Overview. Til Death or Shotguns Do Us Part: The Importance of Shareholders Agreements OCTOBER 22, Why they are necessary?

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1 Til Death or Shotguns Do Us Part: The Importance of Shareholders Agreements Presented by: Andrew Fraser & Christine Pound OCTOBER 22, 2013 Overview Why they are necessary? What they should address? When to address them? Consequences of not having a shareholders agreement. 2 October 22,

2 Why are they necessary? Govern relationship of shareholders with each other and the company. 3 October 22, 2013 What should a shareholders agreement address? Issue and transfer of shares Death and permanent disability Termination of employment Bankruptcy of shareholder Third party offers Irreconcilable differences Method of valuation Payment terms Management issues Non-competition covenants Confidentiality obligations Funding options 4 October 22,

3 Issuance and transfer of new shares What majority is required? Must existing shareholders be offered opportunity to acquire new shares? Can shares be issued to holding companies? Restriction on shares of holding companies? 5 October 22, 2013 Death Should surviving shareholders or company be required to buy out shares held by deceased shareholder? Should surviving shareholders or company have option to buy shares of deceased shareholder? Should estate have option to sell? Is insurance feasible to fund purchase from estate? 6 October 22,

4 Disability Should permanent disability oblige other shareholders to buy? How is buy out financed? 7 October 22, 2013 Termination of employment If shareholder is employed by company, and quits/is terminated as an employee, should the employee be bought out? How is buy out financed? 8 October 22,

5 Shareholder Bankruptcy If a shareholder goes bankrupt personally, should the other shareholders be obliged to buy the shares from the trustee? Should purchase from trustee be at fair market value, or at a discount? Too much of a discount may trigger challenge from trustee. 9 October 22, 2013 Third Party Offers Must third party offer made to one shareholder be made to all shareholders (drag along / tag along rights). Should other shareholders have opportunity to match third party offer? What time frame? 10 October 22,

6 Irreconcilable differences Shotgun clause When triggered, there will only be one shareholder standing. Ideal if equal economic resources. Time frames should be carefully considered. Frequently a deferral of some period of time before the right can be exercised. If more than two shareholders, all shareholders must be on the same page, or else exercise of the right is nullified. Pros and cons of Shotgun clauses. Other options? 11 October 22, 2013 Valuation Usually agreement by the shareholders or determination by the company s accountants. Usually arbitration clause for a shareholder unhappy with valuation. Question of who pays for the arbitration. 12 October 22,

7 Payment terms If insurance is received, capital dividend mechanism is used to minimize tax implications to company. If no insurance proceeds received, matter of negotiation over how long payment is to take place and at what interest rate, if any. Shares serve as collateral for payment of obligation. Shareholders loans dealt with separately from shareholder purchase. 13 October 22, 2013 Management issues Agreement should specify who is responsible for day-to-day management. Identified major issues require special majority. Address how many directors each shareholder is entitled to. 14 October 22,

8 Non-competition covenant Agreement should address whether shareholders are restricted from carrying on any other business in competition with the company. Address non-competition obligation if a shareholder is bought out. Address non-solicitation covenants. 15 October 22, 2013 Confidentiality obligation Agreement should specify obligation of shareholder to maintain proprietary company information in confidence. Obligation survives individuals ceasing to be a shareholder. 16 October 22,

9 Funding options Agreement can address procedure if shareholders have to advance additional funds to company. Consequences to shareholder failing to make pro rata share of advances. Agreement can address obligation to provide personal guarantees. 17 October 22, 2013 Timing Address at time of incorporation. Delay works to the advantage of the shareholder who believes shareholders agreement will be to his detriment. 18 October 22,

10 Shareholder remedies majority rules In a corporate setting, both management power and shareholder rights are exercised by the passage of resolutions. Resolutions are governed by the principle of majority rule. Sometimes, the principle of majority rules can be unfair to the minority. Rules have developed to protect the minority when this happens. 19 October 22, 2013 Protecting the minority Canada Business Corporation Act provides two avenues to protect minority shareholders: A Derivative Action (Section 239) The Oppression Remedy (Section 241) 20 October 22,

11 Derivative action Occurs when someone (such as a director) has violated their obligations to the corporation. However, the director, or affiliates, control a majority of the shares. Since harm is being done to the corporation by parties who control the corporation, corporation cannot enforce its rights. 21 October 22, 2013 Derivative action (cont d) A complainant defined in Section 238 may bring an action: Definition of complainant very broad. Must get leave of the Court prior to commencement of the action. 22 October 22,

12 Oppression remedy Second statutory option for minority shareholder under CBCA. Different than derivative action: In derivative action Action is on behalf of the corporation In oppression remedy Action is on behalf of the litigant personally, NOT the corporation 23 October 22, 2013 Atlantic Canadian Statutes Oppression remedy: New Brunswick Business Corporations Act, Section 166 Newfoundland Corporations Act, Section 371 Nova Scotia Companies Act, Third Schedule Prince Edward Island does not have a statutory oppression remedy (Rights may be available at common law). 24 October 22,

13 What is the oppression remedy? Has been called the Charter of Rights and Freedoms of corporate law. (Patterson). Described as a judicial brake against the abuse of corporate powers (Budd v. Gentra). Attempts to allow the reallocation of power from those who would otherwise be free to engage in conduct detrimental to others to those who may be the victims of such conduct. Has been described as designed for inter-personal breakdowns experienced in small corporations. 25 October 22, 2013 What Are The Grounds? CBCA, Section 241(2), provides relief when conduct is: Oppressive; Unfairly prejudicial to the interests of any corporate stakeholder; or Unfairly disregards the interests of any corporate stakeholder. 26 October 22,

14 Oppressive Oppression is conduct that is coercive or abusive. Most serious of the grounds enumerated in the CBCA. Oppression has been described as: Conduct that is burdensome, harsh and wrongful. A visible departure from the standards of fair dealing. An abuse of power which results in an impairment of confidence in the probity with which the company s affairs are being conducted. Bad faith has been held to be an element of oppressive conduct. 27 October 22, 2013 THE IMPORTANCE OF SHAREHOLDERS AGREEMENTS Unfair prejudice Prejudice may occur in a corporate setting. Key is that it cannot be unfair prejudice. Why unfair prejudice? Corporate decisions often prejudice the interests of certain stakeholders without making such actions the subject of judicial intervention. 28 October 22,

15 THE IMPORTANCE OF SHAREHOLDERS AGREEMENTS Unfair prejudice (cont d) Unfairly prejudicial conduct lesser standard than oppressive conduct. Can be unjust and inequitable, and can exist without bad faith. 29 October 22, 2013 Unfair prejudice (cont d) Examples: Squeezing out a minority shareholder because of personal desire to exclude her and not because the best interest of the corporation demand it. Failing to disclose related party transactions in financial statements and preparation of financial statements contrary to GAAP. Paying dividends without a formal declaration. Paying directors fees higher than the industry norm. 30 October 22,

16 Unfair disregard Arguably the least rigorous ground upon which to found a claim. Has been interpreted to mean unjustly or without cause, paying no attention to, ignoring or treating as of no importance, the interests of the complainant. 31 October 22, 2013 Unfair disregard (cont d) Examples: Failing to prosecute claims of a corporation diligently where one of the directors benefited from the improper prosecutions. Reducing a shareholder s dividend by setting off the value of other benefits against it when this had not been done in the past. Failing to deliver property that belonged to the complainant. 32 October 22,

17 General comments on the grounds Some debate about the nature of the three enumerated grounds: Some Courts have determined that the grounds are not individual categories, but rather create a spectrum. Establishment of conduct somewhere along the spectrum will entitle relief. 33 October 22, 2013 Reasonable expectations Heart of the issue is fairness. Fairness may be interpreted using the reasonable expectations of the parties. Reasonable expectations has been presumed to include: that directors and officers will fulfill their statutory duties of good faith and loyalty to the corporation. that shareholders will share the profits of the company in proportion to their ownership of a given class of shares. that distributions of equity of the company will only be made to shareholders. 34 October 22,

18 Reasonable expectations Sources of evidence as to the parties reasonable expectations include: General commercial practice. The size, nature and structure of the corporation. Shareholder agreements. Past practice. The nature of the relationship between the parties. Representations made. 35 October 22, 2013 Who can apply? Much like the remedy itself, the class of complainants able to access the oppression remedy. It includes: Present and former shareholders. Directors. Officers. Also includes any other person who, in the discretion of the court, is a proper person to make the application. 36 October 22,

19 Conclusion Ideal scenario: Shareholders agreement like an insurance policy; it s better to have it and not need it, than to need it and not have it. 37 October 22, 2013 What if there is no shareholders agreement? Consequences differ depending on whether the company is a Canada Business Corporations Act (CBCA) corporation or a Nova Scotia Companies Act (NSCA) company. CBCA and NSCA each provide framework for recourse in certain circumstances. 38 October 22,

20 Majority/minority scenario Majority shareholder can prevent minority shareholder from having any representation on the Board of Directors. Directors run the company; no approvals required from shareholders except in very limited circumstances. Directors can issue additional shares without the consent of the minority shareholder. Some recourse to minority shareholder under CBCA and NSCA. 39 October 22, /50 scenario Deadlock because no mechanism to break ties. CBCA and NSCA may provide some recourse. 40 October 22,

21 41 October 22, 2013 These materials are intended to provide brief informational summaries only of legal developments and topics of general interest. The materials should not be relied upon as a substitute for consultation with a lawyer with respect to the reader s specific circumstances. Each legal or regulatory situation is different and requires review of the relevant facts and applicable law. If you have specific questions related to these materials or their application to you, you are encouraged to consult a member of our Firm to discuss your needs for specific legal advice relating to the particular circumstances of your situation. Due to the rapidly changing nature of the law, Stewart McKelvey is not responsible for informing you of future legal developments. 42 October 22,