There are often various circumstances under which a company (existing or future) requires its shareholders to sign a shareholders agreement.
The reason for the above can be varied: an agreement between the founders of a company, an agreement between old shareholders and new shareholders in a particular company, a voting agreement between some of the shareholders of a public company and other such circumstances that vary from one case to the other.
A clear outcome of this is that it is of significant importance to understand the reasons for the parties to sign such shareholders agreement so that the appropriate legal mechanisms can be applied in order to bridge any gaps there may be between the parties to the agreement and also to contain any future disputes between the parties. One must also consider the weight of the company’s article of association, which also regulates the relationship between the shareholders themselves and between them and the company, and the legal standing of the shareholders agreement and the article of association.
Background
During its life, a company will be affected by various factors, both internal and external, that place challenges before its decision makers (directors, CEO, etc.), often requiring them to take action in order to continue its effective management and maximize its profitability.
A company is a legal entity whose activities are determined and regulated in its documents of incorporation, with the main document being the article of association; which is in fact an agreement between the company and its shareholders, and between the shareholders and themselves. The company’s article of association also regulates the delegation of powers with respect of the rights and obligations of the various organs of the company, such as its board of directors and general assembly.
Deciding between conflicting documents
Shareholders are often faced with complex situations that require reaching to resolutions that will sometimes find their way also into the company’s article of association, but at other times will be left only as a discreet internal agreement between shareholders and will not find expression in the company’s article of association (“internal mechanisms”). It is important to understand that the legal status of internal mechanisms is lower and inferior to the provisions of the company’s article of association, and such internal provisions certainly cannot apply to future shareholders in the company. At the same time, in light of the public nature of the article of association, shareholders often prefer for business agreements between them to remain discreet and therefore are not keen to include them in a revised version of the company’s article of association.
Thus, in addition to the company’s article of association, additional agreements are often signed between the existing shareholders in the company and future shareholders (such as new investors), agreements that are external to the article of association, made at different times, which may contradict the contents of the article of association and thereby raise legal and commercial challenges.
For example, suppose that the company’s article of association stipulate that a new allotment of the company’s shares may not be made without the consent of a minority shareholder, and notwithstanding this provision, the company entered into a share allotment agreement without the consent of that minority shareholder. The allotment agreement is, on the face of it, contrary to the provisions of the article of association.
In such a state of affairs, which agreement will prevail, the article of association or the share allotment agreement?
In order to determine which of the conflicting agreements prevails, the legal system offers a number of legal principles, such as: a later agreement overrides an earlier agreement, and a specific arrangement prevails over a general arrangement.
But in addition to the legal rules, case law states that no company is entitled or authorised to place restrictive conditions on its ability to change its article of association. In addition, it was determined that in order to answer the question of which agreement prevails in the event of a conflict, it is also appropriate to examine the conflict between the various documents, in accordance with the guiding principles for deciding a conflict between the will of the majority shareholders and the will of the minority shareholders.
Usually, the central dilemma faced by shareholders is the fear of abuse of power by the majority shareholders on the one hand versus the fear of extortion by the minority on the other. While it is very important to allow the majority shareholders the flexibility needed to ensure effective management of the company and the promoting of the interests of a company as a whole, the majority shareholders should, nevertheless, not be allowed to use their power to advance their own interests and deprive the minority shareholders.
The guiding rule in solving this dilemma is the good of a company[1]. The good of the company, however, sometimes requires deviating from the original agreements established between the shareholders by amending the article of association, even if this results in certain harm to the minority shareholders. By the same token, a provision in one agreement that promotes the good of the company is to be preferred over a provision in another agreement that conflicts with the good of the company.
As stated, the above rationales which were determined by the courts in order to settle the conflict between the wishes of the majority shareholders and the wishes of the minority shareholders, i.e., the good of a company, recognising the importance in the majority shareholders controlling and managing the company efficiently while protecting the interests of the minority shareholders, should also guide us in resolving a conflict between contradictory documents and agreements.
Different types of shareholders agreements
It is important to note that there are various types of shareholders agreements, and these are distinguished from each other by the different circumstances that lead to the signing of the agreement.
The trivial agreements concern broad consent between all the shareholders of a company, before or after its incorporation, and for the most part the vast majority of their provisions are also reflected in the company’s article of association. A prominent example of this is a founders agreement entered into between the founders of the future venture to be incorporated as a company, and its main purpose is to regulate the relationship between the parties, among themselves as well as between them and the future company.
Another example is between existing shareholders in a particular company and new shareholders, whether they be investors or in any other case of future shareholders who are expected to join the company. These agreements mainly regulate the different status between the different groups of shareholders, with an emphasis on joint decisions in the company, as well as on the rights and obligations of the various shareholders in cases of a sale of shares in the company, or in future cases of raising capital for the company.
Yet another example relates to a voting agreement between the shareholders of the company, whether with regard to certain matters or together for the appointment of officers of the company (directors, etc.)[2]. These agreements are usually signed between some of the shareholders in the company, and include narrow mechanisms in relation to the specific issue that the shareholders have chosen to regulate.
Main mechanisms
As noted above, the mechanisms vary from one agreement to another, also due to differing circumstances that led to the making of the agreement. There are, however, a number of standard mechanisms that frequently recur:
Maturity provisions regarding the holding of shares (re-purchase mechanism) – a standard mechanism in founders agreements that regulates their holdings in the company as a function of their commitment to continue to contribute to the venture for a pre-determined period of time (the vesting period).
Composition of the company’s board of directors – the right of every founder to appoint members of the board of directors as a function of his proportional holdings in the company.
Voting rights on the board of directors (restrictive provisions) – the ability of the minority in the company to influence the decision-making process in the company (usually with respect to decisions of great significance for the company).
Right of first refusal – an obligation of shareholders seeking to sell their holdings in the company to offer them first to other shareholders in the company.
Obligation to join and right to join (bring along & tag along / co sale) – the ability of the majority on the one hand, and of the minority on the other, to compel the other party to join a transaction for the sale of shares in the company.
Dispute resolution – it is important to formulate an internal mechanism within the agreement addressing the resolution of disputes that will arise between the shareholders, and in extreme cases even to establish an internal bidding mechanism (BMBY) between the parties to an agreement under which one party will be able to purchase the shares of other, all with the aim of minimizing the harm to the company’s business activity.
Summary
A shareholders agreement is an agreement that must be drawn up in accordance with the relationship between the shareholders who are a party to the agreement, and in accordance with the desired situation. Thus, the nature of the agreement and the mechanisms included in it depend on the connection and even the need of each shareholder with respect of the management of the company. In addition, there are various considerations as to whether the provisions of the shareholders agreement should be imported into the company’s article of association or left as an external agreement, with all that this implies.
As for future changes in shareholders agreements, the legal system recognizes the need to balance the original agreements reached between the parties with the dynamic needs of the company, where the system of considerations in balancing is majority rule versus minority extortion. Thus, the legal system tends not to allow a situation in which the company binds itself against future changes in the company, taking into account, of course, the overall circumstances in each individual case in light of its circumstances.
[1] For more on this matter, see the judgment of Dr. Michal Agmon Gonen in O.M. (T.A.) 986/07 Adv. Elihod Yaari vs. the Maoz Hakrach Co.
[2] It is important to note that in public companies, such agreements can amount to a “joint holding” of the company’s shares, with all that this implies.
For further information please contact us:
Hanan Efraim, Adv. Tsippy Bengi, Adv.
Office: 03-691-6600 Office: 03-691-6600
Email: hanan@ekw.co.il Email: tsippy@ekw.co.il