A company's articles of association are the public document regulating the internal management of the company between its directors and shareholders.
Many companies have adopted the most recent government-prescribed form of default articles (known as "the Model Articles").
Others are using older versions of articles of association which refer to outdated sections of the Companies Act or contain provisions that are no longer relevant for the company.
Either way, the company's articles may no longer be fit for purpose, rendering some actions incompetent, unenforceable or even illegal.
It is less common for companies to adopt bespoke articles which perfectly suit their commercial and corporate governance requirements.
In our experience, two areas where companies frequently become unstuck are:
- the composition of the board; and
- provisions on share allotment and share transfer.
This blog:
- explains why your company's articles might not do the job required in these areas; and
- suggests that companies review these provisions to see whether they should now be amended.
1. Board Composition
Directors carry out the day to day management of the company. They usually have the power to declare dividends. Each director has the authority to bind the company. Their actions (or inactions) can have significant implications for the company financially and contractually.
The composition of the board is therefore of key importance, as are the provisions in a company's articles relating to a directors' appointment and removal.
Where a company has adopted Model Articles, or the articles of association are silent on this point, the shareholders have the power to appoint/remove a director by passing an ordinary resolution (a simple majority of the shareholders).
Companies should consider if the percentage of votes required to appoint or remove directors should be higher or lower than 50% depending on:
- the composition of the board;
- the number of shareholder directors; and
- the percentage of voting rights held by each shareholder.
For example, a family company may wish the appointment or removal of a director to require approval from named shareholders.
2. Offer rounds
An offer round provision protects existing shareholders from an unwanted third party obtaining shares in the company by ensuring that any shares which are available are first offered to existing shareholders in the company.
As regards any new issue of shares, the default position under company law and the Model Articles is that any new shares must first be offered to existing shareholders before they can be offered to a third party. This prevents existing shareholders from being diluted.
However, there is no such protection if a shareholder chooses to transfer their existing shares to an unwanted third party. If shareholders wish to guard against that, it is necessary to include transfer restrictions in the company's articles of association.
Articles can be drafted to ensure that on any proposed transfer of shares in the company, the shares are first offered to the remaining shareholders proportionately.
3. Permitted transfers
Where a company's articles contain offer-round provisions, they will usually also contain a list of "permitted transfers". These provisions enable shares to be transferred freely to family members or family owned trusts without requiring any of the above mentioned 'offer round' provisions to apply.
Permitted transfers are particularly recommended for the articles of family-owned companies. One main advantage is the potential tax benefits of a permitted transfer, including no requirement to pay stamp duty at 0.5% if there is no price paid for the shares.
4. Compulsory Transfers
A compulsory transfer provision requires a shareholder to offer their shares for sale to the other shareholders if a 'trigger event' occurs.
Any of the following are examples of potential 'trigger events':
- a shareholder becomes mentally or physically impaired;
- a shareholder retires from their employment or office with the company;
- death, bankruptcy or insolvency of the shareholder;
- a shareholder who had received their shares under a "permitted transfer" provision ceases to fall within the definition of a "permitted transferee" (e.g. original shareholder transfers to spouse, then two years later, they get divorced).
Compulsory transfer provisions act as a safeguard for the company to prevent a shareholder who is no longer actively involved in the day to day running of the company, or in the family, retaining shares which would allow them to have a degree of control and influence.
5. Good Leaver/Bad Leaver
Where a company has shareholders who are also directors, employees or consultants, it should include good and bad leaver provisions in its articles.
These provisions would initiate a compulsory transfer of shares if the shareholder ceased to be employed or engaged by the company or cease to hold office.
The price paid for the shares would depend on whether the shareholder is a 'good' or 'bad' leaver.
Ordinarily a 'good leaver' is a shareholder who leaves the company by mutual consent or through an event outwith their control (e.g. death or retirement). The articles should set out the definition and agreed sale price structure for a 'good leaver'. Generally, any 'good leaver' would receive fair market value for their shares.
Articles commonly provide that anyone who is not a 'good leaver' is a 'bad leaver'. Any 'bad leaver' would receive a heavily discounted (or even just nominal) price for their shares.
The good leaver/bad leaver provisions are useful in management owned-companies. They provide:
- a loyalty incentive for employees/directors who are also shareholders; and
- certainty that, if a director or employee leaves, they will not remain a shareholder.
6. Drag and tag provisions
Drag and tag provisions in articles of association ensure that, if an offer is made to purchase the shares in a company, all the shareholders will be entitled to (or compelled to) sell their shares to the potential buyer.
A drag provision allows a majority shareholder(s) (usually more than 75% in nominal value) to force the remaining minority shareholders to accept a third party offer to purchase the shares of the company.
The tag provisions typically allow minority shareholders to force other shareholders (who wish to sell their shares) to procure an offer for their shares on the same terms and conditions.
This extinguishes the risk of:
- the minority jeopardising any potential takeover by refusing to sell their shares; and
- a majority shareholder selling their shares to a third party without an offer being made to the minority.
Prospective purchasers often look for drag and tag provisions (particularly in companies with a number of minority shareholders) to satisfy themselves that: (1) they can buy 100% of the company; and (2) there would be no shareholder disruption in any potential deal.
Brodies can help
Brodies' corporate team is experienced in drafting articles of association, shareholders' agreements and advising businesses in relation to appropriate corporate governance arrangements. Please contact any member of the corporate team or your usual Brodies contact for further information.
