Avoid costly dispute resolution with constitutional documents, particularly a unanimous shareholders’ agreement
by Michelle Awad
Stakeholders in privately owned companies, particularly an entrepreneur or family business, have varied interests. If expectations are unfulfilled or frustrated, the result can be costly legal disputes and the inevitable distraction from building the business.
The best way to reduce the risk of such a dispute, and the time and energy consumed in resolving it, is to identify those expectations and deal with them in the company’s constitutional documents, particularly a unanimous shareholders’ agreement.
Many businesses start with a single person who comes up with an idea and then builds it from scratch. With growth, however, comes the need for financial and human resources. This usually leads to the expansion of ownership, a board of directors, an executive management team, and financing.
New shareholders, directors, officers, and financiers may have different interests and expectations from the original owner or majority shareholder. At times, differing expectations can lead to conflict with the majority shareholder, who views the company as his or hers. The biggest mistake a dominant or majority shareholder can make is to believe that he or she can do whatever they want with their company. There are legal limits on the power of majority owners, of which they should be aware and by which they should abide.
The first limit on a majority shareholder’s power is that the company is a separate legal entity from the majority owner and has independent interests that may differ from those of the majority. Second, a board of directors owes its primary duty (“fiduciary”) to act in the company’s best interest and not those of a particular shareholder or group of shareholders, including the majority.
If a board controlled by the majority makes a decision that other corporate stakeholders (usually the minority) believes isn’t in the best interest of the company or violates the minorities’ “reasonable expectations,” the minority has a variety of legal recourses by which it may attack the decision.
The first of those recourses, and a potent one, is the “oppression” remedy. This remedy allows present or past minority shareholders, directors, creditors, or other legitimate interested individuals to seek to overturn a corporate decision if it’s “unfairly prejudicial to,” “unfairly disregards,” or “is oppressive to” their interests. It isn’t necessary for a majority owner to intend to harm the interests of other corporate stakeholders; rather, it’s enough if that’s the effect of any decision or action.
A second recourse is the derivative legal proceeding. A minority shareholder or other corporate stakeholder may seek the permission of the court to begin a legal proceeding against anyone who has acted against the company’s interests. This can include a legal proceeding against sitting directors regardless of the fact that they represent the majority of the board and the majority shareholder. This is because the company’s interests are distinct from those of the majority and may conflict with the majority’s interests.
The best way to reduce the risk of corporate infighting between the stakeholders is, to the extent possible, to identify the expectations of those stakeholders and set them out in the constitutional documents of the company. The best vehicle for this is usually a unanimous shareholders’ agreement. Such an agreement must be a “living” document, which is amended over time to meet the changing expectations of the stakeholders. If such steps aren’t taken, the chances of a costly legal dispute are significantly higher, which in some circumstances can threaten the health and existence of the company.
Eric LeDrew and Michelle Awad are lawyers with McInnes Cooper, who advise start-ups, entrepreneurs and mature businesses on risk management and business disputes. This is part of an ongoing series authored by McInnes Cooper corporate specialists. This column is prepared for information only and is not intended to be either a complete description of any issue or the opinion of our firm. McInnes Cooper should be consulted regarding any situation to which any topic discussed herein might apply.