SHAREHOLDER AGREEMENTS: RECENT CASE LAW - COMPULSORILY ACQUIRING THE SHARES OF ANOTHER SHAREHOLDER

It pays to have a professionally drafted Shareholder Agreement.  A professionally drafted Shareholder Agreement will record the terms and conditions for the management, control, operation and ownership of the relevant company. 

In our experience, the sticking points of Shareholder Agreements are as follows:

  1. How are decisions to be made, e.g. by a majority vote, unanimous vote or a mixture of both?  If there is an equality of votes, how are deadlocks to be resolved?
  2. Are there any circumstances in which a shareholder or shareholders can compulsorily acquire another shareholder's shares, e.g. in the event of death or bankruptcy?
  3. If a shareholder wants to exit the business and they cannot find a third party to purchase their shares (which is often the case with tightly held small proprietary companies), is there to be a particular exit procedure?
  4. If a shareholder exits the business, will they be restrained from competing with the business or soliciting clients of the business?

In our view, the above points are the most hotly contested when drafting a Shareholder Agreement  They are also the most commonly litigated.  If your Shareholder Agreement doesn't contain a workable process to deal with the above issues, question whether you should have your Shareholder Agreement reviewed, and possibly re-drafted.

Point number (2) above, in particular, has recently been the subject of litigation.  Two recent New South Wales Supreme Court cases demonstrate the importance of having a Shareholder Agreement drafted by a firm experienced in this area.  The cases are:

 

The Pioneer case

In the Pioneer case, Morgan Stanley Capital Group Inc and Blue Oil Energy Pty Ltd owned 100% of the shares in a company called Pioneer Energy Holdings Pty Ltd.  Morgan Stanley owned 75% of the shares and Blue Oil owned 25% of the shares.  Their relationship was governed by a Shareholder Agreement.

Blue Oil and Pioneer Energy were involved in the construction and development of an oil shipping terminal in Mackay, Queensland.  In simple terms, the shareholders agreed to contribute capital of $51,777,948 - known as the "Initial Funding Budget".  The Board of Pioneer had the power to increase the Initial Funding Budget by an amount not exceeding $5 million.

In the event of an increase to the Initial Funding Budget, each shareholder was required to subscribe for additional shares in their requisite percentages.  If a shareholder ("Defaulting Shareholder") failed to subscribe for their proportion of additional shares, the other shareholder had the right to purchase all of the Defaulting Shareholder's shares for $1.00.  There was some question as to whether this meant $1.00 per share or $1.00 in total for all the shares.  The court decided that the correct interpretation was $1.00 for all of the Defaulting Shareholder's shares (see paragraph 52).

On 11 April 2013, the Pioneer Board resolved to increase the Initial Funding Budget by $4.99 million.  Blue Oil did not pay the amount it was required to pay by the time it was required to pay it.  Blue Oil argued that the default clause was unenforceable as a penalty.  Bergin CJ confirmed that an attribute of a penalty is "if the sum stipulated for is extravagant and unconscionable in amount by comparison with the greatest loss that could conceivably be proved to have followed from the breach" (paragraph 59).

Bergin CJ agreed that the default clause in the Shareholder Agreement was an unenforceable penalty.  His Honour stated (at paragraph 74) that: "Blue Oil’s loss of the whole of the value invested in the joint venture is out of all proportion to the breach.  This is a punishment for the default".

In the result, Morgan Stanley was unable to acquire Blue Oil's shares for $1.00.

The McCausland case

In the early 1980s, Mr McCausland, Mr Mountford and Mr Bennett founded a surfing hardware business known as "Fin Control Systems".  Their small business became a prominent Australian surfing brand.  In August 2002, Mr McCausland engaged Macquarie Bank to facilitate the buy out of the interests of Mr Mountford and Mr Bennett and to introduce other capital to the business. 

Essentially, the business was acquired by a company called SHI Holdings Pty Ltd (the "Company").  Following the re-structure, Mr McCausland and his wife held approximately 30% of the shares in the Company, with approximately 22% of the shares being held by each of Macquarie Bank and Crescent Capital Partners.  In January 2003, the Company appointed Mr Ford as its CEO, and as a director.  Mr McCausland remained a director of the Company, and an employee of the business.

As part of the re-structure, the parties entered into a new Shareholder Agreement.  The Shareholder Agreement contained, amongst other provisions, a drag along clause.  A drag along clause can be useful where a shareholder wishes to sell its shares to a third party, but the third party will only purchase the shareholder's shares on the condition that the third party can purchase 100% of the shares in the company.  In these circumstances, the selling shareholder can compel (i.e. drag along) the other shareholders to sell their shares to the third party.

Clause 12 of the Shareholder Agreement provided:

12.2   If the Company or any Shareholder receives an offer from a bona fide buyer for the Share Capital (Third Party Offeror), it may serve notice, on behalf of the Third Party Offeror, (Offer Notice)...

 ...

12.3   If Drag Along Notices are served, then ... each Shareholder must deliver title to all of its Shares, free from all encumbrances, to a purchaser nominated by the board pursuant to clause 12.2(b).

After the re-structure, ongoing disagreements occurred between Mr McCausland and Mr Ford.  By July 2003, the relationship between Mr McCausland and Mr Ford had broken down irretrievably.  According to Slattery J (at paragraph 23), "[a] degree of cultural conflict between the polished Harvard Business School graduates from Macquarie and a creative self-made man who had built and managed a surfing hardware business on Sydney's Northern Beaches could probably have been predicted even before these parties met in 2002".

On 28 August 2003, the Company terminated Mr McCausland's employment.  Not surprisingly, this created even more bitterness in both Mr and Mrs McCausland, who continued to hold board positions representing their 30% interest in the Company. 

From the Macquarie/ Crescent point of view, a final break from Mr and Mrs McCausland at the board level seemed a rational and desirable objective.

In May 2004, the Company commenced a sale process, whereby it tried to locate a buyer for 100% of its shares.  During the sale process, Crescent Capital Partners offered to purchase 100% of the shares in the Company for $0.67 per share.  This was treated by the Company as having engaged the drag along clause in the Shareholder Agreement.  In the end, the McCauslands' shares were compulsorily transferred to a consortium of co-investors including Crescent and Macquarie for $0.675 per share.

Mr and Mrs McCausland claimed damages for the difference between what they considered to be the fair market price for their shares ($1.46 per share) and what they were paid for their shares ($0.675 per share).  The McCauslands argued that:

  1. Crescent could not offer to purchase all of the shares in the Company since, as an existing shareholder, Crescent already held some of those shares; and
  2. Crescent was not a "bona-fide buyer" on the basis that its offer was part of a plan hatched to invoke the drag along mechanism.

In relation to point (1), the trial judge agreed.  A shareholder cannot offer to purchase all of a company's shares because, as a shareholder, they already own some of those shares.  The trial judge held that clause 12 was "couched in language that does not contemplate that a shareholder may be the Offeror, and rather excludes that possibility".

In relation to point (2), the trial judge stated that a bona-fide buyer was someone who "genuinely intends to carry through a particular kind of buying transaction, namely acquiring 100% of the Ordinary Shares of the company".  The trial judge held that Crescent was not a "bona-fide buyer" because Crescent and its co-investors already held shares in the Company for which they had no intention to purchase or legal ability to purchase.  However, the trial judge acknowledged that Crescent was a genuine buyer for all the share capital that it did not own.

The trial judge also stated that Crescent's plan to oust the McCauslands, if there was one, did not otherwise diminish the bona fides of Crescent's offer.

It is also interesting to see that the main dispute commenced in 2003, and it wasn't until 2013 that a decision was handed down by the court.

Required Action

Halsey Legal Services recommends that you: (i) check that the default value in your Shareholder Agreement is not "extravagant and unconscionable" or "out of all proportion to the breach"; (ii) check that your Shareholder Agreement contains a workable exit procedure; and (iii) check that your Shareholder Agreement contains a workable forced disposal provision.

All of Halseys' solicitors have litigation, dispute resolution and commercial experience.  Using our combined knowledge of these areas, we are able to draft documents and implement mechanisms to protect our clients' interests.  Halseys has extensive experience drafting Shareholder Agreements.