Inside: Drafting the proper shareholder agreement to avoid a messy break-up

Drafting a proper shareholder agreement raises a host of questions that shareholders should answer

One way to prevent shareholder disputes, or at least reduce their frequency, is to make sure that your company has a strong and well-crafted shareholder agreement that lays out the rights and responsibilities of the shareholders.

A shareholder agreement can fulfill a variety of roles for a corporation. It can supply the answers to such important questions as the transfer of shares, corporate organization and the enforceability of these provisions.

Transfer of shares

Given enough time, something is bound to happen that will cause a shareholder to leave the corporation, whether willingly or not. And, in many smaller corporations where there are only a few shareholders, that can cause a great deal of upheaval, as one person leaving can change the entire balance of power.

It is impossible, of course, to craft a solution to every possible contingency, and very few corporations are formed with a clear endgame in mind, but a shareholder wanting out of the business is almost an inevitability and should be anticipated. How will a corporation handle the transfer of shares? Can they be sold to an outside party? If not, then will they be bought back by the corporation? If they can be sold to an outside party, are there any limits to who they can be sold to, and will the buyer have the same voting rights the seller had? Will other shareholders have a right of first refusal on those shares? And how will the valuation of these shares be made? Will more stock be issued by the corporation? And, if so, will the current shareholders have pre-emptive rights to acquire that stock to prevent their shares from being diluted? Will there be a limit to how much stock one shareholder can hold? If so, how much will that be?

A good shareholder agreement will answer most, if not all, of these questions. The final factor to consider when drafting the portion of the shareholder agreement that corresponds to these issues is how they will interact with the corporate law of the jurisdiction where the incorporation has or will take place. For example, in both Delaware and Model Business Corporation Act jurisdictions, there are laws regulating agreements that deal with the transfer and valuation of stock, and any shareholder agreement that violates those laws will be found to be invalid.

Corporate organization

Another set of questions that a shareholder agreement should answer is how the company should be run. For example, who will be the directors of the corporation, and who will be the officers? Must they be shareholders? Even if those answers are obvious when the company is being formed, but down the line, circumstances might change so that the issues become muddled. Eventually, officers and directors will likely need to be replaced, and a good shareholder agreement will make that process as streamlined as possible.

The complicating factor in shareholder agreements dealing with the appointment of directors and officers, though, is that a shareholder agreement, by its definition, is an agreement between shareholders. It can only bind the parties who sign it. In many corporations, however, the shareholders are not the only ones who have power in a corporation, and a shareholder agreement will not bind officers and directors, and that can change how a shareholder agreement operates.

For example, a shareholder agreement may provide for the appointment of officers by the shareholders. Under Delaware law, however, the board of directors will still have the power to remove any officers appointed by the shareholders, and in some MBCA states, including New York, the board can suspend officers for cause without shareholder approval.

Access to the information

One other issue that a shareholder agreement should address is what rights to information and inspection a shareholder will have. Obviously, this issue is a matter of balancing competing interests. On the one hand, allowing a shareholder too much oversight can slow down the normal operation of the business and create other headaches for the personnel charged with actually running the corporation. On the other hand, shareholders, for obvious reasons, will want to have access to at least some information so that they can monitor how the company is performing and, if necessary, use whatever power granted to them by the articles or bylaws in order to make changes.

It is worth nothing, however, that both Delaware and MBCA corporate law does give shareholders the right to be allowed to access certain types of information related to their interest as shareholders. As a result, a shareholder agreement that restricts information beyond that point will not be valid.

Voting

Finally, a shareholder agreement ought to address any situations where a supermajority of shareholders, or even unanimous consent, will be required for a corporation to take action. For example, major outlays of capital, or entering into a new field of business are two activities that can radically reshape the contours of a business, and, to prevent lingering disputes, it might be better to require a supermajority or unanimous consent to make sure that there is a consensus among the major shareholders.

One problem with these sorts of agreements, however, is while the agreement can bind shareholders, they will not necessarily bind the directors of a corporation. For example, any shareholder agreement that would require the board of directors to get the approval of a supermajority of directors before acting will not be binding on the directors. A shareholder agreement can, however, bind the shareholders to approve an article or bylaw that would require the directors to get a supermajority or unanimous consent for a particular action.

Enforceability

One final issue is making sure that the shareholder agreement will be enforceable. In general, a validly executed shareholder agreement will be binding on the parties, but if the agreement is held to injure shareholders who have not signed the agreement, or third parties to the agreement, however, a court may rule that it is not enforceable.

Drafting a valid shareholder agreement can be a difficult proposition, and the use of an experienced commercial litigator is almost certainly necessary in such an effort. But they can be invaluable tools in avoiding the even greater costs that come from shareholder disputes.

Contributing Author

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Thomas Patterson

Thomas E. Patterson started the Patterson Law Firm in 2000. He has 32 years of experience preparing and trying lawsuits for businesses, professionals and entrepreneurs—often...

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