KerrLaw Logo JAMES D. L. KERR
CLIENT MEMO
TO:           Business Clients FROM:   James D.L. Kerr Lawyer
            17 – 151 Merton St.
            Toronto
, Ont., M4S 1A7
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E-mail: jkerr@kerrlaw.ca
            www.kerrlaw.ca

            Certified Specialist Civil Litigation
DATE:      May 6, 2002
RE:          Shareholder Agreements (Ontario Corporations)


GENERAL:

Being in business with another person is like being married to that person; the relationship will experience both accord and discord and sometimes that discord will lead to divorce.  During times of prosperity, the parties to the relationship will be encouraged by the success of the venture to find mutually acceptable accommodations.  At other times, the parties will seek to enforce their strict rights and, in that regard, will look to legal principles of general application to resolve their differences.  Unfortunately, those principles are only of limited assistance; the governing law does not deal with matters as diverse as limits on the issue and/or transfer of ownership interests in the business, "buy-outs" between owners, enforced or otherwise, and the right of a minority owner to participate in the business both as to management and distribution of profit.

 
Owners, who in the corporate context means the "shareholders", will normally address contingencies not dealt with in the general law by writing their own private law in the form of a contract which, in the case of corporate ownership, is called a  "Shareholder Agreement" (Americans refer to such a contract as a  "Stockholder Agreement").

 
A particular type of shareholder agreement which includes all of the shareholders of the corporation and which strips the directors of their powers and transfers those powers to the shareholders is called a "Unanimous Shareholder Agreement"; such an agreement, however, also imposes directors' liabilities on the shareholders and would, accordingly, not be desirable in the case of shareholders who are not participating in the management of the business (so-called "silent partners").

 
One purpose is a Shareholder Agreement is to restrict or eliminate a shareholder's right to seek redress in the courts from conduct by the other owners which the shareholder considers to be unfair or oppressive.  Needless to say, litigation is time consuming and very expensive; it is not uncommon for a shareholder to commence an "oppression" action against the other owners as a means of forcing an issue not by virtue of the righteousness of the shareholder’s position but by virtue of expense which will be incurred to defend the litigation.  It is our opinion that the shareholder’s only remedy in the event of a disagreement ought to be the buy-sell mechanism discussed below.  Accordingly, we include, in Shareholder Agreements prepared by this firm (and subject to our client's instructions otherwise), a waiver of the so-called "oppression remedy".

 
CHECKLIST:

Directors:

Voting Trust: Shareholder Agreements were, historically, first used to impose a "voting trust" on shareholders; that is to say, an obligation that each shareholder would vote to elect each of the other shareholders as a director of the company.  Directors are charged by statute with the management of the company and only directors have an absolute right to view all of the company’s records including, and in particular, the books of account.  It is fundamental, therefore, that a Shareholder Agreement include a voting trust so that each shareholder will be entitled to attend meetings at which management decisions are to be made and will have full access to the company's books of account.

Quorum:  Typically the Shareholder Agreement will specify the quorum for directors meetings.  By statute, the quorum may not be less than 2/5's or the minimum number of directors permitted by the Articles of Incorporation.

Officers:

Historically, corporations were required to have at least a President and a Secretary.  This is no longer the case; in fact, corporations are no longer required to have any officers at all.   It is, however, the usual practice to designate officers, mainly to facilitate the execution of documents and in particular the signing of cheques.  In fact, it is the practice of most banks to require that signing authorities be designated by reference to offices rather than by designating individuals by name.

Registered Office:

The corporation's registered office may be changed by the directors within the municipality specified in its Articles and may be changed to any place in Ontario by 2/3's of the shareholders.  Accordingly, if it is important that the corporation’s office not be moved except by unanimous agreement, then this must be specified in the Shareholder Agreement.

Financial Year End:

The selection of and adherence to a fiscal period can have taxation implications for both the corporation and its shareholders.  Accordingly, if it is important that the corporation’s year-end not be changed except by unanimous agreement, this must be specified in the Shareholder Agreement.

Accountants/Auditors:

All corporations are required, by law, to audit their accounts for the benefit and protection of their shareholders.  Audited financial statements are considerably more expensive than the  "Notice to Reader" statements common for small businesses.  The legislators also recognized that in small corporations the shareholders and the managers were, generally, one-in-the-same and that, accordingly, such protection is redundant.  The law therefore permits the shareholders, by unanimous agreement, to exempt the corporation (up to certain limits) from audits.  The law contemplates, however, that the exemption will be addressed yearly.  A disgruntled minority shareholder wishing to exert financial pressure on the majority can decide, in any given year, to withhold the necessary consent.  If the shareholders are in agreement, at the outset, that the corporation's accounts will not be audited, then the Shareholder Agreement should contain a provision to preclude one or more of the shareholders from resiling from that agreement.

 In addition, if it is important that a particular accountant, or firm of accountants, be appointed accountant/auditor, and that such appointment not be rescinded except by unanimous agreement, then such should be stated in the Shareholder Agreement.

Transfer or Disposition of Shares:

It is generally considered important by business owners that some  control be exercised over who may become a participant in the  business.  Depending on how stringent these controls are intended  to be, the issue may be address in one of several ways including  the following:

(a)       A provision that there be no issue of new shares and no  transfer of existing shares without the prior consent of  all shareholders;

 (b)       A provision providing for a "pre-emptive right"; that is  to say, that the directors are free to offer shares in  the corporation for sale as the directors see fit  subject only to the requirement that such shares must  first by offered to the existing shareholders;

 (c)        A provision that no shareholder may transfer shares  without first offering those shares to the existing  shareholders ( a "right of first refusal").

Buy-Sell:

 It is generally accepted that there is no secondary market for the sale of shares in a private corporation (except with respect to a sale of 100%).  It is, therefore, virtually impossible for a shareholder to extract his/her investment from the business except where the remaining shareholders are willing, or can be compelled, to buy-out that shareholder's interest.  A "buy-sell" situation can arise either through the desire of a shareholder to leave the business or as a result of irreconcilable differences between the owners.  Various devices have been developed to permit a forced purchase or a forced sale of shares.  It is not uncommon for owners to seek a mechanism based on a valuation to be done by some third party.  Such mechanisms, however, beg the question of who is entitled to buy and, conversely, who is obligated to sell.  The result is inevitably a "first-past-the-post" method of establishing entitlement; in other words, whoever gets to the other shareholder with the requisite "paper" first, wins.  This can easily result in an injustice particularly in a falling market.  Accordingly, we do not favour these forms of buy-sell.

 Instead, we favour a form of buy-sell generally referred to as a  "shot-gun" clause.  A shot-gun clause permits any shareholder(s) to make an offer at any time to any other shareholder(s) to purchase, at an arbitrary price, the target shareholder's entire interest in the corporation (which should include shareholder loans, since this is the more common way for small business owners to finance their undertakings).  The receiving shareholder has a set period of time to either sell in accordance with the offer or to purchase the offeror's interest at a price calculated on the same basis.  In the event that the receiving shareholder does not respond to the offer, then that shareholder is deemed to have accepted the offer to sell and is contractually bound to do so.   The advantage of this method is that the onus is on the shareholder triggering the mechanism to state a price which will effect the desired result; if the recipient considers the price to be high, then the recipient will likely sell; if, on the other hand, the recipient considers the price to be low, then the recipient will likely purchase the offeror's interest.  The method works best where the shareholders' respective interests in the business are relatively equal.  To the extent that a shareholder or a group of shareholders hold a disproportionately large interest in the business the smaller shareholders may be exposed to economic oppression.

 Sometimes, a right of first refusal, mentioned above, is considered to be an adequate alternative to a buy-sell provision.

Disposition on Death:

For the same reasons, a need exists to provide for the purchase and sale of a deceased shareholder's interest.  The deceased’s estate wishes to extract the deceased's interest in the business so that it may be distributed to those beneficially entitled and the surviving shareholder(s) presumably does not wish to be in business with the deceased's executor.  Buy-sells during the lifetimes of the shareholders usually arise in an adversarial context, which is not usually the case where a shareholder has passed away and, accordingly, the moral gloss is dissimilar.

 In the "best of all possible worlds", the contract will provide for a mandatory purchase of the deceased shareholder's interest at market value.  This raises two issues: firstly, valuation; secondly, funding.  With respect to valuation, the shotgun approach would be clearly inappropriate.  Accordingly, some other method of fixing the price is called for.  One common method which was historically favoured, was to have the shareholders specify a value annually.  Our experience with this method is that shareholders inevitably neglect to do so and the system fails.   Another method is to base the valuation on a formula to be calculated with reference to the corporation's financial statements (for example, book value of hard assets plus some multiple of earnings as an allowance for goodwill).   Unfortunately, book values do not usually reflect true market values and multiples of earnings suffer from the same inefficiency; accordingly, injustice can result.  Still another method is to combine the annual stipulated value method with the formula method by providing that the second shall apply by default if the first has not been adhered to.

 A more desirable method would be one which does not require the owners to turn their minds to valuation after the agreement is signed but which will produce a market valuation in its application.  We prefer a mechanism which calls for a third party valuation with a further provision to resolve any disagreement with respect to such valuation.

With respect to funding, the preference is to fund the buy-sell by life insurance on the lives of the shareholders.  Of course, this will impose a cost and that cost is not tax-deductible.  Where the buy-sell is funded by insurance, the Shareholder Agreement should specify who is to pay the premiums (i.e., the company or the individual shareholders) and who is to retain the excess proceeds of the insurance in the event that those proceeds exceed the purchase price of the deceased's interest.

 Where the owners are not prepared to bear the cost of insurance, a mandatory cash purchase could impose an unfair burden on the surviving shareholders.  It is fair, in such circumstances, to provide for payment of the purchase price over time on a basis which will not impair the viability of the enterprise.  Similarly, where the shareholders have funded the buy-out through insurance, the Shareholder Agreement should still provide for a payment over time with respect to any deficiency.

 Another option, where funding is not provided through insurance, is to provide for a purchase at the option of the surviving shareholders.  Of course, by doing so one is favouring the interests of the surviving shareholders over the interests of deceased shareholder's beneficiaries.  Where, the buy-sell is made optional, then it is important to specify whether or not the option is limited to a purchase of the deceased's entire interest  (whether pro rata or otherwise).

Arbitration:

Shareholder Agreements typically have provisions which state that disputes will be settled by arbitration without resort to the courts.  The advantage of arbitration is that the parties can pick their own "judge"; that is to say, someone with expertise in the area of dispute.  Furthermore, arbitration generally resolves a  dispute much faster than the court process.  The disadvantage is  that arbitration is considerably more expensive in the short term.

Expropriation:

It is not unusual to find that an offer has been made to the  majority shareholders to sell the business but that the minority  shareholders are refusing to sell (possibly, to extract a premium  for their interests).  This contingency can be treated by  including a provision that permits shareholders controlling a  specified level of votes to compel a sale of all of the shares of  the corporation.

Financing:

One of the more sensitive and complex areas for consideration is  whether a majority of the shareholders can compel further  contributions of capital by the other shareholders and, if so,  what are the consequences of default.  Normally, provisions  calling for mandatory contributions of capital provide,  ultimately, for the erosion or complete forfeiture of a defaulting  shareholder's interest.

Full-time Involvement:

If it is intended that the owners should devote their full  attention to the business of the corporation, then such should be  stated in the Shareholder Agreement.

Non-Competition:

It is typical to provide that the shareholders shall not compete  with the corporation while they are shareholders of the  corporation.  More complex is the question of competition by a  former shareholder.  Shareholder Agreements often contain  agreements not to compete once a shareholder has ceased to be a  shareholder.  Such agreements are in restraint of trade and not  enforceable unless reasonably limited in scope.  The usual  limitations involve time and geography.  The greater the  limitation, the more likely that a court will enforce the  non-competition agreement.  The real issues are, firstly, the  amount of time which will be reasonably necessary for the  remaining shareholders to secure the goodwill which they have  purchased and, secondly, the true market area of the corporation's  activities.

In addition, it is common to include restrictions on the  solicitation of the corporation's employees by former  shareholders.

Other Provisions:

Shareholders sometimes wish to include other provisions,  particularly provisions relating to the actual management of the  corporation's undertaking (for example, mandatory distribution of  profit).  Virtually anything can be written into a Shareholder  Agreement.  It is important to remember, however, that the future  is often not predictable and that to bind the hands of the  directors at the outset may create more problems than it solves.

Independent Legal Advice:

 It is only rarely that a lawyer can adequately represent the  interests of more than one party to a transaction.  The  negotiation of a Shareholder Agreement is complex and we recommend  that each party to the negotiation obtain independent  representation.  If such representation is declined then I recommend that each party obtain independent legal advice before  signing the Agreement.  In any event, I include a statement in  all Shareholder Agreements prepared by me that each party  has been advised to obtain independent legal advice and has either  done so or has declined to do so but at the declining party's own  risk.

 In any event, I will not act for more than one party in the  preparation and execution of a shareholder agreement and that  Party will be the party who retained me in the first instance.

Tax Advice:

I am not a tax advisor and do not render, nor will I render in the context of any retainer, advice with respect to taxation matters.   I recommend that the parties obtain competent tax advice from their chartered accountants or other tax advisors.  My reporting letter to be delivered on the completion of my work will confirm that the parties have either done so or have declined to do so at their own risk.


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DISCLAIMER: The foregoing is not intended to be a comprehensive guide to the applicable law. General Client Memoranda and mailings from James D.L. Kerr ● Lawyer are intended to inform clients and acquaintances with respect to current issues that may be of interest to them. Memos are current to the date shown on the Memo. The law is constantly changing, however, and for that reason a Memo may not be completely accurate after it's stated date. Where circumstances warrant, the advice of a lawyer or other qualified professional should be obtained.

2005 James D.L. Kerr