Companies and their shareholders – unfair prejudice – a complex legal area – the need for a common sense approach

Friday 11th February 2011

Not only shareholders

There have been many articles written since the implementation of section 994 of the Companies Act 2006 offering guidance to shareholders (usually minority shareholders) whether or not to petition the court when they believe that they have been unfairly prejudiced by decisions of the majority or the directors of the company. It is important for directors and majority shareholders to have an understanding of unfair prejudice claims. In this article, “the petitioner” refers to the person making such a claim. Prevention is certainly better than cure and also is likely to be less costly in the long term for directors personally or the company.

A common sense approach

Unfair prejudice is a complex area that is rooted in both statute and case law and this outline can only act as a reminder about the common sense decisions that should be made to avoid a petition. If an unfair prejudice petition is brought against you or your company, it is essential to seek specialist legal advice as soon as possible.

One initial point to note is that companies are often joined in as a respondent to an unfair prejudice petition because the relief claim is directed against them, such as a request to the court for an order that the company must purchase the petitioner’s shares. Despite this, directors cannot use a company to fund their defence, and petitioners will be suspicious of directors being awarded bonuses or pay increases which could be seen to be funding a defence.

The statutory remedy

Under section 994 of the 2006 Act, a shareholder may bring a petition against a company if he or she considers that the company’s affairs have been conducted in a manner that is unfairly prejudicial to the petitioner’s interests. Section 996 of the 2006 Act allows a court to make such order as it thinks fit if it is satisfied that the shareholder’s petition is well founded. The fact that a court may make such order “as it thinks fit” should in itself be enough to encourage directors or majority shareholders to be aware of the principles underlying the test for unfair prejudice and the classic actions that can result in a successful petition.

The test

The petitioner must be a shareholder (or an individual to whom shares have been transferred where the registration of those shares is pending). Therefore, it is important to have regard for not only current shareholders of a company but also individuals who can prove they have taken a valid transfer or, for example, a trustee in bankruptcy or personal representative of a shareholder on whom the shares have devolved.

The company’s affairs

The alleged unfairly prejudicial conduct of a director must be regarded as conduct of the company’s affairs, and a petitioner must prove that it related to the exercise of the powers conferred on them by statute or the company’s constitution. This could be seen to give directors some respite as should a member of the board, for example, steal money from the company, this would be an obvious breach of the thief’s fiduciary duty to the company, but will not be grounds for an unfair prejudice petition because there is no act “done in the conduct of the company’s affairs”. However, should the other directors not take steps to recover the stolen money, that failure would constitute conduct of the company’s affairs.

It is also important to note that the affairs of a parent company can amount to the affairs of a subsidiary company and vice versa, especially where the directors are the same.

Unfairly prejudicial

The conduct complained of must be prejudicial and also unfair. It is not enough for a petitioner to prove only one element. A shareholder is likely to be able to establish unfair prejudice where he or she can show that the economic value of their shareholding has been seriously diminished or put in jeopardy by a director’s conduct.

The concept of fairness is based on an objective test of what the hypothetical reasonable bystander would deem to be contrary to good faith. A clear indicator of fairness may be found in the articles of association of a company or a shareholders’ agreement. It is therefore important that these documents are carefully drafted, but also understood and followed. Ordinarily, if the affairs of the company are being conducted in accordance with the company’s constitution, the conduct is unlikely to be deemed to be unfair.

Interests of shareholders

Unfairly prejudicial conduct must relate to the interests of shareholders. The interests of shareholders are not necessarily strictly confined to the constitution of the company or shareholder agreements, but a court can look beyond those contractual interests to legitimate expectations which arise from understandings between the parties. Such interests have in the past been held to include: employment; office as a director; participation in management (sometimes referred to as a ‘quasi partnership’); and a right to be consulted about policy decisions affecting the company. The allegation by the minority shareholder of his or her ‘right’ to receive dividends is, however, a less clear area.

Classic allegations

There are a number of classic allegations that directors and majority shareholders should be aware of. The list below sets out a number of scenarios that have resulted in successful petitions in the past, but should not be seen as definitive:

  • Excluding a shareholder from management (including the removal of directors and shareholders) where the shareholder has a legitimate expectation of participation;
  • Failure to consult a shareholder or to provide them with information;
  • Misappropriation of corporate business or assets, often to another company which the director or majority shareholder has an interest in;
  • Serious mismanagement of the company’s affairs;
  • Abuses of power and breaches of the constitution;
  • Payment of excessive directors’ remuneration or the award of excessive financial benefits to a majority shareholder;
  • Failure to pay reasonable dividends to shareholders where there is a reasonable expectation that dividends would be paid;
  • Allotments of shares and rights issues which are arranged so as to have the effect of diluting the petitioner’s shareholding;
  • Failure to comply with the 2006 Act;
  • Dismissal of auditors without proper grounds; or
  • Breach of a director’s fiduciary duty.

A timely reminder

The provisions in the 2006 Act relating to unfair prejudice largely restated the provisions of the Companies Act 1985, but this restatement should act as a reminder to directors that they must approach the management of a company with a degree of common sense. It is important for directors to ensure that there exist clear written statements of responsibility from the outset. This can be achieved with a carefully drafted constitution and the diligent recording of board decisions. It is important that directors hold formal, minuted, board meetings to discuss and agree matters of possible contention, even in smaller companies where formal board meetings are rare. Holding regular board meetings is considered good practice in any event.