Minority Shareholder Protection — SQE1 FLK1 Business Law and Practice

Two people founded a software company and ran it together for eight years. One holds 60% of the shares, the other 40%. Both were directors from the start, both drew equal salaries, and each was to have a say in how the business was run. The articles allow shares to be transferred only to existing members.

Then they fell out. The majority holder removed the other from the board by ordinary resolution, with the special notice the Act requires. Perfectly lawful. The minority holder keeps the shares, but has no part in management, no salary, and no way out.

Is there a remedy? Yes. And why there is one, when nothing unlawful has happened, is the whole of this topic. Keep those two in mind.

Here is the route. The rule in Foss v Harbottle first, because everything after it is a way round it. Then unfair prejudice, the remedy you will meet most. Then quasi-partnerships, which decide when lawful conduct becomes unfair. Then what the court can order. Then derivative claims and the permission filter. Then winding up, personal actions and reflective loss. And finally class rights.

Start with the problem. Companies run on majority rule. More than 50% of the votes carries an ordinary resolution and 75% carries a special resolution. So a minority can be squeezed by excessive director pay, by a dividend policy that suits the majority, or by simply being shut out.

Four remedies answer that. Unfair prejudice, under s.994 of the Companies Act 2006, much the most used. A derivative claim, under ss.260 to 264, to enforce the company's own rights. Just and equitable winding up, under s.122(1)(g) of the Insolvency Act 1986. And a personal action, where your own rights as a member are infringed.

But first, the rule that makes them necessary. Foss v Harbottle, 1843. Minority shareholders sued the directors for misapplying the company's funds, and they sued in their own names. The claim was dismissed. Two principles came out of it. The proper claimant for a wrong done to a company is the company itself. And where the wrong is one the company can ratify, an individual member cannot sue.

The reasoning is separate legal personality. The company is a person distinct from its members, so a wrong to it is its wrong, and the member's loss is only a reflection of it. But notice the trap. If the wrongdoers control the company, they can stop the company suing them.

Now the remedy itself. A member may apply to the court on one ground. That the company's affairs are being, or have been, conducted in a manner unfairly prejudicial to the interests of members generally. Or of some part of its members, including at least himself. Two phrases there decide most questions.

Prejudice, and unfairness. The prejudice must be to your interests as a member, not in some other capacity. And the conduct must be unfair, judged objectively, by standards of fair dealing. Two separate hurdles. Clear one and not the other and the petition fails.

Unfairness is where petitions die. In O'Neill v Phillips, 1999, a minority shareholder complained when the majority holder withdrew an informal profit-sharing arrangement. The petition failed. Unfairness means one of two things. A breach of the terms on which it was agreed the affairs would be conducted. Or the use of legal rules in a way equity would regard as contrary to good faith.

So test the line. A woman buys 30% from a retiring member. The founder says she might in time join the board, and that they will see how it goes. Nothing is agreed, and the price she pays is fixed on the footing of a minority holding with no board seat. Five years later he declines. Unfair? No. Disappointment is not unfairness.

What does qualify? Exclusion from management, above all. Excessive remuneration to director-shareholders. Withholding dividends while paying high salaries. Diverting business opportunities. Breach of a shareholders' agreement. Issuing shares to dilute a minority. Picture two brothers paying themselves £400,000 a year and declaring no dividend for five years, while the third member gets nothing.

Now the limiting words. Interests of members. Prejudice to interests you hold in another capacity, as employee, creditor, landlord or director, falls outside. A man holds 10% under a scheme open to all the staff, was never a director, was promised nothing about management, and is dismissed as warehouse manager. He keeps his shares, his votes and his dividends. That is an employment complaint.

Now the idea that does the real work here. The quasi-partnership. In Ebrahimi v Westbourne Galleries, 1973, Lord Wilberforce identified three characteristics. An association formed on a personal relationship involving mutual confidence. An understanding that some or all of the shareholders will participate in running the business. And a restriction on transferring shares, so an excluded member cannot take out his stake and go elsewhere.

Not a checklist. His words were one, or probably more. And the consequence matters more than the label. In a quasi-partnership, conduct that is perfectly lawful may still be unfairly prejudicial, because it defeats the understanding the members associated on. Back to our two founders. Personal relationship, shared management, transfer restriction. All three.

Removing a director by ordinary resolution is a power the members are given under s.168, and no agreement can take it away. So the removal was lawful. That is where the analysis begins, not where it ends. If lawfulness were an answer, s.994 would add nothing.

If the petition succeeds, s.996 gives the court a wide discretion. Such order as it thinks fit. It may order the respondent to buy the petitioner's shares, or the company to buy them. It may regulate the future conduct of the company's affairs. And it may authorise civil proceedings in the company's name.

In practice the purchase order is made in most cases. Once the relationship has gone, let one side buy the other out. Then the money question. Where the company is in substance a partnership and the petitioner was unfairly excluded, the shares are valued rateably, without the discount usually applied to a minority holding.

Two reasons for that. The petitioner is not a willing seller. And a discount for lack of control would let the wrongdoer buy at a price cut by his own wrong. So a 20% holding in a company worth £1 million fetches £200,000, not £140,000.

The date matters as well. The starting point is the date of the order. But the court may take an earlier one where fairness requires it. Two designers excluded the third, then moved the best client accounts to a studio of their own, taking the agency from £2 million to £700,000. The fair date is the exclusion.

One more point, and it decides real cases. Once the respondent offers to buy the shares on reasonable terms, the unfairness is removed and pressing on becomes an abuse liable to be struck out. Reasonable means pro rata value, no discount, a jointly instructed independent expert, and your costs.

Derivative claims now, and the shape is different. Here the wrong is done to the company, the cause of action is the company's, and any recovery goes to the company, not to you. Section 260 confines it. The claim must arise from an act or omission involving negligence, default, breach of duty or breach of trust by a director. It may be brought against the director, another person, or both.

It does not matter that the cause of action arose before you became a member. But you need the court's permission, in two stages. First, on the papers, does the application disclose a prima facie case? If not, the court must dismiss it. Then a full hearing.

At that hearing s.263 does the work, in two halves. Three mandatory bars, where the court must refuse. That a director acting under s.172, the duty to promote the success of the company, would not continue the claim. That the act was authorised. Or that it was ratified.

Then five discretionary factors. Whether the member is acting in good faith. The importance a s.172 director would attach to continuing. Whether the act could be, and is likely to be, ratified. Whether the company has decided not to pursue the claim. And whether the member could bring a personal claim instead.

Ratification deserves a moment. It is the bar that most often ends these claims. Under s.239 the votes of the wrongdoing director, and of anyone connected with him, are disregarded. So a family voting to ratify its own member's embezzlement achieves nothing. And fraud or misappropriation of company property cannot be ratified at all. Mere want of care can.

Then the practical objection. Derivative claims are expensive, the money goes to the company, and the costs land on you. The court can order the company to indemnify a member acting reasonably and in good faith, but it is not guaranteed. This is why they are rare.

Just and equitable winding up. Under s.122(1)(g) of the Insolvency Act 1986 the court may wind a company up where it thinks that just and equitable. Solvency is beside the point. The grounds are breakdown of trust and confidence, deadlock, exclusion from management in a quasi-partnership, failure of the company's substratum, and fraud or illegality.

Substratum means the purpose the company was formed for. Two people incorporate to develop and sell one patented medical device, the articles record that object and no other, and the patent is revoked. That company can be wound up.

But s.125 lets the court refuse where another remedy is available and the petitioner is unreasonable not to pursue it. A firm offer to buy the shares is exactly that. Winding up destroys a going concern a purchase order would preserve. A last resort, and rare.

Personal actions. Where the wrong is done to you, you sue in your own name. Breach of a shareholders' agreement you are party to. Breach of the articles affecting your personal rights, s.33 making them a contract between the company and its members and between the members themselves. Acts beyond the company's capacity. Fraud on the minority. Infringement of class rights without consent.

The classic personal right is the vote. A chairman declares a resolution carried by 52% to 48%, having rejected proxy votes he says arrived late. The company's own records show they arrived a clear day before the deadline, and counting them would have defeated it. The right to have your votes counted belongs to you.

Now the rule that catches the unwary. Reflective loss. A shareholder cannot recover a fall in the value of his shares where that loss is the shadow of one the company has suffered and can sue for. A company and its shareholder both sued the same solicitors, and the shareholder's claim for the fall in his shares was barred.

In Sevilleja v Marex Financial, 2020, the Supreme Court confined the rule. It applies to a shareholder suing as a shareholder, for that kind of loss, and to nothing else. A creditor is not barred, even one who happens also to hold shares. So a supplier with an unpaid judgment of £100,000, who also holds 15%, sues as a creditor and is not caught.

Finally class rights. Different classes carry different rights, and a class is protected against having them varied without consent. Under s.630 you follow the procedure in the articles. If the articles are silent, you need the written consent of the holders of 75% of the class by nominal value. Or a special resolution at a separate meeting of that class.

There is also a right to object. Holders of at least 15% of the class who did not consent may apply to have the variation cancelled, within 21 days of the resolution. The court cancels it if satisfied the variation would unfairly prejudice the class. That window is short, and it runs from the resolution.

But everything turns on whether what is proposed is a variation at all. In White v Bristol Aeroplane, 1953, a company issued bonus ordinary shares, and the preference shareholders said their class rights had been varied because their voting power was diluted. No variation. Their rights were exactly what they had been before. Affected, not varied. Only variation triggers class consent.

So which remedy? Ask who was wronged. The company, and it is a derivative claim. You, and it is unfair prejudice or a personal action. Then ask what you want. Out, with money, and it is a buyout under s.994. The company made whole, and it is a derivative claim. Back to our minority holder. Section 994, and no minority discount.

A word on how SQE1 tests this. You are not asked to recall case names or section numbers. You get a scenario, five answers, and one instruction: pick the best. So learn the rules and how they decide facts. The names in this episode are memory pegs, nothing more.

If you keep only three. Foss v Harbottle, for the proper claimant rule, because every remedy here is a way round it. O'Neill v Phillips, because unfairness needs a broken agreement or bad faith, not a disappointed hope. And Ebrahimi v Westbourne Galleries, for the three marks of a quasi-partnership, which is what turns lawful conduct into unfair prejudice.

Four traps. One: lawful is not the end of the analysis. Every quasi-partnership petition begins with something the majority was entitled to do. The question is whether it defeated the understanding the members associated on.

Two: watch the capacity, and watch whose conduct it is. The prejudice must be to interests as a member, so a dismissal or an unpaid debt is outside. And the section reaches the conduct of the company's affairs. Where three director-shareholders petitioned against the fourth for joining a competitor, the section was not engaged.

Three: varying class rights and affecting them are different things, and the distinction is narrow and heavily tested. Issue more shares and a class loses voting strength, but its rights are untouched. No consent needed. A class wanting protection against dilution must bargain for it.

Four: do not reach for the drastic remedy. Winding up ends the company, and the court can refuse it where another remedy is open and you unreasonably decline it. Derivative claims are expensive and the recovery is not yours. Most disputes end in a negotiated buyout.

Quick check. A member holding 25% of the shares has discovered that one of the company's directors took secret commissions from suppliers for placing orders with them. The company paid £150,000 more for its goods than it should have, and the director has repaid nothing. The board will not act, and the conduct has not been ratified.

She is content to remain a member, and wants the money restored to the company so all the members benefit. Which remedy should she pursue? Three candidate answers. One: an unfair prejudice petition, the only remedy for a director's misconduct.

Two: an unfair prejudice petition, because that would let her sell her shares and leave. Three: a derivative claim, because the loss is the company's and any recovery belongs to it. Pause here if you want a moment.

The answer is three. Accepting a benefit from a third party by reason of being a director is a breach of duty owed to the company. The company overpaid, so the cause of action is the company's. A derivative claim is how a member enforces it when those in control will not, and the recovery restores every member's shares rateably.

Why the others fail. One is far too wide. A breach of duty by a director is the paradigm subject matter of a derivative claim. Two identifies a real procedure but the wrong objective. A buyout takes her out of a company she wants to stay in, and leaves the £150,000 where it is.

Five things to take away. One: the company is the proper claimant for a wrong done to it, and a member's loss is usually only its reflection. Two: unfair prejudice needs prejudice to your interests as a member, plus unfairness measured against what was agreed. Lawfulness is no answer on its own.

Three: the marks of a quasi-partnership are a personal relationship, an understanding of participation, and a restriction on transfer, and a buyout there carries no minority discount. Four: a derivative claim is the company's cause of action, needs permission in two stages, and fails if the act was authorised or ratified.

Five: class rights need 75% to vary, and a dissenting 15% has 21 days to object. And our two founders? Quasi-partnership, exclusion, no way out. A s.994 petition, and a buyout at full pro rata value. Next time, Capital Maintenance and Distributions.

Practise this topic with exam-style questions at sqe1prep.co.uk. This episode is for education and exam revision only, not legal advice, and we are not affiliated with or endorsed by the SRA or Kaplan.