The Why’s and What’s

by Shelley Bentley

Darrell Wickstrom and Frank Schober, both partners at Russell and DuMoulin, spoke to Business Law Section members on why a shareholders’ agreement should be required for private, closely held corporations and on the key provisions found in it.

Why a Shareholders’ Agreement?
Marketability
A shareholders’ agreement is the basis of the marketability of the shareholders’ investment in a private, closely-held corporation. A minority interest in such a corporation will, without a properly drafted shareholders’ agreement, only be marketable at a great discount.

Fair and predictable treatment
A shareholders’ agreement provides an assurance of fair, or at least predictable, treatment by the corporation and by the other shareholders.

Clear objectives and planning
Shareholders’ agreements force the parties to clarify the objectives of the business venture and try to ensure that those objectives are shared by all shareholders. They also force the shareholders to contemplate the future and to anticipate problems. This allows issues and misunderstandings to be dealt with at the outset.

Estate planning
A shareholders’ agreement also provides some certainty for the individual shareholders to deal with their investment in the company as an asset for estate planning purposes.

Minority interests
Such agreements also have the capacity to protect minority interests without unduly restricting the management of the company.

What Should be in a Shareholders’ Agreement?
Drafting Considerations
In drafting a shareholder’s agreement the drafter is attempting to create an agreement which will govern the behaviour of parties in the future and which attempts to anticipate future statutory economic and business situations.

Every business situation is different. The agreement must be tailored to the client’s individual business circumstances. The statutory background must be kept in mind to ensure the rights and obligations in the agreement do not conflict with Company Act provisions in effect at the time the agreement is entered into. Solicitors must clarify who they are preparing a shareholders’ agreement on behalf of so that conflicts of interest do not arise. It should be confirmed that all parties understand this and have the opportunity to obtain independent legal advice.

Content
The basic issues dealt with in a shareholders’ agreement include:

• the conduct of the affairs of the company;
• financing, including shareholder contributions;
• restrictions on transfers of shares, including rights of first refusal;
• compulsory buyouts and their triggers;
• death, incapacity or departure of a shareholder; and
• default of a shareholder pursuant to the agreement.

Special majority requirements can be imposed for major decisions. Major decisions often involve such matters as a change in the nature of the business, employment contracts, remuneration of key employees, approval of budgets, designation of signing officers and the sale of the undertaking of the company.

Minority shareholder rights can be protected without unduly restricting management of the company by including provisions regarding the appointment of directors, quorum requirements and provisions to deal with deadlocks in votes of the directors or the shareholders.

Default by a shareholder of obligations under the shareholders’ agreement will often trigger buyouts, a suspension of voting rights or a dilution of shares. Many agreements provide for different remedies for non-defaulting shareholders, depending on the default that has taken place.

Restrictions on Transfers
The balance to be considered in these provisions is between the shareholders as business partners, wanting to have a say in the identity of future partners, versus ensuring the marketability of each shareholder’s interest in the company. According to Mr. Schober an absolute prohibition on the transfer of shares is probably unenforceable. Courts will normally narrowly construe any restriction on the alienability of shares.

Another method of dealing with this tradeoff is to provide for hard or soft rights of first refusal or preemptive rights for the other shareholders. A “hard” right of first refusal operates as follows; the shareholder desiring to sell must obtain a firm offer from a third party and then allow the remaining shareholders an opportunity to match that offer. This allows the other shareholders to know the identity of the third party who is offering to purchase the selling shareholder’s shares before deciding whether to buy. With a “soft” right of first refusal no outside offer is required. If the right of first refusal is not exercised by the remaining shareholders, then the selling shareholder can simply go into the marketplace and sell his or her shares on the same terms and conditions.

Other common provisions often include “draw-along” provisions whereby a majority shareholder wishing to sell to a third party can compel minority shareholders to sell as well on the same terms and conditions. Similarly, with “piggyback” provisions minority shareholders can demand that their shares be purchased on the same terms and conditions if a majority shareholder decides to accept an offer from a third party to sell its shares.

According to Mr. Schober, compulsory buyout provisions, such a “shotgun” clauses ensure liquidity and may be necessary in certain breakup situations. The tradeoff is that these provisions may force parties to do something they would rather avoid: for example, where one shareholder presents an offer to sell and the other must buy or sell to the offeror.

The valuation and appraisal mechanism is often a critical part of a compulsory buyout clause in order to ensure fairness. Common mechanisms are: a third party appraisal or auditor, a formula intended to calculate the value of shares, or having the shareholders agree each year on the value of their shares.

Tax Consequences
Selling shares
If a shareholder sells his or her shares to another shareholder, a taxable capital gain may be triggered. If the shares qualify as “qualified small business corporation shares” and certain other tests are met, the shareholder may be entitled to a $500,000 lifetime capital gains exemption. If , on the other hand, the company buys the shares, there is no exemption available and the tax consequences to the shareholder, in general, will be a deemed dividend rather than a capital gain. The deemed dividend rates are slightly lower that the capital gains rate at the moment, but the advice of a tax practitioner is recommended in each case.

Death of a shareholder
On the death of a shareholder, the remaining shareholders may not want to be in business with the heirs and each shareholder has an incentive to ensure the liquidity of their estate. Accordingly buyouts triggered on death are often funded by life insurance, and for tax reasons, the company takes out the insurance on each of its shareholders. Life insurance proceeds received by the company go into its capital dividend account, which can be paid out tax free to the other shareholders as a dividend to fund the buyout of the shares from the deceased’s estate, or to the estate on the repurchase of the shares by the company. The deceased has a capital gain because of the deemed disposition on the death of all of his or her assets, and the tax on this capital gain is paid by the estate. The estate then has a high tax cost for those shares, which reduces possible future taxable capital gains on a subsequent disposition of those shares by the beneficiaries of the estate. Often the best that can be done with respect to dealing with buyouts on death is to ensure flexibility, allowing the estate to choose whether it will sell its shares to the company or to the other shareholders.

Conclusion
There is no standard form which will adequately address a client’s needs. In light of this Mr. Wickstrom cautioned that it is important that shareholders’ agreements be reviewed in detail with a client to ensure that he or she is aware of all details, terms and conditions and that the shareholders’ agreement will suit that client’s business circumstances.

Shelley Bentley is in-house counsel at CIBC Trust Corporation in Vancouver.

This article was published in the October 1998 issue of BarTalk. © 1998 The Canadian Bar Association. All rights reserved.