director and the company. A special procedure, including giving special notice of 28 days (s.168(2) CA 2006) would need to be followed. Also note that employment rights would need to be taken into account (e.g. if the director has a service agreement which says he will be employed as a director).

vii) Further protection for shareholders under the CA 2006

  • Requisitioning a general meeting: shareholders holding not less than 5% of the paid up voting share capital can require a general meeting, by serving a request on the company (s.303 CA 2006; The Companies (Shareholders’ Rights) Regulations 2009). The request must state the general nature of the business to be dealt with at the meeting, and may include the text of the resolution they want proposed at the meeting.
  • Require the circulation of statements: shareholders holding 5% of the total voting rights or not less than 100 shareholders holding shares with the right to vote which have been paid up an average sum per shareholder of not less than £100 can requisition the circulation of a statement of up to 1,000 words regarding any resolution or business to be dealt with at a general meeting (s.314 CA 2006).
  • Force resolutions onto the agenda of an AGM: (public companies only) (s.338 CA 2006): the requirements are the same as for requiring the circulation of statements.

Conclusions

A shareholder whose financial interest in a company has been depleted following the misconduct of a company's affairs can seek a remedy for the unlawful activity. The course of action pursued will largely depend on whether the shareholder is seeking a personal remedy or one on behalf of the company and also whether the company is a private or public company.

When considering what action to pursue, the remedy that the shareholder is seeking must always be considered. A personal remedy is likely to provide an exit route from the company for the shareholder while a derivative action will not. It should also be noted that the court may refuse an application for the commencement of a statutory derivative action, where the applicant has the ability to commence proceedings in his own right.

At present, shareholder activism is at a much higher level than in previous years. This is likely to be a result of increased transparency in the way that companies are run and the economic downturn (as people seek to attach blame for poor performance).

Shareholders own the company in which they hold shares. Although directors are in charge of how the company is run on a day to day basis, shareholders have considerable power afforded to including the ability to question the board at company meetings and a number of important decisions are reserved for their approval. Shareholders are showing that they are prepared to challenge an incumbent board of a UK company and they certainly have a range of tools at their disposal.

It remains to be seen if directors will start playing a more defensive game to ensure that they do not leave the goal wide open for unwanted shareholder activism.

Paul Taylor is a partner at City law firm Fox Williams LLP (www.foxwilliams.com). Paul can be contacted by telephone on 020 7614 2512 or by email at PTaylor@foxwilliams.com. Duncan Jones is a trainee solicitor at Fox Williams LLP (www.foxwilliams.com). Duncan can be contacted by telephone on 020 7614 2647 or by email at DJones@foxwilliams.com.


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