The most common disputes that have the most damaging effects on an SME are not the external litigation, but internal boardroom disputes. When directors and shareholders or partners don’t see eye to eye, and are unable to manage those disagreements effectively, there is the perfect recipe for a dispute. This situation can often end with the company being closed, stagnating or losing significant sums of money.
Conflict in context
Having said that, it is important to note that disagreement between directors and shareholders (who are typically also shareholders in small businesses) or partners is sometimes a good thing. There should be vigorous discussion and debate about the direction of the company; no one director , shareholder or partner should expect to rule the roost and have their way all time. But the line between healthy discussion and a full blown dispute leading to deadlock is a very fine one.
As with most boardroom disputes, prevention is the best medicine. Having solid structures in place at the outset will usually avoid the worst disputes wreaking havoc on businesses and relationships.
Preparation: How to set things up so disputes the possibility of conflict is minimised
At the outset, a shareholders agreement or partnership agreement should be put in place. The agreement should cover everything from decision making authority and processes, succession planning [in event of death or incapacitation of a director], pre-emption rights, responsibilities for different areas of the business, how many hours each director is expected to work, levels of remuneration and dividends, employment contracts, restrictive covenants, how investors will realise their investment, what to do if further funding is required, deemed transfers [events which automatically trigger a requirement for a shareholder to offer to sell his shares to the other shareholders], share valuation and sale in event of a shareholder exiting the company, and perhaps most important, dispute resolution processes.
- an agreement on the business/venture to be operated together with arrangements concerning the company’s business plan and annual budget;
- setting specified levels of director/shareholder/partner consent for certain reserved issues;
- granting certain rights (for example, to dividends and voting) to different classes of shares;
- pre-emption rights and procedures in relation to the issue and transfer of shares (including circumstances in which shareholders must offer shares to other shareholders based on an agreed valuation mechanism – often a distinction is made when valuing shares depending on whether a shareholder is a good or a bad leaver);
- arrangements for the giving of guarantees;
- provisions dealing with general shareholder exits including tag-along and drag-along rights (these allow a majority to force an exit and a minority to participate in an exit by a majority).
The process of drawing up this agreement forces the shareholders / directors / partners to work through some key issues which could give rise to problems later, and encourages them to seek solutions at the outset whilst the relationship is still good.
Agreements usually state that in the event of a dispute mediation should be used first. Early mediation can help avoid a dispute escalating and positions becoming entrenched to the point that the company is jeopardised.
What are the most common disputes among shareholders / directors?
Lack of adequate agreement
A number of small businesses are founded by friends and family, or colleagues from another business setting. In scenarios such as these, where people already know each other well, it is tempting to not bother with the ‘nitty gritty’ of shareholder, director or partnership agreements.
But regardless of the nature of your business, failure to set these things out clearly at the start can cause lots of heartache later. You must make crystal clear who controls what, and everyone’s responsibilities, rewards and exit rights.
In a limited company the articles are rarely a substitute for a shareholders’ agreement they simply establish the firm as an entity and enable it to transact business with third parties. Unless a bespoke set of articles have been drafted with the explicit aim of managing shareholder relationships in detail, you must never rely on them to manage disagreements.
If there is no agreement in place, it is most likely that a dispute will end up in a deadlock. Some sets of company articles will state that the chairperson of a meeting of shareholders has a casting vote, which although it may create a clear decision it will not in reality resolve an underlying dispute.
The personal relationships are likely to suffer because of this, with neither side able to communicate with the other. The next step in such a situation is normally to engage lawyers in costly legal struggles, and the end result is usually a failure of the business.
Here are some of the most common causes of dispute:
- the level of dividends
- salaries paid to shareholders who also work for the business
- disproportionate contributions of money and/or time from each shareholder
- the price to be paid when a shareholder or partner is bought out
- disagreements over strategy
- power struggles and poor personal relationships
- conflicts of interest, and dealings between the company and a private business owned by one of the directors
- concern over financial issues and potential insolvency
- service contracts and remuneration
- a change in personal circumstances of one of the key parties
- employment of family members
- transactions with businesses owned by family members
- differing needs for drawings between partners
What are the legal possibilities to resolve disputes?
Resorting to the courts to resolve a dispute between directors / shareholder should always be a very last resort.
The Law Commission records a case which, when it reached the courts, took 43 days of court time and cost £320,000 even though it concerned shares valued at only £24,000. Although this is an extreme case, it does serve to highlight the cost and inconvenience of going down the litigation route. On the other hand, a mediated settlement might be reached in a day at a cost closer to £1,500. It is invariably better to try to reach a mediated settlement.
Bear in mind also that decisions made by a court are often unsatisfactory to all parties concerned, particularly in the context of an SME, not to mention the financial implications and aggravation, as well as lost business due to directors being engaged in a legal struggle.
What to do once a dispute has come about?
If a dispute has come about, here are some helpful tips to avoid escalation:
- Try and understand what is important to the other party and why the dispute has arisen.Put yourself in their shoes and try to understand what they want to achieve rather than looking just at the legal rights and wrongs. There may be a moral argument that supports the other side, even if the law supports your position.
- In the first instance, aim to negotiate, rather than rely on your perceived legal rights.It is almost always quicker and cheaper to negotiate a solution (if necessary using your strict legal rights as bargaining counters) rather than end up in court. Ideally, reach a solution that implements practical changes which enable the aggrieved shareholder to stay in the company.
- Make a reasonable offer to the aggrieved shareholder.The courts are keen to encourage settlement in shareholder disputes, and will view your efforts to achieve a settlement positively.
- You may offer the aggrieved party to attend a mediation in an attempt to resolve your differences. If you submit to mediation or alternative dispute resolution, you are also unlikely to have acted ‘unfairly’.
How to choose a Mediator?
You may know of a Mediator in your professional or social circle. If you do not know a mediator personally, your next step would be to ask friends or colleagues for a recommendation.
There are also several mediation service providers who transact directly with aggrieved parties, and there are panels of mediators often drawn up on a geographical basis, where each mediator has an area of expertise. You will initially contact the panel and tell them about your dispute, and they will recommend a shortlist of mediators with experience in the field of you dispute.
In summary, a little foresight and planning is well worth the investment both in time and in money. Disputes are crippling for business and not good for one’s health, often festering for years with nobody gaining anything and in many cases trickling down to the next generation.
In the event of a dispute that threatens to get out of hand swift intervention by means of mediation is almost always preferable to lengthy, costly and emotionally draining litigation.
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