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Shareholder Disputes Increase: How To Manage Risks?

Emma Allen and Edward Chapman

8 January 2024

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The authors are Emma Allen, senior counsel, Edward Chapman, partner

The current macroeconomic environment has created an ideal breeding ground for shareholder disputes. Sustained economic pressure arising from geopolitical crises, inflation, rising interest rates, and reduced market liquidity is leading to a general increase in commercial disputes, but a recurring theme is disputes between shareholders.  

Companies which have not reached maturity (i.e. those in their start up, growth or expansion phases), are particularly impacted by this trend. Those businesses typically have relatively short cash runways, meaning that they are less able to deal with balance sheet stressors. Companies in the growth/expansion phase have also often completed several equity funding rounds, which can result in complex cap tables with multiple classes of shares, differing voting/participation rights, and economic misalignment. That can become problematic when the business wants (or needs) additional investment as new investors typically want more straightforward share structures.  

This is often when shareholder disputes arise and early input from a lawyer to manage the risks is essential, particularly where the valuation of the company has stalled or fallen. If, in those circumstances, the board determines that the company will require additional investment soon, it should first conduct a careful analysis of all available sources of investment.  

This is usually a choice between debt or equity financing:

-- current economic and trading conditions mean that debt finance is not as readily available as it has been, particularly for cash-strapped companies; and

-- the volume and value of equity financing rounds has fallen dramatically from the highs of 2021, with companies struggling to attract fresh investment at all stages.

Existing shareholders might be asked to make further equity injections (or indeed to provide debt financing by way of a short-term loan) to stave off insolvency, but they may not be able or willing to do so. 

That leaves the board with limited options and, in those circumstances, those who are willing to provide funds will often seek to ensure that they are rewarded for the risks they are taking, whether through enhanced liquidation preferences or by enforcing terms that are highly dilutive to non-participating shareholders (e.g. forced conversions of preference shares into ordinary shares).

Careful consideration needs to be given to the relevant consents which are needed to make any proposed changes to the classification of shares and the rights attaching to them. That is often anticipated and catered for in the company's articles of association and shareholders' or investment agreements, but even if a dilution or re-classification of shares has taken place strictly in accordance with the company's articles and other relevant agreements, relationships between majority and minority shareholders can quickly become strained, particularly where the minority shareholders have played a significant role in establishing and managing the company.  

If it is not communicated and handled sensitively, that can lead to a disgruntled group of shareholders and potentially complaints of unfair prejudice. That can linger over the company for years where those unhappy shareholders adopt a "wait and see" strategy of reserving their position and waiting for the company's valuation to increase before deploying their claim at a strategically important juncture for the company (e.g. when an exit event is looming). 

Some tips for mitigating and managing the risks are:
1. Ensure clear communication from the outset. Regular updates should be given to all shareholders regarding the company's financing needs and clear summaries should be provided of the alternative options being considered and explored to obtain that financing. It is particularly important to ensure that there can be no suggestion that any material fact was concealed from shareholders as that could have the consequence of extending the limitation period for claims; 

2. Thorough record-keeping in relation to decision-making; 

3. Careful consideration of the articles and other key documents such as shareholders' agreements. That should include an analysis of all consents and approvals needed to make any proposed changes to the articles or other agreements and an analysis of how any proposed investment or changes to shareholder rights will impact each class of existing shareholders. That might involve offering participation rights which go above and beyond what is strictly required to reduce the risk of complaints;

4. Conflicts of interest should be carefully considered, declared and recorded. Particular complaints can arise where the board is populated by majority shareholders, or their representatives and it is often advisable to identify the financial interests of all directors and how they might benefit from the transactions proposed. Where possible, the board should seek to establish a sub-committee of directors who do not have a financial interest in the company to manage the process; and 

5. Consider whether additional legal advice is required, for example in relation to directors' duties, including considering whether insolvency advice is needed.