Article reference: UK-IA-SHA12

Preventing conflicts between shareholders and directors using a shareholders' agreement

Conflicts can occur when a director-shareholder, who as a director is accountable to all company owners, makes an operational decision that some other shareholders disagree with.

It is often difficult to ascertain whether he was carrying out his duty as a director or acting in his interests as an owner.

This article discusses how to minimise conflicts by using a shareholders' agreement.

A recap on the role and status of directors and shareholders

You can read in more detail about the role of directors here, but in summary, the directors manage the company. They are responsible to all the owners.

Directors can either be executive, in that they are involved in the day to day decision making, or non-executive, effectively as part-time consultants to the executive directors.

Every executive director is an employee. He or she has all the rights and obligations of an employee and is as well protected through employment law as any other employee. Given that he or she also has a lot of knowledge about the company, and most likely the ability to overstep procedures to which other employees must adhere, you should take extra special care over the terms of her contract of employment and her job description.

A well drawn contract of employment for a director (often called a service agreement) will contain strong provisions to prevent the director from abusing his or her powers or stepping out of line with the wishes of the owners. It will also cover stronger protection of the intellectual property of the company, including business plans, accounts and product and customer information, and may specify rights and privileges more precisely than the employment contracts of other employees.

The contract of a non-exec director is likely to cover many of the same issues. However, because a non-exec director usually is not an employee, it is often much easier to remove him or her. Additionally, because he or she does not play as active a role in the management, he or she is likely to have less information and to make fewer operational decisions.

The role of shareholders

A shareholder, also called a "member", can be as active in the running of the company as she wishes and the other members allow, from being a director, to being an active supporter offering advice, to being a "sleeping" lender providing finance only.

How conflicts of interest can occur with shareholder-directors

The decisions that owners make tend to be more strategic and less frequent. Whereas the directors might decide on the introduction of a particular accounting software package, the members are more likely to consider issues such as the management structure of the company.

Fast decisions

In companies where directors are also shareholders - which is common - the distinction as to whether a decision is for owners or directors can easily become blurred. Especially when the decision can't wait, it is often made on a basis that produces a reasonable result, rather than perhaps the optimal result. For example, directors may decide a matter on a basis of "one hand one vote" of those who were in the office when the vote was made.

Such systems can work well - not making decisions can be as costly as making bad ones. But if decisions that shareholders would expect to make as owners in proportion to their holdings are made on a different basis, control of the company can change hands, and some owners could lose out.

Those who aren't also directors, such as sleeping investors, or those with a proportionally large shareholding compared to other directors might find it hard to exercise their rights.

Remuneration and benefits

Pay is often a source of conflict. While the payment of dividends is usually approved by members, often the payment of salaries and bonuses is approved by directors alone. When some directors are also members, there is an imbalance of power - some shareholders can decide on salary levels and bonuses that directly affect the level of dividends that can be paid to others, or of course, the cash resources left in the company.

To some extent, other spending decisions are similar in that they reduce the cash available in the business. Some shareholders might find it unreasonable that the CEO "needs" first class travel or a very qualified - and expensive - personal assistant. Benefits such as company cars or spending accounts for client entertainment can also cause friction.

A dominant shareholder-director acting in her own interests

A shareholder-director may overstep his or her limits of authority intentionally because she disagrees with the other director-shareholders. She may believe what she does is for the greater good of the company, or she may do it for personal gain. Overriding what has been agreed is unlikely to happen for the most important decisions, but it is reasonably common to find a dominant shareholder-director taking lesser decisions without consulting or notifying anyone else.

The employment status of a shareholder-director gives her additional leverage over non-employed owners. If other shareholders object or complain, she can threaten great disturbance and expense by taking what is an employment related dispute to an employment tribunal.

The threat is not powerful because she is likely to win at a tribunal, but rather because the disruption to the business of defending against a shareholder-director is costly, and the other owners are likely not to take the risk.

Removing the potential for conflicts

The way to remove potential for conflicts is to plan for them in advance and decide how each might be resolved should it happen. Shareholders' agreements and the directors' service contracts are the documents in which the plan should be set out.

Clarity of decision making

Shareholders should agree in an agreement what decisions are to be made by them only and how those decisions should be made (read about what to consider). They should also agree amongst them what powers the directors have - perhaps even to the detailed level of which individual directors have those powers.

The powers of individual directors should be set out in their service contract. This should be precise about the job description and the limits to which decisions need to be referred to the board of directors, or to the body of shareholders.

Disclosure of decision making

Disclosure of decision making is important. A shareholder-director may be able to make decisions that are not reported to other owners. It is therefore most important to clarify what a director may and may not do without notifying the other directors and shareholders, and whether notification is required in advance, or in hindsight.

Using budgets and business plans

One way of remaining agile as a business is to use budgets and business plans.

Shareholders can agree a budget for a short time in advance (such as the interim between meetings) that gives directors freedom to make spending decisions up to the budgeted amount without having to return to the owners.

The process for authorising an increase in spend over the budget can be set out in the shareholders' agreement, or a special meeting (an EGM) could be called in exceptional circumstances to authorise a new budget.

Similarly a short term business plan can be agreed by shareholders to give directors freedom to make operational decisions.

At the end of the period, a report by the directors to the owners can disclose what did take place.

Please note that the information provided on this page:

  • Does not provide a complete or authoritative statement of the law;
  • Does not constitute legal advice by Net Lawman;
  • Does not create a contractual relationship;
  • Does not form part of any other advice, whether paid or free.
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