Most companies have a Constitution1 setting out the rules governing its activities and the rights and obligations of its shareholders and directors. It is not uncommon for shareholders in a closely held or joint venture company to also decide to adopt a Shareholders Agreement to regulate their relationship. But if shareholders are thinking of adopting a Shareholders Agreement, they need to closely consider its potential impacts on the Constitution and the shareholders’ rights under other documents.
3 key things to be aware of are:
- Don’t assume that you can always rely on an “Inconsistency Provision” (i.e. a provision which says that if there is any inconsistency between the Shareholders Agreement and Constitution, the Shareholders Agreement prevails to the extent of the inconsistency) to deal with inconsistencies between the Shareholders Agreement and Constitution. There may not actually be an inconsistency, even between provisions that deal with similar subject matters, if the provisions have different purposes.
- A Shareholders Agreement between all shareholders of the company may have the practical effect of modifying the rights and obligations of the shareholders, even if the Constitution is not amended.
- A Shareholders Agreement to which all shareholders and the company are party can affect the nature of the shares in the company and the shares’ inherent rights and obligations, thereby affecting the rights of third parties who have interests in those shares (such as a mortgagee).
The practical implication is that a Shareholders Agreement should not be viewed as a standalone document and the parties need to take care to consider how it interacts with the company’s other corporate governance documents and rights and interests of shareholders and third parties.
Is there an inconsistency between the Shareholders Agreement and the Constitution?
As the Shareholders Agreement and Constitution both deal with the governance of the company, there is a chance that some provisions in the 2 documents may overlap or be inconsistent.
In an attempt to deal with this, Shareholders Agreements commonly include a provision such as this (Inconsistency Provision):
“If there is an inconsistency between this Shareholders Agreement and the Constitution, this Shareholders Agreement prevails to the extent of that inconsistency.
On receipt of a request in writing from another party, each party must take all necessary steps to amend a provision of the Constitution that is inconsistent with this Shareholders Agreement so as to remove the inconsistency.”
The parties may expect that, because of the Inconsistency Provision, the Shareholders Agreement will trump the Constitution and therefore, there is no need to consider all potential areas of inconsistency between the 2 documents. The danger of making such an assumption was highlighted in the New South Wales Supreme Court case of Cody v Live Board Holdings Limited.2
In this case, Live Board Holdings issued preference shares to new shareholders to raise about $1 million and also issued ordinary shares to its existing shareholders pursuant to anti-dilution provisions.
The Constitution provided that the directors could cause Live Board Holdings to issue shares with such preferred, deferred or other rights to any person, in such proportions or numbers and for such consideration as the directors determined. However, if this would directly or indirectly vary the rights or obligations of an existing class of shares, then the variation must be approved by holders of 75% of the shares of that class.
The Shareholders Agreement provided that although the board of directors would be responsible for the overall direction and control of the management of the company, certain matters were reserved to shareholders. One of these reserved matters was the issue of any shares which required the approval of a simple majority of shareholders.
The Shareholders Agreement also contained an Inconsistency Provision.
On the face of it, both provisions cover the same subject matter – the issue of shares by the company – and therefore, it was argued that because of the Inconsistency Provision, the Shareholders Agreement should prevail and only a simple majority approval of shareholders was required for the issue of the preference shares.
However, the Court held that there was no inconsistency between the provision in the Constitution and the provision in the Shareholders Agreement. This was because the roles of these 2 provisions were different.
The role of the provision in the Constitution was to protect class rights when a share issue is contemplated. On the other hand, the role of the provision in the Shareholders Agreement was to remove from the directors and reserve to the shareholders the power to issue shares, but not to remove the prohibition on varying class rights without the approval of holders of 75% of the shares of the affected class.
The Court also expressed some doubt about the validity of the Inconsistency Provision, but did not ultimately have to decide on this issue.
The key point from this case is that even where provisions deal with similar subject matters, there may not be any inconsistency between them if they have different purposes. So far as possible, the Shareholders Agreement should be read together with the Constitution, so as to be consistent with it. Therefore, it is important for shareholders and directors to understand how provisions in the Constitution and Shareholders Agreement operate and their respective roles and purposes.
The Shareholders Agreement may have the practical effect of modifying Constitutional rights
In Rectron Australia BV v Chien Min Lu3, the Victorian Supreme Court held that the Shareholders Agreement constituted a resolution of shareholders to amend the Constitution.
In this case, the company, Rectron Electronics, had 2 shares – 1 held by Rectron Australia and the other held by Jimmy Lu.
The Shareholders Agreement provided that:
- Jimmy and Rectron Australia would each be entitled to appoint two directors to Rectron Electronics.
- A quorum for any directors’ meeting would be three directors, but if a quorum was not present within 30 minutes of the appointed time for the meeting, the meeting would be adjourned for a week and the directors present at the adjourned meeting would form a quorum.
- Rectron Australia or its duly appointed director would be appointed as the Chair of any shareholders’ and directors’ meeting, and would have a casting vote.
There was an Inconsistency Provision in the Shareholders Agreement.
Prior to the Shareholders Agreement, there were 2 directors of Rectron Electronics – Jimmy and Mark (who was considered as Rectron Australia’s nominee).
In 2013, Rectron Australia purported to appoint 2 new directors as its nominee directors pursuant to the Shareholders Agreement. These 2 nominee directors then purported to pass several resolutions, including the suspension of Jimmy’s role as managing director and the appointment of a new CEO.
One of the issues for the Court’s consideration was whether Rectron Australia was entitled to appoint the 2 new directors to replace Mark. Jimmy argued that the Shareholders Agreement did not provide for the removal of a current director (i.e. Mark), only the removal of such directors as may have been appointed “under the shareholders agreement”. As Mark had been appointed as a director prior to the Shareholders Agreement being entered into, Jimmy contended that Rectron Australia could not remove him as a director and replace him with the two new nominee directors.
However, the Court held that:
- The change in regime brought about by the Shareholders Agreement was something which the shareholders in general meeting could have achieved, and by their agreement are taken to have achieved.
- The Shareholders Agreement was effective in itself, as a resolution of members, to alter the Constitution so as to introduce new director appointment rights, a limitation on the number of directors and a casting vote.
What this case does not address is whether the amendment to the Constitution effected by the Shareholders Agreement would bind new shareholders who are not parties to the Shareholders Agreement.
Under the Corporations Act4, a Constitution of a company has effect as a contract between each shareholder and each other shareholder as well as with the company. Therefore, if a person agrees to become a shareholder of the company and their name is entered in the register of shareholders, that person will automatically be bound by the Constitution of the company and any future amendments to it (subject to certain exceptions).5
On the other hand, to be bound by a Shareholders Agreement, a new shareholder will need to expressly agree to do so (usually by executing a “deed of accession”). If a Shareholders Agreement can, in certain circumstances, constitute an amendment to the Constitution, it would follow that the Shareholders Agreement, to the extent that it amends the Constitution, would be binding not only on present but also future shareholders even if they do not become party to the Shareholders Agreement.
The South Australian Supreme Court in Elders Forestry Ltd v BOSI Security Services Ltd6 (Elders v BOSI) took a somewhat different view on the effect of a Shareholders Agreement on the Constitution. In this case, the Court held that although, in a practical sense a variation to the Shareholders Agreement may effectively alter the rights and obligations of the company and those of its shareholders who are party to the Shareholders Agreement, the variation does not amend the Constitution itself. The court further made clear that for a shareholder who is not a party to the Shareholders Agreement, the provisions of the Shareholders Agreement cannot prevail over the Constitution because the Shareholders Agreement would have no application to that shareholder. This seems to us to be the better view.
Whichever view is accepted, the point is that a Shareholders Agreement may have the practical effect of varying Constitutional rights, and therefore, when adopting a Shareholders Agreement, it should be checked against the Constitution to ensure that no unintended effects arise.
The Shareholders Agreement may affect the rights of third parties
The Elders v BOSI case also illustrates that a Shareholders Agreement may, in certain circumstances, impact on the rights of third parties who are not shareholders of the company.
This case involved an incorporated joint venture between ITC and Timbercorp, each of which had 50% of the shares in the joint venture company.
Timbercorp granted an equitable mortgage over its shares in the joint venture company in favour of BOSI. Administrators and thereafter, liquidators were appointed to Timbercorp.
The Shareholders Agreement provided that either one of the shareholders was entitled to acquire the other’s shares upon the occurrence of a defaulting event. The appointment of administrators and liquidators to Timbercorp triggered a defaulting event which entitled ITC to exercise its default option to acquire the shares of Timbercorp.
This triggered a dispute between ITC and BOSI over their competing equitable interests in Timbercorp’s shares in the joint venture company – ITC’s interest arising from the default option and BOSI’s interest arising pursuant to its mortgage.
The Court held that:
- A restriction in a company’s Constitution on the transferability of shares is an integral part of the bundle of rights comprising the chose in action which constitutes the property represented by the share.
- The entitlements of a shareholder may be affected by an amendment to the Constitution of the company after the allotment of the shares. It therefore followed that the rights of a mortgagee of shares must be equally subject to change by any such amendment.
- The Court did not want to deny a Shareholders Agreement to which all shareholders and the company were parties the same legal effect that is given to the Constitution.
- Therefore, a mortgagee is as bound by a Shareholders Agreement, to which all of the shareholders and the company are parties, as it is by the company’s Constitution, and the Shareholders Agreement here affected the very nature of the share and its inherent rights and obligations.
- BOSI was thus bound by ITC’s exercise of the default option under the Shareholders Agreement. Timbercorp was ordered to transfer its shares to ITC and on such transfer, BOSI had no further interest in or right over those shares.