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A recent Court of Appeal case has demonstrated the importance of documenting shareholder rights and restrictions in a formal shareholders’ agreement, according to a leading corporate lawyer.
“Shareholders in a private company almost always wish to control the admission of new shareholders to the company, as their original decision to invest in the joint venture is usually based on a relationship of mutual trust between the parties,” says Philip Round, a corporate partner of George Green LLP. “A shareholder will rarely allow a co-owner to sell their stake to an unknown third party, without first being given an opportunity to purchase those shares. Such pre-emption rights are not automatically granted by law, and must therefore be incorporated expressly into a shareholders’ agreement or the company’s articles of association (being the company’s main constitutional document).”
Mr Round continues, “Shareholders in start-up companies are often reluctant to incur the cost of drawing up legal documents, and sometimes choose to record the terms of their relationship in a less formal manner. The case of Dixon and another v Blindley Heath Investments Ltd has demonstrated this to be a false economy.”
The case concerned shareholders in a private company, EFI (Loughton) Ltd. Philip explains, “The shareholders originally agreed that if any of them wished to sell his shares, the others would have a pre-emptive right to purchase them. Unfortunately, this was documented through an informal exchange of letters. The company’s articles merely conferred on the directors a discretion to refuse to register a transfer.”
“On the subsequent death of a shareholder, the deceased’s shares were transferred to his brother, a Mr Dixon. The shareholders had apparently forgotten about the letters, as the board approved the transfer without seeking to give effect to the pre-emption rights. A few years later, another shareholder proposed to transfer his shares to a third party. At that point, Mr Dixon recalled the initial correspondence, and sought to prevent the transfer by enforcing the pre-emption”.
The Court held that Mr Dixon was “estopped” from enforcing the rights, a decision upheld on appeal. “Estoppel by convention is a legal principle invoked when parties have conducted themselves based on a mistaken assumption of law or fact,” says Mr Round. “Once the common assumption is discovered to be false, a party can nevertheless be prevented from arguing the true position where it would be unconscionable to do so.”
“In this case, Mr Dixon had, in acquiring his brother’s shares, benefited from the mistaken assumption that no pre-emption existed, and it would therefore be unjust if he then sought to rely on the pre-emption to prevent a transfer by someone else.”
Mr Round concludes, “parties often believe that it is sufficient to record their understanding in an informal side letter. As this case demonstrates, it is easy for such a brief memorandum to be overlooked or mislaid, with potentially serious consequences. ”