Shareholder Protection: Ensuring Business Continuity
Shareholder protection is a crucial aspect of business continuity planning. It safeguards the interests of shareholders and minimizes disruptions caused by the sudden loss of a key shareholder. In this article, we will explore the importance of shareholder protection and discuss three main methods to implement it.
The Need for Shareholder Protection
Shareholders play a vital role in any company’s success. However, the unexpected departure or demise of a shareholder can have significant implications for the business. To ensure business continuity, it is helpful to review the company’s articles of association and identify the need for shareholder protection.
Every company has a memorandum and articles of association. The memorandum outlines basic details such as the company name and registered office, the articles of association govern internal affairs, including share transfers and sales. It is necessary to understand the provisions outlined in these documents to determine the level of protection required.
Irvine & Ors v Irvine & Anor: In this case, a minority shareholder director brought an action against the majority shareholder director for the acquisition of the minority’s shareholding. The minority shareholder claimed he was excluded from managing the company’s affairs and was not given financial information nor included in business decisions. The minority shareholder’s claim was based on the right in the Companies Act to claim unfair prejudicial treatment of a minority shareholder. The court agreed with the minority shareholder and ordered the majority shareholder to buy out the minority shareholder.
The court instructed an expert to value the minority’s shares, which included a 30% discount on the price per share to reflect the minority shareholding.
Methods of Shareholder Protection
There are three main methods to implement shareholder protection:
- Pre-emption Clause: Many companies incorporate a pre-emption clause in their articles of association. This clause provides existing shareholders the first opportunity to purchase shares from a critically ill or deceased shareholder. While this approach aims to maintain control within the existing shareholder group, challenges may arise when determining a fair value for the shares and raising funds for the purchase.
- Cross-Option Agreement: A cross-option agreement allows shareholders to enter into an agreement that grants each other an option to buy or sell their shares in certain circumstances. This method provides flexibility and ensures that shareholders have a choice in deciding whether to buy or sell shares.
- Company Purchase: In some cases, companies opt to purchase shares directly from critically ill or deceased shareholders. This approach provides immediate liquidity to the affected shareholder’s estate while allowing the company to maintain control over its ownership structure.
Re Sevenoaks: In this case, the court ordered a director’s dismissal and disqualification after minority shareholders claimed that he had not prepared proper accounting records, used company funds for his own personal benefit, failed to send the required returns and accounts to Companies House, and failed to submit the company’s corporation tax return.
Benefits of Shareholder Protection
Implementing shareholder protection offers several benefits:
- Business Continuity: Shareholder protection ensures that businesses can continue operating smoothly, even in challenging circumstances.
- Controlled Ownership Transition: By providing mechanisms for share transfers, shareholder protection facilitates controlled ownership transitions.
- Fair Value Determination: Shareholder protection methods aim to establish fair values for shares, minimising disputes among shareholders.
- Liquidity Provision: Certain methods, such as company purchases, offer immediate liquidity to affected shareholders’ estates.
All of the above will normally require the availability of written agreements and cash.
It is not possible to predict when the benefits of shareholder protection will be called upon, and it is not possible to know for sure if cash will be available at that time.
The best means of providing this form of protection is to arrange for shareholder protection insurance. What is shareholder protection insurance? It is a means of offsetting the financial risk to a third party, normally an insurance company, paying affordable premiums that will convert to hard cash in the event of a claim for death or disability.
Arranging shareholder protection insurance can provide additional flexibility when drafting different agreements on how to manage the shares; for example, owners could buy shares back from a shareholder who’s diagnosed with a critical or terminal illness. This avoids costly buy-out capital without resorting to dipping into your own savings.
Shareholder protection is essential for maintaining business continuity and safeguarding shareholder interests. By implementing appropriate measures such as pre-emption clauses, cross-option agreements, or company purchases, companies can navigate unexpected events more effectively.
Remember, every company’s circumstances are unique, and it is crucial to seek professional advice when implementing shareholder protection strategies.
Bilta (UK) Ltd (in liquidation) v Nazir: In this case, a liquidator brought an action against two former directors of Bilta (UK) Ltd for breach of their duties under section 172 of the Companies Act 2006. The directors were alleged to have participated in fraudulent VAT transactions that caused Bilta to suffer losses and become insolvent. The court held that the directors had breached their duties under section 172 and were liable to compensate Bilta for its losses.
Shareholder protection can have several tax implications depending on the specific circumstances. Here are some key points to consider:
A business trust used for shareholder protection is typically subject to the ‘relevant property’ regime that applies to discretionary trusts.
This means that lifetime transfers into the trust may be subject to immediate inheritance tax (IHT), and periodic charges at every 10th anniversary.
When you pay premiums as part of a proper commercial arrangement, it means you are not generally giving gifts or making lifetime transfers.
Note that the 10th-anniversary charges are unlikely to be applicable to life cover, as the funds are usually paid out immediately following a death claim.
Proceeds from shareholder protection insurance policies generally do not attract income tax liabilities.
If you personally pay the premiums (rather than having the business pay them), you won’t personally receive any tax relief benefits.
If the company pays for shareholder protection plans on behalf of individual shareholders, the cost of premiums is usually tax-deductible as a business expense.
However, individual shareholders may be liable for relevant tax payments due to the P11D benefit status.
A shareholders’ agreement is a legally binding contract among the company’s shareholders. It typically outlines the shareholders’ relationships, their control over the company’s management, their rights and responsibilities, as well as exit provisions. To ensure the resilience of your shareholder agreement, you should consider implementing shareholder protection to provide financial support in case a shareholder is unable to meet their financial obligations due to sickness or death. This can be achieved by offering life insurance to strengthen any such agreements.
The above is essential for companies with a number of directors, all with competing interests.
For family-owned businesses with a focus on succession planning, it is advisable to give greater importance to establishing a business trust. This approach ensures that taxation does not disrupt your succession plans.
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