Shareholder’s agreement: When a shareholder fails to perform

Shareholder’s agreement: When a shareholder fails to perform

In a recent case in the Supreme Court of New South Wales[1], a question arose as to the entitlement of an ASIC registered shareholder to have access to the records of the relevant company (Company) highlighting the shareholder non-performance consequences. The relevant shareholder (Claimant) demanded to inspect the Company records in circumstances where he had never contributed any value to the Company but was registered as a shareholder because of a promise to obtain a $500,000 credit note from a supplier in favour of the Company, being credit that was essential for the company’s success. The Claimant in this case failed to perform his promise, underscoring the shareholder non-performance consequences.

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Sweat equity and “paid” shares

Many start-up companies are registered with the best intentions of the founders to provide services to the company in consideration for “paid” shares (sometimes called “sweat equity”). Notwithstanding that the “sweat equity” is required to be performed in order for those shares to be paid, it is common when the company is registered for the ASIC register to state that the shares are “paid” with a limited monetary value nominated prior to the performance of the “sweat equity”. This practice often leads to situations that highlight the shareholder non-performance consequences.

In this case, the Claimant not only failed to deliver any credit note to the Company, he added no value whatsoever and, as a consequence of his lack of performance, the other shareholder (Director) who was the sole director was required to secure in injection of capital in the value of $250,000 and run the company on his own. The shareholder non-performance consequences were further exemplified when the Claimant was given multiple opportunities to contribute to the capital injection but he refused and the Director ended up paying the $250,000 into the Company himself and the Company issued further shares to the Director to reflect the contribution, which was recorded with ASIC.

After it became known that the Claimant would not perform, the Company, through the Director, had intended to cancel the shares of the Claimant but, due to the Director being busy running the business alone and the interruption of Covid-19, never got around to it. Five years after the registration of the Company, the Claimant demanded from the Company to have access to all of its records, which was refused on the basis that he was not a paid shareholder of the Company, a decision underscored by the shareholder non-performance consequences.

Rights to view accounts

Eventually the Claimant made an application to the Supreme Court under section 247A of the Corporations Act for an order that the Company release all accounts and financial information of the Company to the Claimant. Consequently, the cost of the application was so expensive that the Company considered it would become insolvency and it was placed into External Administration. The shareholder non-performance consequences culminated in the Director losing all capital that he had injected into the Company and all goodwill he built in the Company over 5-years.

As a result of the appointment of an Administrator, and eventual winding up of the Company, the application was dismissed with no finding as to whether the Claimant was (1) a shareholder; and (2) entitled to receive a copy of the accounts of the Company. However, the shareholder non-performance consequences extended further when the Claimant then applied for a “special” costs order against the Director, and the Director was ordered to pay the costs of the Claimant.

Shareholder’s agreement

Had the shareholders in the Company agreed and signed a shareholder’s agreement at the beginning of the Company, they could have mitigated the shareholder non-performance consequences by agreeing on what consideration each shareholder was required to provide to the Company and what would happen if they failed to perform. Many shareholder agreements include a “bad leaver” clause, which can address the shareholder non-performance consequences by allowing a company may cancel the shares of a founder in the event of non-performance, akin to the shareholder failing to pay for the shares. If the Company had a shareholder’s agreement that gave the Company the right to cancel shares for non-performance of each shareholder’s initial promise, it is likely that the Claimant would never have pursued this action, and it is possible that the Company would still be trading.

In this case, the Director always expected that the Claimant would object to the cancellation of the shares but remained confident that the Company would have been ultimately successfully in having the Claimant removed as a shareholder even without a shareholder’s agreement. However, the Director has acknowledged on multiple occasions that a shareholder’s agreement would have saved him a lot of time and money, further illustrating the critical importance of considering shareholder non-performance consequences in corporate governance.

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[1] The identity of the matter needs to remain undisclosed for the time being for confidential reasons

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