Shareholders' agreement explained

A shareholders' agreement (sometimes referred to in the U.S. as a stockholders' agreement) (SHA) is an enforceable agreement amongst the shareholders or members of a company. In practical effect, it is analogous to a partnership agreement. There are advantages of the shareholder's agreement: they provide a contractual remedy if their terms are broken,^[1] and they can help the corporate entity to maintain the absence of publicity and maintain confidentiality. Nonetheless, there are also some disadvantages that should be considered, such as the limited effect to the third parties (especially assignees and share purchasers) and that alteration of the terms of an agreement can be time consuming.

Purpose

In strict legal theory, the relationships amongst the shareholders and those between the shareholders and the company are regulated by the constitutional documents of the company. However, where there are a relatively small number of shareholders, like in a startup company, it is quite common in practice for the shareholders to supplement the constitutional document. There are a number of reasons why the shareholders may wish to supplement (or supersede) the constitutional documents of the company in this way:

• a company's constitutional documents are normally available for public inspection, whereas the terms of a shareholders' agreement, as a private law contract, are normally confidential between the parties.
• contractual arrangements are generally cheaper and less formal to form, administer, revise or terminate.
• the shareholders might wish to provide for disputes to be resolved by arbitration, or in the courts of a foreign country (meaning a country other than the country in which the company is incorporated). In some countries, corporate law does not permit such dispute resolution clauses to be included in the constitutional documents.
• greater flexibility; the shareholders may anticipate that the company's business requires regular changes to their arrangements, and it may be unwieldy to repeatedly amend the corporate constitution.
• corporate law in the relevant country may not provide sufficient protection for minority shareholders, who may seek to better protect their position by using a shareholders' agreement.
• to provide formulas for share valuation to cut down on shareholders disputes over the value they can demand for their shares either on voluntary or on compulsory transfers
• to restrict the activities of shareholders – preventing abuse of position and competing activities
• to provide mechanisms for removing minority shareholders which preserve the company as a going concern.^[2]

Risks

There are also certain risks which can be associated with putting a shareholders' agreement in place in some countries.

• In some countries, using a shareholders' agreement can constitute a partnership, which can have unintended tax consequences, or result in liability attaching to shareholders in the event of a bankruptcy.^[3]
• Where the shareholders' agreement is inconsistent with the constitutional documents, the efficacy of the parties' intended arrangement can be undermined.^[4]
• Countries with notarial formalities, where notarial fees are set by the value of the subject matter, parties can find that their agreement is subject to prohibitively high notarial costs, which, if they fail to pay, would result in the agreement being unenforceable.
• In certain circumstances, a shareholders' agreement can be put forward as evidence of a conspiracy and/or monopolistic practices.^[5]

Common characteristics

Shareholders' agreements vary enormously between different countries and different commercial fields. However, in a characteristic joint venture or business startup, a shareholders' agreement would normally be expected to regulate the following matters:

• regulating the ownership and voting rights of the shares in the company, including
  • Lock-down provisions
  • restrictions on transferring shares, or granting security interests over shares
  • pre-emption rights and rights of first refusal in relation to any shares issued by the company (often called a buy-sell agreement)
  • "tag-along" and "drag-along" rights
  • minority protection provisions^[6]
• control and management of the company, which may include
  • power for certain shareholders to designate individuals for election to the board of directors
  • terms of employment for directors ^[7]
  • imposing super-majority voting requirements for "reserved matters" which are of key importance to the parties
  • imposing requirements to provide shareholders with accounts or other information that they might not otherwise be entitled to by law
• making provision for the resolution of any future disputes between shareholders, including
  • deadlock provisions^[8]
  • dispute resolution provisions
• protecting the competitive interests of the company which may include
  • restrictions on a shareholder's ability to be involved in a competing business to the company
  • restrictions on a shareholder's ability to poach key employees of the company
  • key terms with suppliers or customers who are also shareholders
• protecting selling rights of shareholders, including
  • piggy-back clauses, which come into effect when a majority shareholder decides to sell all or a significant part of their shares to a third party. Other shareholders can then 'piggy-back' onto the original shareholder's offer to the third party, and offer to sell their shares to the third party for the same agreed upon price.

In addition, shareholders' agreements will often make provision for the following:

• the nature and amount of initial contribution (whether capital contribution or other) to the company
• the proposed nature of the business
• how any future capital contributions or financing arrangements are to be made
• the governing law of the shareholders' agreement^[9]
• ethical practices^[10] or environmental practices
• allocation of key roles or responsibilities

Registration

In most countries, registration of a shareholders' agreement is not required for it to be effective. Indeed, it is the perceived greater flexibility of contract law over corporate law that provides much of the raison d'être for shareholders' agreements.

This flexibility, however, can give rise to conflicts between a shareholders' agreement and the constitutional documents of a company. Although laws differ across countries, in general most conflicts are resolved as follows:

• as against outside parties, only the constitutional documents regulate the company's powers and proceedings.
• as between the company and its shareholders, a breach of the shareholders' agreement which does not breach the constitutional documents will still be a valid corporate act, but it may sound in damages against the party who breaches the agreement.
• as between the company and its shareholders, a breach of the constitutional documents which does not breach the shareholders' agreement will nonetheless usually be an invalid corporate act.
• characteristically, courts will not grant an injunction or award specific performance in relation to a shareholders' agreement where to do so would be inconsistent with the company's constitutional documents.

External links

• Shareholders' Agreement Guide - English and Welsh law
• Shareholder Agreements: the 30 minute guide

Notes and References

1. Stephenson's Shareholders’ Agreements, accessed 26 August 2023
2. For example, in many countries, the only remedy where the company is being run in a manner prejudicial to the minority shareholders is a just and equitable "winding-up" of the company, which is the commercial equivalent of the judgment of Solomon. By putting put and call options in a shareholders' agreement, the parties can ensure that a dissenting minority can be bought out at a fair value without destroying the company.
3. Under English law, a shareholders' agreement is often suggested as an inference of a "quasi-partnership", which entitles disappointed partners to certain shareholder remedies, see Ebrahimi v Westbourne Galleries Ltd [1973] AC 360
4. Michael J Duffy, 'Shareholders Agreements and Shareholders' Remedies - Contract Versus Statute?'(2008) 20 Bond L. Rev 1
5. Although, in each case, this would only be likely if the agreement covered more than one company.
6. For the normal position in relation to minority rights, see for example, Foss v Harbottle (1843) 2 Hare 461
7. Coyle, M., Shareholder Agreements, Lawdit Solicitors, published 9 March 2022, accessed 26 August 2023
8. In a joint venture, "deadlock" refers to the parties being unable to agree on a key matter. If there are only two key parties, this can deadlock the vehicle, and leave it wallowing.
9. Whilst this is often the same as the law of the company's incorporation, it is sometimes chosen deliberately to be different, so as to allow a more flexible law of contract to overcome perceived limitations in the corporate law of the company's jurisdiction.
10. It is not uncommon to see shareholders' agreements between parties from developed countries and parties from emerging markets which provide that the company shall not engage in corrupt practices. Although in many countries it may be considered normal for local business to bribe officials to facilitate the conduct of business, many Western countries impose severe penalties on business who engage in corrupt practices abroad, and so Western investors often seek to ensure that their partners do not engage in anything which could breach such legislation in the Western investors' jurisdiction. See for example the Foreign Corrupt Practices Act in the U.S. and the Bribery Act 2010 in the UK