Shareholder Protection From Unfair Prejudice: Part (4) Examples commonly encountered in practice

Transcript of seminars delivered by Andrew Marsden on Shareholder protection from unfairly prejudicial conduct

Note: It is recommended that you watch the videos of the seminars delivered by Andrew Marsden rather than relying on this transcript. The videos of this seminar series can be seen at: https://commercialchambers.org/videos/

Part (4) Examples commonly encountered in practice

Good afternoon everybody, and welcome to this, the third in this series of short seminars on the subject of the relief of shareholders from unfairly prejudicial conduct of the company in which they are invested.

Once again, I have muted the sound and I have turned everyone’s camera off so as to preserve bandwidth.

Following last week’s lecture I received, again, some kind comments. They are gratefully received. These seminars do involve considerable preparation and I am very glad that they are seemingly well received.

I have, as I had in previous seminars, prepared some slides to accompany them and I’ll share them now with you using the screen share function. You should now have in front of you the cover slide to this presentation.

In the first of these seminars I introduced you to the jurisdiction and we examined some of the procedural and practical regulations applying to applications under section 994 of the Companies Act. Last week I turned to look at some of the requirements and, in particular, the requirements of “unfairness” and “prejudice” that need to be satisfied in order to invoke the jurisdiction under section 994. This week I am going to be examining the some examples of unfairly prejudicial conduct that are frequently encountered in practice.

At the outset, I think it’s important to stress that the categories of unfairly prejudicial conduct are in no way closed. Unfairly prejudicial conduct can take very many different forms. The courts are constantly being required to consider novel circumstances alleged to involve unfairly prejudicial conduct and are regularly identifying previously unseen examples of unfairly prejudicial conduct.

I’m certainly not going to attempt to describe every example of unfairly prejudicial conduct that’s been considered by the courts. Rather, I’m just going to address the most common examples of unfairly prejudicial conduct that are encountered in practice.

First, I want to start with what I describe as the “exclusion from participation” cases. This is certainly one of the most common forms of unfairly prejudicial conduct that one comes across in this area. Exclusion from participation can take a number of different forms. Of course, it can take the form of an exclusion following the removal of the petitioner from his office as a director of the company. But, as I emphasised last week, the petitioner does not need to hold a directorship of the company. And so, of course, an exclusion from participation may also take the form of his removal from a senior management position within the company.

It’s not even the case that the exclusion cases necessarily involve a removal of the petitioner from a position within the company. Very often these cases are demonstrated at a more pragmatic or practical level. So, for example, a failure on the part of persons in control of the company to hold the meetings required of a company might involve unfairly prejudicial conduct in the form of exclusion of the petitioner from his participation in the conduct of the affairs of that company.

Even if meetings are held exclusion may still take place in the form of a failure to permit the petitioner involving himself in participation in those meetings. Even if he is permitted to attend the meetings, the exclusion may take the form of a failure to give proper consideration to the views expressed by the petitioner at those meetings.

In relation to the exclusion from participation cases. I think it’s important to remember that there is no general right on the part of a shareholder to participate in the conduct of a company’s business and affairs. In other words, the recognition of a right to participation is the exception rather than the rule. In the absence of an agreement between the participators in a company that they should have a right to involvement in the conduct of the business and affairs of the company, or, in the absence of what might be categorised as a quasi partnership where one incidence of that relationship is a right to participate recognised in equity, in the absence of either of those situations, then no rights to participation in the management and conduct of the affairs of the company arises.

In the case of widely owned companies; for example, those listed on public stock exchanges, it’s highly unlikely, therefore, that any right of participation will be found to exist.

Likewise, if the articles of association or a written shareholder’s agreement regulating the relationship between the participators in a company specifically denies any such right of participation, then that agreement is likely, in fact almost certainly, is determinative of the position and no right of participation will arise.

I also want to stress that whilst a right of participation in the conduct of the business and affairs of a company is regularly recognised, particularly in relation to closely controlled companies or corporate successors to partnerships or, indeed, family companies for example; whilst those rights to participation are widely recognised in such situation the right to participation through employment with the company is much less common. Rights to continued participation in the form of employment do occasionally receive recognition in the courts but generally the agreements between participants do not extend to include agreement that the participants should be entitled to continued employment by the company for so long as they hold their shareholdings in the company. As I say, such agreement to continued employment is not unheard of but is relatively rare and generally termination of employment alone is insufficient to establish unfair prejudice.

Generally, these sorts of cases involve the dismissal of a shareholder from his position as a director of the company. There is generally no unfair prejudice if a minority shareholder/director voluntarily resigns from his position as a director of the company. In practice, whether a shareholder director has voluntarily resigned or been pushed often involves pretty fine distinctions being made.

It’s also worth highlighting the issue that sometimes arises in relation to a failure to reappoint. Where there’s been a voluntary resignation. But the shareholder then has a change of mind and seeks reappointment the cases tend to suggest that the failure to reappoint does not involve unfairly prejudicial conduct of the affairs of the company even if a right to directorship was initially contemplated, whether by agreement or as a result of an incidence according to a finding of quasi partnership. It seems to me that if there exists some form of formal or informal agreement that a participant should be entitled to involvement in the conduct and management of the company’s affairs then there might arguably be unfair prejudice in refusing to reappoint a shareholder as a director when that participant seeks to reassert that right. But as I say, in practice, the cases tend to find against that conclusion holding that a failure to reappoint once a shareholder director has resigned from his position does not generally involve unfairly prejudicial conduct.

I also want, in this context finally, to just remind you of an issue which I raised, I think, last week, which is that, particularly in the exclusion from participation cases, the petitioner’s own conduct can often be raised as relevant. It’s very often suggested that the petitioner’s own conduct justifies his dismissal, such that his dismissal from his position, say, as a director of the company, should not be considered unfair.

As I think I mentioned last week and I certainly want to emphasise this week, generally in order to justify an exclusion of a participant from involvement in the conduct of the affairs of a company, that petitioner’s own conduct must be pretty serious misconduct. There’s no doubt, for example, that misconduct, if it took the form of a misappropriation of funds from the company, would certainly justify a petitioner’s removal from his position as a director. But it’s fair to say that the courts are understandably reluctant to engage in a balancing assessment of counter allegations of various day to day misdemeanours by the participants which often results when allegations of exclusion from participation are relied upon and the riposte to that is to raise issues of the petitioner’s own misconduct.

I now want to turn to perhaps the other most common example of unfairly prejudicial conduct. I call these the “misappropriation cases”. Cases of this sort generally, it seems to me, fall into one of three categories. They either involve (1) misappropriation of funds or they involve (2) the misappropriation of business property belonging to the company or resources owned by the company; and finally, they involve (3) misappropriation of business opportunities that should have been exploited for the benefit of the company. Usually these sorts of misappropriation cases also involve breaches by directors of the duties that they owed to the company to promote its success. They often involve directors also acting in circumstances which represent or present conflicts of interest or the making of secret profits.

The first category of cases under the heading “misappropriation” that I want to consider in a little bit more detail is the misappropriation of funds. I describe these in their most basic form as cases involving one participant having his “hand in the till”. In practice. I’m sorry to report that these sorts of cases are sadly commonplace in my experience. They clearly involve unfairly prejudicial conduct, but to my mind, they go beyond that. These sorts of claims where monies are taken out of a company seem often to me to involve straightforward criminal behaviour. They look and smell rather like theft from the company or from the participants in the company in an indirect sense. In practice, it is extremely difficult to persuade the policing authorities to take any interest in such cases. They, in practice, consider these matters to be civil matters rather than criminal matters. Though I have to say that in many cases I find it hard to see the distinction.

These cases are not always quite so blatant or culpable as to involve a “hand in the till”. They often involve a person making, for example, unjustified or excessive expense claims. In that regard, a hotbed of disputes is the area of hotel expense claims; one participant claiming that the other is incurring excessive and unjustified hotel expenses as compared to his more modest tastes.

Sometimes the controller of a company may seek to use the company’s funds for his own personal benefit. He may use or try to use the funds for the meeting of what are, in substance, his own personal expenses. Again, a very commonplace allegation in this regard is the use of the funds of the company to meet the costs of personal or family holidays dressed up to look a little bit like business trips but, in substance, really involving little business purpose and substantially comprising a personal holiday.

Another form of use of funds for personal benefit that I’ve already mentioned to you, and I draw it again to your attention because it is again commonplace in practice, is the use of the company’s funds to meet the costs of the respondents defence to the section 994 proceedings. As I mentioned to you last week, the use of such funds is a clear misappropriation of funds from the company to meet what are, in substance, the personal legal expenses of the participants themselves.

Sometimes the use of company funds is dressed up as a loan. It’s recorded as a loan in the accounts of the company; a loan to the director who has taken those funds. If that loan is made otherwise than on commercial terms or the terms that might be expected between parties dealing at arm’s length, then such loans can often involve unfairly prejudicial conduct of the affairs of the company.

Similarly, if those conducting the affairs of the company procure that the company should deal with him or with persons connected with him on terms that are otherwise than those that might be expected between parties dealing at arm’s length, then the procuring of the company entering into such dealings may also involve unfairly prejudicial conduct.

For example, a director who procures that the company pays excessive rents for occupation of the business premises that he owns or makes excessive payment for management or administration charges is certainly likely to be involved and unfairly prejudicial conduct of the company’s affairs.

Let me look at the second category of “misappropriation” cases. This is the category that I describe as misappropriation of business property or business resource cases. And these might be described as cases involving potentially one’s “hand in the stock”. Again, they seem equally criminal to me if they’re of that blatant nature. But again, it’s difficult to engage the police interests in such matters. An example of these sorts of cases might be where a majority shareholder or director of a company, say a building company, procures the construction of a new extension to his home using the company’s materials and workforce but without properly paying for the same.

These misappropriation of business property cases can apply not only to the trading stock and resources of the company but also to the capital assets of the company.

The same principles apply whether those business properties, items of business property or business resources are withdrawn from the company without any consideration or whether they are paid for simply at an undervalue or a rate below that which might be anticipated as being payable between parties dealing at arm’s length. Whenever company, property or resources are transferred from the company to a person conducting the affairs of that company or a person connected with him there is a real need in practice to be able to demonstrate that those transfers are made in return for the market value of that property or those resources. It’s certainly desirable to obtain independent evidence of the value of that property. Ideally, it’s best to leave consideration of those sorts of proposed disposals to independent directors who have no other personal interest in the proposed disposal.

Let me turn to the third category of “misappropriation” cases that I want to consider. That is the misappropriation of business opportunities. Sometimes the misappropriation takes the form of an appropriation of a business opportunity or a commercial opportunity by a participant for his own benefit rather than that of the company concerned. Again, that sort of conduct is very likely to involve unfairly prejudicial conduct of those left out of participation of that business opportunity.

The misappropriation of business opportunities can take a positive form in that a director of the company may engage in working competitively for another enterprise to secure the award of the contract or deal in question for the benefit of that competing enterprise rather than the other company with which the ownership is shared. Alternatively, it can involve a misconduct by way of omission. So, simply failing to pursue a business opportunity available for the benefit of the company resulting in it being won by another enterprise with which he has connection, can involve misappropriation of the business opportunity.

Generally, these misappropriation of business opportunity cases arise in circumstances where, as I say, the director is involved in a competing business or, quite commonly, where a director/shareholder considers himself to have been the principal reason for the generation or the identification of the business opportunity itself. Greed and self-interest can often take over in those circumstances.

In this context, I just want to reflect with you on one interesting case that I was involved in relatively recently, where the outcome came as something of a surprise to me. The company concerned was owned and operated by two director shareholders. They fell out and my client chose to resign from his position as a director of the company. There was no unfairly prejudicial conduct in his losing his directorship as he voluntarily resigned. The remaining director then continued to operate the board of directors alone and decided to close the business, cease trading and wind up the company. Now, there was nothing wrong per se in reaching those decisions. What troubled me was that that director then started a new company with which my client had no involvement at all and all the business opportunities which then existed, potential contracts, identified potential contracts, were then secured for the benefit of that new company. I argued that this involved unfairly prejudicial conduct of the affairs of the old company. It seemed to me to involve an appropriation of those business opportunities from the old company to the new. At the very least, it seemed to me that those business opportunities should have been realised for the benefit of the old company in terms of a sale of the business and assets of the old company, including those business opportunities, such that the shareholders in the old company would have continued to participate in those business opportunities. The courts disagreed with me. I still cannot understand the rationale behind that decision. It seems to me that this was a clear case of the diversion of business opportunities to a new company to the exclusion of the petitioner. As I say, I still can’t understand it. Perhaps one of you may be able to explain it to me one day.

Let’s turn to the next category of case that I want to examine by way of example of unfairly prejudicial conduct. These are the category of cases that I describe as “excessive remuneration” cases. These cases involve allegations of unfairly prejudicial conduct through the payment of excessive remuneration to shareholders who are also employed by the company whether in a directorial capacity or in some other capacity.

That remuneration can, of course, take the form of a salary payment or it can involve bonus payments, one off or recurring bonus payments, and very often it can include substantial contributions to personal pension arrangements held for the benefit of that participant.

Unfairly prejudicial conduct of this type can also take the form not only of remunerative payments made to the participant or person conducting affairs of the company himself but it can also take the form of remuneration made available for the benefit of persons connected with that other person. In other words, it can include payments to spouses or other family members. There’s quite clearly a tension between the payment of salaries and bonuses and pension payments made to those employed by a company, whether in a direct or other capacity, and the level of profits available for distribution to shareholders. Obviously, the higher salaries, bonuses or pension contributions that are paid, the less is left available for distribution to shareholders.

There are essentially two types of case that deal with excessive remuneration. The first is remuneration being paid in excess of the rates agreed between the participants as that which should be paid to them for the services that they provide to the company. So for example, there is often agreement between the participants either that they should be paid equally or that they should be paid unequally, but only at agreed rates. If one shareholder controller takes more than the other or more than it has been agreed that he should be entitled to then that readily involves unfairly prejudicial conduct of the affairs of the company.

The second type of case in this area are those remuneration cases where excessive remuneration is taken by a participant when compared to the market rate for the services that would be paid if the individual was dealing at arm’s length with the company. Again, payment at excessive rates frequently involves unfairly prejudicial conduct of the affairs of a company.

Let me say a word about the importance of expert evidence in this context. Expert evidence as to the market value of services provided is often very important in these sorts of cases. It may very readily be required to demonstrate that the rates of remuneration are not excessive. Likewise, once again, I should stress the desirability of independent directors setting rates of remuneration for the participants in a company or, indeed, the use of remuneration committees in making decisions over salaries, bonus payments and pension contributions. Their involvement can often be crucial in terms of the objective justification of the payments made. In this context, I’d just draw your attention to a quote that I find quite helpful, which is that of Mr. Justice Blackburn in the Irvine case, where he said that when looking at excessive remuneration, the test is “whether applying objective commercial criteria, the remuneration which the respondent took was within the brackets which executives carrying the responsibility and discharging the sort of duties that the respondent was would expect to receive”.

Note from that quote. It’s an objective assessment, of course, and that the assessment is usually made of a bracket as to the remuneration that might be considered reasonable for any particular services rather than at a particular level. In practice, there are a number of guides as to the levels of remuneration that are considered reasonable as between persons dealing at arm’s length in various roles and in companies in various sectors. One such survey is published by the Association of British Insurers. I think it’s called “The Principles of Remuneration”. Other firms of accountants publish similar reviews and guidance in this area and they are often of considerable importance when trying to persuade the courts as to what is a fair level of remuneration for the services provided.

Before moving away from the “excessive remuneration” cases. I will just say this; in my experience, it is often difficult to challenge the salary, bonus or pension contribution levels being paid to directors and employees as being excessive and so involving unfairly prejudicial conduct of the company’s affairs. It’s often difficult to challenge them because, quite naturally, those setting the levels of remuneration tend to be quite careful in the steps they take to demonstrate or permit them to demonstrate the objective commercial justification for the level of salary or other remuneration that they are provided with.

Another area of unfairly prejudicial conduct that one comes across pretty regularly is the payment of wrongful or inadequate dividends. These allegations are often the counterpoints to allegations of excessive payments by way of remuneration for services. It’s often alleged that as a result of an excessive payment of salary, for example, or bonus payments, there have been inadequate dividends or insufficient dividends paid to the other shareholders. Again, these sorts of cases can take a number of different forms. So, for example, they can take the simple form of a failure to pay a sufficient dividend. They can take the form of cases where there is a failure to give proper consideration to the payment of dividends. They can take the form of a failure to implement a prior agreement as to the dividend policy to be adopted and implemented by the company. And they can also take the form of a case whereby there is a failure to pay dividends proportionately between the holders of a particular category of shares in the company. I will just simply mention the fact that it is pretty clear from the authorities now that the directors, as part of their duties, do owe a duty to shareholders to give proper consideration to the payment of dividends so that, if they fail in that duty in some respect, that generally would involve unfairly prejudicial conduct of the company’s affairs.

Let me just mention in passing some other issues relating to shares that represent unfairly prejudicial conduct in practice.

Using new issues of shares, for example, for an ulterior purpose, rather than simply to raise required share capital for the benefits of the company, may involve unfairly prejudicial conduct. So, if a controller seeks to make an issue of shares in order to obtain greater control for himself that may involve unfairly prejudicial conduct.

Likewise, a failure to adhere to pre-emption rights in respect of new issues of shares. Where those pre-emption rights are provided in law or under the terms of the articles or any shareholders ‘agreement may well involve unfairly prejudicial conduct. Such denials of pre-emption rights often results in shifts of power or control within a company and that is something that the courts have frowned upon when a denial of those rights is attempted.

Likewise, a failure to adhere to restrictions on the transfer of shares imposed by the articles of association of a company or a shareholders’ agreement may well involve unfairly prejudicial conduct Similarly, the reclassification of shares; for example, varying entitlements to vote or entitlements to participate in dividends may involve unfairly prejudicial conduct of the affairs of a company.

The penultimate category that I want to consider is the cases that involve what I describe as “procedural irregularity”. Unfair prejudice may arise where those conducting the affairs of the company do so otherwise than in accordance with the procedures set by the company’s constitutional documents. So, for example, if a controlling participant fails to observe the procedural rules set out in the memorandum and articles of association or fails to comply with the requirements set out in a shareholders’ agreement then those failures in procedure, specified procedure, may well involve unfairly prejudicial conduct.

It’s worth emphasising, however, that whether a procedural irregularity will justify any particular type of relief depends, crucially, on the seriousness of the irregularity and that rather depends on the consequences of that irregularity. Sometimes the irregularity is of such serious nature that it will justify a purchase order being made. Other times, it may simply be corrected by the making of a mandatory or prohibitory form of injunctive relief.

These sorts of procedural irregularities include failures to call meetings of directors or shareholders, a failure to lay accounts or information before directors and shareholders, and a failure to give notice of meetings of directors or shareholders as required.

The final category I want to draw your attention to are those cases that involve a failure to conduct the business of the company in accordance with a pre-agreed policy or plan. These cases are common and somewhat complex in practice. I think it’s sufficient for the purposes of this introductory series of seminars to simply say that a failure by the participants to act in accordance with an agreed business plan, for example, or a failure to implement resolutions of the board of directors or indeed of shareholders, may well involve a breach of the agreement between the participants that founded the basis of their participation in the company and so may involve unfairly prejudicial conduct.

I think that is a convenient place to bring this lecture to an end. I thank you once again for all joining me. I hope that you found this lecture and the subject matter of this lecture interesting.

I think, perhaps, that the next lecture, which is next Monday; and it’s a lecture where I’m going to be concentrating on the remedies that the courts give for unfairly prejudicial conduct and the question of the ability to make application to strike out a petition on the basis that it represents an abuse of the process of the court in the face of a sufficiently fair offer to purchase the petitioners shares, is likely to be the last in this series of seminars.

I will then address the questions that have been sent to me by email. If you’ve got any further questions, then please let me have them.

In the meantime, until next week. I wish you all well and I look forward to speaking with you as I say, this same time next week. Many thanks, indeed. Bye bye.