Epiq Systems, Inc.
Corporate, Securities

Common drafting mistakes in shareholder agreements

By Cameron MacCarthy and Chris Johnston

This is the first article in a two part series discussing common issues arising from or related to shareholder agreements.

If you are operating your business with one or more business partners, then it is often prudent to enter into an agreement to set out how the business will run, where financing will be obtained, whether and how additional owners can be recruited and, most importantly, how the business relationship can be ended if you and your partners no longer wish to work together. Operating a business with another person is like any other relationship – the owners usually get along well at the outset but inevitably there are some rocky periods. Regrettably, the relationships inherent in small and medium-sized enterprises often deteriorate rapidly as a result of a dispute, even when the underlying business is thriving. If you and your business partners have not decided ahead of time how to unravel the business relationship, then the process can quickly become contentious and costly.

Shareholder agreements typically address two major concerns for you and your business partners: (1) the management and governance of the corporation, and (2) the terms by which business partners may be admitted or removed as shareholders. Shareholder agreements can be crafted to protect the interests of minority shareholder or give additional rights and entitlements to major investors. In many cases, however (and particularly for businesses that are early in the business cycle) shareholder agreements are intended to create fair and equitable relationships and seek to protect the economic interest of each business partner.

It is essential that any provisions in a shareholder agreement purporting to govern the terms by which shareholders may sell their interest in the corporation are carefully drafted. It is even more important that the provisions that govern the terms by which a shareholder is forced to sell their shares is clear and unambiguous.

Below are two examples of common terms found within shareholder agreements. These provisions will seem innocuous at first glance, but a careful reading will reveal issues that may defeat what the shareholders originally intended.

Example 1: “If any shareholder makes an assignment for the benefit of creditors or is the subject or proceedings under any bankruptcy or insolvency law, the other shareholders will have the right to purchase all, but not less than all, the shares owned by the bankrupt shareholder.”

The intention of this provision is to provide the other shareholders with the right to purchase the shares of the bankrupt shareholder before those shares fall into the hands of the trustee in bankruptcy. However, the provision may not accomplish that objective because it does not address the timing and process through which the shares of the bankrupt shareholder will be acquired by the other shareholders. The likely result from this basic provision is that the shares of the bankrupt shareholder will fall into the hands of the trustee in bankruptcy and the other shareholders will have to make court applications to recover the shares. That exercise is likely timely, costly and would be undertaken without a significant degree of certainty as to the result.  Put simply, better drafting can ensure that the potential issue is avoided entirely.

Example 2: “If a shareholder dies, its shares will be sold and the Corporation will purchase those shares for their fair market value at the time of death.”

This provision is intended to ensure that the shares of a deceased shareholder are acquired before they fall into the deceased shareholder's estate. This is often desired because it ensures that the surviving shareholders maintain their proportionate control of the corporation without having to worry about who will ultimately take control of deceased’s shareholdings. However, as drafted, this provision will disqualify the spouse of the deceased shareholder from taking advantage of the spousal rollover under s. 70(6) of the Income Tax Act. The spousal rollover is a commonly used estate planning tool that defers the income tax liability on any accrued gains on the shares until the spouse’s death or until the spouse disposes of the shares. The tax savings can be significant. In order for a spouse to take advantage of the spousal rollover, the shares must vest indefeasibly in the spouse or a trust. In this case, a carefully drafted provision can provide commercial certainty whilst still allowing for tax planning and savings. It need not be an either or scenario.

Too often, shareholder agreements are seen by business partners as an unnecessary expense and by advisors as a commoditized service offering. Although many shareholder agreements will contain similar terms or provisions, there is not a one-size-fits-all solution. Careful consideration should be given to the underlying business, the personal circumstances of the business partners, and the manner in which those business partners want to grow, develop and protect the underlying business. 

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