Wednesday, 31 July 2013

Should we have a concept of "abuse of a minority shareholder position" in English law?

The essence of the venture capital model is taking minority stakes in what are hoped to be fast growth companies. This means that us lawyers spend a lot of time on making sure that minority protections are appropriate, both to the venture investor and the target company. However, we do intermittently encounter scenarios where minority investors wield a high level of indirect power over key events in the life cycle of the target company, either actively by objecting or tacitly by totally disengaging from company matters... and increasingly I am not sure that is right as a matter of policy.

To illustrate this, I have set out three general scenarios where a minority can threaten a sting in the tail.

Exit reluctance.

Confronted with an exit opportunity, on the face of it, any shareholder could turn around and announce "I'm not selling". The Companies Act 2006 does provide a solution to this, in the form of a statutory "squeeze out" procedure set out in Part 28 of that act. However, this involves a prescriptive timeline and process, not to mention a 90% acceptance threshold. It may not therefore be a practical option in the context of many transactions. In many private company deals, advisors tend to see this as a last resort. The preference instead is to be able to point to a well drafted drag-along procedure in the target company's articles. Even drag-alongs come with a note of caution though. Many of them are just not very well drafted. If I had to single out the two areas of a typical set of articles which require closest attention, these would be the waterfall (who gets what on liquidation or exit) and the drag-along. In that context, the elation of winning a sale mandate has been tempered more often than I would like it to have been by discovering that the drag along which comes with it falls in a grey area of enforceability. There is a trickle of case law that highlights some drag-related pitfalls, including the much cited 1900 case of Allen v Gold Reefs of West Africa Limited. The judgement in that case states that that where changes to a set of articles include any compulsory transfer provisions, shareholders must exercise their voting power in good faith and in the best interests of the company, rather than merely in their own best interests. This is why it is always best to incorporate a detailed drag at the earliest possible stage in a company's life, and preferably with a 100% shareholder vote (although even that is not always enough (see Constable v Executive Connections Limited if you're interested)).

Class rights.

The default position under the Companies Act 2006 is that a variation of rights attaching to shares of any given class basically requires written consent from the holders of at least three-quarters in nominal value of the shares of that class in issue. This can be disapplied in a company's articles and it is usually advisable to do so, even if it is replaced with some other consent mechanic. Again, the class consent regime comes with a note of caution - there is no statutory guidance on what constitutes a "class" of shares. This can leave you with issues where shareholders can construct an argument that they have class rights which go beyond the designations of share classes (As, Bs, Ords etc) set out in the articles. Added to the fact that shareholders holding >15% of the shares of any given class have a statutory right to object to any variation of those class, you can see the potential for minority shareholders to wield unintended power through their class rights. 

Unfair prejudice and other minority claims.

Another potential source of minority leverage is to claim "unfair prejudice". This is the statutory remedy for a (normally minority) member who considers that the company's affairs were being conducted in an unfairly prejudicial manner. It's actually quite a difficult claim for a minority shareholder to take all the way. This doesn't stop people threatening it on a pretty regular basis - while in many cases, this comes from the misconception that a grievance of having been treated "unfairly" gives rise to this cause of action, the other problem is that it can be as difficult to conclusively rebuke these claims as to prove them. Bear in mind that the most likely remedy for such a claim is the somewhat neutral answer of a court ordering that the prejudiced shareholder should be bought out for fair value.

In addition to the specific examples set out above, there is a smorgasbord of other traps for the unwary in terms of statutory procedure and entitlements, and rights in shareholder agreements (with a classic problematic example being shareholder agreements which can only be varied or terminated with 100% shareholder approval).

So what?

Fair enough, you may say, minorities are shareholders too and entitled to the protection afforded to them by law. However, some minorities get more than protection: they get a licence to unreasonably block matters or cause cost/ delay to their company. Tail wags dog!

There are of course things that can be done to mitigate this risk of minority stranglehold including having decent bespoke shareholder agreements and articles, working hard on good shareholder relations and seeking to take disgruntled shareholders off the cap table, whether by compulsory transfer mechanism for employee leavers or by encouraging incoming investors on later rounds to make a secondary acquisition of some or all minority shareholdings (wishful thinking this last one!). However, where I am going with this is that I would like to see a change to the law, drawing inspiration from other juridications (e.g. France) where there is a prohibition on abuse of a minority position.

Specifically, I would like to see an evolution of English company law to provide for:

- a general duty on shareholders who are blocking the will of the majority to demonstrate that in doing so they have struck an appropriate balance between their individual interests and the interests of the company and its shareholder base as a whole;
- a rebuttable presumption that any uncertainty on construction of provisions in company documentation should be resolved in favour of the majority position; and
- consent of shareholders to any procedural matters (e.g. consents/ resolutions) to be deemed given in the case of silence within the period for response.

For smaller companies in particular, this would be a great help in avoiding shareholder deadlock situations and the associated cocktail of cost and ill-feeling. Compared to some of my other ideas for reform (what would I give to have a more straightforward tax code in the UK!) it's not exactly earth shattering, but it would be a helpful step in the right direction.

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