SHAREHOLDERS REMEDIES [1997] EWLC 246(5) (24 October 1997)

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Introduction

5.1 In the consultation paper we provisionally recommended that it was desirable to include additional regulations in Table A. These would therefore form part of any new companys articles of association unless specifically excluded. The aim of the regulations was to encourage shareholders to provide in advance for what would happen if there was a dispute. We hoped that this would help to avoid litigation in many cases, or at least substantially reduce the issues in dispute. We also pointed out that recent cases had emphasised the need for better protection in the articles. (1) This approach is consistent with our fourth guiding principle (sanctity of contract) set out in paragraph 1.9 above.

5.2 Our approach received widespread support on consultation. A few respondents disagreed with the approach. Two reasons given by those who disagreed were that the articles would only apply to new companies (and so would not apply to the large number of existing companies); and of those new companies, many would routinely exclude any novel provisions. However, we remain of the view (which was supported by the vast majority of respondents) that Table A could serve a useful educational purpose in encouraging parties to address potential areas of dispute at the outset. We therefore recommend that appropriate provisions should be included in Table A to encourage parties to sort out areas of potential dispute at the outset.

5.3 In the consultation paper, we put forward three specific draft regulations which we suggested should be included in Table A. (2) These were: a shareholders exit article for smaller private companies; an arbitration article; and a valuation procedure article. Changes to Table A can be made by statutory instrument under section 8 of the Companies Act 1985. We consider each of the proposed new regulations in turn.

Shareholders exit article for smaller private companies

5.4 This regulation was intended to encourage shareholders in smaller private companies to make arrangements to deal with the situation where a disaffected shareholder wants to leave the company. In the consultation paper we noted that it was often the case that shareholders in such companies resorted to proceedings under section 459 in order to try to have their shares bought out, and that this often resulted in costly and cumbersome litigation.

· exit rights could be attached to particular shares by passing an ordinary resolution;

· the exit rights would be exercised by service of a notice requiring those on whom it was served to purchase the shares of the outgoing shareholder;

· no particular circumstances which would trigger the exit rights were set out, leaving it to the company to set these out (if required) in the resolution;

· if there was a disagreement the shares were to be valued on a basis which required the valuer to disregard the fact that the shares formed part of a minority shareholding;

· the outgoing shareholder could force the company to be wound up if the purchase of his shares did not go through within the timescale laid down in the regulation;

5.6 There was widespread support from respondents for an exit article along the lines proposed. A few respondents expressed reservations. Three particular points were made. First, some of these were concerned that the proposed regulation was not of sufficiently general application to be included in Table A. One respondent drew a comparison with pre-emption provisions which had never been included in Table A even when there was a separate part for exempt private companies, and although such provisions were often expressly included in the articles of such companies. (3) There was never any common form suitable for Table A. The point was made that an exit provision would either be deleted, or adopted without sufficient thought, leading to difficulties.

5.7 Secondly, another respondent was concerned that providing exit routes too readily may be economically damaging, leading to the break up of small businesses at the first sign of disagreement. Thirdly, several other respondents were concerned that serving an exit notice might enable shareholders to exert pressure improperly, knowing that the other party could not afford to pay for his shares.

5.8 Dealing with the last two points, we have already indicated that we consider that there are strong economic arguments against exit rights at will for shareholders. (4) But the proposed regulation does not go that far. It requires the shareholders to take a positive decision by passing a resolution that exit rights will attach to particular shares. This is reinforced in the revised draft by a requirement that every shareholder subject to it should have expressly agreed to the resolution. We do not consider that the article will have the effect of causing businesses to break up any more frequently than at present. Indeed, it is hoped that by encouraging the parties to make provision for a future breakdown in their relations, the regulation will have the opposite effect and allow parties to manage the break down in such a way as to cause the minimum disruption to the business itself. There can of course be no guarantee that a party does not seek to take advantage of any rights he has in the event of a dispute, but we do not consider that the regulation as proposed will give rise to any particular difficulties in this respect.

5.9 So far as the first point is concerned, the regulation in the consultation paper leaves it to companies to decide when the exit rights will apply (either by passing a resolution, or by modifying the regulation to set out the relevant circumstances). The article is therefore very versatile and does not suffer from the difficulties to which a standard form pre-emption article would give rise. As we stated above, we believe that the inclusion of the article will encourage companies to consider what circumstances might be appropriate for their company at the outset. We are also supported in this view by the fact that a large majority of respondents who considered this question were in favour of a regulation along the lines proposed.

5.10 Turning to the details of the provision, we have altered the emphasis to require the shareholders to make positive choices about, in particular, the basis of valuation and the choice of the valuer when the resolution is passed applying the regulation. If they do not do so, the regulation will not be effective. This reflects concerns expressed by a number of respondents that the article could operate unfairly. We are not in favour of an exit article which would apply automatically (ie unless excluded by incorporators) as appeared to be favoured by several respondents. We consider that this would increase enormously the risk of shareholders becoming subject to exit rights inadvertently. On the other hand, if the parties did want an "automatic" no-fault type provision, they could simply make the giving of notice at any time a specified event for the purposes of the new draft regulation. (5)

5.11 We have taken into account the responses received on the regulation and in order to meet as many as we can of the points that were made we are recommending a redrafted regulation 119 which will be found in Appendix C. The main features of the regulation are:

· every shareholder who is to have or be subject to exit rights must be named in the resolution and must consent to it;

· the resolution must set out the events in which the exit rights are to be exercisable. The exit right could be exercisable by personal representatives on the death of a named shareholder;

· when an exit right is exercisable the shareholder entitled to the right may require other shareholders named in the resolution to buy his shares at a "fair price";

· those shares must be shares he held when the resolution was passed or shares acquired in right of them, eg on a bonus issue. The exit right does not apply to other shares which were transferred to him later;

· the resolution must state how the "fair price" is to be calculated. Various of the possible methods are suggested for convenience;

· if the shares require to be valued, the resolution must say how the valuer is to be appointed. He must be an independent person who appears to have the requisite knowledge and experience;

· the resolution comes to an end when one of the named shareholders dies or disposes of his shares;

· the company cannot amend the resolution or the regulation without the consent of the named shareholders.

5.12 We have gone as far as we can to prevent shareholders from creating exit rights without being aware of their consequences. The adoption of exit rights under this regulation would be an interactive process between the various shareholders involved requiring them to make a series of positive choices. The only way of protecting those who will enter into exit rights without giving them proper thought is by not having the regulation in Table A. We think that this level of protection would be excessive since it would prevent any shareholder from having the benefit of the regulation in Table A. We now consider the provisions of the revised draft regulation in more detail.

Restriction to companies with less than 10 members

5.13 We no longer consider that the availability of the article should be limited to companies with less than 10 members. We accept the concerns of those who considered that the limit could be evaded by splitting shareholdings so as to increase the number of members beyond 10. We also agree that, since the company has to pass a resolution to bring the article into effect, there is already a sufficient restriction on its applicability. On further consideration we are of the view that the 10 member limit is unnecessary and could be arbitrary.

Circumstances giving rise to exit rights

5.14 The views of respondents appeared to be evenly split between those who considered that the article should set out specific circumstances in which the exit rights should be available and those who considered that it should not.

5.15 For those who considered that the article should set out specific circumstances the point was made that, as it was primarily intended for companies without ready access to expert advice, it would be more user friendly if it did have the circumstances set out. Few attempted to list what these should be, but one respondent suggested including: (a) loss of directorship without cause; (b) misappropriation of assets; (c) non-trivial breaches of statutory provisions; (d) loss of effective right to participation in management by retirement, illness or death.

5.16 Those who were against setting out circumstances in the draft regulation gave two main reasons. First, that it may lead to disputes as to the circumstances in which the right to serve an exit notice arises; secondly, the parties would not have the opportunity to address their minds to the circumstances which would be appropriate for them.

5.17 One respondent pointed out in respect of this issue that it was not entirely clear whether the article was designed to offer a no-fault quasi-partnership retirement route, or intended to be a remedy for unfairly prejudicial conduct by the majority. He saw no reason in principle why the regulation should not deal with both types of situation, provided its terms were even-handed as between seller and buyer. Other respondents went much further and suggested that the right to serve an exit notice should apply in any circumstances (without the need for a resolution to bring the rights into effect).

5.18 Our view is that it is often impossible to apportion blame between parties in many cases where there has been a break down in relations between owner-managers in small private companies. (7) What is important is resolving the position with as little cost and disruption to the parties and the company as possible. We would envisage that the regulation would be used in the sorts of circumstances where currently claims are brought under section 459, although it may be that in some of the cases the petition would not in fact be successful because the petitioner could not show unfair prejudice. If the regulation assists parties in avoiding bringing such proceedings we consider that it is worthwhile as it will save the parties considerable expense, loss of time and anxiety.

5.19 We agree that it would be helpful to some companies if the regulation set out the circumstances in which the exit rights would apply. In this way the rights could be made to apply without the need for a resolution. Also, even if the companies wanted to modify the regulation, it would give them a starting point as it would set out some of the more common circumstances in which it might be appropriate for the exit articles to arise. On the other hand, we accept that it may be dangerous to include a list of circumstances in the article as they may not be appropriate for a particular company, but the company may adopt the standard Table A articles without giving proper consideration to this issue.

5.20 As a way of addressing these competing concerns, we recommend that the article should include reference to the two most common situations in which shareholders are likely to want to invoke the exit rights, but that these should only be by way of example. It should still be up to the shareholders to set out the relevant circumstances in the resolution applying the article (or by amendment to the article itself). The two situations we have mentioned in the revised draft are: (a) the removal of a shareholder who is a director from his office as a director of the company otherwise than where he is in serious breach of his duties as a director; and (b) the death of a shareholder. (8) Neither of these events would, of course, necessarily give rise to a buy out under section 459. But we are not seeking to replicate the result which could be achieved under that section; rather we are seeking to encourage the parties to make their own provision for the type of circumstances in which they consider a named member should be able to leave the company on agreed terms, so as to avoid (so far as possible) the risk that legal proceedings will be commenced.

Who is bound to purchase the shares of the outgoing shareholder and when does the provision become operative

5.21 Under the previous draft of the regulation which was appended to the consultation paper, it was proposed that an exit notice should be served on all the other shareholders of the company and that this should require them to purchase the exiting members shares within three months of the notice. Under our revised draft it is only those shareholders named in the resolution who must purchase the exiting members shares. The regulation provides that unless the resolution otherwise states or the parties make some other agreement, they must do so in proportion to the number of shares they held at the date of the resolution. (9) In addition, the revised draft provides that the resolution shall not be valid unless every shareholder who is named in it gives a notice to the company (before the resolution is passed) stating that he consents to it. (10)

5.22 The reason for these changes is to ensure that it is only those shareholders who are aware of the exit rights and have consented to them who are bound by them. We wish to avoid the situation where, for example, a person acquires shares without considering fully the articles, or without knowing that a resolution has been passed, and finds later that he is obliged to purchase shares belonging to another shareholder.

When does the resolution cease to have effect

5.23 The draft regulation contained in the consultation paper did not include any provision for the resolution to cease to have effect. This could have lead to unfairness if some of the named shareholders ceased to hold shares, but the resolution continued to be effective as between the remaining named shareholders. Those shareholders would have had an obligation to purchase a greater proportion of an outgoing shareholders shares (if an exit right became exercisable) than they might have anticipated at the date the resolution was passed. In order to deal with this problem, the revised draft provides that the resolution shall cease to have effect (unless it states otherwise) if a named shareholder ceases to hold the shares which he had when the resolution was passed or shares allotted directly or indirectly in right of such shares. (11) This is without prejudice to any exit notice which has already been served. (12) In order to prevent a transfer which would defeat the object of the exit article rights, the regulation provides that the directors must refuse to register a transfer which would cause the resolution to be ineffective, ie a transfer as a result of which a named shareholder would cease to hold any of the shares which he held when the resolution was passed or any shares allotted directly or indirectly in right of such shares, unless all the relevant persons agree. (13)

5.24 We also consider that it would not generally be appropriate for an exit right to be enforceable against the estate of a deceased member. It could delay the administration of the estate if there was a potential liability to purchase the shares of other named shareholders which remained outstanding. For this reason, the revised draft provides that the resolution shall also cease to have effect (unless it states otherwise) when a named shareholder dies. (14) However, if the death of the shareholder is the event which triggers the exercise by his successor of the exit right, then the resolution is to continue so far as that event is concerned. (15) This is also without prejudice to any exit notice which has already been served before the death.

5.25 The draft regulation also provides that the resolution may be brought to an end by the unanimous agreement of the named shareholders (or their successors in the event that the resolution survives their death). (16) Neither the resolution nor the regulation can be varied without the consent of those persons. (17)

Who is to carry out the valuation

5.26 In the consultation paper we proposed that the valuation of the exiting members shares should be carried out by an independent accountant, and we set out provisions for the appointment of that person in default of agreement between the parties. In our revised draft we refer to an "independent person who appears to have the requisite knowledge and skill". (18) We accept the point made by several respondents that the auditor or even an accountant may not always be the best person to value the shares. The auditor may have a conflict of interest so far as his duties to the outgoing shareholder are concerned because of his ongoing relationship with the company. (19) Moreover, share valuation requires particular skills which do not necessarily form part of an accountants training or practice; on the other hand, there may also be experienced valuers who are not accountants. (20) Our revised draft regulation also leaves it to the resolution to specify the manner in which the independent person is to be appointed.

Basis of valuation

5.27 The regulation put forward in the consultation paper provided for only one basis of valuation, namely non-discounted. In our revised draft we include a number of alternatives which shareholders can choose when passing the resolution which brings the article into effect. These are: fair value; pro rata to the aggregate market value of the whole of the ordinary share capital; net asset value; and return of capital. This is intended to give greater flexibility so that the article can be adapted more easily to the needs of the particular shareholders, and any special factors arising on valuation, such as the fact that some shares have special rights. In order to avoid potential unfairness which might arise if the shareholders did not properly consider the basis of valuation when passing the resolution, the revised draft regulation makes it clear that the resolution will be invalid unless it sets out a basis of valuation. (21)

Provision for winding up in default

5.28 The draft of the regulation put forward in the consultation paper gave the outgoing member the power to force the company into liquidation if the remaining shareholders failed to purchase his shares within the timescale set out. A number of respondents expressed concern at the "draconian" nature of the consequences of this provision, and the increased risk that it would enable a shareholder to put unjustified pressure on the other shareholders. The point was also made that it appeared to be unfair since the provision came into effect if only one shareholder out of many failed to purchase some of the outgoing shareholders shares. We accept these points and our revised draft does not include provision for winding up. We propose that the outgoing shareholder should have to rely on his remedy of specific performance against those shareholders who do not complete the purchase of his shares in accordance with the terms of the article. This is the position also under common form pre-emption articles.

Withdrawal of notice

5.29 We had also proposed that a shareholder could withdraw an exit notice at any time. However, on further reflection, we consider that this might lead to undesirable uncertainty, and could increase the risk that the provision is used inappropriately, as a means simply of putting pressure on the other shareholders. We therefore propose that a shareholder should not be able to withdraw a notice unless all the shareholders named in the resolution agree.

Payment by instalment

5.30 In the consultation paper we raised the question of whether the regulation should provide for the purchase price to be paid by instalments. (22) Responses indicated that there were mixed views on this point, with many respondents indicating that they considered that this should be left up to the shareholders to decide. We agree that it would not be possible to include a provision in the regulation which would be suitable for all situations, and we have not sought to do so. However, it would be open to parties to make modifications to the regulation if they knew in advance what instalment arrangements they would want.

Shareholders agreement

5.31 It would still be open to shareholders to choose to regulate their affairs by having a shareholders agreement. Indeed, the existence of regulation 119 in Table A may prompt registration agents to encourage their clients to consider such agreements, or even provide standard form drafts.

5.32 Accordingly, we recommend that a shareholders exit article in the terms of the draft Regulation 119 set out in Appendix C should be included in Table A.

5.33 In addition, we would encourage Companies House to consider whether reference can be made in the explanatory material which it supplies to persons forming companies to the desirability of addressing the issue of providing an exit mechanism for a shareholder to withdraw his investment from the company. We also hope that registration agents would, as a matter of good practice, provide information to their customers on the new draft regulation. (23)

Arbitration

5.34 This draft regulation was not limited to any particular type or size of company and required disputes between shareholders and the company to be referred to arbitration. However, it provided that the arbitration would be suspended if the parties sought to resolve the dispute through an ADR procedure (for example, mediation). The object was, of course, to encourage incorporators to consider providing for means of dispute resolution other than the courts.

5.35 The regulation made it clear that it only applied to disputes in respect of which a member could maintain legal proceedings. This was so as not to extend the areas in which a shareholder can interfere with the companys management. (24) In the event that the parties could not agree on the choice of an arbitrator, he would be nominated by the President of the Institute of Chartered Accountants in England and Wales.

5.36 Support for an arbitration article was much less enthusiastic than for the other two draft regulations. In fact only a small majority of respondents were in favour of its inclusion in Table A, and a majority of the practising lawyers who addressed this question were against its inclusion. A number of reasons were given. First, it was said that there may be argument as to whether a dispute was one in respect of which a member could maintain legal proceedings; secondly it was pointed out that ancillary proceedings and enforcement would be dealt with in the Commercial Court rather than the Chancery Division which, for matters of this kind, would be undesirable; thirdly, it was noted that the interests of other shareholders may be affected, but it was not clear how they were to be represented; fourthly, it was suggested that there was scope for abuse as a member dissatisfied with a proposed resolution might initiate arbitration proceedings, which may not be disposed of as easily as would court proceedings; finally the point was made that legal aid would not be available for the arbitration proceedings.

5.37 There was also considerable disagreement, even amongst those in favour of the regulation, over who should nominate the arbitrator. A majority of those who considered the issue appeared to be against the nomination by the President of the Institute of Chartered Accountants as proposed in the draft regulation, but no alternative appeared to be clearly favoured by respondents.

5.38 We are reluctant to recommend the inclusion of an article into Table A which does not have the whole hearted support of respondents, particularly when a majority of practising lawyers appeared to be against its inclusion. We are persuaded that the potential difficulties which have been highlighted outweigh the benefits which may accrue. It is of course open to parties to refer any disputes to arbitration and we would wish to encourage the greater use of ADR techniques generally. However, we do not consider that this is best achieved by the inclusion of the proposed article in Table A. Accordingly, we recommend against the inclusion of an arbitration and ADR regulation in Table A.

Valuation procedure

5.39 In the consultation paper, we drew attention to the situation where all the shareholders of a company are agreed that one or more of them should sell their shares to the rest, but no agreement can be reached on value. Currently there is no remedy to which shareholders can resort in this situation in the absence of unfairly prejudicial conduct. (25) This means that shareholders may try to bring a petition under section 459 when the circumstances do not in fact justify a claim of unfairly prejudicial conduct, and when all they are seeking to resolve is a dispute about the price to be paid for the shares. This is clearly a waste of time and costs for the parties and for the court.

5.40 The draft regulation proposed in the consultation paper was designed to meet this need. It provided that where shareholders are agreed (apart from price) on the sale or purchase of particular shares in the company, they shall appoint an independent accountant to determine the fair value of the shares, and in default the President of the Institute of Chartered Accountants may do so. It stated that no discount is to be made for the fact that the shares form part of a minority shareholding. But it made no provision for default by the purchaser in completing the sale, leaving the vendor to exercise his remedies at common law if this occurred.

5.41 The valuation article received considerable support on consultation, but serious concerns were expressed by a number of respondents about how such an article might work in practice. Two particular points were made.

5.42 The first was that price is an essential element of agreement to a sale. If there is no agreement on price, what exactly is meant by shareholders being "agreed ... on the sale or purchase of particular shares"? What is necessary for the regulation to bite? This point was developed in several different ways.

5.43 One respondent considered that the concept of agreement to sell but disagreement as to price was probably impossible to define in any sufficiently realistic way to make the regulation of significant use.

5.44 Another respondent suggested that for there to be an agreement, the parties would have to have agreed that they will buy and sell subject to the price being settled under the new regulation. This would effectively convert the valuation provision into a voluntary one, and so there may be little point in including it in Table A.

5.45 A third respondent was concerned that the regulation might be regarded as being operative when shareholders were simply in negotiation about a possible sale of shares. In his view the regulation should make it clear that the provision would only become operative as and when a sale contract was entered into which expressly included the regulation as a term.

5.46 The second point made by those who disagreed with the article was that it could operate unfairly. A valuation without a minority discount would not be appropriate in every case. If the parties could not agree on the basis of valuation, it might be unfair to impose a non-discounted valuation on them; if they were able to agree on the basis of valuation, then the article would probably serve little use in practice.

5.47 On further consideration, we agree with these concerns. The parties should not be bound by the valuation procedure at too early a stage in any discussions between them. This may discourage them from entering into negotiations at all, which would clearly have the opposite effect from that which we are seeking. But if the regulation is only to apply once the parties have reached an effective agreement, then they must have either agreed on the price or a method of fixing a price. In order to avoid any potential unfairness, we consider that the parties should also be given the opportunity to choose the basis of valuation. The regulation should not have the effect of imposing a pro rata valuation where, for example, the parties have simply made an agreement that the shares be sold at a fair value to be determined by an independent third party. Otherwise, the regulation might apply where the parties had positively disagreed about the basis of valuation but reached agreement that the shares would be sold on the basis of a valuation by a third party in ignorance of the effect of the article.

5.48 We consider that if the parties are able to agree on both the method and basis of valuing the shares, then there is little that a valuation article can achieve, since the parties can set these matters out in the agreement itself. Accordingly, we recommend against the inclusion of a valuation article in Table A.

Conclusion

5.49 To summarise, we recommend that a shareholders exit article should be included in Table A, setting out a mechanism by which shareholders can require their shares to be purchased in certain agreed circumstances. Whilst the regulation should set out a framework for the exercise of these exit rights, it should require the shareholders to make positive choices (notably in relation to the events triggering the rights, the basis of valuation and the choice of the valuer) in order to bring the regulation into effect. (26)

5.50 We recommend against the inclusion of an arbitration article and a valuation article in Table A.

(1) In particular, the case of Re Saul D Harrison & Sons plc [1995] 1 BCLC 14. See Consultation Paper No 142, para 19.2.

(3) Table A does not contain a standard form pre-emption article, that is an article giving members a right of first refusal if a member wishes to dispose of his shares. If a company wishes to adopt a pre-emption article and an exit article it would have to make suitable amendments to avoid a conflict between the two provisions.

(6) Particulars of the resolution would need to be sent to the Registrar of Companies in accordance with s 128(3) of the Companies Act 1985.

(7) In the context of allegations of exclusion from management, see the comments of Hoffmann J in Re XYZ Ltd [1987] 1 WLR 102, 110 where he said: "Each party blames the other but often it is impossible, even after lengthy cross-examination, to say more than the petitioner says in this case, namely that there was a clear conflict in personalities and management style ".

(17) Ibid, draft regulation 119(21). This provides that if a resolution is passed, a variation of the regulation or of the resolution is to be treated as a variation of the rights attaching to the shares held by the named shareholders, and that those rights may only be varied with their unanimous consent.

(19) Moreover, the company may be, or become, exempt from the requirement to appoint auditors under s 249A of the Companies Act 1985.

(20) There is not yet a recognised professional qualification in the United Kingdom for share valuers. The Society of Share and Business Valuers in the United Kingdom is only in its second year of existence.

(23) Publicity in legal and accountancy journals would also be helpful, as well as dissemination of information by trade organisations, professional bodies, Business Links and Chambers of Commerce; see Consultation Paper No 142, para 19.18.

(24) There are restrictions on the extent to which an individual shareholder can enforce provisions in the memorandum and articles of association. See para 7.5 below, and see Consultation Paper No 142, paras 2.15-2.39. The draft arbitration regulation was not intended to affect these restrictions in any way.

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You are here: BAILII >> Databases >> The Law Commission >> SHAREHOLDERS REMEDIES [1997] EWLC 246(5) (24 October 1997) URL: http://www.bailii.org/ew/other/EWLC/1997/246(5).html Cite as: [1997] EWLC 246(5)

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