Mark Cornish, Partner
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Shareholder disputes are not for the faint hearted, and the ending of a business relationship can be every bit as acrimonious as the ending of a marriage. Indeed sometimes the end of a marriage also involves the end of a business relationship as well. Separating couples often own shares in a business that they will have spent significant amounts of investment of time and energy in. Whatever the circumstances, when a business relationship breaks down the business itself is often both parties' "baby" and they are always understandably reluctant to part with it.
The courts' powers for resolving disputes between shareholders are very wide, but as a consequence they are also very unpredictable, and invariably expensive. Hence it is almost always in the client's best interest to seek a settlement out of court than to try and rely on the vagaries of the court system.
In the absence of an external buyer, an orderly winding up is often undesirable. Goodwill would be lost and the parties are unlikely to realise the true value of the business. This means that a settlement ususally entails the sale of one person's share in the business.
Usually when acting for clients who want to sell or buy a business the parties have established a good deal of common ground in terms of what they want to achieve before they actually instruct their lawyers to effect a sale of the business or its shares. But where the reason for the need to sell is as a result of a business relationship breakdown it can prove very difficult to get the parties to come to the table and negotiate a sensible settlement. The parties' respective shareholdings often mean that the business is deadlocked and unable to make or approve significant decisions about its future. The parties may be unlikely to agree on any number of matters. Asides of the obvious sources of disagreement such as the actual value of their shares, they may also be unable to agree on who will take certain customers and how they may compete once shares are sold. Initially, they may not even be able to agree on who should sell to who.
Advising clients on this type of matter can be as much about encouraging the parties to negotiate and see the potential problems if they fail to reach agreement, as it is about advising them on the law. The need to compromise has to be recognised however difficult that agreement may be to stomach. Of course, a shareholders agreement at the birth of the business might well have resolved at least some of the potential areas for dispute. But this is not often high on the list of priorities of new business partners, particularly if they are (or perhaps the word "were" is more appropriate by this stage) married as well.
But assuming the parties are able to broker some form of broad agreement through their lawyers and/or other professional advisers, the adviser will need to ensure that the structure of a deal meets the requirements of company law. Although I focus here on the company buy back as a possible method of structuring a settlement there are of course other options open to the parties.
Company buy backs
Company buy backs are often suggested as a means of structuring a deal, and often this does indeed prove to be the best means of structuring the settlement. But of course, it will be viable where one of the parties is prepared to allow the other to continue the business and benefit from the goodwill that the business may have built up over time (i.e. where one party is not intending to work in the particular industry of the company any more and only wants to see a return on their investment of time or money, or where one of the parties does not believe there is much goodwill invested in the name of the business itself).
At one level a share buy back is not a complex transaction to understand. The company is simply buying back one of the parties' shares which are then cancelled, leaving the other party (or parties) as the only remaining shareholder(s).
If it is viable, a share buy back has significant advantages. For example it may enable the parties to consider larger sums for the payment of shares than might otherwise be possible where it is the company who will be paying. The other shareholders may not be in a position to afford the same sums personally.
Tax concerns are also often the biggest factor in the decision to use a company buy back of the outgoing partners' shares. Providing certain conditions are met the proceeds received from the buy back may be treated as a capital transaction (liable to capital gains tax, which can be useful if the parties qualify for Capital Gains tax relief). However, clients are well advised to take specialist tax advice on the precise tax implications of a buy back and to do so in good time before the transaction is too far advanced. It is usually also advisable to seek revenue clearance on this type of transaction and this must be factored in to the planning of the timing of a deal. The Revenue can take up to 28 days to reply to a request for clearance.
There are some important procedural formalities to follow when effecting a buy back. The Companies Act 1985 lays down a specific procedure of a company buy back of shares in section 164. Key points to be aware of are:
- the company's articles of association must give it the authority to effect the purchase. If they do not then the shareholders will have to pass an appropriate special resolution enabling it to do so;
- a special (and preferably written) resolution must be prepared confirming the company's authority to effect the buy back;
- where an extraordinary resolution is used, the company's proposed buy back 'contract' must be filed at its registered office for 15 days prior to the resolution being passed/contract being entered into (using a written resolution makes this unnecessary).
- the shares must be fully paid up;
- payment for the shares should be made out of distributable profits. The purchase may also be made out of capital (but it requires still more stringent formalities - see below).
Failure to observe the Companies Act requirements may make the buy back void and legally unenforceable. Additionally the company could find itself liable to a fine, and the company's officers liable to both a fine and imprisonment.
By way of illustration consider the following scenario.
Four brothers, Matthew, Mark, Luke and John decide to set up and run a marketing company in equal shares. The business proves successful although Mark and Matthew take increasingly less interest and involvement in the business. After a while Luke and John become frustrated that they are doing all the work in the business whilst Mark and Matthew continue to profit from their shareholding. Luke and John propose a deal to end Mark and Matthew's involvement with their company. Mark and Matthew are paid £50,000 each from the company accounts, and give Luke and John signed stock transfer in favour of the company buying their shares back.
Luke and John pass the stock transfer forms to their accountant, who files the appropriate paperwork at Companies House (form 169) within the required statutory 28-day filing period. He also ensures that stamp duty is paid. The accountant then confirms to Luke and John that they are now the only owners of the shares.
Twelve months later, Luke and John receive a surprise offer from a large public company offering to buy their company for £1 million. They are then very surprised to hear from Mark and Matthew, who having heard about the offer approach Luke and John asking for their share of the £1 million.
In this situation case law has held that the original buy back of the shares would be invalid because of a failure to meet the formalities required by the Companies Act. Procedural irregularity and a failure to follow the provisions of the Companies Act will not simply be overlooked or corrected by the courts. The question of whether the parties had knowledge of the requirements of the Companies Act is irrelevant. The transaction could be unwound and Mark and Matthew would still own the shares. The sums received by Mark and Matthew would have been treated as loans from the company to them. This of itself could also cause problems for the Company, Mark and Matthew with the loans being a benefit in kind and subject to tax accordingly. Tax which they didn't pay at the appropriate time.
Another issue that must be carefully considered is whether there are in fact sufficient distributable profits from which to effect a buy back. This must be clearly established before the transaction proceeds. Often the business owners or their accountants suggest that the company pays the outgoing shareholder money over a period of time. Although in fact there is nothing in the legislation to prevent staged payments for the company's shares, it is usually the case that the consideration will have to be paid in full and at the point of sale. If there is any suggestion that the parties want to pay in stages, a company buy back may well be inappropriate. The outgoing shareholder would have to be asked to take a probably unacceptable risk that if the company does not have distributable profits at the time a payment is due they could be left without a legal remedy to insist on the company making the payment.
For further information email Mark Cornish or call 020 7940 4000.
