Shareholders’ agreement (Part 2)

Continued Part 2 of 2

2. Governance Framework

A corporation is a legal entity with personality granted by law, and it acts through its Board of Directors and its officers. The Board of Directors approves and sets the company’s direction, while the officers are responsible for implementing the decisions. In corporations with multiple shareholder groups, it is essential for the parties to agree on the allocation and division of directorships and officer positions.

READ: Shareholders’ agreement

For example, one of our clients in the law office is a corporation with two shareholder groups. They agreed that, of the five members on the Board of Directors, each group would appoint two directors, with the fifth member chosen jointly by both groups.  Regarding officers, one group appoints the President and Treasurer, while the other selects the Corporate Secretary, Financial Controller, and Compliance Officer.

Additionally, the shareholders agreed that any disbursement or approval of funds exceeding P500,000 must be approved by one representative from each group.

3. Financial Considerations

Shareholders should agree in advance on how to handle the company’s earnings, particularly regarding distribution and reinvestment. These discussions should occur before the company generates profits.  Will the corporation distribute earnings through dividends, or will it reinvest all profits?

Discussing these matters beforehand ensures transparency and allows shareholders to plan financially, as they may have different financial situations or needs.

For instance, our law office had a corporate client that had two shareholder groups. Although the business was thriving, the partnership did not continue beyond the third project because one group wanted to sell products on a cash basis to maximize short-term cash flow, while the other preferred long-term installment sales, which would generate less immediate cash but provide a higher return over 15 years due to interest income.

4. Funding Matters

Before launching a business venture, shareholders must agree on financial and funding matters, ideally in writing. If the company performs well and requires additional funds for expansion, the shareholders should already have a plan in place for sourcing these funds. Will they raise capital internally by contributing more money, or will they seek external funding through loans?

Disagreements over how to raise additional capital can create tension among shareholders. For example, if funds are raised internally, some shareholders may be unable to contribute, leading to dilution of their ownership. Alternatively, if the company borrows money, not all shareholders may be comfortable with taking on debt. Banks may require principal shareholders to sign a Joint and Solidary Signature (JSS), making them jointly liable for the loan.  Shareholders who are required to sign the JSS might seek compensation or some form of benefit in exchange for taking on this additional risk.

Agreeing on these financial matters in advance is crucial to avoid conflicts that could undermine shareholder harmony.

5. Working Partners

If some shareholders contribute time and effort to the business in addition to their capital contributions, it is important to establish clear agreements on how to compensate working partners. This ensures that shareholders who only contribute capital are not left with misunderstandings about the distribution of profits or responsibilities.

6. Protection of Minority Shareholders

Shareholders can agree that certain decisions require the approval of a minimum number of shareholders or directors. While the Revised Corporation Code sets out voting requirements for Board and shareholder approvals (typically by majority vote), shareholders may choose to implement more stringent voting thresholds.

For example, one of our clients included in their shareholders’ agreement that a valid quorum for board meetings requires not just the attendance of a majority of the directors but also the presence of a representative from each shareholder group.  Additionally, they stipulated that board decisions must be approved by a supermajority, requiring four out of five directors to agree, rather than a simple majority.

In shareholders’ meetings, the agreement allowed minority shareholders to veto certain decisions to prevent the majority from forcing through changes without considering minority interests.

7. Exit and Succession Plans

It is important to address provisions that allow shareholders to exit the business when their goals or objectives no longer align. While the Revised Corporation Code provides an Appraisal Right for shareholders who disagree with certain corporate decisions, this may not always address situations where a minority shareholder wants to exit the company.

Shareholders may agree that those wishing to exit can sell their shares either to the other shareholders or to third parties. In some agreements, the selling shareholder must offer the shares at book value to the remaining shareholders, which may limit their options. In other cases, the majority shareholder may guarantee to buy out the shares of any minority shareholders who wish to leave.

8. Dispute and Conflict Resolution

A shareholders’ agreement can include a conflict resolution policy for disputes between shareholders. This policy might provide for mediation or arbitration, with a neutral third party chosen to resolve the dispute, instead of resorting to court litigation.

Experience has shown that mediation or arbitration is generally less costly, quicker, and less damaging to relationships compared to going to court.

9. Confidentiality

It is standard practice for shareholders’ agreements to include confidentiality provisions, requiring shareholders and their representatives to keep business and operational secrets confidential. This obligation may be explicitly stated in the shareholders’ agreement or in a separate confidentiality agreement.

10. Non-Competition

Some shareholders’ agreements include non-compete clauses to prevent shareholders from starting or engaging in businesses that directly compete with the company. These clauses can also protect the company from former shareholders poaching employees or clients.

Conclusion

Ultimately, a shareholders’ agreement is a legally binding contract that offers protection to all parties involved. By formalizing the expectations, rights, and responsibilities of each shareholder, the agreement provides security in the event of legal disputes, financial issues, or other unforeseen circumstances.

It is important to note that the discussion here are some examples of possible provisions shareholders can include in their shareholders’ agreement.  As contracts, shareholders are free to stipulate any provisions they deem necessary, provided these agreements do not contravene the law, morals, good customs, public order or policy.

(The author, Atty. John Philip C. Siao, is a practicing lawyer and founding Partner of Tiongco Siao Bello & Associates Law Offices, an Arbitrator of the Construction Industry Arbitration Commission of the Philippines, and teaches law at the De La Salle University Tañada-Diokno School of Law. He may be contacted at [email protected]. The views expressed in this article belong to the author alone.)