What are the common shareholder disputes in private equity?

We regularly advise private equity firms and their portfolio companies on a range of strategies to build scale and create value in their portfolio. One particularly common area of dispute is where individual (minority) shareholders were never aligned, or stop being aligned, with those strategies, or fall out with the majority shareholders in some other way. 

Where a shareholder has an issue with the way in which a company is being run, and it cannot be resolved, there are two main groups of claims:

  1. Derivative actions
  2. Petitions for unfair prejudice

This article explains the basics of each and gives some high-level tips of how to try to avoid these claims.

Derivative actions

The first category of claims are brought against the directors for breach of their statutory and fiduciary duties under the Companies Act 2006.  These duties are owed by directors to the company and are actionable by the company. The way shareholders can access these claims is through derivative actions.

A derivative claim is a claim brought by the shareholders in their own name, but on behalf of the company to seek remedy against the director(s) for wrongdoing committed against the company.

This provides shareholders with a means of holding director(s) to account for their wrongdoings against the company, even if the company cannot be compelled to sue those director(s) directly through the inaction of directors or other shareholders (so for example where a company is in deadlock or where the majority refuse to take action).

The right to bring a derivative claim is generally confined to the shareholders of the company against which the wrong has been committed, but it also includes a person to whom shares:

  • Have been transferred but not yet formally registered as a shareholder of that company.
  • Transmitted by operation of law (e.g. to a trustee in bankruptcy or the personal representatives of the deceased shareholder).

A shareholder may bring a statutory derivative claim against a director for any of the following reasons:

  • Negligence of a director i.e. a breach of a director’s professional duty of care to the company.
  • Default/failure of a director to perform their obligations under the Companies Act 2006.
  • Breach of a contractual, tortious, or fiduciary duty of a director to the company.
  • Breach of trust by a director to the company.

To bring a claim, a shareholder must first seek permission from the court to commence derivative proceedings.  The court will consider whether to grant permission to bring the derivative claim based on whether there is a prima facie case to bring.

If the court considers there to be a prima facie case, a hearing will take place at which the court will decide whether the application should be allowed to continue.

Permission (or leave) must be refused if the court is satisfied:

  • That a person acting in accordance with section 172 (duty to promote the success of the company) would not seek to continue the claim.
  • Where the cause of action arises from an act or omission that is yet to occur, that the act or omission has been authorised by the company.
  • Where the cause of action arises from an act or omission that has already occurred, that the act or omission was authorised by the company before it occurred or has been ratified by the company since it occurred.

Where the court is satisfied that none of the above apply, it will consider whether to exercise its discretion to give permission and will consider:

  • Whether the shareholder bringing the claim is acting in good faith.
  • Whether a person promoting the success of the company would bring such a claim.
  • Whether the act or omission is likely to be authorized or ratified by the company.
  • Whether the shareholder has another remedy they can pursue in their own name.

In summary, although there is a mechanism for shareholders to bring such claims, there are some difficult bars to clear first which are designed to protect the company from claims to enforce its directors' duties that may not be in its best interests.

Unfair prejudice

An unfair prejudice petition is a claim typically brought by a minority shareholder in relation to the conduct of a company under section 994 of the Companies Act 2006 (the "Act"). The grounds for bringing a petition are either:

  1. That the company's affairs are being or have been conducted in a manner that is unfairly prejudicial to the interests of members generally or of some part of its members.
  2. That an actual or proposed act or omission of the company is or would be so prejudicial.

The provision gives protection to minority shareholders where the conduct of the company is both prejudicial (causes harm to the members' interest) and unfair. The test of unfairness does not require the conduct to be in bad faith, only that a reasonable bystander would consider it to be unfair in the context of a commercial relationship and considering the company's articles.

The meaning of unfairly prejudicial conduct was considered by our team in this earlier article: Unfair Prejudice claims: The case of Cardiff City Football Club | Foot Anstey. In this piece, we discussed the importance of directors considering the interests of minority shareholders, as even when their conduct is commercially justified and in accordance with their duties, it could still have the effect of prejudicing the interests of the minority in favour of majority shareholders. 

The types of company conduct that may be sanctioned under this provision include:

  • Excluding management where there is a legitimate expectation of participation.
  • Redirecting business to another company in which a majority shareholder has an interest.
  • Awarding excessive financial benefits to a majority shareholder.
  • Abusing power and breaching the company articles.

Under s996(2) of the Act, the Court may make an order to:

  • Regulate the company's conduct or affairs in the future.
  • Require the company to (i) refrain from taking or continuing an action; or (ii) take an action that the petitioner has complained it has omitted.
  • Authorise civil proceedings to be brought in the name of and on behalf of the company.
  • Prevent the company from amending its articles without leave of the court.
  • Provide for the purchase of shares of any member of the company by other members or the company itself (in practice this is the most common remedy awarded).

Why are these claims relevant to PE firms and their portfolio companies?

It's fairly common to see tensions between shareholder groups in newly acquired companies whether involving PE or otherwise.  Our experience is that these kinds of claims are commonly encountered by private equity owned companies due to a frequent, inherent tension between the often short term interests of the original (now minority) shareholders of a company and the plans for the company (often towards a medium term anticipated exit) for their new (majority owners).

Most of the time both sets of claims are about protecting “the bargain” represented by the limited company structure and its constitutional documents.  Claims become harder to pursue and harder to win where a company's articles of association and its shareholders’ agreement are future-proofed at the point of acquisition, making them fit for purpose and where they are complied with consistently.  A lot of the disputes that we see most commonly arise where the new majority seeks to change “the bargain” later, making changes to equity structures, etc. Very often these are perfectly legitimate and for many good reasons, but we find most disputes arise when someone is affected financially, or where their expectations of realisation on exit change materially. Given the challenging financial circumstances in the last couple of years, we have seen an increase in these types of claims.

How can these claims be avoided? 

Most of the time, prevention is better than cure so thought should be given to incentivisation and integration of management teams through deal structures and post-integration planning. Our PE team regularly works with PE firms and portfolio companies to plan and deliver their post-acquisition strategy - more information about our services can be found here: Post-acquisition Integration | Foot Anstey.

Where disputes do arise, the key is to engage early rather than to let matters simmer.  There are often early warning signs ranging from opposition to integration steps after acquisition and insistence on maintaining the economic identity of the acquired business, to more obvious opposition to plans, such as refusing to agree to necessary shareholder approvals and resolutions. Of course, it is always important to engage in good governance and decision making, which is compliant with the company’s constitutional documents, but a sharp focus falls on these processes if disputes later arise.

If this article raises any questions, please do get in touch with our expert team who can advise.

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