What happens when director shareholders don’t perform their duties?

Director shareholders could run into trouble because of differing views of input and success, leading to a dispute. The first step is to check the governing documents of the business starting with the Articles of Association and Shareholder Agreement. Within a well drafted Shareholder Agreement there will often be a list of ‘trigger events’, allowing for the removal of a shareholder and provisions which require an outgoing shareholder to resign from their office as director. You can place a Shareholder Agreement retrospectively if all of the shareholders are on board. Whilst it is possible to remove a director (who may also be shareholder) as a director via an ordinary resolution which involves a majority vote of over 50% of the remaining shareholders, it doesn’t remove their status as a shareholder. They still have equity.

The director shareholders of growing businesses may sometimes have differing views on the amount of individual work and effort needed to succeed. Over time, this can cause frustration and irreparable damage to working relationships, and hamper business growth. There are a number of legal issues to be aware of but what, if anything, can be done?

In recent months, I’ve dealt with several separate instructions from companies who have asked how they can potentially oust a director shareholder, who in the view of the majority of the shareholders, isn’t pulling their weight within the business anymore. It is especially hard in a business which is fast growing because the whole team needs to be fully committed and focussed on meeting key objectives and deadlines. It could be a reflection of the times or differing expectations within different generations in the business. The recent economic climate means many business sectors have been facing a number of challenges and are perhaps less likely to tolerate a director shareholder not performing effectively.

Whether it is just a difference in the approach of the generations, too high expectations or a person’s behaviour change which is causing concern, then it is important to take legal advice to see what options are available to the company.

Documents and shareholder agreements

The first step is to check the governing documents of the business starting with the Articles of Association and Shareholder Agreement. Shareholder Agreements are not compulsory, so not every business has one. Within a well drafted Shareholder Agreement there will often be a list of ‘trigger events’, allowing for the removal of a shareholder and provisions which require an outgoing shareholder to resign from their office as director. The shareholders agreement should also outline the process and how the valuation of their shares will be determined to enable their removal from the business. For businesses without a shareholder agreement then removing a director shareholder can be more difficult.

In some of the cases I have dealt with recently I have been asked if it is possible to put in place a shareholder agreement retrospectively. If all the shareholders are in agreement, then the answer is yes this is possible. Interestingly, it has improved the situation within one business I worked with, because all of the shareholders had to be in agreement as to what the trigger events for their removal were going to be. It can be the wake-up call that some director shareholders need to get back on track and improve relationships with others. Sometimes improving communication and discussing these issues can help to avoid a more painful and protracted dispute.

If the shareholder were still in breach of their duty after signing the shareholder agreement, even if it was implemented after a business has been operating for some time, then it will set out a potential pathway for that person’s removal.

A shareholder is under no obligation to sign a retrospective shareholder agreement which means the other shareholders may need to consider their other legal options.

The firm’s Articles of Association (governed by the Companies Act 2006) will include details about how directors are appointed and removed and may contain within it provisions which require a director shareholder to step down if they fail to perform their duties.

Whilst it is possible to remove a director (who may also be shareholder) as a director via an ordinary resolution which involves a majority vote of over 50% of the remaining shareholders, it doesn’t remove their status as a shareholder. They will still retain the equity in the business, but they won’t be involved in day-to-day decision making.

If a deadlock situation is created, i.e. 50% of shareholders agree with the removal of the person as a director and 50% against it, then the resolution will not pass and fractures within the business may become more apparent – which may only be resolved through a negotiated settlement. This can be time-consuming, expensive and distract the committed director shareholders away from the day-to-day running of the business. If the court becomes involved it could order that the director shareholder at the centre of the dispute is bought out by the other(s) or they buy out the remaining shareholders, or the business is dissolved and remaining profits split between the shareholders – there is not one outcome for all matters.

What if the shareholder is an employee?

Whilst the focus of this article is on director shareholders, it is also important to note that there can be circumstances where the shareholder is an employee. Their removal from the business can give rise to an employment dispute or unfair dismissal claim so it is important to take legal advice before taking any action.

Depending on whether the decision is taken to remove a director shareholder, there are other legal issues to consider. If the director shareholder has commercially sensitive information, they could provide a serious threat to the success of the business in the future by moving to a rival firm or by setting up in direct competition. Such items often protected against in a well-drafted shareholders’ agreement.

Where there is a breakdown of trust and the relationship between director shareholders, then there can be immediate damage to the business. Taking swift and decisive legal action is important.

Toby Walker is an associate solicitor at Taylor Walton Solicitors.

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