The Perils of Shareholders Agreements in South Africa

How enforceable are the clauses in your company’s shareholders agreement?

Unfortunately, for many shareholders an investigation into the legal aspects regulating shareholders agreements will lead to the conclusion that many of the provisions in their shareholders’ agreements are void.

When buying shares in a private company or forming a new private company, it is common practice to enter into a shareholders agreement with company’s other shareholders. The shareholders agreement is intended to regulate the important internal governance structures of the company like the appointment of directors and the calling of directors and shareholders meetings, and in many instances give important protection mechanisms to minority shareholders.

In many cases shareholders agreements are concluded without the shareholders considering the impact that the company’s constitutional documents (the company’s memorandum of incorporation (MOI) might have on the validity of the shareholders agreement.

This means that it is common for a company’s MOI to render many clauses in a shareholders agreement void and unenforceable if there is a dispute between the shareholders.

To understand why, I will briefly explain how the practice of concluding shareholders agreements without the necessity to consider the company’s MOI developed in terms of the old Companies Act (Act No 61 of 1973), and the significant changes that the new Companies Act (Act No 71 of 2008) had on this practice.

The Historical use of Shareholders Agreements

Under the old Companies Act a company’s constitutional documents were its memorandum of association and articles of association. These documents, and any amendments to them, had to be registered at the Registrar of Companies and became public documents that were open to inspection. An amendment to the articles of association needs to be registered, and this makes the provisions that regulate the company’s internal affairs public.

A shareholders agreement was, however, a private contract that didn’t need to be registered. It could be concluded between the shareholders at any time, even after the company’s incorporation, and it was enforceable between the shareholders and the company even though it was not registered.

A shareholders agreement could be used to regulate important aspects of the company without amending its articles of association and making those provisions public.

Provisions in the shareholders agreements were often in direct conflict with the company’s articles of association. To counteract this a shareholders agreement would typically include a clause stating that if there was any conflict, the shareholders agreement would be the document that takes precedence. Under the old Companies Act a provision like this, making a private shareholders agreement trump the company’s public registered constitutional documents, was permitted in law.

Practically this lead to a situation where a private company’s constitutional documents could effectively be ignored by its shareholders, and the shareholders would merely regulate the affairs of the company through a shareholders agreement.

Changes to Shareholders Agreements under the New Companies Act

The new Companies Act has, however, dramatically changed the possible scope and effectiveness of shareholders agreements in two ways:

  • it has altered how conflicting clauses the MOI and a shareholders agreement are resolved; and
  • it has curtailed what the shareholders are entitled to regulate in a shareholders agreement by now providing that some issues can’t be changed or regulated at all (unalterable provisions), and that some issues can be regulated but only if they are regulated in the MOI (alterable provisions).

The New Companies Act: Conflicts between the MOI and Shareholders Agreements

Shareholders agreements aren’t prohibited under the new Companies Act, but it does limit the potential ambit of shareholders agreements by requiring that any shareholders agreement must be consistent with the provisions of the act and with the company’s MOI (section 15(7)).

If there is any inconsistency between the shareholders agreement and either the Companies Act or the company’s MOI, then the conflicting provision in the shareholders’ agreement is void and will be unenforceable (section 15(7)).

A clause in a shareholders agreement that provides that the shareholders agreement will take precedence over the memorandum of incorporation if there is a conflict is void, first because the clause would itself be a provision that is inconsistent with the act (section 15(7)), and secondly because it would fall afoul of the acts anti avoidance provisions by attempting to defeat or reduce the effect of the acts prohibitions or requirements (section 6(1)). These types of provisions would not provide any assistance to the shareholders if they attempt to enforce a conflicting provision in a shareholders agreement.

Under the new Companies Act shareholders are still entitled to enter into shareholders agreements, but they must now inspect the company’s MOI before concluding these agreements to make sure that the shareholders agreement doesn’t conflict with the MOI.

If there is a conflict between what is in the MOI and what is in the shareholders’ agreement, the clause in the shareholders’ agreement is void and gives the shareholders’ no protection.

The New Companies Act: Unalterable and Alterable Provisions

A legal aspect that is related to the requirement that a shareholders agreement must be consistent with the company’s MOI, is the introduction of the concept of “unalterable” and “alterable” provisions by the new Companies Act.

The new Companies Act contains provisions and principles that are stipulated as unalterable. A company’s MOI can’t contain any clause that negates, restricts, limits, qualifies, extends or alters the substance or effect of an unalterable provision (section 15(2)(d)). Any attempt to alter these unalterable provisions in the MOI will be void (section 15(1)).

Likewise, these unalterable provisions of the Companies Act can’t be negated or altered by the shareholders in a shareholders agreement because these provisions in the shareholders’ agreement would be contrary to the act, and void (section 15(7)).

Opposed to unalterable provisions, the new Companies Act contains provisions and principles that are specifically stipulated as being alterable. These alterable provisions may, however, only be altered if they are expressly altered by the company in its MOI (section 19(1)(c)(ii)). (A company did have a two year transitional period to update its MOI, but this period ended on 30 April 2013. I have previously written an overview of the Companies Acts transitional period for shareholders agreements here.)

Any attempt by the shareholders to alter an alterable provision by concluding a shareholders agreement will be void because these provisions in the shareholders’ agreement would be contrary to the act (section 15(7)).

Limitations Placed on Shareholders Agreements

A shareholders agreement:

  • can’t be used to alter an unalterable provision in the Companies Act; and
  • can’t be used to alter an alterable provision in the Companies Act; and
  • can’t conflict with any provision in the company’s MOI.

These legal restrictions didn’t exist under the old Companies Act, meaning that shareholders agreements prepared according to the old Companies Act could be void under the current act. Also, it means that when preparing new shareholders agreements care should be taken to ensure that the new shareholders agreement complies with the new Companies Act.

Unfortunately it is not possible to give a complete list of unalterable and alterable provisions in this article, but a list of the most common clauses that are found in shareholders agreements, that may be void because they conflict with the Companies Act are briefly discussed.

Unalterable Provisions

The following provisions can’t be altered at all, and any clause in a shareholders agreement that conflicts with them will be void:

  • A private company must restrict the offer of shares to the public (section 8(2)(b));
  • A private company must restrict the transferability of its shares (section 8(2)(b));
  • If a company has more than 2 shareholders, a meeting may not begin or a matter may not be decided, unless 3 or more shareholders are present (section 64(3);
  • Private and public companies must provide for the election by shareholders of at least 50% of the directors, and 50% of any alternate directors (section 66(4)(b));
  • A company may only pay remuneration to its directors for their service as directors if the remuneration has been approved by special resolution within the previous 2 years (section 66(8) and (9));
  • The Companies Act takeover regulations apply to private companies if the percentage of the issued securities of that company that have been transferred within the period of 24 months immediately before the date of a particular affected transaction or offer exceeds the prescribed percentage (section 118(1)).

Categories of Provisions that are Alterable Only in the MOI

These are alterable provisions that can only be altered in a company’s MOI. An attempt to regulate these matters in a shareholders agreement will be void.

These aspects of a company and its management can only be regulated in the MOI:

  • Management of the Company:
    • the removal of the boards power to make binding interim rules that are incidental to the governance of the company (section 15(3));
  • Amendment of the MOI:
    • the change in the requirements that must be met to amend the company’s MOI (by default the MOI can be amended by a special resolution which may be proposed by shareholders that hold 10% of the voting rights) (section 16(1) and (2));
  • Shareholders Rights and Protections:
    • the addition of shareholders rights to access information relating to the company and its management (by default only certain listed information and documents can be accessed by shareholders) (section 26(3));
    • the addition of an obligation for a private company to have its annual financial statements audited (section 30(2)(b));
    • the alteration of shareholders rights to appoint concurrent proxies, and the proxies right to further delegate authority (section 58(3));
  • The Regulation of Shareholders Meetings:
    • the right to call a shareholder meeting (section 61(3), (4) and (11));
    • the location of shareholder meetings (section 61(9));
    • the notice period required for a shareholder meeting (section 62(1));
    • participation at a shareholder meeting by electronic communication (section 63(2));
    • quorums (section 64(1) and (2));
    • meeting adjournments (section 64(4), (5) and (6));
  • Regulation of the Board of Directors
    • the minimum number of directors to be appointed (section 66(2) and (3));
    • the procedure used to appoint directors (section 66(4) and 68(2));
    • minimum qualifications and grounds of ineligibility or disqualification of directors (section 69(6));
    • the power to appoint board committees (section 72(1));
  • The Regulation of Directors Meetings:
    • the right to call a directors meeting (section 73(1));
    • participation at a directors meeting by electronic communication (section 73(3));
    • the notice period required for a directors meeting (section 73 (4));
    • quorums (73(5)(b))
    • voting of directors (section 73(5)(c) and (d));
    • casting votes (section 73(5)(e));
  • Company’s Shares
    • the classes of shares that a company is permitted to authorise, and the rights attaching to the shares, must be contained in the MOI (section 36(1));
    • the board has a wide discretion regarding the company’s securities, including:
      • the power to alter the authorised share capital of the company, classify, and reclassify shares (section 36(3));
      • the power to issue secured or unsecured debt instruments (section 43(2));
      • the power to issue debt instruments that may grant the holder grant special privileges, such as voting at general meetings, and the allotment of shares (section 43(3));
      • the power to issue any of the company’s shares as capitalisation shares (section 47(1))
  • Boards Power to Issue Securities Other than Shares:
    • The board has the power to issue secured or unsecured debt instruments at any time.
    • The board has the power to issue debt that grants special privileges, which may include the privilege to (i) attend and vote at general meetings; (ii) appoint directors; or (iii) allotment of securities, redemption by the company, or substitution of the debt instrument for shares of the company (section 43(3)).
  • Boards Power to Give Financial Assistance for the Subscription of Securities (section 44)
  • Boards Power to Give Loans and Financial Assistance to Directors and Related Parties (section 45)

Ensuring that the Shareholders Agreement complies with the Companies Act

When buying shares in a private company or forming a new private company, it is important to ensure that when a shareholders’ agreement is entered into, that the shareholders agreement is fully valid.

A comparison between the shareholders’ agreement and the company’s MOI must be done:

  • no changes can be made to an unalterable provision of the Companies Act at all;
  • if the shareholders want to change the application of any alterable provisions, this must be done in the MOI because the provision will be void if it is only in the shareholders’ agreement;
  • if there is any inconsistencies between the MOI and the shareholders’ agreement, the provision in the shareholders’ agreement will be void.

An important observation to take away from this discussion is that the MOI, not the shareholders’ agreement, should be the primary focus for shareholders.

How enforceable are the clauses in your company’s shareholders agreement?

This work by Clinton Pavlovic is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.

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