Shareholders’ Agreement or Constitution – inconsistencies

It is the usual practice for shareholders’ agreements to include a clause dealing with inconsistencies between the shareholders’ agreement and the constitution.  The wording will commonly state that the shareholders’ agreement will take precedence over the constitution where there are conflicts between the relevant clauses dealing with the same subject matter.

For this reason, your company’s constitution may never have been amended since the company was established.   Why take the time to amend the constitution when the “inconsistencies” clause in the shareholders’ agreement means that the latter will always prevail?

Well, the New South Wales Supreme Court's recently gave an answer to that question, demonstrating that failure to consider the constitution may result in unexpected consequences. The case of Cody v Live Board Holdings Limited shows that provisions of a shareholders’ agreement and a constitution covering the same matter may both apply if the relevant clause in the constitution does not really conflict with that of the shareholders’ agreement.

What happened in Cody?

The shareholders claimed that the board had not complied with relevant provisions of the company’s constitution and shareholders’ agreement when issuing preference shares to a new shareholder and ordinary shares to existing shareholders.

The constitution

The constitution of Live Board Holdings’ stated that the directors were permitted to issue and allot shares with such preferred, deferred or other special rights as the directors determined, provided that if the share issue directly or indirectly varied the rights of a class of shares, the variation would need the approval of at least 75% of that class of shareholders.

The shareholders’ agreement

The shareholders' agreement stated that the management of the company was the responsibility of the board, with certain powers reserved for decision by shareholders. These reserved matters included the issue of shares or the grant of rights over any shares in the company, which were to be approved by a simple majority of shareholders.

The dispute

The existing shareholders objected to the directors issuing preference shares to a new shareholder without the approval of 75% of ordinary shareholders.  They insisted that to do so would vary the existing rights of ordinary shareholders under the constitution.

The directors’ position was that the 75% majority was not required as the issue of preferences shares was an "issue of shares" pursuant to the shareholders' agreement, and required only a simple majority approval.  The board believed that the issue was transacted appropriately, but referred the matter to court for determination.

The court’s decision

The court said that although the relevant provisions in both documents covered the same subject matter, the purpose behind the provisions was not the same.  The judge expressed some doubt that a shareholders’ agreement could control the constitution in the way provided by the inconsistencies clause - although all parties to the dispute did agree that it could.

Despite the judge’s misgivings about the inconsistencies clause he did state that the clause was unenforceable.  He concluded that there was no inconsistency between the provisions, and, as a result, both the constitution and shareholders' agreement had to be complied with. In the judge’s view, the clause in the constitution was meant to protect the interests of the holders of shares, and the rights attached to the ordinary shares "would be varied, at least indirectly, by the issue of preference shares which would… rank ahead of them".  The relevant clause in the shareholders' agreement was to reserve the power to issue shares to the shareholders.

The judge made it clear that:

• the clause in the constitution served to protect the interests of the holders of specific classes of shares where a share issue is considered

• the clause in the shareholders’ agreement served to remove from the directors the power to issue shares, and reserve this right to shareholders

• the clause in the shareholders’ agreement did not remove the prohibition on varying class rights without the approval of holders of 75% of the shareholders of the affected class.

What Should I Do?

While it is prudent to have a conflicts clause in your shareholders’ agreement you may find that it does not cover all disputes that may arise relating to particular clauses in each of the documents. Your company’s constitution and your shareholders’ agreement may need to be reviewed. A provision of the constitution may well prove to be a handicap to the intention of the shareholders’ agreement.  If that is the case, your constitution will need to be amended to reflect the intention of your shareholders’ agreement. This will serve to reduce the risk of disputes with company’s shareholders in the future.

Changes to both documents may be essential to ensure that, if they are to be read together, so far as possible, they will achieve the parties' intentions.

You should also be mindful of the impact of the Corporations Act 2001, which also regulates the issue of shares, particularly preference shares.

Contact You Legal for confidential legal advice on the effect of your constitution or shareholders’ agreement. It is important that your company clearly establishes its intentions in respect of its operations, rather than ask a court to rule on the matter.

What Next?

Make sure your shareholder’s agreement covers all the non-negotiables – get your FREE Playbook of recommended provisions for a shareholders agreement here.

* This blog is for general guidance only.  Legal advice should be sought before taking action in relation to any specific issues.