Overview
If you are starting a new business with friends and you set up a small private company where everyone is a director and shareholder, you will no doubt be full of excitement and your focus will be on opening the doors and starting the journey ahead.
But as the business grows, the excitement may fade as differences of opinion emerge. At some point, you may find you are no longer on the same page with your business partners about key aspects of the business. In some cases, this may become a deadlock situation, stifling the business and the ability to continue operations. Alternatively, if one of the co-founders has a majority ownership stake, they may seek to take control of the business and exclude the other founders from ongoing management and ownership.
So how can you protect your interests when, despite good intentions, a small business dispute arises?
Oppression
Under sections 232-233 of the Corporations Act 2001 (Cth) (Corporations Act), a court may grant relief where the conduct of the company’s affairs, an actual or proposed act or omission by or on behalf of the company, or an actual or proposed resolution of shareholders is either:
- contrary to the interests of shareholders as a whole; or
- oppressive, unfairly prejudicial to or unfairly discriminatory against a shareholder or shareholders.
Oppression is rarely an isolated act. It usually arises through a pattern of conduct designed to marginalise minority interests in a company.
Common examples of oppression are:
- where a minority shareholder is excluded from management without commercial justification – despite being a co-director or in circumstances where there was a mutual understanding among the co-founders that they would all play an active and ongoing management role in the business;
- providing minority shareholders with only selective access (or denying it altogether) to financial and strategic information about the company;
- refusing to declare dividends despite majority directors receiving inflated remuneration;
- the use of company funds for personal expenses or the diversion of the company’s property or business opportunities to related entities; and
- issuing new shares to dilute minority interests without a genuine capital need for the company or a proper process being followed (even if there are no express restrictions contained in the shareholders’ agreement of the company’s constitution).
The court adopts a substance over form approach, assessing whether an action or proposed action or resolution has or will cause genuine commercial prejudice to minority shareholders.
Importantly, mismanagement or poor financial performance does not, without more, give rise to oppression. The court will not get involved in commercial matters simply because a company’s directors and shareholders cannot agree on how to run the business.
A mere personal conflict is also not sufficient. Rather, to make out oppression, a shareholder needs to link the relevant circumstance to actual or expected economic or financial disadvantage, such as reduced share value or the loss of returns or management rights.
The court has wide powers to make any orders it considers appropriate if it finds there has been oppression. Most commonly, orders are made for the majority to buy out the interests of the minority at fair value. Otherwise, the court may make orders regarding the conduct of the company’s affairs in future – including its reporting obligations, the payment of dividends, related party dealings and directors’ reinstatement. Modifying or repealing the constitution of the company is another possible order.
If you are thinking of bringing an oppression claim, one of the key things you should turn your mind to is what expectations the business founders had when establishing the business in the first place – specifically, any representations made or any common understandings regarding how the business would be conducted, for example in relation to a right to participate in management, the dividends to be paid and the goals and objectives for the business.
You should also gather supporting evidence – such as board minutes, financial records, emails and diary notes – which points to a pattern of oppressive and prejudicial conduct impacting minority interests.
Just and equitable winding up
Another option in the event of a business dispute is to seek to wind up the company on “just and equitable” grounds under section 461(1)(k) of the Corporations Act.
In practice, this ground is usually relied on where there has been a complete breakdown in relationships, a deadlock in the management of the business or a shared understanding concerning the conduct and operation of the business that has not been complied with.
Some of these grounds overlap with oppression, but the key difference is that – necessarily – an application to wind up a company will, if successful, end the company’s existence. As a result, just and equitable winding up is seen by the courts to be an extreme remedy of last resort. The court will do its utmost to avoid winding up a solvent company, particularly when employees will be affected.
If it is possible for a dispute or deadlock to be resolved in another way – for example ordering the purchase of shares at fair value (similar to oppression) – the court will make alternative orders.
Breach of constitution or shareholders’ agreement
A further option may be to issue proceedings for breach of contract where the directors, or other shareholders, have breached the company’s constitution or a shareholders’ agreement. The constitution is treated as a contract between the company and each director and shareholder, while the shareholders’ agreement is regarded as a contract between shareholders.
These governance documents typically contain provisions regulating the payment of dividends, a right for directors and shareholders to access certain information about the company, meeting procedures and tag-along or pre-emptive rights provisions that limit the scope for the majority to dilute minority interests.
If one or more of these provisions have not been complied with, an application can be made seeking damages and/or an injunction flowing from the relevant contractual breach.
Statutory derivative action
Under sections 236 and 237 of the Corporations Act, a shareholder (or other eligible applicant) can bring an action not in their own personal capacity, but rather in the name of the company.
Proceedings are typically instituted against a director, alleging a breach of the director’s duties to the company – such as a failure to act with due care, skill and diligence or a failure to act in good faith in the best interests of the company.
Derivative actions are designed to provide a remedy for a minority shareholder to still pursue a claim against a director when those controlling the company refuse or fail to act – usually out of self-preservation!
While a useful remedy, the threshold for commencing a derivative action is very high. An applicant must obtain leave of the court, which will only be granted if the court is satisfied an action is in the best interests of the company, there is a serious question to be tried and the applicant is acting in good faith. This prevents misuse of the court process for tactical or personal reasons which could impact on the company’s reputation or financial stability.
An applicant will need to provide prima facie evidence of the wrongdoing asserted on the part of those controlling the company and the use of that control to prevent proceedings being instituted to remedy the wrongdoing. Harm to the company – not the applicant personally – will also need to be established, such as the misappropriation of the company’s assets or loss flowing from a director’s breach of duty.
Takeaways
Disputes among small business owners are one of the most common issues our clients come to us with.
A dispute gives rise to a range of litigious measures – including oppression, just and equitable winding up, a breach of contract claim or a statutory derivative action. However, before pursuing a claim, you should conduct a cost-benefit analysis. It is expensive to pursue these types of proceedings and court delays may serve to further incapacitate a business which has already stalled due to the conflict among the founders.
A negotiated exit should always be the goal at the first instance. If that is not possible, and informal dispute resolutions have been exhausted, then litigious options remain available.
Ultimately, the best way to manage the potential for business disputes is to – at the outset – establish the parties’ expectations and goals.
Good governance and corporate practices are not reserved for listed or large entities – rather, they are just as critical for small companies to set the “rules of play” that can help to navigate often close personal relationships and blurred lines between business and personal priorities.
Before commencing a new business, you should therefore always ensure you have in place a well-drafted constitution and shareholders’ agreement setting out matters such as the decision-making process, exit and buyout options, the right to information, tag-along and pre-emptive rights for minority shareholders, dispute resolution mechanisms, meeting procedures and board/shareholder relations. This will ensure everyone is on the same page and minimise the potential for misunderstandings that may be costly and, in some cases, spell the end of a business you have worked so hard to build.
The K2 difference
Every business deserves stability and fairness. At K2 Law, we have a dedicated team of experts who act for clients across a range of corporate, commercial and litigation matters – helping them to protect their rights, preserve their businesses and achieve their goals.
If you are wanting to put in place an effective governance structure for your small business – or if you are navigating a shareholder dispute or a conflict over minority rights that has arisen and want to discuss your options – please get in touch with Alyce Corbutt or James Barritt.
The content – including publications – on this website is intended only to provide a summary and general overview on matters of interest. It is not intended to be comprehensive, nor does it constitute legal advice. We attempt to ensure that the content is current, but we do not guarantee its currency. You should seek legal or other professional advice before acting or relying on any of the content.
