Thinking | 28 November 2007

Shareholder Disputes: When friends fall out – disputes between business owners in private companies

Many businesses are started between friends who have a shared vision or idea they hope can be turned into a successful venture. Often, those involved are young and have the ability to devote, if not capital, a large amount of “sweat equity” to the business. Because capital may be scarce, or in the excitement of starting up no-one is prepared to contemplate that it might all go horribly wrong, little attention may be paid to what is to happen financially (and personally) if things do go sour or circumstances change and someone wants to exit. As a result, the temptation is to save the money and not consult a lawyer to have a formal shareholders’ agreement drawn up to regulate the parties’ relationship.

And so, off they go. Many such businesses flourish and turn into valuable concerns. For others, the venture is not as rewarding. But the stresses associated with running a successful business, or dealing with one that is not making money, or changing personal circumstances (as, perhaps, a young family becomes the primary focus of one shareholder rather than the business), can lead to tension between business owners who might feel that someone has “dropped the ball” or having a “I’m doing all the work around here” attitude that festers away poisoning a once solid friendship. Eventually, such animosity can become a threat to the business itself, and now it really does seem like false economy that no-one ever planned for the possibility of an end to the personal relationship or how an exit from the business might be implemented or funded.

Of course, the easiest outcome is a negotiated solution that allows the owners to separate while hopefully remaining friends. But there are times when a negotiated solution cannot be achieved – for example, the parties may each have a very strong view that it is the other party who should exit, or personal issues are muddying the waters to the extent that a compromise isn’t a possibility one or more party is prepared to contemplate at that time.

Frequently enough, the first time a lawyer might be consulted in such situations is when one party asks for advice as to “how can I force so and so to sell their shares to me?” It is usually a surprise for them to be told that absent a provision in the company’s constitution or a shareholders agreement, no shareholder can be forced to sell their shares to another just because there is a disagreement – and a Court cannot order a sale unless what is commonly referred to as oppression is found to exist and the Court is persuaded that that is the best course to take in resolving the matter (about which see below).

So, if you can’t negotiate an “out”, what options are available?

The most commonly used litigious options by shareholders who have fallen out involve:

  • instituting proceedings under the ‘oppressive conduct’ provisions of the Corporations Act (Act)
  • instituting proceedings in respect of the breach of a director’s duty; or
  • bringing an application to wind up the company under the Act.

In practice, it is not uncommon to see all three options used in the one proceeding.

Oppression

Briefly, the oppressive conduct provisions of the Act provide that a court may grant relief where:

  • the conduct of the company’s affairs; or
  • an actual or proposed act or omission by or on behalf of the company; or a resolution, or a proposed
  • resolution, of members or a class of members,

is either:

  • contrary to the interests of the members as a whole; or
  • oppressive or unfairly prejudicial to, or unfairly discriminatory against, a member or members.
  • Accepted examples of oppressive conduct include:
  • an unfair allocation or restrictions on the payment of dividends to particular shareholders;
  • refusing access to information about the company’s affairs;
  • use of company funds for improper purposes – for example personal expenditure;
  • denying other directors the opportunity to carry out their functions for example failing to call directors’meetings when required;
  • a combination of the inability to sell out of a private company where improper exclusion from management has occurred and there is no reasonable offer to buy the oppressed party’s shares; and
  • paying excessive remuneration to the person having control of the company.

It is important to remember that the categories of oppressive conduct are flexible and can arise in numerous situations. However, a history of engaging in oppressive conduct is not always required. A single act may be sufficient to attract the court’s intervention. Mere mismanagement does not mean that oppression is occurring and the oppression provisions are not designed to substitute a court’s decision in those instances when shareholders simply cannot agree on how to run the business.

The court has very wide powers to make orders it considers appropriate if it finds there has been oppression, including:

  • winding up the company;
  • making orders regulating the conduct of affairs of the company in the future;
  • ordering the purchase of the shares of any member by other members;
  • ordering the company to institute, prosecute, defend or discontinue legal proceedings, or authorising the institution of such proceedings by a member of the company on behalf of the company;
  • appointing a receiver or a receiver and manager of the property of the company; ordering a person to restrain from engaging in specified conduct; ordering a person to do a specified act or thing; or
  • modifying or repealing the constitution of the company.

Establishing oppression

A vitally important matter to note about oppression is that before the court can make any orders, it must find that there has actually been oppression. Oppression as a plan of attack is not going to work where there is simply a breakdown in the parties’ relationship.

Human nature being what it is, in situations where a relationship has broken down, “short-cuts” in proper conduct might be taken, or conduct that might once have been thought unthinkable becomes “justified”. Thus, when a party no longer feels an obligation to another shareholder, or has unresolved anger toward that person, it becomes easier to ignore that other in decision making, to cut a few corners with the businesses’ money and so forth because “it’s only fair since I’m doing all the work”. The cause of the breakdown itself might be the improper use of company property by one party, or acting unilaterally to exclude the other from the conduct of the company’s business. Fortunately (at least for the oppressed shareholder), such conduct almost always involves or leads to a breach of a director’s duty to the company and gives ground to an oppression claim in its own right (apart from any rights the company itself may have against the offending director).

Directors have numerous obligations imposed on them by the Act and the common law.  In summary, their general duties comprise the following:

  • the duty to exercise their powers and discharge their duties with reasonable care and diligence;
  • the duty to exercise their powers and discharge their duties in good faith in the best interests of the company and for a proper purpose;
  • the duty to not improperly use their position to gain an advantage for themselves or someone else or cause detriment to the company;
  • not to improperly use information obtained as a director to gain an advantage for themselves or someone else or cause detriment to the company.

It can be seen that a director who is breaching one or more of the above duties is almost certainly going to be engaged in conduct that is unfair to shareholders or the company and – particularly if a controlling director – causing the company’s affairs to be conducted in an oppressive manner.

But if there is no oppression, sometimes the only option is to “sit tight” and wait for the other party to slip up and start doing the things that might amount to oppression. This often means keeping detailed records of things that are occurring (or not), keeping track of the cash and so forth. What it more often means is an increasing level of frustration as the relationship deteriorates and anger rises.

Winding up

In situations like this, there is another part of the Act that can be useful. Section 461 provides that a court may order the liquidation of a company in a number of situations, including where the court is of the opinion it is “just and equitable” that the company be wound up.

Determining when it is ‘just and equitable’ to wind up a company is complex.  In short, the Court will consider whether, in all the circumstances, the deadlock or dispute so serious that it is not capable of being resolved in any way other than by bringing the company’s existence to an end. The law has particularly been held to be applicable in the case of small private companies where, notwithstanding that a corporate structure is in place, in truth the relationship between the shareholders is one of mutual trust and confidence akin to being partners. In the same way as the breakdown of trust and confidence between partners justifies a court exercising its power to dissolve a partnership, so too does the court consider it appropriate to use its power under section 461 to effectively end a corporate “partnership” that has gone the same way.

Some might reasonably argue that by applying to wind the company up in the face of a shareholders’ dispute, the disgruntled shareholder is applying a cure worse than the disease. A court will do its utmost to avoid winding up a solvent company, particularly when employees will be affected, perhaps by ordering early mediation, but ultimately will wind up if there is no other way. However, from a tactical point of view, the mere foreshadowing of such a proceeding  may force the recalcitrant party to the negotiating table.

Other options

In addition to those listed above, other options are available to shareholders in dispute. These include statutory derivative actions, injunctions under the Act and the enforcement of personal remedies (for example, there may be a breach of the company’s constitution or a shareholders’ agreement in respect of which an action can be maintained).

Conclusion

Shareholder disputes are common. Fortunately, there are a number of options available to shareholders who seek to have unfair or improper conduct dealt with. Nonetheless, many of these disputes between owners are best dealt with by one or more parties being bought out. It sometimes takes legal proceedings for the parties to come to this realisation.

With prompt action and the tactical use of proceedings (or threats of proceedings), disputes can often be resolved in a way that allows the parties to exit or get on with the far more productive activity of running a business.

Contact

Graydon Dowd

Graydon Dowd leads the Hall & Wilcox commercial dispute resolution practice and provides expertise in litigation and mediation.

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