It’s a family affair: unfair prejudice in a 'business divorce'

We read in the media on an almost daily basis about the latest celebrity couples splitting up and ultimately getting divorced. Then there’s speculation about how the assets will be distributed. Is there a prenup? Isn’t there a prenup? As heartbreaking as divorce is, it doesn’t just happen within families; the headlines that newspapers don’t run are what happens when business partners fall out, often akin to a divorce. A ‘business divorce’ can be very stressful and have a huge impact on business owners, especially when the shareholders are friends or even family.

The knock-on effect to the business can be drastic, causing deadlock and preventing the business from functioning as it should on a day-to-day basis.

How do disputes arise?

Like a matrimonial divorce, there isn’t a straightforward answer, but one of the shareholders might misbehave, such as withholding information from other shareholders, taking money out of the business, dilution of shares when another shareholder becomes involved, or majority shareholders may ignore the wishes of minority shareholders, leading to frustration, upset, and a lack of trust.

Are shareholders entitled to legal advice?

Rather like a marital divorce, when the relationship between shareholders breaks down, often shareholders simply don’t trust fellow shareholders. The first point is that shareholders are entitled to their own legal representation separately from the company. The Company is its own legal entity, and while directors may choose to instruct solicitors on behalf of the company, as a shareholder, even as a minority shareholder, the shareholders are entitled to independent legal advice. Company funds should not be used to fund personal disputes between shareholders.

The prenup?

There isn’t a prenuptial agreement in a business dispute. There are, generally, two key documents in any business dispute of this nature. The shareholders’ agreement and articles of association. The shareholders’ agreement is often compared to a prenuptial agreement.

The shareholders’ agreement is a private document between shareholders, and the articles of association or articles are a publicly available document available via Companies House, and are essentially a constitutional document.  

Shareholders agreement

A well-drafted shareholder agreement can save hours of anguish and a lot of money. A shareholder agreement may contain information about what will happen if shareholders are to part company. Things to look for:

• Deadlock clause – shareholders can agree in advance what happens if there is a deadlock (for example, in a company where there are two shareholders and they vote differently). A shareholders’ agreement should map out what happens in such circumstances.
• Some shareholder agreements contain a ‘Russian Roulette’ clause, which is the ability for one shareholder to buy out the other at a price set by the selling shareholder. This enables a shareholder to exit.
• Another clause contained in a shareholder agreement might be a ‘Texas shootout’ clause. This is when each shareholder submits a sealed bid to a third party.
• There may also be a ‘compulsory buy-out’ clause which sets out how one shareholder can buy out another.

Articles of association

The company’s articles of association are another good source of information. The articles are the company’s constitutional document and can contain, for example, good and bad leaver provisions which dictate what is to happen to a shareholder’s shares if they exit the business.

Shareholders' agreements and articles of association can, therefore, contain important precautionary measures (rather like a pre-nup) to help provide clarity in the event of a dispute and to minimise the fallout, and the emotional turmoil which can be an unwelcome distraction, in the event that shareholders no longer wish to work together.    

Business valuation

If a court is to intervene and require one or more shareholders to be bought out, the court will require an independent valuation of the business. Specialist forensic accounts offer this as a service. Parties can obtain their own valuation, or there can be a single joint expert to value the underlying shares. A single joint expert removes the risk of the parties disputing the valuation, but the level of distrust between parties often prompts separate valuations being obtained.

The account may take into account several factors, such as assets the business owns, such as property, intellectual property, and any other assets, such as a debt book.  

Can the court help minority shareholders whose interests are being unfairly prejudiced?

The simple answer is yes, the court can step in to help.

The procedure to ask the court to intervene is known as an unfair prejudice petition. Essentially, the minority shareholder would ‘petition’ the court and ask that the court provide relief.

It is possible for the majority shareholders to use the same procedure; however, by virtue of their majority shareholding, they are more likely to have the ability to take control of the board and resolve any issues that they might have without the need to seek the court’s assistance.

What does a shareholder need to show?

In order for there to be ‘unfair prejudice,’ the shareholder needs to demonstrate two elements to unfair prejudice, and they are found in s. 994 of the Companies Act 2006. There must be:

• unfairness; and
• prejudice.

What is unfairness?

For the court to find unfairness, the conduct must be negatively impacting the interests of one or other of the shareholders. The test applied by the court is whether a reasonable person would regard the conduct as unfairly prejudicing the relevant shareholder’s interest.

Some decisions may seem unfair to the shareholder, but wouldn’t necessarily be regarded by the court as unfair. The decision (whatever it is) has to have prejudiced the shareholder as a shareholder. This usually manifests itself in a decrease in the value of a shareholding.

An example of a scenario that might, on the face of it, seem unfair, but wouldn’t necessarily be deemed to be unfair, might be, if a board were to declare that no dividend was payable, but instead the board would prefer to invest that money in machinery or other advancement of the business. Assuming that the decision to invest was legitimate and taken in the best interests of the company, the failure to declare dividends in those circumstances would not likely be considered to be unfair, although the shareholder may not receive the money as expected.

What is prejudice?

In terms of prejudice, the court doesn’t particularly want to intervene in the running or ownership of companies. Therefore, the prejudice must be substantial, and that would usually sound in financial terms. An example might be if the shareholding has been devalued by the negative conduct of a controlling shareholder or in circumstances when there has been non-compliance with directors' duties or other fiduciary duties.

Other examples might be the misappropriation of funds, mismanagement of the business, and even the dilution of shares.

What is the relief?

The court has wide-ranging powers, from an order for the minority shareholding to be purchased at the market value (purchase order), the court can also order the shareholders to refrain from certain conduct or regulate the management and conduct of the company in other ways.