April 20, 2022
By James Comyn, partner at Hunton Andrews Kurth LLP.
Case law is full of examples of aggrieved minority shareholders in private companies seeking redress from the courts for wrongs suffered at the hands of a majority shareholder.
A well negotiated and documented shareholder’s agreement, agreed prior to investment, would have avoided many of these disputes. The absence of those governance and exit rights commonly included in a shareholders agreement, places a minority investor in a difficult position. In many instances, the courts will not come to their aid. Further, litigation can erode the value of their shares, by drawing attention to and accentuating areas of disagreement and the lack of enforceable governance and exit rights.
The rights of a minority shareholder in a private company will depend on a number of factors, including the provisions of applicable law and the relative bargaining strength and expertise of the parties. We consider below the sources of those rights and typical investor rights at differing levels of equity ownership.
Sources of shareholder rights
Shareholder rights in a privately held company are derived from three principal sources:
Which source of rights takes priority?
As a general rule, the provisions of applicable law that are mandatory take priority. In most jurisdictions, the parties have more latitude in drafting the company’s constitution, although some provisions are mandatory and others are prohibited. Parties have more freedom in drafting the shareholders’ agreement.
Reversing the order of priority
Lawyers have devised a number of mechanisms to reverse the order of priority. A shareholders’ agreement often provides that, as between the shareholders, the terms of the shareholders’ agreement prevail over applicable law and the constitution. This principle is often buttressed by a general long form further assurances clause in which the shareholders agree to exercise or waive rights granted by applicable law in such manner as gives effect to the shareholders’ agreement. Shareholders also agree to use their best endeavours to procure that any directors appointed by them do the same.
In addition, the shareholders’ agreement can be drafted to take account of mandatory provisions of applicable law. For example, a shareholders’ agreement could include a specific provision in which shareholders expressly agree how they will exercise or waive specified rights arising under applicable law.
Constitution or shareholders’ agreement?
Once governance arrangements have been agreed between investors in a privately held company, counsel need to consider whether those arrangements should be documented in a shareholder’s agreement, in the company’s constitution or in both.
There are a number of considerations to be taken into account here, as summarised below:
Given the above, constitutions normally only include provisions governing:
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