What is the difference between company constitutions and shareholder agreements?
Company Constitutions
Should you just have one or do you need both? Why do you need a constitution in the first place? And what do constitutions cover that replaceable rules don’t?
These are just some of the many questions Damien Lehmann of ADLV Law in Sydney will discuss with you in this episode.
Here is what we learned but please listen in as Damien explains all this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
Company Constitutions
There are replaceable rules, company constitutions and shareholder agreements – what is each of these about?
Replaceable Rules
You find the replaceable rules in the Corporations Act. If your company doesn’t have a constitution, the replaceable rules determine the basic legal functioning of your company. They govern how directors are appointed and remunerated, how director meetings work and what directors can and can’t do. They outline the issue or transfer of shares and how shareholders come to a decision. Just to give you a few examples.
If you are the sole director and shareholder you don’t need any of this, since it is just you. No room for disputes.
Company Constitutions
Company constitutions are lodged with ASIC and are a statutory contract between the company, its shareholders as well as directors.
Shareholder Agreements
Shareholder agreements are just a private document between shareholders. They govern how the shareholders own and administer their company.
Just Have One Constitution
While shareholder agreements used to be popular, scrap them and just have one constitution – for the following seven reasons.
1 – Less Room for Confusion
If your constitution is your only rule book – in other words: there is no shareholder agreement – there is less room for confusion. And less confusion means less disputes.
Yes, shareholder agreements usually override a constitution where there is a inconsistency between the two. But still better to avoid this issue in the first place. Why have two documents governing the same thing?
2 – No Escape
When a new member (aka shareholder) joins a company, the constitution automatically applies to them. There is no escape.
But shareholder agreements only apply if they sign.
This might not seem important but can be crucial when shares are transferred upon death or when the company becomes insolvent.
A new shareholder – receiving the shares through a will and not through negotiations – doesn’t have to sign the shareholder agreement. And so can do as they see fit as long as they act within the constitution.
When a shareholder becomes insolvent, the constitution will automatically bind the external administrator – a shareholder agreement wouldn’t.
3 – Set and Forget
A shareholders agreement needs to get signed every time a new shareholder arrives. If they don’t sign, the agreement doesn’t apply to them.
A constitution you set once and then you can forget about it – apart from regular reviews – until you need it. The constitution will bind all shareholders and directors, whether they sign or not.
4 – Easier Change
To change a company constitution you usually need 75% by way of a special resolution.
Changing a shareholder agreement generally requires unanimous consent – even for a very small change.
Some shareholder agreements allow less than unanimous consent, but this is an ‘agreement to agree’ which is not legally enforceable.
You an incorporate ‘power of attorney’ provisions in the shareholder agreement to mitigate this issue, but these are complex and often give rise to disputes.
5 – Covers Directors
A shareholder agreement is a contract between shareholders, but not directors. A constitution on the other hand is a statutory contract between the company and its directors as well as shareholders.
This is important for directors when there is an inconsistency. They need to comply with the constitution.
6 – No Breach with Replaceable Rules
A constitution will automatically displace a ‘replaceable rule’ under the Corporations Act, whereas a provision in a shareholder agreement will not necessarily.
So if you act in accordance with a shareholder agreement, you may cause an inadvertent breach of a replaceable rule in the Corporations Act. With a constitution you won’t.
7 – Embedded rights
A constitution is an embedded right. The constitution forms part of s shareholder’s ‘interest’ in the company.
Rights and obligations under a shareholder agreement are more akin to an ‘encumbrance’ against the interest, or a separate ‘collateral agreement’ having its own value.
So if a shareholder becomes insolvent, an external administrator can void the terms of the shareholders agreement, but must take the shares subject to the rights in the constitution.
Privacy
You might argue that a shareholder agreement is more private, since not lodged with ASIC.
However, only public companies need to lodge their constitutions with ASIC making it a public document. A private company doesn’t.
And public companies are highly unlikely to use shareholder agreements anyway.
So all up there isn’t really any reason for a shareholder agreement. So put everything into your constitution and then scrap your shareholder agreement. Will save a lot of legal fees later on.
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