When people go into business together, it’s common for them to enter into a Shareholders’ Agreement to govern how they will own and administer their company.
Our preference is to use a tailored version of the company’s ‘Constitution’ as the primary instrument to regulate the affairs of a company. In this article, we talk about the reasons why.
Why would you use a tailored Constitution?
Our reasons for this include:
Simplicity
A Constitution provides a single source of rules about the company – which makes it easier for all members to use, including members who may not be experienced in interpreting multiple, and sometimes conflicting, documents, (i.e. a Constitution and a Shareholders Agreement).
That said, having all the rules governing the company in one place does produce a relatively long document. However, if you put the normal Constitution and Shareholders’ Agreement together, you often find that the total is longer than a single tailored Constitution – because with two documents you get the unnecessary double-up of provisions (which are often inconsistent).
Consistency
Following on from the above point, if all the provisions governing the company are contained in the one document you avoid the chance of a dispute as to which document takes precedence. Although most Shareholders’ Agreements override a constitution to the extent of any inconsistency, it is not always clear when an ‘inconsistency’ exists. For example, does an additional requirement in one document amount to an inconsistency with the other document?
Transfers and succession
When a new member joins the company by subscribing for or acquiring shares they are automatically bound by the Constitution, without having to sign a further document. This is particularly important when shares are transferred on the death of a member – when the recipient is receiving the shares as a ‘right’ under a Will, rather than ‘negotiating’ to become a member. It is also relevant when a member becomes insolvent, as the terms of the Constitution will automatically bind the external administrator as a consequence of them taking a transfer of the shares, (whereas they would ordinarily have the option of voiding a contractual Shareholders Agreement).
Administration
As a practical matter, a Shareholders’ Agreement rarely gets signed by all the members and can be overlooked when new members are admitted. However, with a Constitution, agreement to the terms of the Constitution is automatically part of the process of becoming a member.
Modification
A Constitution, or certain provisions within a Constitution, can be modified by less than unanimous agreement between members (usually 75% by way of a special resolution). In contrast, a change to a Shareholders’ Agreement generally requires unanimous consent – even to a very small change.
Some Shareholders’ Agreements provide that a future change may be made to the agreement by less than unanimous consent. In our view, this amounts to an ‘agreement to agree’ which is not legally enforceable. Whilst it is possible to incorporate ‘power of attorney’ provisions in a Shareholder Agreement to mitigate this issue, these are complex and often give rise to disputes between parties to the Shareholders’ Agreement.
Statutory contract
A Constitution acts as a statutory contract between the company and its directors, and between the company and its members, not just as a contract between the members. (See section 140 of the Corporations Act) This fact is important for directors who may be required to act in accordance with a Shareholders’ Agreement that would ordinarily be inconsistent with their duties as a director. If the requirements are contained in the Constitution, then the directors are not subject to this conflict.
Replaceable Rules
A provision in a Constitution will displace a ‘replaceable rule’ under the Corporations Act, whereas a provision in a Shareholders’ Agreement will not automatically displace a replaceable rule. Accordingly, acting in accordance with a Shareholders’ Agreement may cause an inadvertent breach of a replaceable rule in the Corporations Act. Using a Constitution will avoid this issue.
Embedded rights
When valuing a share in the company the rights and obligations under the Constitution must be considered, as they form part of the ‘interest’ of the member in the company, as represented by their share. On the other hand, rights and obligations under a Shareholders’ Agreement are more akin to an ‘encumbrance’ against the interest, or a separate ‘collateral agreement’ having its own value.
This can be relevant if a shareholder becomes insolvent, because an external administrator holding shares would ordinarily be able to void the terms of the Shareholders’ Agreement, but must take the shares subject to the rights in the Constitution.
Why would you want a Shareholders’ Agreement?
There are reasons why a separate Shareholders’ Agreement may be used in preference (or more accurately, in addition) to a Constitution, including:
Privacy
For a public company, the Constitution must be lodged with ASIC, and therefore becomes a public document, whereas, the provisions of a Shareholders’ Agreement may be kept private, (at least initially). That said, Shareholders’ Agreements are rarely used in the context of public companies. The Constitution of a private company does not need to be lodged with ASIC, and present and former members can agree to adhere to confidentiality provisions.
Amendments
It is only possible to amend a Constitution by means of a special resolution passed by a 75% majority vote. (We note that it is also possible to include in the constitution a higher threshold, e.g. unanimity.) Arguably, a Shareholders’ Agreement can contain a mechanism to achieve an amendment with a lower majority, (using powers of attorney). However, this is not simple to achieve and is rarely used properly.
Inconsistency with Corporations Act
Any provision of a Constitution that is inconsistent with the Corporations Act will be invalid. It is arguable that a Shareholders’ Agreement may contain provisions that are inconsistent with the Corporations Act and yet still be valid in itself.
However, in practice, while the Shareholders’ Agreement may not itself be invalid, any exercise of those powers will likely cause a similar breach of the Corporations Act, and therefore either be invalid or give rise to remedies.
Our conclusions
So, on balance, we prefer the use of appropriately drafted tailored Constitutions in place of Shareholders Agreements.
If you are going into business with other people call us on 1300 654 590 or email us for a tailored Constitution that will take the stress out of owing and administering your company.
The information contained in this post is current at the date of editing – 17 June 2024
