Using shareholders’ agreements as security

August 2013 | EXPERT BRIEFING | BANKING & FINANCE

financierworldwide.com

This article is devoted to the enforceability of shareholders’ agreements concluded with third parties as a security for monetary obligations. We highlight the following issues: (i) the discrepancies between the nature and regulation of shareholders’ agreements in countries with common law versus civil law, including Russia; (ii) recent developments in the corporate law of the Russian Federation (updating of the Civil Code); and (iii) advantages and disadvantages of shareholders’ agreements executed inter alia with the third parties, in particular with the lender of a legal entity.

In the Russian Federation, corporate agreements are a hot topic of discussion. This is attributed to the current modernisation of the Civil Code and civil legislation that is desperately required for Russia’s economy and to improve the investment climate. Many scientists, lawyers, officers and financiers were engaged in the discussion on the new draft bill of the Civil Code, thus there were many ideas on the corporate regulation including the nature and enforceability of shareholders’ agreements concluded with third parties. Some of those ideas were borrowed from Anglo-Saxon law, which is of interest for Russian comparisons. But it is worth noting that due to the globalisation and development of international business, the approximation of civil and common law is a phenomenon of the governing legislation in many developed and developing countries.

The nature and regulation of corporate agreements in the US and the UK

In Anglo-Saxon countries, a legal entity has a contractual nature. This means that all constitutional documents are considered to be contracts and thus may be altered only by an act of a contractual nature. Subject to the Model Business Corporation Act 2002, a corporate agreement may change the provisions of the company’s constitution and a special procedure is not required. Thus a corporate agreement has a priority over the constitutional documents. But should the company go public, the corporate agreement must comply with the public order and cannot alter the constitutional provisions. Similar restrictions are enacted in English law. Moreover, in Russia, corporate agreements cannot hinder the rights of third parties, such as employees, trustees and creditors.

A corporate agreement is therefore supposed to be the corporate act which is legally binding upon third parties. But in the UK, the corporate agreement is executed only in small private companies.

Moreover, in some instances a corporate agreement may also be contracted with third parties, including creditors, in order to grant them powers to participate in the management and financial issues of the entity. Courts are, however, reluctant to validate these agreements. More often, creditors participate in the corporate management of a company via a pledge of shares and by specifying certain requirements for the lender in the security documents.

Parties to a corporate agreement in the US and the UK

Since a corporate agreement is considered to be a corporate act with no obligatory nature, the legal entity may be party to the agreement. Thus there are two types of corporate agreement: the first executed only between the shareholders, and the second concluded between the shareholders and the legal entity itself. The first type is not legally binding upon third parties (i.e., the successors of the shareholders or shareholders that are not party to the agreement). The second type of corporate agreement, however, contains provisions that are enforceable against third parties, in particular the guarantor of the shareholders’ obligation.

The nature and regulation of a corporate agreement under the civil law system

In the civil law system, a corporate agreement is considered to be a contract. Thus this agreement is supposed to comply with the entity’s constitutional documents and be enforceable only against the parties. Moreover, in the event of a breach of a corporate agreement, a suffering party may claim only damages, while in the US it is empowered to demand the invalidity of a general meeting decision. In addition, under civil law the corporate agreement generally governs the voting procedure, thus the parties to the agreement must be shareholders (not the company or third parties).

In the Russian Federation, a corporate agreement cannot alter the provisions of the company’s charter and be contrary to statutory provisions; such acts are otherwise considered invalid (Federal Arbitration Court of West-Siberian region of 31.03.2006 № F04-2109/2005 (15210-А75-11), F04-2109/2005 (14744-А75-11), F04-2109/2005 (14785-А75-11)). Subject to the RF Law No. 208-FZ on Joint Stock Company of 26 December 1995, the parties may specify in the shareholders’ agreement how to dispose their rights deriving from the shares and/or their rights to the shares and/or cases where the shareholder is to abstain from doing something. Moreover, the law specifies that a corporate agreement may be concluded only with respect to all shares of the party thereto. Furthermore, the corporate agreement with creditors, trustees, pledge holders of shares and depository receipts is commonly invalidated by the courts. The conclusion is that an agreement may be executed only among shareholders. The Concept of Civil Legislation Development dated the 7 October 2009 characterises corporate agreements in the same way.

In the course of discussing the new civil code, the group working on the development of the International Financial Centre in Moscow has suggested that third parties should be allowed to be the parties to the corporate agreement if they have an ‘economically feasible interest’ in respect of the legal entity. However, this concept is rather vague and cannot be used efficiently in day-to-day activities. Moreover, it may trigger abusive practices, impairment of the minority shareholders ‘rights and dilution of control over the company.

The Economic Development Ministry also expressed its opinion on this issue, saying that parties to a corporate agreement may be any person with an interest in the conclusion of the agreement, including affiliated persons, contract partners or even employees.

Fortunately in the end the most ‘radical’ ideas were rejected and Article 67.2 of the draft bill of the Civil Code (which has passed the first reading) stipulates that third parties, including creditors, with legally protected interests in respect of the legal entity, may be party to an agreement concluded with members of the legal entity. But this is not a corporate agreement; this contractual act is governed by the rules applicable to the corporate agreement which still may be concluded only among shareholders. It should be noted that the above contractual act is intended to avoid impairment of creditors’ interests. Furthermore, the draft bill contains provisions allowing parties to a corporate agreement to contest management decisions that are contrary to the corporate agreement. But this shareholder power is established only for private entities where all members or participants are subject to the corporate agreement. In addition, decisions may only be contested if they do not disadvantage creditors.

Advantages and disadvantages of corporate agreements concluded with third parties

The provisions of the civil law require a legal entity to have fixed or solid capital that is tailored to protect creditors’ interests and rights. Common law entities have refused the idea of charter capital since the Model Business Corporation Act, common law enshrines the concept of contractual protection for creditors. This concept is derived from Law and Economics doctrine, devoted to cost saving via a range of market mechanisms. Thus, creditors may participate in the management of a legal entity (in some instances through the pledge of shares or a corporate agreement) in order to get a kind of a guarantee for the loan instead of increasing the interest on loans. Creditors may monitor the management and capital inflows of the entity acting as an insider and, assuming something is going wrong, take necessary measures to protect their rights. Moreover, insolvency issues are of importance.

In civil law, the charter capital is a kind of protection for creditors, including in the course of bankruptcy proceedings. But empowering creditors to be party to an agreement (governed by the rules applicable to a shareholders ‘agreement) may be favourable for the development of investment and business. At this moment, however, in the event that a contract is breached by participants of the entity, the remedies available to creditors are vague; moreover, this mechanism may cause dilution of control over the company in a favour of a person who has not contributed anything to the charter capital.

Svetlana Yudina is an associate at Khrenov & Partners. She can be contacted by email: s.yudina@yklaw.ru.

Svetlana Yudina

Khrenov & Partners