Avoiding Deadlock – Court Intervention or Shareholders’ Agreement?

If the attendance of a specific director is a requirement of a company’s constitution, can a decision made at a directors’ or shareholders’ meeting be valid if that director is not present?  Further still, can that director’s removal as a director of the company be possible without their attendance?  

Simply put, the answer to this question is no, which leads to a situation in which it may be impossible to remove an uncooperative director without breaching the company’s constitution, resulting in a deadlock situation.

Perhaps unsurprisingly this situation is commonly encountered by many small and often family run businesses and, whilst understandable that a director wishes to ensure that the management and strategy of the company remains under their control and that their interest remains secure, the situation becomes complicated when director relations start to fall apart.

Court Intervention

Section 306 of the Companies Act 2006 provides some comfort to companies, as a court may, at the request of a director or shareholder, order a general meeting to be called, held or conducted in any manner it thinks fit where it is impractical to call or conduct the meeting in the manner prescribed by the company’s articles (as supplemented by the Companies Act 2006).  Furthermore, the court has the general power to make any necessary directions to give efficacy to the operation of the company, which may include amending a company’s quorum from two to one, amongst other things.

Smith v Butler & another [2011] EWHC 2301 (Ch)

The case of Smith v Butler successfully illustrates s.306 in action.  The claimant, Smith, was the Chairman of a company and held 68.8% of the shares whilst the Managing Director, Butler, held the remaining 31.2%.  The quorum requirement for general and board meetings was two, one of which had to be Smith unless he waived the requirement.  In 2011 the parties fell out with suspicions of fraud being raised by Butler against Smith culminating in Smith wanting to appoint a new CEO and Butler seeking to suspend Smith as a Director.  Butler proceeded to hold a meeting in which Butler and a third director signed a resolution of the board authorising the suspension.  Following this, Smith requested that a general meeting be held in order to remove Butler and the third director as directors, Butler’s refusal to attend the meeting led to the meeting be held inquorate causing Smith to make an application to court to seek an order that a general meeting be called with a quorum of one.

It was held by the court that a quorum of one would be allowed as the Articles were designed to give excessive protection to Smith who could not be dismissed as a director.  As a point of interest, the court also commented that Butler, as a minority shareholder, could in fact have commenced unfair prejudice proceedings and/or sought permission to commence a derivative action.

Conclusion – the need for a Shareholders’ Agreement

Whilst this case is an example of court intervention in a deadlock situation, the reality is that a s.306 application is often an option of last resort, as the courts are generally hesitant to interfere in company matters unless absolutely necessary.  A preferable and potentially more cost effective option would be for a company to invest in the drafting of a clear and concise shareholders agreement to strike an effective balance between protection and flexibility and which contains specific provisions dealing with potential deadlock scenarios. This would enable the company to function successfully and thrive irrespective whatever the situation.

For more information on the drafting or interpretation of shareholders’ agreements or any of above, please feel free to contact Partner Andy Wilks  on 0207 841 0390.

Common FAQs for Shareholders and Directors

How do Shareholders’ and Directors’ roles differ?

A company is an independent legal entity separate from its Directors and Shareholders.

A Director of a company is responsible for directing its affairs on a day-to-day basis, promoting its success and protecting all stakeholders (i.e. Shareholders, employees, the company itself and, in certain circumstances, creditors).  

The Shareholders of the company have an interest in the equity (i.e. the net value of its assets), which they own in accordance with the shares allocated to them.  They have certain powers under the relevant legislation in terms of how their decisions (referred to as “resolutions”) are reached, how the structure of the company is managed (including its funding and Directors’ appointment) and how they can deal with company assets (e.g. payments to Directors).  The Shareholders otherwise have no role in managing the company or determining its direction, other than as determined in the company’s constitution (i.e. the Memorandum and Articles of Association), any Shareholder’s agreement and by way of resolutions passed at general meetings of Shareholders.

Directors must call an Annual General Meeting of Shareholders (“AGM”) but there is also an ability for Shareholders, of the requisite number, to request a meeting outside of these time limits during the year – this is called an Extraordinary General Meeting (“EGM”). Shareholders’ decisions are normally reached by reference to the Shareholders present (or voting by a nominated proxy, usually the chairman) voting on specific decisions and such decisions are passed either by an Ordinary Resolution (requiring 50%) or a Special resolution (requiring 75%).

What happens if Directors or Shareholders disagree on a decision?

The Company’s Articles of Association and/or Shareholders’ Agreement sets out the rules as to how company decisions can be taken and what Directors can do as part of their day-to-day governance of the company’s affairs.  

Beyond the day-to-day decisions, the majority of decisions made by a company (e.g. the removal of a Director and the approval of “conflict” situations) require a simple majority (i.e. 50.01%) of Shareholders present at a general meeting to agree to pass an “Ordinary Resolution”.  

In the event that a Director or Shareholder disagrees with a decision made at a general meeting, it is first necessary to consider whether correct notice of the meeting was provided, all other formalities complied with and whether the appropriate Shareholder Resolution was passed to validate the decision being complained of.  In the event that this is not the case then the decision (i.e. the Resolution) may be invalid and the decision will not stand.  The status quo will therefore continue until a valid Resolution is passed and a decision made. This can raise difficulties in practice and specific advice should be sought on the relevant facts.

How can a Director be removed from a company?

The most important point to note is that the removal of a Director requires Shareholder support (save a decision to demote a Managing Director to Director).  At a general meeting, Shareholder support of in excess of 50% (i.e. an Ordinary Resolution) is normally required for a decision to be taken to remove a Director from a company (unless varied by the Shareholder Agreement or Articles of Association).  It should be noted that 28 days notice (referred to as “Special Notice”) must be given to the Director of the resolution to remove him/her and, in the event that sufficient notice is not provided, the resolution to remove the Director will be invalid.  Upon receipt of notice, the Director is entitled to distribute to Shareholders his/her written representations contesting his/her removal as a Director.  The Director is also entitled to make verbal representations at the general meeting itself (note that an actual meeting is required and that the resolution to remove a Director cannot be passed by way of written resolution in lieu of a meeting).  Following representations in defence of his/her position, the Director will or will not be removed depending on whether the requisite majority of Shareholder votes is cast in favour of the Resolution to remove the Director.

What are a Director’s fiduciary responsibilities?

Directors have a number of legal responsibilities and duties to the company, primarily stemming from a general duty to act in good faith in the best interests of the company.  More specifically, Directors are required to act within the powers conferred upon them by the company’s Articles of Association; they must promote the success of the company and exercise reasonable skill and care and diligence in their particular area of management; they must avoid conflicts of interest (save those declared and approved at a general meeting) and they must not accept personal benefits from third parties without authorisation at general meeting (subject to any alternate provisions within the Articles of Association).

How to resolve a “deadlock” situation?

A deadlock situation commonly occurs in small or medium-sized businesses under the control of only a few Directors and/or Shareholders.  

Occasionally, the Directors may have a disagreement on certain decisions and, as a result, the board is split 50:50 and the decision is “deadlocked”.  It is not uncommon to have a provision in the company’s Articles of Association to provide for this situation and provide a casting voting to one of the Directors (usually the chairperson) or alternatively to provide for a third party to intervene.  If there is no such provision then the board is deadlocked and this will prevent the decision being decided upon.

In such a situation, the Directors should then turn to the Shareholders who have wider powers to terminate a Director’s appointment or pass Resolutions on specifically addressed matters.  However, especially with a small business, an identical situation can occur where the same individuals are both Shareholders and Directors with no other parties involved.  A deadlock situation therefore continues.

The solution to a Shareholder deadlock will again be dependent on the company’s Articles of Association and any Shareholder agreement.  If there is no provision to deal with this deadlock and no alternative provision for (e.g.) formal mediation, then the parties must look to negotiation to resolve the problem or, ultimately, their legal options. 

If the Shareholders must resort to a legal route to settle the dispute or recover their interests (sometimes as a minority shareholder – see below) then the available options include seeking to wind-up the company, issuing a petition against a Director for unfairly prejudicing a Shareholder right or seeking a derivative claim on behalf of the company (derivative meaning that the authority derives from your equitable interest in the company). 

What rights do I have as a minority shareholder?

Any shareholder with at least 5% shareholding can, subject to a company’s Articles, require the board to call a general meeting of Shareholders and to propose a Resolution for consideration by the Shareholders at a general meeting.  The decision, whether requiring an Ordinary or Special Resolution, will or will not be passed according to shareholder support.

In the event that a minority shareholder’s rights are being breached, they are entitled in the appropriate circumstances to apply to the Court for an Order stipulating that the Company has acted or continues to act unfairly (Section 994 of the Companies Act 2006).  Such a Petition is commonly referred to as an “Unfair Prejudice Petition”.  Dependent upon the facts, such a Petition, if successful, may give rise to an order giving such relief as necessary in respect of the matters complained of.  This includes orders made to regulate the company’s affairs, require the company to do or refrain from doing the action(s) complained of, authorise proceedings to be issued on behalf of the company, direct alterations to the company’s Articles of Association or provide for the purchase of shares by other Shareholders.

Where appropriate, minority Shareholders can also apply to the Courts for a company to be wound-up upon the grounds that it is just an equitable to do so (Section 122 of the Insolvency Act 1986).  Such a Petition can lead to the company being wound-up in the event that no alternative solution exists, including the purchase by the company of the petitioning Shareholder’s shareholding.  However, great caution needs to be taken in such matters as the Court is hesitant to allow minority Shareholders to disrupt a company’s business in contravention of the majority’s rights and so will only consider this an option of last resort.

Legal action can be taken against the Directors personally in respect of negligence/breach of a Director’s fiduciary duty by way of a derivative action (i.e. an application issued in the name of the company itself) against a Director personally.  Such an action can result in the Director being forced to compensate the Shareholder or the company or, if merited, the Director’s removal as Director.  

As a general note, other than as described above, minority Shareholders have a limited entitlement to affect the company process through day-to-day communication with Directors and/or Shareholders (especially in smaller businesses with common Directors and Shareholders) and to criminal redress through the police or the use of a mediation service, where applicable. 

For advice or further comment on the above, please contact Partner Andy Wilks on 020 7841 -390.