The Importance of Shareholders’ Agreements – Part 1
Starting a business is an exciting venture, filled with possibilities and potential. However, as businesses grow and evolve, the relationships between their ‘owners’, better referred to as shareholders—can become complex and challenging to manage. This is where shareholder agreements come into play. A shareholder agreement is a vital document that sets out the rights, responsibilities, and obligations of shareholders within a company. It acts as a blueprint for how the company will be managed and how major decisions will be made, helping to prevent disputes and ensure smooth operations.
A shareholder agreement serves multiple critical functions that are essential for the operation and stability of a company. Firstly, it provides protection against disputes by clearly outlining the rights and responsibilities of shareholders, which helps set expectations and reduce misunderstandings that could lead to costly and prolonged litigation, potentially harming the company's reputation and financial stability. Secondly, it offers clarity on roles and decision-making authority by defining the powers of directors, voting rights of shareholders, and procedures for making significant business decisions, ensuring a clear process for handling major decisions such as mergers, acquisitions, or large capital expenditures. Additionally, shareholder agreements are crucial for ensuring business continuity by including provisions for situations where a shareholder wants to sell their shares, passes away, or becomes incapacitated, often incorporating buy-sell provisions, rights of first refusal, or drag-along and tag-along rights to manage such transitions effectively. They also play a vital role in attracting investors and raising capital by demonstrating robust corporate governance, reducing perceived risks, and clearly outlining shareholder rights and the process for issuing new shares, thereby facilitating smoother negotiations during fundraising or acquisitions. Finally, these agreements are particularly valuable for closely-held companies like family businesses or startups, allowing for customized governance structures that cater to specific needs and concerns not adequately addressed by general corporate laws or articles of incorporation.
In this first part of our series, we will explore the importance of shareholder agreements, provide a brief history of their development, and highlight key case law that has shaped their use in Canada.
A brief history
Shareholder agreements have been around for centuries, evolving alongside the concept of corporations and the development of company law. The need for agreements between shareholders became apparent as early joint-stock companies emerged in the 17th and 18th centuries, primarily in England. The growth of the British Empire and international trade necessitated the formation of corporations, leading to the creation of legal frameworks governing how these entities operated.
Initially, company governance was governed solely by common law principles and corporate charters, which often left gaps in terms of shareholder rights and obligations. The development of the Companies Act in England in 1844 marked a turning point, providing a statutory basis for the creation and regulation of companies, including provisions related to shareholder rights. Over time, the complexities of business relationships and corporate management highlighted the need for agreements specifically tailored to address the rights, responsibilities, and disputes between shareholders.
In Canada, company law evolved similarly, influenced by English law but with unique features tailored to Canadian business practices. Shareholder agreements became a common practice to fill in the gaps that statutes and bylaws could not adequately address, especially concerning closely-held companies and startups. These agreements are now an essential part of corporate governance in both jurisdictions.
Reasons for Having a Shareholders' Agreement
There are several compelling reasons to formalize agreements in writing. One of the most important is to prevent misunderstandings. Another is to ensure that all parties are clear that what has been discussed has now become a binding contractual term with corresponding legal consequences.
(Austin v. Warner, 2008 BCSC 1076 at para. 89)
A shareholders’ agreement defines the overall business arrangement between the shareholders and the company. At its core, it serves as a mechanism to "fill in the gaps" between the stipulations of the Business Corporations Act, S.B.C. 2002, c. 57 (the “BCA” or the "Act") and the company's articles.
Shareholders' agreements are often essential or highly beneficial for companies that are closely held or "private" (i.e., not publicly traded) and involve multiple shareholders who participate in the company’s financing and daily management.
Typically, one of the primary objectives of a shareholders’ agreement is to protect minority interests. Additionally, it can safeguard majority shareholders against potential future claims of oppression or other allegations from minority shareholders who may contend that the majority has acted unfairly. Essentially, a shareholders’ agreement clearly defines the relationship between all parties involved.
Under the BCA, a special resolution may require approval by a majority ranging from two-thirds to three-quarters of the votes cast, depending on the specific terms of the company's articles. If the articles do not specify, a special resolution can be passed with a two-thirds majority of votes cast or, in the case of a pre-existing company subject to the Pre-existing Company Provisions, with a three-quarters majority. As a result, shareholders holding less than one-quarter to one-third of the voting shares, depending on the scenario, may be outvoted on significant corporate decisions if they do not have protections beyond those provided by statutory and common law.
The process of creating a shareholders' agreement necessitates discussions between the shareholders and their professional advisors, enabling them to articulate, in writing, their mutual understanding of the business relationship regarding the company’s operations. Professional advisors can identify critical issues that should be covered in a shareholders' agreement, which shareholders might not have considered independently. This discussion phase also helps clarify the shareholders’ goals and expectations for the business and, importantly, determine whether these objectives are shared.
Although drafting a comprehensive shareholders’ agreement can involve considerable costs, it may prove to be a minor expense when weighed against the potential costs associated with disputes about shareholder relations or litigation involving the company.
Statutory Protections
Shareholders of companies incorporated under the BCA are entitled to certain statutory protections. For instance, some actions undertaken by the company require a "special resolution" from the shareholders or special separate resolutions from a class or series of shareholders. A special resolution typically involves the approval of a majority ranging between two-thirds and three-quarters of the votes cast, depending on the specific provisions outlined in the company’s articles. Examples of situations where a special resolution is necessary include:
The BCA also allows for the articles of a company to mandate that certain matters be approved by an "exceptional resolution," which requires an even higher majority than that needed for a special resolution.
It is essential to consider these statutory provisions when drafting a shareholders’ agreement to determine which additional protections might be necessary. For example, depending on the terms set out in the articles, if a shareholder controls more than one-third of the voting shares, it may prevent the other shareholders from passing a special resolution. This statutory limitation might already provide adequate protection for that shareholder without needing further safeguards through a shareholders' agreement. However, shareholders' agreements often expand upon the limited protections available under the BCA by addressing a broader range of issues, explicitly protecting minority shareholders, and setting higher thresholds for shareholder approval on critical decisions.
For companies that were incorporated before the enactment of the BCA and that remain governed by the Pre-existing Company Provisions, there are additional statutory protections available for shareholders. The most notable protections include:
Notice of Articles and Articles
The Notice of Articles provides essential details about a company, including its name, the location of its registered and records offices, the names of its directors, the authorized share structure, and any special rights or restrictions associated with its shares.
Unlike the Notice of Articles, the Articles of a Company (which some refer to as the byelaws) can include various provisions designed to protect minority shareholders. Some examples of these provisions are:
1. A company is prohibited from engaging in any business activities that its articles restrict it from conducting (s. 33(1)(a)).
2. A company is not permitted to exercise any of its powers in a way that exceeds or is inconsistent with the restrictions outlined in its articles (s. 33(1)(b)). For instance, this restriction on corporate powers could be used to limit the company’s ability to guarantee debts.
3. Special rights or restrictions can be attached to shares as specified in the company's articles. These rights may grant certain shares privileges regarding voting, dividends, or the return of capital upon the company’s dissolution, which may not be available to other types of shares. Other special rights might include the ability to convert shares into or exchange them for a different number or type of shares from any other class or series. Additionally, the articles could grant specific rights concerning the nomination or appointment of directors. There are no statutory limits on the kinds of provisions that can be included in the articles to help shareholders formalize the business arrangements they have agreed upon.
Shareholders’ Agreement vs Articles
When deciding what provisions to include in the articles of a company versus a shareholders’ agreement, several considerations must be taken into account. Some matters are more appropriately included in the articles, while others might be better suited for a shareholders' agreement, or in some cases, both. You should keep the following points in mind:
1. Public Availability of Articles:
Articles are publicly accessible documents (to a degree), which can be an important consideration for shareholders who wish to keep certain details of their agreement private. Due to privacy concerns, shareholders often prefer to outline their relationship in a shareholders’ agreement rather than in the articles. Conversely, there may be situations where it is beneficial for certain provisions of a shareholders' agreement to be publicly available and therefore included in the articles. For example, provisions that restrict the transfer of the company's shares may be desirable to have in the articles.
2. Shareholders' Agreements and Voting Rights:
A shareholders’ agreement may explicitly outline provisions regarding shareholders’ voting rights to establish, particularly for corporate tax purposes, that a specific shareholder or group does not have de jure control of the company, even if they hold 51% or more of the voting shares. In Duha Printers (Western) Ltd. v. R. (1998 CanLII 827 (SCC)), the Supreme Court of Canada ruled that, in determining whether a shareholder has effective (de jure) control over a company’s affairs, it is necessary to consider the governing statute, the company's share register, and any specific limitations on the majority shareholder’s power to direct the board or the board’s authority to manage the company’s affairs as expressed in the company’s constating documents or a unanimous shareholder agreement. In the context of British Columbia, the court is likely to focus on unique restrictions contained within a company's constating documents (such as its articles). The court in McGillivray Restaurant Ltd. v. Canada (2016 FCA 99), also clarified that a de facto control analysis involves a broader assessment of factors beyond just voting power.
3. Amendment of Articles:
The articles alone do not provide comprehensive protection for shareholders, as they can be amended by a vote of between two-thirds and three-quarters of the votes cast (or by a simple majority of votes or a directors' resolution, depending on the articles and subject to the BCA). Although it is possible to address this issue by attaching special rights or restrictions to different share classes, provisions placed in a shareholders' agreement generally require unanimous consent for amendments, thereby offering stronger protection to minority shareholders.
4. Transferring Director Powers:
Section 136 of the BCA mandates that the directors are responsible for managing or supervising the management of the company's business and affairs, subject to the Act and the articles. However, Section 137 allows the articles to transfer all or part of the directors’ powers to one or more other persons. If such a transfer is only stated in a shareholders' agreement, it would not be valid or enforceable. The articles must explicitly reference s. 137 to transfer management powers to the shareholders. In such cases, a shareholders' agreement can detail how the shareholders will manage the powers transferred to them.
5. Provisions That Must Be in the Articles:
The BCA specifies certain provisions that must be included in the Articles to be effective. Examples include quorum requirements for general meetings (s. 172(1)(a)), director share qualification provisions (s. 125), and rights related to redeeming or purchasing the company’s shares (s. 77(a) and (b)).
When drafting a shareholders' agreement, it is crucial to carefully review the agreement and the articles to ensure consistency. For instance, it is essential to ensure that no article prevents the company from carrying out an action it is contractually obligated to perform under the shareholders’ agreement. Generally, in the case of inconsistency, the articles will take precedence (CIPC (Ocean View) Ltd. Partnership v. Churchill International Property Corp. 2006 BCSC 1127). Therefore, a shareholders’ agreement should include a provision that obligates shareholders to amend the articles to align with the shareholders' agreement in the event of any conflict. However, this provision should not replace a thorough review of the articles before entering into a shareholders' agreement.
Parties to the Shareholders’ Agreement
It is common practice to include the company as a party to a shareholders’ agreement because these agreements often contain provisions that impose obligations on both the shareholders and the company. For example, the agreement may require the company to purchase shares from any of its shareholders under certain conditions.
In Russell v. Northern Bank Development Corporation Ltd ([1992] 1 WLR 588 (House of Lords)), the English court confirmed the binding nature of shareholder agreements and established that while shareholders can agree among themselves not to exercise certain statutory powers, they cannot bind the company itself to those limitations, as it was not a party to the agreement.
Additionally, it is wise to ensure that any new shareholders formally agree to become a party to an existing shareholders’ agreement. Although a purchaser who acquires shares with notice of the agreement may be bound by its terms, it is still advisable for the purchaser to expressly acknowledge and agree to be bound by the shareholders’ agreement. This includes making any required representations, warranties, and covenants as stipulated in the agreement.
Tax Considerations
One of the primary concerns when drafting a shareholders’ agreement is the potential income tax implications for both the shareholders and the company. These implications arise from the investment in the company and the provisions of the agreement related to the sale of shares and additional investments. The tax consequences can be substantial, complex, and subject to continuous changes. Significant tax considerations should be made regarding the buy-out of a shareholder’s shares, whether during their lifetime or upon death. It is essential to consult with a qualified tax expert when preparing a shareholders’ agreement to ensure compliance with the latest tax laws and regulations.
Conflicts
Lawyers must remain mindful of the potential conflicts of interest that can arise between a company and its shareholders, as well as among different shareholders. When acting as a lawyer for the company, the duty is to the company as an independent legal entity. Conversely, when representing a shareholder, the duty is to that specific shareholder. The interests of the company may not always align with those of the shareholders, and disagreements may arise between individual shareholders or between shareholders and the company.
The British Columbia Supreme Court has recognized that conflicts in representation can occur in shareholder litigation. For instance, in Mottershead v. Burdwood Bay Settlement Co. (1991 CanLII 2284 (BC SC)), the court disqualified a lawyer who acted for both the company and its majority shareholders in an oppression claim brought by minority shareholders. Similarly, in Gaylor v. Galiano Trading Co. (1996 CanLII 3547 (BC SC)), the court addressed similar concerns. However, in Maedou Consulting Inc. v. 0887455 B.C. Ltd. (2015 BCSC 2009), the court did not disqualify a law firm representing both the company and majority shareholders in an oppression action, as the interests were aligned regarding the matters at hand.
Conclusion
Shareholder agreements are indispensable tools for managing relationships and protecting the interests of all parties involved in a business. They provide clarity, prevent disputes, and ensure smooth operations by setting out the rules and expectations for all shareholders. In the next part of this series, we will dive deeper into the key provisions that every shareholder agreement should include and how they help manage potential conflicts and business challenges.