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Shareholders’ Operating Agreement

Introduction

Before we discuss the common characteristics and uses of Shareholders’ Operating Agreements, it is important to understand the reasons why they have been created. Most people that carry on business using a corporation usually fail to distinguish between the different roles and obligations that they have as shareholders, directors, officers, employees and creditors of their own corporations. Usually people involved in a closely held corporation consider themselves partners and often act accordingly.

The basic rules that cover the roles and obligations of “partners” in a corporation are set out in the articles of the corporation, the Business Corporations Act and the common law that has been developed by the Courts.

The articles of a corporation are one of the documents that are filed with the Corporate Registry to create a corporation. The articles form a contract between the shareholders and the corporation which establishes certain rules regarding the conduct of the company.

The Business Corporations Act supplements the rules set out in the articles and adds some additional rules about corporate conduct. In some circumstances, the rules in both the articles or the Business Corporations Act may override each other.

The common law is the body of law that has been developed by the Court system making decisions over time, regarding the affairs of corporations. All the rules that may be established by the articles and the Business Corporations Act, must be considered with the way that Courts have interpreted those rules and applied them.

Although the entire body of law that governs different aspects of the company’s conduct is large and complicated, most of these rules focus on the conduct of the company from a regulatory, administrative or technical standpoint and they do little to govern dealings between the parties regarding more practical business affairs of the company.

For this reason it is important to create a Shareholders’ Operating Agreement. Simply put, this is a contract between the company and its shareholders which establishes certain groundrules for more practical concerns about operating the specific business of the company.

Some confusion exists about these agreements because they often go by different names, such as “Shareholders’ Agreement”, “Shareholders’ Operating Agreement”, and “Buy Sell Agreements”.

The following sections of this article discuss many of the practical situations that arise in the operation of business of a company that are commonly dealt with in a Shareholders’ Operating Agreement. There is no clear standard form agreement, however most agreements contain a variety of common characteristics. It is important to understand that every corporation brings different requirements to the creation of a Shareholders’ Operating Agreement and what is important in one specific business situation may not be necessary at all for the operation of the affairs of another company.

Conduct of the Affairs of the Company

One of the important things to understand with regards to the different roles and obligations that corporate principals may have as shareholders and directors of a corporation is that the majority shareholder usually is in a position to unilaterally determine the direction a company will go. As long as a shareholder holds one vote more than 50% of the voting shares of a company, they are in a position to unilaterally decide how many directors there will be and who those directors are going to be. This means that a majority shareholder can determine that the other shareholders of the company have no practical say in the day to day decisions to be made.

It is also important to know that once a board of directors is established, the rule of decision making is one vote per director. This means quite simply that if there are three directors, any two directors voting in favour of an issue determines the outcome of that vote.

With both of these understandings in mind, it is apparent that a majority shareholder can set up the board of directors in such a way that they decide every practical issue associated with the day to day affairs of the company, without any input from other shareholders. This prejudice in favour of the majority shareholder is one of the inequalities that a Shareholders’ Operating Agreement can be set up to address.

A Shareholders’ Operating Agreement can agree in advance as to the make up of the board of directors to ensure that a minority shareholder obtains representation on the board. This can be further enhanced by defining the quorum in such a way that it must include minority shareholder nominees to the board of directors and to require certain decisions on the direction the company may take to include either unanimous consent of the board of directors or mandate the approval of a particular minority nominee to the board.

These types of clauses allow both a minority input and some reassurance that the company’s business direction will not change from that originally contemplated when the company was established.

Shareholders Contributions & Distributions

There are times in a company’s existence where it may require more money to properly finance its operations, or it may be in the position where it is time to distribute monies that the company has made to the shareholders. In the absence of an additional agreement, the company would revert to the situation described in the preceding paragraph regarding voting control and a majority may make that decision without regard to the minority.

It is preferable for the shareholders and the company to agree in advance as to what may happen if the company requires additional financing and how profits are to be distributed in the future.

This will allow a shareholder to know clearly at the outset what his or her future obligations in regards to injecting money may be and what criteria must be met before the company begins to distribute its profits.

Restrictions on Transfers of Shares

Most company’s articles contain a statement that the transfer of its shares must be approved by the board of directors and absent any further agreement, there are really no guidelines as to when share transfers by shareholders, either amongst themselves or otherwise, will be approved. A Shareholders’ Operating Agreement can be set up to create some clear rules on when share transfers can occur and the rules to be followed.

Most Shareholder Operating Agreements contain a variation on a right of first refusal which means that before a shareholder can transfer his or her shareholding interest, it must be offered for sale to the existing shareholders of the company.

There are two principal types of rights of first refusal. The first one makes the shareholder determine the price of his or her shareholdings and the terms and conditions upon which the sale will occur, and he or she must then offer it to the existing shareholders. To the extent that the existing shareholders do not purchase those shareholding interests on those terms and conditions, the shareholder is then able to offer his or her shareholding interest for sale to a third party.

The second variation of a right of first refusal is that the shareholder goes out into the marketplace and obtains a firm offer to purchase his or her shareholding interest. The shareholder then must make an offer to the existing shareholders which must be accepted within a period of time, and if the existing shareholders do not pick up the entire interest, then the shareholder may complete the sale to the third party identified from the marketplace.

Most companies that are closely held will require the new shareholder to enter into an amended Shareholders’ Operating Agreement with the existing shareholders and to require the production of certain pieces of information about the status of the new shareholder, before those existing shareholders will consent to a share transfer.

Some agreements will even contain further restrictions where the new shareholder must be approved by the company’s lender or parties that the company has material contracts with.

There are some additional agreements that you will often see in a Shareholders’ Operating Agreement which expand upon the protections and obligations set out in this paragraph.

You may see something which is commonly known as a “piggy back” right which states that a majority shareholder will not sell his or her shareholding interest in the company to a third party, without including the minority shareholder’s interests. This will prevent the majority shareholder from selling out his or her interest for a large profit, without including the same benefit for the minority shareholders. If this type of right is given, the minority shareholder will often be required to give a corresponding commitment that he or she will sell his or her shares if the majority shareholder enters into an agreement with the third party to sell all of his or her shares.

Another type of clause that is commonly seen is a clause which states that there will be no further shares issued in the company without the unanimous consent of the shareholders. This type of clause ensures that the shareholders are not going to have their shareholding position diluted by a further share issuance, or have additional shareholders coming in to the company, unless everyone is in agreement.

Shotgun Mechanisms

A shotgun clause is a clause whereby any one of the shareholders can specify a price for his or her shares and give notice to the other shareholders requiring them to either buy the person who has enacted the shotgun clause out of the company, or be bought themselves. This situation creates quite a drastic solution when the parties are not able to get along. One of the parties is going to be leaving the company, whether he or she has any desire to or not. It is important to know that this type of clause can lead to some inequitable situations if one party knows in advance that the other party is not in a position to raise any monies to conclude a purchase.

In that case, the person setting the share value is able to take advantage of the lack of liquidity of the other shareholder and specify a share price which is quite low. There is some inherent fairness in this mechanism because if a share price is set too low then the other shareholders will be buying, while if a share price is set too high the other shareholders will be selling. While this might seem quite draconian to some, it may be the only mechanism available to settle a fundamental dispute between shareholders and ensure that the company can continue working into the future.

Some variations on shotgun themes will see the parties agree on an annual basis as to the share valuation to be given, or require the use of a formula in determining share value. A third alternative is to use a chartered business valuator to determine the fair market value of the shareholdings being transferred. This takes some of the problems associated with an inequitable value out of the consideration.

Share Transfers on Death

One of the biggest short comings of not having a Shareholders’ Operating Agreement is that the articles of a company and the Business Corporations Act do nothing to deal with a corporate situation when one of the shareholders dies. As a corporation continues to exist despite the death of its shareholders, most shareholders in a closely held company wish to set out the terms and conditions of transfer once a death occurs. From the perspective of the surviving shareholders, the surviving shareholders want to be comfortable with the person that they are going to continue in business with. From the perspective of the deceased, the estate is going to want to ensure the sale of the shares in the company with as little difficulty as possible.

A Shareholders’ Operating Agreement is an opportunity for all of the shareholders of a company to set the ground rules of share transfers in advance. This will ensure that the surviving shareholders have a say in who their partners are, and that the estate of the deceased is assured of a marketplace for the sale of the deceased’s shares.

The valuation of shares is considered to be at the fair market value of those shares immediately prior to the death of the shareholder, as this mirrors the requirements of the Income Tax Act which states that a deceased is deemed to dispose of their assets immediately prior to their death for fair market value.

The difficulty with a mandatory sale of shares upon a party’s death is that the company or the surviving shareholders may be faced with two difficult situations. They may be required to come up with monies to buy out the estate of the deceased’s shareholder, and they may also find themselves having to replace the resources and expertise that the deceased shareholder may have provided to the business of the company. It is common for companies to provide for both of these eventualities by maintaining insurance sufficient to fund the anticipated purchase obligation, or to maintain what is called “key man insurance” to fund the ability of a business to go out into the marketplace and purchase replacement manpower.

Although the concept of purchasing a deceased’s shareholder’s interest in a company is quite straight forward, there are many tax planning considerations to look in to. Depending upon the time that the parties create the Shareholders’ Operating Agreement and when their insurance was in place, there may be significant income tax advantages available to the estate of the deceased to allow for receipt of insurance proceeds in a tax advantaged manner. Even with insured buy out schemes that have been put in place since some income tax changes were made in 1995, there can be some significant tax savings made by proper structuring. It is important when a corporation sets out to insure the lives of the shareholders for the purpose of buying out their interest, that the principals obtain proper legal and accounting advice before committing to the scheme, in order to make sure that they have maximized their income tax advantages.

When the company and its shareholders have failed to put in place insurance, the impact of the death of a shareholder can still be softened by creating a mechanism whereby the shares are paid for over a period of time rather than right at the time of transfer near the principal’s death.

Shareholder Defaults

When shareholders in a company enter in to business together through a corporation, they generally have certain expectations of performance by the other shareholders and an equitable contribution to the ongoing running of the corporation’s business. If the principals do not live up to providing their continued input to the operations of the company, then the common law and the Business Corporations Act do not really provide any solutions for such failures. It is one of the tasks of a Shareholders’ Operating Agreement that the parties can set out what happens when certain situations arise regarding the shareholders’ failure to live up to their obligations under the agreement, or if they face a situation where someone with a judgement against a shareholder is trying to seize the shares in satisfaction of their debt. The mechanisms put in place usually allow the defaulting shareholder an opportunity to cure the default that exists or face the consequences. The consequences that can arise usually involve the deemed making of a loan, if the default is financial, whereby the defaulting shareholder is required to pay back the deemed loan at high interest rates.

Where the default is non-financial, it provides the other shareholders with an opportunity to force the sale of the defaulting shareholders’ interest in the company, which usually occurs at a discount.

Without these types of clauses in place, there may be no effective alternative to solving the problems associated with a delinquent shareholder.

Summary

Many people consider preparing a Shareholders’ Operating Agreement as an unnecessary luxury which does not need to be done at the time of incorporation. At the start up, most principals normally get along with all the other principals and they feel it is an unnecessary expense at a time when revenues have yet to be generated. We always recommend the creation of a Shareholders’ Operating Agreement, because it acts much like an insurance policy. Until a difficult situation arises, the agreement may never be looked at but at the time it may be needed, it is too late to create it if does not already exist. The creation of a proper Shareholders’ Operating Agreement will set out clear guidelines for the parties roles and obligations in the future affairs of the company and set out mechanisms to resolve any disputes or deal with any situation that may arise. If the parties do not get along in the future and there is no Shareholders’ Operating Agreement in place, the company may falter without any way to resolve a deadlock. The costs involved in creating a Shareholders’ Operating Agreement are small compared to the possible costs in money, time and frustration involved in attempting to operate a company, or resolve a dispute, where the relationships have soured and there is not such agreement.

The opinions set out in this article reflect generally on this area of law. The impact of the law on any given situation depends upon each individual’s circumstances and the opinions contained in this article should not be relied on for assessing anyone’s legal position. Advice should be obtained directly from our business law lawyers regarding your particular situation.