Companies - Documentation

Documentation

Introduction

In March 1998 the Department of Trade and Industry launched a review of the framework of company law with a view to developing a simple, modern and cost effective infrastructure for carrying out business activity. An independent steering group was formed to oversee the management of the review and, following an extensive process of consultation, presented its final report on 26 July 2001. The proposals cover a whole raft of areas, including company reporting and audit, directors’ duties, obligations on small and private companies, and institutional arrangements. One of the recommendations made is for modernising the process of forming a company, for example by replacing the memorandum and articles of association with a constitution in a single document, and by removing the requirement to have an objects clause. The first White Paper which it has produced as a result of this process endorses the recommendations highlighted above. The Government has recently announced that it aims to introduce those changes as part of a comprehensive reform of Company law “as soon as practicable …” although no date has as yet been indicated.

Memorandum of Association

This sets out the name, place of registered office (i.e. in England and Wales), share capital and objects of the company. The objects clause should set out the purpose for which the company is in business, and what it is empowered to do. Although a company’s objects used to be set out in detail, in order to cover everything that a company wanted to do, it is now possible to have a main objects clause, stating simply that the company is a general commercial company. If this wording is used, the company can generally carry on any business it wishes, thereby enabling it to diversify its business without encountering problems with limitation from the objects clause. This wording also enables the company to do anything incidental or conducive to its business.

What happens if a company attempts to act outside of the objects – ie “ultra vires”? It used to be the case that any ultra vires action taken could be challenged, and any contract entered into could be set aside. However, it is now the case that acting “ultra vires” has no implications for the validity or enforceability of any contract entered into – in other words there are no implications for third parties, provided such third party has acted in good faith in dealing with the company. What is possible is that any shareholder can challenge a proposed ultra vires act on the basis that the company does not have the capacity to enter into the transaction concerned, and may ask the court to grant an injunction restraining the proposed action. Note however that this can only be done before the company on the contract incurs any legal obligation. After that, an aggrieved shareholder’s only remedy is to claim against the directors for breach of duty (see the document entitled “Directors”).

Articles of Association

These set out the rules of conduct for the company. There are three alternatives. Either a company can use the “Table A” Articles – these are appended to the relevant Companies Act, and are the standard regulations. However, companies often wish to tailor their Articles to their specific needs. One option is to use Table A with amendments. The other is to have a completely individual set of articles (although these should follow the basic structure and headings of Table A). Most private limited companies adopt the second approach.

The Articles deal with, amongst other things, the structure of the share capital (i.e. the types of classes) (see the document entitled “Shares”), variation in share capital, rights attaching to shares (i.e. whether they are redeemable or variable, and what rights to dividend they carry) (see the document entitled “Shares”), and variation to such rights, voting rights, notice entitlements for shareholder and board meetings, procedure at general and board meetings, and entitlements on a winding up of a company.

Shareholders’ Agreements

It is also common for a shareholders’ agreement to be in existence. This is a document in which the shareholders regulate the relationship between themselves and the Company. There is usually a degree of overlap between a shareholders’ agreement and the Articles (see below) as well as the provisions contained in the Companies Act 1985 (as amended). It is worth noting that whilst a shareholders’ agreement is governed by the ordinary rules of contract, the Articles are a creature of company law, regulated by statute. Perhaps the most obvious distinction is that the Articles can be amended by special resolution (i.e. a resolution which must be passed by a majority of 75% of the members present and voting in favour of it, and for which 21 clear days’ notice is required), whereas on normal contractual principles, the shareholders’ agreement cannot be varied without the consent of all parties. Another important distinction is that the Articles are a public document (once filed with Companies House), whereas the shareholders’ agreement will not be available publicly, and indeed may contain an express provision that its contents be kept confidential. A further distinction is that the Articles will automatically bind all new shareholders, whereas new shareholders will only be bound by the terms of the shareholders agreement if they subscribe to it. Finally, note that as a shareholders’ agreement tends to be specifically negotiated, often at a later stage from the setting up of the company, it is possible to find the provisions of the shareholders’ agreement differing from those of the Articles. In an ideal world the two documents should be consistent, with the Articles most commonly being the document amended to ensure such consistency. However, in the event that this is not done, and the provisions of the shareholders’ agreement are the ones that are to prevail, this should be expressly set out in such agreement.

A shareholders’ agreement tends to deal with six key areas, although it can be expanded as necessary in a particular situation. This is a very important document and specialist advice should be sought in all instances.

The key areas are: the board of directors; shareholders; financing; transfer of shares; disputes; and restrictive covenants. In addition, a well drafted shareholders’ agreement should deal with “exit routes” for shareholders – (i.e. how they get their money out from the company), and, where relevant, what other contributions each shareholder is bringing to the party.

Board of Directors
Removal of directors: pursuant to the Companies Act 1985 (as amended), a director can be removed by an ordinary resolution (i.e. a simple majority vote of the shareholders), subject to following the procedures set out in the Companies Act. Please see the document entitled “Directors” for a more detailed discussion of the removal of directors. Consequently, it is common for the shareholders (especially a well-informed minority shareholder) to be given the right (either in the shareholders’ agreement or in the Articles by creating different classes of share) to appoint and remove one or more directors.

Quorum: how many directors should be present for a board meeting to be quorate? This is normally two, but in some instances the agreement will provide that board meetings cannot be held without particular individuals, or a director or directors representing a particular group of shareholders, being present.

The mechanics of the decision making process at board level: Table A provides for a simple majority vote but there may be some instances where a unanimous vote of all the directors is considered more appropriate. A frequently used compromise is to have most decisions effected by a majority but have a reserve list of those matters which require a specified majority or unanimous decision of the shareholders (see below) i.e. an entrenchment of protections at shareholder rather than board level.

Chairman: Table A (and therefore most private limited companies’ Articles) provide for the Chairman to have a casting vote. However the shareholders’ agreement may cover the mechanism for appointing a chairman and may state that no casting vote is available. This consideration will be particularly important in cases where simple majority decisions are required and there is an even number of directors. If it is decided that the chairman will not have a casting vote, it may be necessary to consider other ways of avoiding deadlock at board level. This includes referring matters in dispute to an agreed expert or arbitrator. However, leaving matters to be decided by third parties in this way is usually inappropriate for business decisions, as the arbitrator will generally not have sufficient knowledge of the particular company’s business.

Shareholders
As mentioned above, it may be preferable to provide that certain matters cannot be effected without a specified percentage majority or unanimous decision of the shareholders. Commonly included are:

any alteration of the Memorandum or Articles;
a change in the nature of the business carried on by the company;
a change in the capital structure of the company, the issue of further shares, or the creation of any options to subscribe for or acquire shares;
the issue of any debenture or loan stock or the creation of a mortgage, charge, or other third party right over any of the company’s assets;
the giving of any guarantee or indemnity ;
the approval or amendment of annual operating plans or budgets or any activity outside the scope of the annual budget or business plan;
the sale of all or a substantial part of the company, the winding up of the company or any merger with it;
making a loan, providing credit, or creating, renewing or extending any borrowings;
the appointment of any employee whose salary will be over a certain threshold; and
making any capital expenditure over and above a certain threshold.

Financing the Company
It is common to specify in a shareholders’ agreement any agreed arrangements for initial funding and funding on a continuing basis, including working capital requirements and any development and expansion costs. For example, will each shareholder be required, or entitled, to contribute to any continuing calls for funding, pro-rata to his/its original investment or otherwise? Alternatively, will funding be secured only on the assets of the company?

Transfer of Shares
Parties entering into a shareholders’ agreement do not normally expect the other parties to have the right to dispose freely of their shareholdings to a third party since the result could well be that two or more incompatible parties are thrown together. It is common to provide that a shareholder cannot transfer shares (other than in certain permitted circumstances, such as a transfer to existing shareholders, or to a member of the same group of companies) without first offering them to the other shareholders at a fair value.

It is also common to provide for mandatory transfer provisions in certain specified circumstances. Typically, in the case of an individual shareholder his bankruptcy, death or breach of a service agreement may give rise to an obligation on that shareholder to sell his shares.

It may be prudent to consider the situation where a third party offer is received by a majority shareholder and consider whether that majority shareholder ought to be obliged to bring along the other shareholders by procuring the third party offer extends to them (“tag along rights”) and/or should the other shareholders be obliged to sell their shares if the majority shareholder receives a third party offer (“drag along rights”). This mechanism is favourable because that a business is far more saleable in its entirety.

Disputes
Although shareholders will usually be approaching the negotiations of a shareholders’ agreement with optimistic hopes for the company, a well-prepared shareholders’ agreement should provide for the possibility of a dispute. Where the traditional mechanism in a shareholders’ agreement is used – i.e. a list of matters requiring a specified percentage majority or unanimous decision then it is usually considered unsatisfactory where the percentage is not achieved to continue with the status quo. In such a situation, commonly referred to as “deadlock”, the following might be considered:

a reference to a third party arbitrator as referred to in Section 4.3.1 above;
the right to require the liquidation of the company;
“Russian Roulette” – under this mechanism, any party may serve a notice on the other, either requiring the receiving party to purchase its entire holding from it, or for the receiving party to sell its entire holding to the initiating party, at the price set out in the notice.

However, an alternative school of thought is that almost by providing a deadlock resolution mechanism, this can encourage deadlocks to occur. If no such mechanism is provided for, then the parties just have to thrash out a conclusion to the particular matter.

Restrictive Covenants
Parties to the shareholders’ agreement will also need to consider whether each shareholder should be prohibited from competing with the company both during and after their involvement. These restrictions are additional to those commonly found in employee shareholder’s service contracts.

Exit Routes
It is also common for a shareholders’ agreement to deal with the intentions with regard to exit routes i.e. ways in which the shareholders can get the benefits of their investments. For example, it might provide that dividends will be payable after the first two or so years (to allow for stability) and even that certain shareholders will have preferential rights upon payment of such dividends. Alternatively, the shareholders might agree in the shareholders’ agreement that they are aiming to sell the company in so many years’ time, and that all should work towards that common goal.

Contributions
In addition to providing cash by way of subscription monies, shareholders might also be providing services to the company. For example, a telecommunications company which invests in a “start up” might also be providing platform and other telecommunication services to the company often on favourable terms. This should be dealt with in the shareholders’ agreement.

‘Quasi Partnership’
A shareholders’ agreement can also be important in ensuring that the relationship between the parties is not viewed as a ‘quasi partnership.’ Case law has established that where a private company is a ‘quasi partnership’, a winding up order can be made on the just and equitable ground where the facts would enable the dissolution of a partnership. This route gives a minority shareholder further protection, in addition to the more usual remedies of a derivative action and an ‘unfair prejudice’ petition, and could be a nasty surprise for a majority shareholder. For this reason, it is common to see included in the shareholders’ agreement a declaration that the parties are not partners, although note that this is not sufficient in itself to prevent a ‘quasi partnership’ being found.