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Role of a Company's Constitution and a Shareholders Agreement
Lawyers are often asked to draft shareholders agreements, most commonly for small and family businesses.[1] These agreements work in conjunction with the traditional company constitution to govern the relationship between key stakeholders with more specific rules, rights and obligations. When incorporating a new company, stakeholders should carefully consider whether a shareholders agreement would help to better define their rights and obligations.
Elizabeth Murphy, Maddocks LawyersOverview
Whilst company constitutions and shareholders agreements both govern shareholders' rights and obligations, they generally traverse different topics depending on the company's circumstances. The two documents should work in conjunction with each other and need to be carefully drafted to ensure they do not conflict or add uncertainty in circumstances where certainty is the objective.
When should you supplement a constitution with a shareholders agreement?
Generally the answer is when the stakeholders want to put in place some specific rules about why the company exists, how it will be managed, who can be involved and how it will be owned in the future. We've grouped some of the common reasons under the following headings.
Agreeing rules for management
Corporations Law generally has the effect of providing a framework for pooling capital (through shareholdings) and managing that capital efficiently (by conferring appropriate powers on management to manage that capital). The Corporations Act 2001 (Cth) (Act) provides a framework for decision making, however a shareholders agreement can set down specific rules governing how the directors must act.
A shareholders agreement can:
- confer a specific power to appoint a director or directors, and remove those directors, on a particular shareholder or shareholders holding more than a specified percentage of shares;
- alter the usual voting power of directors, for example by adopting voting entitlements which reflect the proportional shareholding of the shareholder who appointed them;
- prescribe arrangements for meetings, including who must be present for a quorum and how often they must be held;
- include a list of decisions which the directors must take to shareholders, such as decisions to sell key assets or businesses, acquire businesses, acquire assets of a specific type (e.g. land), borrow money or make certain personnel decisions (e.g. appointing or removing a CEO): this is in addition to those decisions which the Act says directors must take to the shareholders (changing the company name, constitution, certain share buy-backs etc.),
A shareholders agreement can therefore give shareholders more certainty regarding when, and the nature of, decisions which directors must refer to them.
Agreeing rules for shareholders
A normal constitution will have provisions regarding the issue and transfer of shares, and the process by which these transactions can take place. A starting point is that the power to issue shares or approve transfers rests with the directors, but they may also be required to offer shares to existing shareholders in proportions (known as 'pre-emptive rights').
Again, a shareholders agreement can more specifically regulate these transactions, including by:
- valuation — agreeing the method of valuing shares;
- succession plans — providing for the transfer of shares at particular times, for example in order to give effect to succession plans;
- call options — agreeing which events (or 'default events') may give rise to other shareholders having a right to purchase the defaulting party's shares;
- put options — agreeing which events may give rise to shareholders having an obligation to buy other shareholders' shares;
- drag along — prescribing when majority shareholders can require minority shareholders to join in a share sale to a third party; and
- tag along — prescribing when minority shareholders can require majority shareholders to involve them in a share sale to a third party.
Protection of minority
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SIGN UP FOR FREEShareholders who hold less than 50% of shares in a company may find themselves in the minority in a range of circumstances. For example:
- having less than 50% of voting rights means shareholders must rely on the voting intentions of others to appoint directors;
- having less than 25% of voting rights means decisions such as changing the constitution, approving certain share buy-backs and capital reductions, and approving 'financial assistance' transactions,[2] can be made without the consent of the minority.
A shareholders agreement therefore provides an opportunity to set out which decisions cannot be made without:
- the approval of all shareholders; or
- the approval of shareholders with more than a specific percentage of voting rights; or
- the approval of a particular shareholder.
Shareholders agreements can also provide agreed dispute resolution procedures, which may have a focus on alternative dispute resolution. This can be useful given that, although the Act enables minority shareholders to bring oppression proceedings against a company, this process can be costly and time consuming with uncertain outcomes.
Dealing with unexpected events such as death and disability
Shareholders agreements are also useful when contemplating unexpected events. If a shareholder dies or is no longer able to partake in the running of the business, a shareholders agreement can set out what rights and obligations the respective parties have.
The clearest example of these provisions is where key people have entered into an undertaking together on the basis that they will each be involved in the day to day management. If one of those people loses capacity or dies, then the remaining person(s) may wish to take control of the undertaking so that they are not required to operate it with the other key person's guardian or estate. Shareholders agreements can also describe how shares are valued and when they must be transferred and paid for.
So, back to basics, what is a company constitution?
A company constitution usually forms part of the documents produced when creating a new company, but can also be adopted at a later date. Company constitutions are, in part, governed by the Act. There are a number of provisions in the Act known as 'replaceable rules'. Company constitutions can incorporate these rules into their own constitutions or put in place provisions different from those set out in the Act. Company constitutions generally deal with matters including:
- General powers of directors;
- Appointment of directors or company secretaries;
- Directors' meetings;
- Meetings of members;
- Transfer of shares;
- Shares in the company generally (issuing shares, pre-emptive rights, variation of class rights); and
- Appointment and removal of directors.
It is important to note that the company constitution binds all the shareholders, whether or not they were involved with how the document was prepared.
What is a shareholders agreement?
A shareholders agreement is a contract, which takes into account the specific purpose of a company, and the terms of which have been negotiated and agreed upon by all the company's shareholders. As discussed above, shareholders agreements are tailored documents which deal withspecific management situations or unexpected scenarios. As this document is a commercial agreement between the parties, the parties involved are able to contract whatever matters they wish to include, provided those matters do not conflict with requirements of corporations law.
What are the key differences between a shareholders agreement and a constitution?
Despite the fact that these documents cover similar territory, commonly there are a number of key differences between a company constitution and a shareholders agreement.
One important distinction is the way in which the documents are varied:
- Constitutions may only be varied by special resolution, that is, by at least 75% of the shareholders agreeing to and passing the resolution (the constitution can also prescribe additional requirements);
- Shareholders agreements generally, however, require unanimous consent to vary in that — as with most contracts, all the parties to the document need to agree to an amendment.
Another key difference between the two documents are the matters that are covered in the documents. A constitution is generally a broad overview of the relationships between the company and its board or the directors, the company and its shareholders and between the shareholders themselves. However, as discussed above, a shareholders agreement is a more tailored document which includes greater detail, especially with respect to corporate governance and share ownership.
Conflict between provisions of the constitution and shareholders agreement
If a shareholders agreement is in place, it generally contains a clause to the effect that, in the event of conflict with a constitution, the shareholders agreement prevails to the extent of the inconsistency.
However such clauses are not always sufficient to provide the parties with clarity, as the discussion in this ClearLaw article highlights.
The Cleardocs Shareholders Agreement contains a general clause dealing with inconsistencies, and then further pinpoints specific clauses which take precedence over those specific topics in the constitution. It is important to be clear when drafting the constitution or shareholders agreement that there are provisions dealing with any potential inconsistencies between the documents.
More information from Maddocks
For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.
More Cleardocs information on related topics
You can read earlier ClearLaw articles on a range of company-related topics.
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andrew.wright@maddocks.com.au
Qualifications: LLB (Hons), BCom, University of Melbourne
Andrew is a Partner in Maddocks Tax and Structuring team. He has significant experience in advising Australian and multinational companies, high net worth individuals, accountants and financial advisers on all areas of taxation law.
Andrew regularly provides advice on:
- structuring of businesses and transactions,
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