Avoiding 50/50 Shareholder Paralysis – Why Shareholder Disputes In Ontario Are Best Dealt With Before They Happen
Starting a business with a business partner is a lot like starting a new romantic relationship. Everything seems perfect at the outset. The partners are in lockstep with major decisions as well as the general direction of where this relationship is going. Perhaps there have been some early disagreements, but those are relatively minor in nature and are resolved quickly and civilly. In essence, you have found your person. How could anything go wrong?
Unfortunately, rose coloured glasses fade. As time goes on, those minor disagreements may not be so minor anymore; nor are they resolved nearly as quickly or civilly. Maybe someone starts harbouring some resentment towards the other about not pulling their weight, or not properly involving them in the management of the business. Maybe things have gotten stale over the years and suddenly one of the partners has eyes towards a more attractive (business) partner/opportunity.
Frankly, the possible reasons for a relationship breakdown are endless. No one enters into a business relationship anticipating that the relationship will fail and for that reason – along with the general adverseness people have to incurring costs they deem unnecessary at the time – many businesses pay little to no attention to properly documenting what will happen in the event of a relationship breakdown. This ill-fated decision is to their detriment as the Business Corporations Act (Ontario) (“OBCA”) and the Canada Business Corporations Act (“CBCA”) are not well suited to resolve shareholder disputes. As will be discussed, the best way to resolve a shareholder dispute is a by dealing with it before it even happens through a properly drafted shareholders agreement. Without one, parties in a shareholders’ dispute may be in for a long drawn out process because, just like the end of any romantic relationship, the end of a business relationship can get very ugly.
The Inadequacy of the Business Corporations Acts for Private Corporation Disputes
Legislative Policy Reasoning
As a precursor, its important to recognize that the OBCA and CBCA are broad overarching legislative schemes that attempt to juggle the rights, needs, and obligations for relevant stakeholders in both offering corporations and closely held ones alike. This is a difficult needle to thread. For example, the needs and policy concerns created by a TSX listed company are vastly different than those of a small private corporation.
The OBCA and CBCA have each sought to balance the needs of both types of corporations by creating a formulaic system that is primarily attuned to the needs of corporations with a larger number of shareholders (either public or private) while sprinkling in the odd provision that allows for greater flexibility to the management of small private corporations.[1] Unfortunately, the legislative provisions fall well short of providing private corporations with the type of decision making flexibility and efficiency that’s best suited to their particular needs. In response, the OBCA and CBCA created a fail safe mechanism for such situations – shareholder agreements
Among its many uses, shareholder agreements are an effective tool for private corporations to fill in the gaps on important subject matters that are not properly addressed by the corporation’s governing legislation and corporate by-laws. The problem lies when shareholders to small private corporations neglect to enter into a shareholder agreement. As will be further discussed in the section to follow, not entering into a shareholder agreement subjects the quarrelling shareholders to the provisions of their governing legislation, which are so ill-suited to their needs that whatever dispute the shareholders had at the time is more likely than not to be further exacerbated.
Shareholder Disputes in Practice – Avoiding the 50/50 Shareholder Paralysis
The OBCA and CBCA decision making provisions generally default to requiring majority votes to govern. This naturally benefits larger corporations based on the simple fact that by having more individuals as directors and shareholders its more difficult for individuals, or voting blocks, to hold veto powers over corporate decisions as compared to smaller corporations. Furthermore, larger corporations are more likely to have a separation between the individuals who are directors and shareholders of the corporation. For these reasons, larger corporations are able operate fairly seamlessly within the constructs of the OBCA and CBCA. Is an officer of the corporation not doing his job to their board’s satisfaction? The board can remove them. Are board members in a disagreement about an important business decision? A majority vote of the board of directors can resolve that issue. Are the shareholders not satisfied with the direction of the corporation during the past fiscal year? They can vote out any and all directors they may so desire at a shareholders meeting.
To be clear, decision making in smaller corporations is very easy when the shareholders have a good relationship with each other. There is less oversight, and decisions may be made through written resolutions by all the shareholders in lieu of calling a meeting. In the case of the OBCA, the ease in which decisions can be made will soon be increased by new amendments allowing written majority resolutions. However, for as easy as it is to make decisions when the business relationship is going well, the opposite is the case when the relationship has broken down.
As an illustrative example, picture in your mind a small corporation where all the shareholders are also directors and officers of the corporation.[2] Now assume further that this small corporation has had a relationship breakdown with one of the current shareholders to the extent that having them remain as a presence within the corporation is completely untenable (the “Exiting Shareholder”). How do the other shareholder(s) (the “Remaining Shareholder(s)”) proceed?
In the case of a corporation that has three or more shareholders, the first thing to be done would be to call a special meeting of the shareholders where at least a 2/3rds voting block of the shareholders would vote to remove the Exiting Shareholder as a director of the corporation (in the case of the OBCA, a written majority resolution removing the director will soon be acceptable). Meanwhile, at the same time and acting in their capacity as directors, the Remaining Shareholders will sign a unanimous resolution to remove the Exiting Shareholder in his or her capacity as an officer of the Corporation.[3] After the meeting has concluded, the Exiting Shareholder would have been effectively removed from all management roles in the corporation and all it took was the slight inconvenience of calling a shareholders meeting to do so. Problem solved, right? Well, not exactly, because the Exiting Shareholder is still a shareholder of the corporation and there is no mechanism that exists in the OBCA or CBCA that would force them to sell away their shares if they don’t want to. Moreover, by removing the Exiting Shareholder from his or her management positions, you are creating a liability risk for a potential oppression remedy suit being commenced.
This is not to mention the financial and emotional costs involved in dealing with the Exiting Shareholder after they have been removed. Make no mistake, the Exiting Shareholder will be angry. Lawyers will need to get involved. Ideally a negotiated buyout can be agreed upon, but nothing is guaranteed when emotions are running high. However, regardless of the eventual outcome from the inevitable buyout negotiations, at least there’s a silver lining in that the Exiting Shareholder has been effectively removed from the management roles of the corporation. The same cannot be said for the other possible scenario – a corporation with only two shareholders.
In keeping with our hypothetical scenario involving an Exiting Shareholder, if the corporation only has two shareholders, then there isn’t much the Remaining Shareholder can do to get rid of the Exiting Shareholder. Neither shareholder has a voting majority to remove the other as an officer or director. Neither shareholder has a legal mechanism to remove the other, nor force the other to buy or sell. In a legal sense, both shareholders are on a completely equal footing. Such a scenario creates a dilemma that can be deemed as the 50/50 shareholder paralysis. In this scenario, no shareholder resolutions can be passed and no board decisions can be made without the consent of both shareholders. The corporation is literally locked in a standstill until the shareholders can resolve their dispute. Either that or each shareholder, via their ostensible authority as an officer of the corporation, goes rogue and continues to enter into legally binding agreements on behalf of the corporation, which brings in a whole new set of concerns. The bottom line is that the shareholders will need to enter into negotiations for a buyout. With no shareholder holding a legal edge over the other, these negotiations can drag on for a long time before they get resolved. That is, if they are resolved at all. Litigation is an ever present threat within 50/50 shareholder disputes.
How a Shareholder Agreement Can Help
Many private corporations do not enter into a shareholder agreement because of the presumed unnecessary costs associated with them. As the above scenarios were meant to demonstrate, not entering into a shareholder agreement can very often be the much more costly decision. The legal time incurred in negotiating buyouts between disputing shareholders can be extensive. Moreover, the negotiations may not even lead to a resolution. At any time, an aggrieved shareholder may decide to go the litigation route, which could easily bring the total cost of the dispute into the hundreds of thousands and taking several years to resolve. Shareholder agreements cost less than that and take less time.
A well-drafted shareholder agreement should deal with many of the following subject matters:
- Dispute Resolution. Deals with how disagreements between the shareholders are to be resolved. Often mandatory arbitration or mediation clauses are included in order to avoid the costs associated with litigation. May also include provisions regarding the sale of shares in the event disputes cannot be resolved.
- Share Transfers. Deals with the rules surrounding the transfer and issuance of shares of the corporation. Can include mandatory buy-sell (aka “shotgun”) provisions as well as exiting shareholder provisions which can help resolve issues regarding shareholders who want to be bought out. Often includes standard right of first refusal (ROFR), tag-along and drag-along provisions.
- Share Valuation. Deals with how shares are to be valued during any transfer of shares to a third party or in a buyout by another shareholder.
- Approval Thresholds for Directors and Shareholders. Specifies which topics are governed by the directors and shareholders of the corporation and further states the required voting thresholds (e.g. unanimous, 2/3rds, majority). Higher voting thresholds are often used as a way to protect the interests of minority shareholders.
- Divorce, Death & Disability. Provisions that deal with what happens to the shares of a shareholder upon that shareholder’s divorce, disability, or death. A common provision is to force the sale of the shareholder’s shares if any of these events occur, although a wide variety of options are ultimately available.
- Non-Participation. Non-participation (as may be defined in the shareholder agreement) can be a common and contentious issue in a corporation if one shareholder is not putting in their fair share of the work or has stopped working entirely. These situations are often due to a shareholder entering into a depression or spending too much time on other business ventures. Provisions forcing the sale of a non-participating shareholder’s shares can be included in a shareholder agreement to address this potential concern.
- Funding Considerations. Deals with how the corporation is to be funded and specifies which institutions the corporation is allowed to borrow from and whether shareholders will be required to provide loans or act as guarantors. Should also deal with what will happen in the event one or more shareholders fall short of their required funding obligations.
- Non-Competition and Non-Solicitation. May be included to deal with the potential threat of a departing shareholder starting a competing business and/or stealing key contacts (e.g. clients, suppliers, manufacturers, distributors, employees, etc.) from the corporation.
If you want a shareholder’s agreement, or are considering the merits of a shareholder’s agreement for you company, speak to a business lawyer at Kalfa Law Firm. You work hard for your money; we work hard for you to keep it.
[1] This is a reasonable policy decision given that larger corporations have a greater financial presence and, as a result, a greater potential risk factor in the Canadian market. Meanwhile, small private corporations are generally assumed to be able to deal with their own issues internally. However, given the sheer number of shareholders disputes our firm deals with on a continual basis, this assumption may be far too idyllic to pass for reality.
[2] This is an extremely common set up for corporations with only a small handful of shareholders.
[3] Technically, the timing mechanism for this resolution would happen immediately after the Remaining Shareholders vote out the Exiting Shareholder as a director, thus allowing the resolution to be unanimous.
-Christopher Manderville, Associate Lawyer
Christopher’s practice is primarily focused on corporate-commercial law, including business formations, corporate reorganizations, shareholder agreements, commercial contracts, the purchase and sale of businesses, as well as secured lending transactions. Christopher graduated from Queen’s Law School in 2019. Christopher also completed his undergraduate degree at Queen’s University where he majored in Political Science and graduated as a member of the Dean’s Honour List. Christopher is a lawyer licensed to practice law by the Law Society of Ontario and is a member of the Canadian Bar Association.
© Kalfa Law 2021
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.
