Shareholder disputes in private companies

Shareholder disputes rarely begin as legal problems. They begin as a disagreement about direction, or about how hard somebody is working, or about money being taken out of the business by one owner and not another. They become legal problems at the point at which somebody reads the articles of association properly for the first time and discovers what they do and do not say. By then the decisions that mattered were taken several years earlier, by whoever drafted the constitution.

The three patterns

Almost every owner dispute in a private company falls into one of three patterns.

The first is deadlock. Two shareholders hold equal parts, or a board is split evenly, and there is no mechanism to break the tie. Nothing can be decided, the business drifts, and each side believes the other is behaving unreasonably. Deadlock is the easiest of the three to prevent and among the hardest to resolve once it has occurred.

The second is exclusion from management. A minority shareholder who is also a director and an employee is removed from the board, taken off the payroll, or simply stops being told anything. Because a private company pays its owners through salary and dividend, and because there is no market for its shares, exclusion is not merely a loss of influence but a loss of income, and the shares themselves are worth very little to anyone outside the company.

The third is value leaking to one side: remuneration set at a level that suits the shareholder who controls the board, transactions with connected parties, and opportunities taken personally that arguably belonged to the company.

What the documents ought to have done

A shareholders' agreement earns its fee at this point, and the provisions that matter are the unremarkable ones.

A deadlock mechanism of any kind is better than none, whether a chair's casting vote, a referral to an expert, or a buy-out procedure under which one party names a price and the other chooses whether to buy or to sell at it. Pre-emption rights should work in practice, with a valuation basis specified and not left to be argued about. There should be clear provision for what happens when a shareholder stops working in the business, which is the most common trigger of all. And the matters requiring unanimity should be defined, so that neither side can claim to have been surprised.

None of this prevents a falling-out. It converts a falling-out into a process with a known ending, which is a great deal less expensive.

The statutory remedies, and where they are heard

Where the documents do not assist, the Companies Act 2006 provides remedies that apply throughout the United Kingdom. The principal one is a petition alleging that the company's affairs are being conducted in a manner unfairly prejudicial to some of its members, and the order usually sought is that the majority buy out the petitioner's shares at a valuation the court settles.

In Scotland such a petition is presented to the Court of Session.

A shareholder who wishes the company itself to sue, typically a director for breach of duty, requires permission to bring derivative proceedings. Scots practitioners need to be careful here. Part 11 of the Companies Act 2006 contains one chapter for England and Wales and a separate chapter written for Scotland, and the procedure is not the same.

English textbook accounts of the derivative claim describe the wrong chapter for a Scottish company.

There is also a remedy of last resort, being a petition to wind the company up on the ground that it is just and equitable to do so.

It is genuinely a last resort, since it destroys the value that everyone is arguing about, and a court will ask why a buy-out would not have been an adequate alternative.

What actually resolves them

In our experience very few of these disputes are decided by a judge. They are resolved once both sides have an honest valuation, a realistic estimate of what a contested proof would cost, and a mechanism by which one can buy the other out.

The obstacles are usually not legal ones. They are that the parties disagree about what the business is worth, that one of them cannot fund a purchase, and that several years of accumulated grievance make it difficult for either to move first. Addressing those three things directly, by way of an agreed valuer, a funded offer, and a structure that allows both sides to withdraw with some dignity, resolves more disputes than any volume of correspondence about breach of duty.

If a dispute has already arisen

Three things are worth doing immediately. Read the articles and any shareholders' agreement in full before taking a position. Preserve the documents, including the informal ones, because the contemporaneous record is what the case will turn on. And establish early whether the company can pay for the dispute, since in a private company both sides are ultimately funding it out of the same business.