Increased Minority Shareholder Protection and the Quasi Partnership
Every minority shareholder in a company has the right to complain if its rights have been unfairly prejudiced. Common examples of unfair prejudice include directors exceeding their powers, misapplication of company funds, and selective share issues. In most cases, the minority shareholder's rights are contained in the articles of association, the duties imposed on the directors by law, and any shareholders agreement which might exist. Actions in breach of those agreements and duties gives the court the ability to require the majority shareholder to buy out the minority interest at a "fair value", usually fixed at the date of the court order following expert valuation evidence taking account of any value reduction caused by the conduct complained of.
It is very rare for a shareholder in a company whose shares are publicly traded to exercise these rights. This is because that shareholder always has the option of selling its shares into the market, and exiting its investment that way. So unfair prejudice rights are, in practice, only exercised by a minority shareholder in a private company. Here, the two usual problems are, first, that the majority shareholder is often only acting in accordance with its strict legal rights (so although action taken by that majority may be prejudicial, it is not unfair), and secondly when it comes to any buy out price payable by the majority, a minority interest is usually worth much less than the pro rata value of the company (because of the lack of control). But if the relationship between the shareholders amounts to a "quasi partnership", not only is the ability of the minority to exit the company increased, that minority can usually be paid the full, undiscounted, price for its shares.
Quasi partnerships are nothing new – they have existed since 1973 – and they usually have the same defining features:
- a relationship between the shareholders formed or continued on the basis of mutual trust and confidence,
- an understanding that they will all participate in the management of the business, and
- restrictions on the transfer of shares.
If these feature are present, a Court will give effect to informal agreements and understandings which have been relied on even if they do not have strict legal effect. The Courts have also made it clear that a purely commercial relationship can evolve over time into a quasi partnership, and equally a quasi partnership at the outset can evolve into a purely commercial relationship. Essentially, a "quasi partnership" is created by a situation where individuals agree to go into a business venture together, share risk and reward, jointly manage, agree that third parties cannot become involved without their joint consent, and rather than conduct their business via a conventional partnership with the unlimited personal liability that involves , instead decide to do this through holding shares in a limited liability company, and being directors of that company.
A fact pattern which gives rise to a "quasi partnership" has three key advantages for the minority shareholder enabling it to exit its investment at full value:
- The first advantage is that unfair prejudice can exist even though the majority is acting within its strict legal rights, and where there is no breach of a legally enforceable agreement or duty. An easy example would be the removal by the majority of a director appointed by the minority interest: under the articles and general company law the majority can usually do this as of right and there is nothing for the minority to complain about. But in a "quasi partnership" this can amount to unfair prejudice if the minority can show a legitimate expectation that it would be involved in the management of the business, even if that expectation is not legally binding.
- The second advantage is that, usually, an irretrievable breakdown in the relations between shareholders of a company is not unfairly prejudicial, but in a quasi partnership where conduct results in an irretrievable breakdown in the relationship of trust and confidence, that conduct can be unfairly prejudicial entitling the minority to complain.
- Finally, on a court ordered exit where the majority must buy out the minority, no discount is applied when the minority interest is valued: it is a simple pro rata valuation.
"Unfairness" is judged by the ordinary meaning of the word, and just because conduct is prejudicial does not mean it is unfair, likewise unfair conduct is not automatically prejudicial. Although the cultural background and expectations of the shareholders can be relevant, both "unfairness" and "prejudice" have to be individually established by objective standards. Simple mismanagement is not enough, nor does it give the minority an exit route from a "deadlocked" company. Typical examples of unfair prejudice in a quasi partnership context include:
- exclusion of the minority from management of the company, usually by removal as a director. But if the articles or any shareholders agreement provides a mechanism for the purchase of the member's shares at fair value, then it will be hard to prove that the member should not be excluded because the articles have contemplated just such an exclusion
- excessive remuneration paid to the majority. This can be difficult on its own for the minority to challenge, but is frequently used if it is clearly excessive given the circumstances of the company
- inadequate dividends, if the basis on which the shareholders went into business was that profits would be distributed, more so if other shareholders are receiving directors' remuneration
- being diluted, although this is harder to do if the minority buys in after the company has been formed without an agreement to retain the existing shareholding proportions
- alteration to the articles of association. A company has the power to do this by special resolution, but that power has to be exercised bona fide for the benefit of the company as a whole and not for the improper purpose of dilution
But it is important for the minority to remember that the Court is carrying out a balancing act. Misconduct on the part of the minority may result in prejudicial conduct by the majority not being unfair. And even though there is no strict time limit for the minority to bring its claim against the majority, delay in doing this, particularly when combined with accepting benefits from the company with full knowledge of the facts, means there is a significant risk of the court deciding that the minority has either accepted the unfairness, or cannot really have been prejudiced.
Simon Moore frequently advises shareholders, and directors, on strategies to exit minority interests.