Exit rights of minority shareholders in a private limited company (IVOR nr. 72) 2010/3.3.8:3.3.8 Scope

Exit rights of minority shareholders in a private limited company (IVOR nr. 72) 2010/3.3.8

3.3.8 Scope

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In this paragraph, two important developments in the unfür prejudice jurisdiction will be described. First, I will describe how the courts have first extended the concept of unfür prejudice and, subsequently, I will describe how the courts have limited its scope of application.

With the introduction of the unfür prejudice remedy, the courts were faced with the question whether the concept of unfür prejudice must be interpreted in a more liberal way than the old concept of oppression. As mentioned before, the oppression remedy only covered existing wrongs. The courts considered the old concept of oppression to be abandoned by the new section, for the reason that Parliament had deliberately chosen the wider concept of fürness instead of that of oppression. With respect to the concept of fürness, the distinction between acts that do and do not infringe rights attached to shares was no longer of relevance.1 As the limitations of the old oppression remedy no longer existed, the courts were challenged to define the scope of the new unfür prejudice remedy.

The concept of unfür prejudice is further elaborated in a number of general principles. At the outset, these principles provide no clear-cut answer to the question as to which conduct amounts to unfür prejudice and which does not. This seems für, as the unfür prejudice remedy is a remedy with an open criterion.

The principles applied under the unfür prejudice remedy have been given shape in the landmark decision of the House of Lords in 0 'Neill v. Phillips.2 Hitherto, this is the only judgment of the House of Lord in a case based on the unfür prejudice remedy. Before paying attention to the principles elaborated by the House of Lords, the facts of the case and the judgment of the Court of Appeal are exposed.

Phillips held the entire issued share capital of an Ltd, which operated in the construction industry. Phillips was impressed by the working skills of O'Neill, an employee of the company. Phillips gave O'Neill one quarter of his shares and appointed him as director in 1985. The same year, Phillips and O'Neill had a conversation in which Phillips expressed the hope that O'Neill would be able to take over the day-to-day running of the company. On that basis, O'Neill would be rewarded with 50 per cent of the company's profits as of some moment in the future. By the end of 1985, Phillips retired from the board, leaving O'Neill as sole managing director. O'Neill was awarded half of the profits (salary and dividends), some of which he lelt to the company. Accordingly, Phillips waived a third of his entitlement to the dividend.

In the years 1989 and 1990, Phillips and O'Neill negotiated in order to double O'Neill's capital share. Phillips indicated that he was willing to increase O'Neill's shareholding to 50 per cent of the share capital and to increase his voting rights, when certain business targets were met. However, the negotiations stopped and a formal agreement never was drafted. In the next years, business went downward. With the aim to improve the results of the company, Phillips resumed being managing director. O'Neill remained on the board as an ordinary director. Phillips told O'Neill that, since O'Neill was no longer managing director, he would no longer be entitled to 50 per cent of the profits, but only his salary and dividends payable upon his 25 per cent holding.

At the end of 1991, O'Neill prepared to sever his links with the company. In 1992, O'Neill issued a petition under S. 994. O'Neill claimed that Phillips had broken his promises to pay O'Neill 50 per cent of the profits and to allot to him 50 per cent of the shares. In the Court of Appeal, Nourse LJ held that O'Neill had legitimate expectations to half of the profits and half of the shares of the company, although this was not laid down in a written agreement. The Court held that these expectations were denied by Phillips. According to the Court, Phillips should have given 0 'Neill notice and the opportunity to defend himself or should have offered to purchase his shares. In the opinion of the Court of Appeal, since the expectations were denied, O'Neill could no longer be expected to remain at the company and was granted an exit under the Section 994 petition.

The House of Lords did not approve of the judgment of the Court of Appeal. What makes the judgment of the House of Lords particularly interesting is that it contains an exposé of the principles that may lead to the application of the unfür prejudice remedy. In its judgment, which was delivered by Lord Hoffmann, the House of Lords chose for a contractual approach towards the relationship between the members:

"In the case of section 459, the background has the following two features. First, a company is an association of persons for an economie purpose, usually entered into with legal advice and some degree of formality. The terras of the association are contained in the articles of association and sometimes in collateral agreements between the shareholders. Thus the manner in which the affürs of the company may be conducted is closely regulated by rules to which the shareholders have agreed. Secondly, company law has developed seamlessly from the law of partnership, which was treated by equity, like the Roman societas, as a contract of good faith. One of the traditional roles of equity, as a separate jurisdiction, was to restrain the exercise of strict legal rights in certain relationships in which it considered that this would be contrary to good faith. These principles have, with appropriate modification, been carried over into company law. The first of these two features leads to the conclusion that a member of a company will not ordinarily be entitled to complain of unfürness unless there has been some breach of the terras on which he agreed that the affürs of the company should be conducted. But the second leads to the conclusion that there will be cases in which equitable considerations make it unfür for those conducting the affürs of the company to rely upon their strict legal powers. Thus unfürness may consist in a breach of the rules or in using the rules in a manner which equity would regard as contrary to good faith."3

The starting point in a case based on S. 994 CA 2006, as set out in 0 'Neill v. Phillips, is whether the rights of the petitioner have been infringed. The question relates to whether rules contained in statute, in the articles of association of the company or in witten agreements between the members, i.e. shareholders' agreements, are breached in a manner that is unfürly prejudicial to one or more member(s). These are the rules on which the shareholders have agreed that the company must operate. This view can be traced back to Re Saul D Harrison and Sons plc, where Hoffmann LJ expressed it as follows:

"Since keeping promises and honouring agreements is probably the most important element of commercial fürness, the starling point in any case onder s. 459 will be to ask whether the conduct of which the shareholder complains was in accordance with the articles of association."4

The second principle from 0 'Neill v. Phillips is that existing rules between the members can be superseded by equitable considerations. These equitable considerations may arise when the existing rules are used in a manner unfürly prejudicial or, which is the same, contrary to good faith. Equitable considerations may even overmie statutory rights and rights that derive from the articles of association and shareholders' agreements. As will be seen below, an important example is the superimposition of equitable considerations when the power of the general meeting of shareholders to dismiss directors is exercised pursuant to S. 168 (1) CA 2006.

According to Lord Hoffmann, the concept of fürness that underlies the unfür prejudice remedy runs parallel with the just and equitable clause in Westbourne Galleries.5 Lord Hoffmann considered that the equitable principles derived from the winding-up remedy could be applied in the same way through the concept of unfürness of the unfür prejudice remedy. This parallel does not mean that conduct that is regarded as unfürly prejudicial, also has to justify a winding-up under the just an equitable clause, as it is a parallel.6 It follows from 0 'Neill v. Phillips, that the parallel is found in the equitable principles upon which the court decides conduct is unjust, inequitable or unfür. This contrasts with the predecessor of the unfür prejudice remedy, the oppression remedy of S. 210 CA 1948. In order to succeed in an application under the oppression remedy it was required that a petitioner could establish that the facts would also justify a winding-up of the company.

The application of equitable considerations makes it possible for the court to take tree intentions of the parties into account. This has traditionally been the role of equity within the English legal system. Whereas common law, in the strict sense, took the view that literal meanings have to prevail, equity could give effect to the real intentions of the parties.7 Of interest is the reflection of Lord Hoffmann on the role of equity:

"This way of looking at the matter is a product of English legal history which has survived the amalgation of the courts of law and equity. (...) one might, as in Continental systems, achieve the same result by introducing a general requirement of good faith into contractual performance. These are all different ways of doing the same thing."8

The true intentions of the parties may be derived from agreements between the members, other than agreements that are laid down in the articles of association or other written agreements applicable to all members. In other words, true intentions may follow from informal agreements. This comes down to the protection of legitimate expectations arising from the bargain between the shareholders. In 0 'Neill v. Phillips, Lord Hoffmann pointed out which expectations can be legitimate:

"(...) I think that one useful cross-check in a case like this is to ask whether the exercise of the power in question would be contrary to what the parties, by words or conduct, have actually agreed. Would it conflict with the promises which they appear to have exchanged? (...) In a quasi-partnership company, they (i. e. limits, PdV) will usually be found in the understandings between the members at the time they entered into association. But there may be later promises, by words or conduct, which it would be unfür to allow a member to ignore. Nor is it necessary that such promises should be independently enforceable as a matter of contract. A promise may be binding as a matter of justice and equity although for one reason or another (for example, because in favour of a third party) it would not be enforceable in law."9

Consequently, informal agreements can be protected by the unfür prejudice remedy. In order to qualify for protection, the existence of an informal agreement has to be tested. This test is called the something more test, because it must be proved that there are more rules between the members as laid down in their formal agreements.10 Proving an informal agreement can be quite complex: the whole history of the company must be examined in order to find out which informal agreements members have made and whether these informal agreements are applicable to all members.

Nonetheless, in 0 'Neill v. Phillips, the House of Lords reaches the minority shareholder a hand, by pointing out that the informal agreement may include positive obligations, but may also include the obligation that the parties have to refrain from certain acts:

"The unfürness may arise not from what the parties have positively agreed but from a majority using its legai powers to maintain the association in circumstances to which the minority can reasonably say it did not agree: non haec in foedera veni."11

In general, the existence of informal agreements can only be assumed when a company has the characteristics of a quasi-partnership. In Ebrahimi v Westbourne Galleries, Lord Wilberforce explained what these characteristics are.12 In 0 'Neill v. Phillips, Lord Hoffmann referred to this characterization. According to Lord Wilberforce, a quasi-partnership involves:

(a)

an association based on a personal relationship, involving mutual confidence;

(b)

a formal or informal agreement that all shareholders shall participate in management; and

(c)

restriction on the transfer of shares, so that a shareholder cannot take out his stake and go elsewhere.

It is very difficult, if not impossible, to prove informal agreements in the event that„ rather than a quasi-partnership, a company with a large number of shareholders or a plc is engaged in an unfür prejudice action. In the later scenario, the court will almost always assess that the way in which the company is regulated is exhaustively laid down in its articles of association and other written agreements, and that informal agreements do not exist.13

For a quasi-partnership to exist, it is not required that shareholdings are equally divided between the members. Even when the member has no more than 10% of the shares in the company at his disposal, the existence of a quasi-partnership may be present.14

In Richards v Lundy, the petitioner, Richards, held no more than 10% of the shares in the company. The judge, Nicholas Strauss QC, considered that it is not required for a quasi-partnership to have shareholdings that are divided equally between the shareholders. He considered that several factors might cause inequality, such as a lack of financial resources of one of the persons involved. The facts turned out that one of the respondents, Lundy, had greater financial resources, greater experience and more business contacts, which had caused the smaller amount of the shareholding of the petitioner. The judge held that these facts could not withhold the conclusion that a quasi-partnership existed.15

Equitable considerations may not only lead to the protection of informal agreements. There are even more circumstances in which equitable considerations may arise, and which can be remedied by S. 994 CA 2006. According to Lord Hoffmann, in order to find out in what circumstances these considerations arise, regard has to be taken to the already established equitable principles that are developed onder the winding-up remedy. So, for instance, S. 994 may apply when the company has been set up to carry out a certain project and this project has been finished. In those circumstances, it can be unfür when the majority shareholder insists on the continuation of the company, whereas the minority shareholder can reasonably hold that he did not agree to the continuation.16 Nonetheless, the scope of the unfür prejudice remedy seems to be limited to circumstances in which formal agreements are infringed or established equitable considerations arise.

As a final point, Lord Hoffivann reflected on the notion of legitimate expectations. This point was of concern, because the notion of legitimate expectations was used by Hoffmann in the judgment in Re Saul D Harrison & Sons Ltd. At that time, Hoffmann was a judge at the Court of Appeal. After deliverance of the judgment in the case of Re Saul D Harrison & Sons Ltd, the question was raised of whether there are any limits with respect to the superimposition of legitimate expectations.

In O'Neill v. Phillips, Lord Hoffmann pointed out that the notion of legitimate expectations does not represent an independent criterion that may lead to the application of the unfür prejudice remedy. He considered that only by application of traditional equitable principles, legitimate expectations can be protected.17 This view on the notion of legitimate expectations can be seen as a restriction of the unfür prejudice remedy, as well as an explanation or clarification of its scope.18

The facts of the case of 0 'Neill v. Phillips led to the conclusion that O'Neill was not unfürly prejudiced in his interests. In the judgment of the House of Lords, Lord Hoffivann stated that the difficulty in this case was, that 0 'Neill was not removed from management by Phillips Lord Hoffmann considered that Phillips was not behaving unfürly in denying the expectations with respect to the creation of an equal shareholding and entitlement to the equal profits. He held that parties had entered into negotiations, but that an agreement was never reached and that no unconditional promises were made. Lord Hoffmann held that there was nothing wrong or unfür in the conduct of Phillips.

Lord Hoffmann admitted that trust and confidence had broken down between the members. In his opinion, a breakdown of trust and confidence does not lead to the application of S. 994 CA 2006. According to Lord Hoffmann„ the test of the unfür prejudice remedy would have been passed if 0 'Neill had been excluded from management, because then it would be unfür to keep him locked in the company as a shareholder. However, as this was not the case, the appeal was granted and the petition was dismissed.

There is debate about the desirability of the limitations introduced by the House of Lords in O'Neill v. Phillips. Currently, the scope of the unfür prejudice remedy only seems to cover breaches of informal agreements insofar as these are protected by traditional equitable considerations and breaches of statute, the articles of association and formal agreements. Two years before the judgment, in 1997, the Law Commission expressed that any limitation on the general words of S. 994 CA 2006 was not desirable. The Commission feared that conduct, which would deserve a remedy, might be lelt unremedied.19

In O'Neill v. Phillips, Lord Hoffmann took a different view. He considered that experience has shown that proceedings onder the unfür prejudice remedy are often time-consuming and expensive and that it is desirable that the outcome of cases become more predictable. He stated that "a balance has to be struck between the breadth of discretion given to the court and the principle of legal certainty."20

After the decision in 0 'Neill v. Phillips, the CLR reports were published. The reports of the CLR show that most of the respondents of its consultation did not favour the restrictions laid down in O'Neill v. Phillips. Nevertheless, the CLR itself supported the restrictions elaborated by Lord Hoffmann. The reason for the support of the CLR reflects that of Lord Hoffmann for restricting the unfür prejudice remedy:

"The effect of the unfür prejudice claim being unlimited is to lead to all manner of factual allegations being potentially admissible, which encourages the widest possible range of evidence being adduced to assemble a case of unfürness. This makes proceedings lengthy and undisciplined and means that there is linie guidance for those operating companies as to what is and is not acceptable conduct."21

In the view of the CLR, abolishing the limits could have a negative effect on small companies, because it could lead to costly and time-consuming proceedings. The CLR defined the basis upon which allegations should be made as a departure of an agreement, broadly defined.22 This interpretation seems to be even more restrictive than that of Lord Hoffmann, who has stated that equitable considerations may also arise in other circumstances than breaches of formal and informal agreements.23

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