Conflicts in Closely-held Companies

While landlords and tenants continue their public skirmish over rent, it is worth considering a more latent but critical point: Covid-19 will be the litmus test for trust and cooperation between those involved in a company going forward. For a closely held company, even more so.

Closely held companies make up a significant proportion of companies in New Zealand. In our experience, many of these are also family owned.

Familial relationships are not a panacea. As a response to pressures caused by Covid-19, acts or conduct relating to the company’s affairs may occur which cause a family member to believe it has been unfairly discriminated against or unfairly prejudiced. Being a closely held company, there is often no ready market for the shares, so simply cutting ties and selling up is not a feasible option. Moreover, there may be constitutional restrictions upon the transfer of shares in that company. Enter section 174 of the Companies Act 1993.

Borrowing from the parable of Cain and Abel, the below describes how s 174 applies across various circumstances where Abel is seeking relief, and how it may resolve them.

Is Abel Entitled to Seek Relief?

Generally, Abel can invoke s 174 by being a shareholder of the company at the time of the relevant conduct. He does not need to be one however, at the time he actually applies for relief. Alternatively, where Abel is not a formal shareholder, he may nevertheless be entitled to seek relief if the company’s constitution (provided it has one) effectively treats him as one. Such is the case where, perhaps by some family arrangement, he is afforded a right to an equal share in any dividends declared.

While s 174 is typically invoked to protect minority interests, its scope is not so limited. To illustrate: Cain holds 30% of the shares in a company and Abel holds 70%. Cain effectively has a veto on major decisions, and Abel does not have effective control at general meetings (the typical threshold being 75%). As I will discuss, Abel may nevertheless succeed in obtaining relief against an obstinate Cain, despite having a majority interest.

Where Cain and Abel hold 50% each and are deadlocked, the position is more difficult. Courts have eventually preferred one party’s interest over the other, despite the brothers likely forming such a shareholding specifically on the basis that neither party’s interest should supersede the other. As will become clear however, something more than basic disagreements over company decisions was required.

Acts and Conduct of the Company Relating to its Affairs

Abel needs to show his lawyer a nexus between his complaint and the affairs of the company. Being acts of the company, decisions made by the board clearly relate to its affairs. Given the wide ambit however, so too can past activities, threatened or continuing conduct, omissions - even passivity.

Prejudice in What Capacity?

Abel must then establish he has suffered prejudice to his interest as a member in the company. He does not need to identify some quantifiable loss in monetary terms. Many cases we see involve Abel wanting to protect his position as a director of the business from which he has been excluded, by Cain or otherwise. Perhaps Abel has lent money to the family business, and is wanting to protect his position as a creditor of the company. Discussions with a lawyer can assist Abel in clarifying the actual capacity in which he suffers prejudice.

“Oppressive, Unfairly Discriminatory, or Unfairly Prejudicial”

The test is a composite one, focused on the objective impact of the relevant conduct on Abel. It is not three separate hurdles to jump. Essentially, Abel needs to demonstrate a visible departure from the standards of fair dealing, taking into account the particular company’s history, structure and the reasonable expectations of its members.

Common complaints surround dividends and issuing shares to the exclusion of the minority, thereby diluting their influence within the company. Regarding dividends, relief has been granted:

  • Where Cain as a majority shareholder operates a no-dividend policy for his own tax benefit, disregarding Abel’s interest and reasonable expectation to a dividend return; and
  • Where dividends are not paid to Abel despite receiving a stable dividend over a number of years, and he has no influence on the dividend policy, and the shareholders never reached an agreement on the company’s dividend policy.

Courts are slow to provide relief for risks inherent in business however. Poor management or errors in Cain’s judgement and business strategy, without bad faith or self interest, do not generally entitle Abel to relief. The acts or conduct need to be objectively unfair; a breach of Cain’s directors’ duties or the constitution perhaps, or Cain opportunistically using such rules in a way which is considered contrary to good faith or fair dealing. Consulting a lawyer can, therefore, assist Abel in accurately identifying valid complaints.

In the case of a deadlock, there needs to be such a breakdown in trust and confidence between Cain and Abel so as to be unfair in forcing either of them to continue working together. Section 174 is not designed to facilitate an exit from the company over simple disagreements concerning company strategy. The company’s constitution or shareholders’ agreement has mechanisms for this, and should be used instead. If Cain simply refused to continue working for the business and froze the company's bank account however, a court would likely grant relief.

As discussed, even majority interests can seek relief under s 174. For instance, where Abel has in fact followed the correct statutory procedures for major transactions, it could be oppressive for Cain to obstinately refuse to sign the special resolution required to complete the transaction.

Were Any Reasonable Expectations Breached?

Conduct perfectly consistent with the company’s constitution and directors' duties may nevertheless be oppressive or unfair if it breaches some mutual understanding between shareholders or does not meet some expectation that certain powers would not be exercised in a particular way. Whether such equitable principles; (a) exist and (b) are engaged, is a tricky concept and requires exploration with a lawyer.

Besides the conduct itself, a significant factor influencing whether reasonable expectations exist is the nature of the company in question. Quasi or incorporated partnerships crop up most often, which involve a mutual understanding that a shareholder will participate in management in exchange for restrictions placed upon the transfer of its shares in the company. Accordingly, Abel may seek relief if Cain began excluding him from significant management decisions after coming onboard with a reasonable expectation that they would run the company together.

Just and Equitable Relief

As the court has broad discretion under s 174, relief can take many forms and a lawyer should set out for Abel the various outcomes a court may decide. Even if unfairly prejudicial conduct is established, the court has a discretion not to make an order. It is a balancing exercise, weighing up the circumstances, interests, and attributable fault of each party.

Buy-out orders, by far the most common given the relatively straight forward nature of the resolution, are ordered where there is likely to be ongoing disputes between the shareholders. This option is not always appropriate however. Suppose Cain has diverted assets from the company which has lead to Abel's shares reducing in value. Given this reduction, the sale of Abel’s shares becomes an unattractive option.

If necessary, the court can even order the company to be wound up. Although rare, the order is typically granted where, in a deadlock, there is a complete breakdown between the parties though neither is at fault, and each wants the other’s shares. As there is no fault by either party, there is often no tenable basis to prefer one party’s pre-emptive rights to buy the other’s share.

It’s important to note, relief can be largely neutralised if Abel received a reasonable offer by Cain to purchase his shares at fair market value, before he brought the application. Whether the offer was reasonable depends on various factors however, so it is important Abel discusses the terms and nature of any such offer with his lawyer. 

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