How the death of a shareholder affects business succession planning

Ed Foulkes, partner and Head of the Corporate Team at national law firm Clarke Willmott LLP, looks at how the death of a shareholder affects succession planning.

The death of a shareholder in a private limited company has the potential to disrupt the running of the business, to create uncertainty and to raise concerns for the remaining shareholders and directors. In many private companies there is a close working relationship between shareholders and directors; individuals are often both, and so the death of a shareholder creates real issues for the business. What happens to his/her shares? What are the implications of

this change of control? If the deceased shareholder was also a director, this will impact on the day to day running of the business. For all concerned with the company, thinking about the consequences in advance and ensuring specific provisions are in place, will enable the business to deal the death of a shareholder with minimal disruption.

There are several possible strategies to ensure a smooth transition for the business, these are explored further below.

Company Law

How a company is run, what it can and cannot do is partly a matter of company legislation and partly what is set out in that company’s specific constitution. The primary source of UK company law is the Companies Act 2006 which has over 1200 sections and covers most aspects of how a company should be financed and managed. In addition, every company has its own articles of association – a detailed set of written rules in accordance with which the shareholders and directors agree the company will be run. This is a contract between company and shareholders determining, among other things: –

• what rights attach to a particular class of share;
• how shares may be issued and transferred;
• how directors are appointed and removed;
• what powers are reserved for shareholders and what are the directors’ duties; and
• requirements for meetings and resolutions of directors and shareholders.

The Companies Act 2006 includes a set of Model Articles as default articles for a private company, but on incorporation, a company may choose to adopt completely bespoke articles or to modify the Model Articles and may amend such articles by shareholders’ resolution at any point in its history. Companies incorporated before 2009 may have Table A articles based on the earlier Companies Act 1985 which differ from Model Articles.

What happens to the shares on the death of a shareholder?

Is there a will? If the shareholder died leaving a valid will appointing one or more executors, following grant of probate, such executor(s) will become the deceased shareholder’s personal representative (PR(s)).

Provided the shares are registered in the deceased shareholder’s sole name then legal title to the shares will transfer to the PRs by operation of law known as transmission. The PRs have authority to act in the deceased’s estate from the date of grant. However, directors of a company dealing with PRs should always check the company’s articles of association for any specific provision.

If the shares are registered in joint names, the position is different. On the death of one shareholder legal title passes automatically by transmission to the surviving shareholder, not to the PRs. The shares are then usually re-registered in the surviving shareholder’s sole name.

If there is no valid will, those who may administer the deceased shareholder’s estate have no authority to do so until they obtain a grant of representation constituting them as PRs. The rules of intestacy must be followed, and this process can be slow which can create difficulties for the company if shareholder resolutions need to be passed.

There are additional pitfalls if the deceased shareholder is also the sole director. If a shareholder dies, provided there are other shareholders in the company, the remaining shareholders can hold a meeting to appoint a new director who is then authorised to deal with the day to day running of the business. On the death of a sole director who is also the sole shareholder there is an immediate problem of how to appoint a new director to manage the business. The Model

Articles do provide that the PRs of the deceased shareholder/director can appoint a new director, but for companies incorporated before 2009, Table A articles contain no such provision which means a practical impasse and the requires the PRs to apply to court to appoint a new director.

From the perspective of the directors and remaining shareholders, the process of the transmission of shares is something of a lottery. The individual who inherits the shares under the terms of the will or intestacy rules may be previously unknown to the remaining shareholders, may have limited knowledge of the business but will now be part of the key decision-making process. To avoid this situation, the issues of what should happen to the shares on the death of a shareholder should be addressed before the problems arise. Since PRs’ rights are subject to any specific provisions in the articles of association or in an existing shareholders’ agreement, it makes sense for the company to

adopt a set of bespoke articles to include among other things, restrictions on the transfer of shares in the event of the death of a shareholder.

Bespoke articles of association

Under the Model Articles, provided PRs have evidence of their entitlement to the shares, they can request the company to formally register them as holder of the shares. PRs may not attend or vote at a general meeting or agree to a written resolution until they become the registered holders. In practice, the shares often remain in the deceased shareholder’s name until transferred to the beneficiary. However, this can be avoided if the company has adopted a set of bespoke articles and/or a shareholders’ agreement which sets out what should happen on the death of a shareholder. Particularly where there are a few founder or other significant shareholders, having a shareholders’ agreement and dovetailed articles of association in place facilitates an orderly transfer and protects shareholders’ rights.

Key provisions in the articles of association include: –

• Pre-emption rights – rights of first refusal for the remaining shareholders to buy the deceased shareholder’s shares.
• Permitted transfer – rights in the articles of association requiring the shares to be transferred directly on death to specific individuals, for example to spouses or children before pre-emption rights apply.
• Compulsory transfer – the requirement that the shares of the deceased shareholder either be sold to the remaining shareholders or bought back by the company.

Cross options – each of the shareholders grant the others, options over their shares which come into effect when one of them dies.

Valuation of shares

Whenever specific provision is made for the transfer of a deceased shareholder’s shares, it is important to agree and set out the basis on which such shares are to be valued. This may be a prescribed formula contained in the articles or alternatively a valuation based on “fair value”. This fair value is usually determined by an expert (typically an accountant) who values the shares in accordance with a set of agreed principles. The articles of association should include detailed provisions as to how such expert is to be appointed and the time frame for this, if any discount is to be applied for a minority holding, any adjustment for future potential and identify any specific accounting principles to be applied.

How do cross option agreements work?

In practice there are two kinds of cross option agreement: –

• Acquisition of shares by the surviving shareholders; or
• Buyback of shares by the Company (where the company itself is a party to the cross-option agreement).

Cross option agreement – surviving shareholders. This involves an agreement entered into by all the shareholders in the company, under which each shareholder grants to the other shareholders put and call options over their shares which are exercisable on death.

Under the call option, the remaining shareholders have the right (but not the obligation) to purchase the deceased shareholder’s shares from its PRs; and under the put option, the deceased shareholder’s PRs have the right (but not the obligation) to require the remaining shareholders to purchase the deceased shareholder’s shares.

In addition, each shareholder takes out a term assurance policy under which any amount which becomes payable is held on trust by the surviving shareholders to pay for the deceased’s shares. Such a policy should be entered into by each shareholder and written under trust, with their fellow shareholders as beneficiaries. As with other pre-emptive rights, valuation of the shares must be considered. The cross-option agreement may simply provide that the purchase price of the shares will be an amount equal to the policy proceeds. If this is the case, the value of the shares and the proceeds of any policy must be kept under regular review.

A buyback of shares by the company

As an alternative to the purchase of the shares by surviving shareholders, the articles may provide for the company to buy back the shares of a deceased shareholder. Part 18 of the Companies Act 2006 sets out strict procedural requirements for such a buy-back and it is important to comply with this as failure to do so will result in the buy-back acquisition being void and an offence being committed by the company and every officer in default. For example, if later on as part of a due diligence exercise on a proposed sale of the company, the buy-back is found to be void, real difficulties will result as the “buy-back shares” will still be owned by the PRs of the deceased shareholder.

In order for a company to acquire a deceased shareholder’s shares: –

• There must be no restrictions in the articles of association;
• The acquisition must be financed out of distributable reserves, or out of capital (this involves a somewhat longer process) or from the proceeds of the issue of new shares;
• The acquired shares must be cancelled as part of the buy-back; and
• The consideration must be paid in cash on completion (i.e. no deferred consideration)

A cross option agreement may be drafted with the company as purchaser of the shares provided these buy-back rules are complied with. The company then takes out key person insurance which pays out when one of the shareholders dies. The proceeds from the policy are used to pay for the shares and once bought back, the shares are cancelled.

In conclusion

Forward planning is important to ensure any smooth transition. To avoid difficult issues for directors and surviving shareholders on the death of a shareholder it is important to: –

• understand the existing default position under the company’s existing articles of association;
• consider the implications of this for the management of the company;
• determine the best outcome for the business; and
• make the necessary provisions e.g. amending articles etc.

Clarke Willmott is a national law firm with offices in Birmingham, Bristol, Cardiff, London, Manchester, Southampton and Taunton and is this year celebrating its 135^th anniversary.

For more information about Clarke Willmott’s corporate work or to contact Ed Foulkes visit Corporate law – Clarke Willmott solicitors