A Comprehensive Guide to Articles of Association and Shareholders’ Agreements

Posted by on May 31st, 2022

Introduction

If you are thinking of starting a company (or are a shareholder), it is important that you know the difference between a company’s Articles of Association (“Articles”) and a Shareholders’ Agreement. Every company registered in England and Wales must have Articles; a company simply cannot be formed without them. The Articles set out the company’s governance structure and basically operate as a rule book. If you are a shareholder, it is within your interests to ensure that the Articles are appropriate to the company and how it operates.

The company’s Articles are a public document and must be lodged at Companies House, visible for public viewing. A shareholders’ agreement, on the other hand, is a private document. It sets out the rights and responsibilities of the company’s shareholders, and operates as a private contract between them. As such, it is not a public document and nor is it compulsory to have one. Unlike the Articles, no provisions are prescribed; it can reasonably contain anything the shareholders wish it to contain. The main purpose of a shareholders’ agreement is to prevent future conflicts, outlining shareholders’ rights and responsibilities at the outset and detail what happens in certain situations (particularly where a source of disagreement would otherwise be likely).

This article details the importance of having well-written Articles, and explains the advantages and disadvantages of having a shareholders’ agreement in place.

Articles of Association

The Articles essentially are a contract between the shareholders and the company itself, and govern how the company is going to be run. Notably, the directors do not sign the Articles, but they are bound by them during the company’s operation as a result of their directors’ duties under the Companies Act 2006. These Articles and the Memorandum of Association are submitted to Companies House and form the basis of the company’s ‘constitution’. It is highly likely that a company’s incorporation will take place using ‘model’ Articles, which are standard Articles developed for this purpose and are available online. Naturally, depending on the type of company being set up, the model Articles will differ. If a company has been formed before 1 October 2009, it most likely has used the former model Articles, known as ‘Table A’ Articles.

It is not necessary to use the ‘model’ Articles, and it may be preferable to create bespoke Articles at incorporation. Many people who set up their own company for the first time use model Articles, or choose to buy an ‘off-the-shelf’ package (a company set up beforehand using a set template and with generic subscribers) where it is possible to adapt these packages to suit your own business needs and shareholdings. Usually, the Articles cover aspects in relation to the day-to-day management of the company as well as rights attaching to share classes including:

  • The number of directors the company will have, their respective powers and duties, and their decision-making capacities and capabilities;
  • The rights attaching to particular shares, how shares are issued / transferred / disposed of, and how dividends are paid;
  • How shareholders can be involved in decision-making, including how many shareholders are needed for a meeting to be considered ‘valid’ (the quorum), how votes take place, and various other matters related to decision-making; and
  • The determination of how notices should be given to shareholders and other administrative arrangements.

In terms of joint ventures (a contract, partnership or company that is set up by two individual businesses to run a common project or venture), the partners in the joint venture will usually choose to set up a company. This ensures, inter alia, that there is a separate legal personality, it can exist in its own right, appoint staff and own assets. The joint venture company’s Articles, therefore, are extremely important. They set out the ‘rulebook’ explaining the governance of the relationship between the shareholding business and the company, and between the shareholders themselves. A shareholder’s agreement can also supplement the Articles, and is particularly useful in joint venture companies due to the various complexities entailed in such businesses. Furthermore, it is unlikely that the ‘model’ Articles would be useful in such a situation as creating bespoke Articles would be most appropriate and may deal with a range of matters arising in joint venture companies, including deadlock, disputes, different share class arrangements and transfers of shares.

Articles are amendable, and may need to reflect changes you have made as a business or updates in the law. Ultimately, you must have a genuine reason to change the Articles and the shareholders must pass a ‘special resolution’ (which must be agreed by at least 75% of the shareholders). This can be done either at a shareholders’ meeting or by a written resolution:

  • Shareholders’ meeting– the directors must call a general meeting of the shareholders, circulate the proposed special resolution and hold the general meeting, where at least 75% of the shareholders must agree to the proposals. The new Articles and a copy of the special resolution are then sent to Companies House.
  • Written resolution – the written resolution proposing to amend the Articles must be sent to all eligible members of the company entitled to receive the resolution (along with a copy of the new Articles) and, once the threshold to pass the written resolution has been met, a copy of the written resolution and a copy of the new Articles must be sent to Companies House.

A copy of the special resolution or written resolution must be sent to Companies House within 15 days of being passed.

For model Articles and general guidance, see: Model Articles Guidance – HM Government.

Shareholders’ Agreements

Although it is not mandatory by law to have a shareholders’ agreement, it is useful in many situations to have such an agreement and they are entered into for the benefit of the shareholders, supplementing the Articles.

Advantages

Key advantages of having a shareholders’ agreement in place includes:

  • It provides certainty as to the rights and responsibilities of the shareholders, avoiding disputes in the future. The Articles usually do not deal with the aftermath of shareholders falling out, and a shareholders’ agreement can prevent these disputes which are costly and damaging to a business;
  • Unlike the Articles, outsiders will not be able to see the shareholders’ agreement because it is not a public document. Therefore, it ensures privacy;
  • The responsibility for the day-to-day running of the company is borne by the directors, not the shareholders. However, a shareholders’ agreement can include certain provisions that shareholders want to oversee or even veto, this is particularly the case if there are directors who are not shareholders or where investors have invested their capital into the company in return for shares;
  • Additional protections are usually afforded to minority shareholders through the implementation of a shareholders’ agreement. Otherwise, the minority shareholders are under the heel of the majority when it comes to decision-making;
  • A shareholder’s agreement is not regulated by the Companies Act 2006 (like the Articles are) and the procedure to amend the document can be governed by whatever is agreed between the shareholders;
  • Shareholders’ agreements can be used in conjunction with employment or service contracts to link shares to employment, or restrict shareholders from setting up competing businesses; and
  • Potential investors and others attracted to your business will take comfort by the fact that a shareholders’ agreement is in place, usually showing stability.

Shareholders’ agreements regulate the shareholders’ relationships and the company’s management. Ultimately, shareholders’ agreements are normally used as a safeguard and can cover what happens if things go wrong. The necessity of shareholders’ agreements is increased in family businesses, and the Articles may be unclear or silent as to shareholder interests and therefore due protection required may not be procured by merely relying on the Articles. Shareholders’ agreements can also be drafted in such a way to effectively protect the rights of minority and majority shareholders.

Disadvantages

Although there are numerous advantages to having a shareholders’ agreement in place, there are some disadvantages:

  • Difficult to amend – for a shareholders’ agreement to be changed, it usually requires all of them to agree (unless agreed otherwise), whereas amending the Articles only requires 75% to agree;
  • Not very flexible – it may be seen that the company cannot operate in a flexible way if a contract governs how shareholder relationships and the company itself is governed;
  • Increased minority shareholder protection – This is often disadvantageous to the majority shareholders who own the highest proportion of the company, as generally speaking shareholder agreements gives minority shareholders further protection than the Articles.

Having a shareholders’ agreement in place that supports the Articles is a wise idea in most situations. Furthermore, although there are a few downsides to having a shareholders’ agreement (difficult to change, less flexible and provides increased protection to minority shareholders which may not be desirable), it ensures that potential future disagreements are mitigated by providing a framework for dealing with them at the outset.

What is included in the Articles of Association and Shareholders’ Agreements?

Articles of Association – Contents

Usually, the Articles will be tailored (as closely as possible) in line with the shareholders’ agreement and will often address the following issues:

  • Share Rights – the rights attaching to the shares, e.g., voting, income and capital rights. Such rights will also detail any different share classes as applicable;
  • Shareholder and Director Meetings – details as to how meetings of directors and shareholders are convened, held and managed. The Articles will also refer to how many directors / shareholders must attend to make the meeting quorate (valid);
  • Appointment and Removal of Directors – management of directorships and processes to appoint / remove directors if necessary. Such clauses will include provisions as to the requirement for them to retire by rotation, along with the maximum and minimum number of directors required;
  • Income and capital rights – how dividends will be declared and distributed. Such clauses will further determine how capital will be distributed if the company needs to be wound up in the future, or how share proceeds will be dealt with if the company is subsequently sold;
  • Drag-along and Tag-along Rights – usually provisions will be drafted to force minority shareholders to sell their shares to a third party if a majority has agreed to sell the company (drag-along rights), and in addition it is often the case that provisions will be drafted to ensure that minority shareholders can insist on participating in the sale (tag-along rights).
  • Anti-dilution Provisions – It is common to have provisions drafted that place restrictions on the issuance of new shares, which could negatively affect the current shareholders’ interests (through dilution) and therefore pre-emption rights are advisable in this regard, but also to prevent strangers from entering into the business.

Shareholders’ Agreements – Contents

It is important to remember that, unlike the Articles, it is not compulsory to have a shareholders’ agreement in place. However, such an agreement will most likely include the following provisions:

  • Rights of Appointment – the CA 2006 provides mechanisms to permit majority shareholders to remove board members. Furthermore, provisions can be included to give a shareholder an appointment as a director, or the right to appoint a director if they do not want the directorship themselves.
  • Company decision-making – provisions will be drafted confirming how company decisions will be made. For example, how will disputes be resolved, or what rights will the shareholders have to information?
  • Restrictions on Transfer – these can range from absolute restrictions to tie-in provisions for a certain period before which a shareholder can sell. Such transfer restrictions can be supported by pre-emption rights, which aim to give the other shareholders the option of acquiring the departing shareholder’s shares before they can sell them to a third party.
  • Restrictive Covenants – provisions may intend to restrict shareholders from competing against the company or poaching its staff (whilst they remain a shareholder and for an agreed period of time after they cease to be a shareholder).
  • Dividend Policy – provisions can be included to determine what the dividend policy will be, notably covering when dividends can reasonably be paid from the company’s distributable reserves (often expressed by way of a percentage) each financial year; such clauses will further include the priority for repayment of shareholder loans before dividends are paid;
  • Buy-back clause – this ensures that the company has the right to purchase shares held by the shareholders where those shareholders wish to transfer their shares;
  • Right of First Offer – this ensures that a shareholder who wishes to sell their shares must first offer those shares to existing shareholders at a specified price. The shareholder is only free to sell their shares to anyone if no other existing shareholders decide to purchase the shares; the price of the shares must be equal to or higher than the original offer;
  • Right of First Refusal – operating slightly differently to the right of first offer, this provision ensures that if one shareholder has received an offer to sell their shares, other existing shareholders must have the first opportunity to match that offer to purchase the shares;
  • Shotgun Clause – such a provision enables one shareholder to sell their shares and leave the company, or require the sale of their shares to the remaining shareholders. One shareholder can set a price for the company’s shares and the other shareholder(s) must then either sell their shares at that price, or purchase the shares belonging to the shareholder who set the price;
  • Deadlock Provisions – these provisions deal with what happens if shareholders cannot agree on the issues affecting them. Deadlock issues include when the shareholders are blocking a reserved matter that is desired by the directors, creating a clear conflict between the shareholders and directors, or when an equal number of shareholders disagree on a course of action; and
  • Reserved Matters – directors make day-to-day decisions regarding the business, and are duty-bound to do so. However, in some respects, shareholders also have very limited rights to control the operation of the business. In many instances, ‘reserved matters’ (also called veto rights) means that the shareholders and the company can agree that certain actions will not be taken without the consent of the shareholders (or an agreed proportion of their number). Reserved matters may include:
    • Significant capital expenditure;
    • Employing staff with salaries in excess of an agreed amount;
    • Amending the Articles; and
    • Payment of dividends.

Enforcement

Articles

Shareholders (or members if the Company is not limited by shares) have certain rights with respect to the enforcement of the Articles. The CA 2006 confirms the applicability of the Company’s constitution, binds the Company and its members and permits for the enforcement of the covenants on the Company.

No fiduciary relationship exists between the Company’s members. For example, any action or vote taken by members can be solely for their own benefit with no regard whatsoever to any other members. However, they must refrain from breaking any rules contained within the Articles and must not contravene any duties or provisions of the CA 2006 under which the Company was formed. Members have the authority to enforce the provisions contained within the Articles.

A fiduciary duty exists to the extent that the directors owe the Company and its members, and must make decisions in such a way that will be of benefit to the Company itself. This duty is explicitly expressed in the CA 2006. Principally, the general duties form a code of conduct to control behaviour as opposed to controlling decision-making. Such duties exist to prevent the directors from placing their interests before the Company and to also prevent negligence, and have been derived from equitable and common law rules.

Duties owed by the directors to the Company have been enforced by courts, whether such duties have arisen by common law, equity, the Companies Act 2006 and the implementation of general duties of directors which is basically existing common law judgments that have been codified into statute. Importantly, the directors owe statutory duties to the Company only, although in some cases the directors also owe common law duties to members, when dealing with their proprietary rights.

If any obligations provided for within the Articles are breached, then the action taken will usually be rendered void albeit in some cases shareholders are able to ratify decisions taken by directors in contravention of the Articles.

Shareholders Agreement

Fundamentally, a shareholders’ agreement is a legally enforceable contract and the rules relating to its enforceability, and all remedies available if such an agreement is breached, is usually governed by the applicable rules relating to contract law. It is most likely for a breach to occur when an action is taken that violates the terms of the agreement. For example, shares could be transferred in a way that is not acceptable per the terms of the agreement, or one shareholder goes rogue and decides to sell some of the Company’s major assets without correct authorisation, or a decision is made by the Company without the prior authorisation of a sufficient number of shareholders.

Although these actions alone may be considered valid, if other shareholders evidence that such action(s) have caused them loss (e.g., the devaluation of their shares), they may claim for breach of contract against the offending shareholder. There are various remedies available to the aggrieved party which include:

  • The innocent party may be able to recover damages in respect of the loss they have suffered as a result of the breach;
  • The court may order specific performance (the contract or provision breached must be performed); and
  • The innocent party may seek a court injunction to prevent a breach (pre-emptively if threatened).

Where there has been a breach of obligations contained within a shareholders’ agreement, the wronged party can claim for breach of contract.

About George Harrison

George is a full-time paralegal at the Jonathan Lea Network. George recently finished his Master’s of Law (LL.M) at King’s College London, where he specialised in banking law.

The Jonathan Lea Network is an SRA regulated firm that employs solicitors, trainees and paralegals who work from a modern office in Haywards Heath. This close-knit retain team is enhanced by a trusted network of specialist self-employed solicitors who, where relevant, combine seamlessly with the central team.

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