Excluding founder from business amounted to unfair prejudice

16 August 2022

The High Court has found that shareholders of a company suffered unfair prejudice when they were excluded from a project that was the reason for the company’s existence.

Dodson and others v Shield and others [2022] EWHC 1751 (Ch) concerned a company (IAEP) established to supply and service the turnkey installation of certain automotive assembly lines.

In late 2012, two individuals (Mr Dodson and Mr Cotterill) became aware that manufacturing lines (the Lines) for a particular type of car engine were about to become available. They established IAEP as a vehicle to acquire the Lines, with a view to selling the Lines on to a third party as a complete unit.

To fund the acquisitions, the two individuals were introduced to a Mr Shield. Mr Shield agreed to provide financing for the acquisition but wanted his own corporate vehicle (SES) to own the Lines outright as they became available, a position that was not acceptable to Mr Dodson and Mr Cotterill.

Ultimately, the parties reached agreement and entered into arrangements to regulate the project. These included a facility agreement, a shareholders’ agreement, and an option under which IAEP was granted fifteen months to acquire the Lines from SES at a pre-set price.

The shareholders’ agreement contained the following key terms.

  • IAEP’s business was to be the design, sale and implementation of turnkey automotive engineering projects on an international basis, with its first project being the acquisition of the Lines.
  • Each party was to use reasonable endeavours to promote and develop IAEP’s business to its “best advantage” (the business promotion clauses).
  • No shareholder would be interested in any business that competed with IAEP (the non-compete clauses).
  • The parties would act in good faith towards each other at all times and conduct any transactions with IAEP on the basis set out in the shareholders’ agreement and on arms’ length terms.

Alongside this, the option agreement stated that, if IAEP were unable to purchase any Lines from SES during the Option Period, the parties will negotiate in good faith to find an alternative mechanism for selling the Lines to IAEP or a third-party buyer.

The project begins

SES acquired the first two Lines. At the same time, the parties began discussions with several potential onward buyers of the Lines.

However, by March 2013, IAEP had exhausted its financing and the possibility of acquiring three further Lines had slipped, causing the project to stall.

In June 2013, without Mr Dodson’s knowledge, Mr Cotterill introduced a Mr Murphy to IAEP with a view to him replacing Mr Dodson as commercial director. From this point, Mr Dodson was excluded from IAEP’s day-to-day business.

Sometime in 2013, Mr Dodson managed to acquire a technical library for the Lines on behalf of IAEP. The library was highly valuable, as it provided installation schematics for the various machines that made up the Lines.

Also in 2013, Mr Cotterill initiated discussions with a potential buyer for the onward sale of the Lines. Under the proposed sale, ongoing turnkey services would be provided to the buyer, not by IAEP (as originally contemplated) but by a separate company (CGI).

CGI was owned by Mr Murphy, but the parties would use it as a joint vehicle for pursuing the turnkey business. To facilitate this, and unknown to Mr Dodson, the library was made available to CGI (and, in turn, SES) with no payment in return to IAEP.

In January 2014, the option expired, allowing SES to sell the Lines without IAEP’s approval.

IAEP’s final board meeting took place in January 2015, at which it became clear that IAEP’s commercial purpose was at an end. By late 2015, SES had sold some of the Lines.

What did Mr Dodson claim?

Mr Dodson brought a petition alleging that he had suffered unfair prejudice, alleging that he had been excluded from the day-to-day running of the business. He also argued that the other parties had acted in several respects contrary to the understanding on which IAEP had been formed.

  • They had failed to initiate negotiations between IAEP and SES to sell the Lines owned by SES to either IAEP or a third-party buyer, which he said amounted to breach of the option agreement.
  • They had effectively “given away” the valuable library to CGI and SES without securing any payment in return for IAEP, which he said amounted to a breach of fiduciary duty.
  • They had attempted to divert the turnkey business from IAEP to CGI, which was a breach of their promise not to compete with IAEP.

Importantly, these allegations (particularly the allegations relating to a failure to involve Mr Dodson in negotiations and of diverting IAEP’s business) rested on IAEP being classified as a “quasi-partnership” (see box “What is unfair prejudice?”).

What is unfair prejudice?

Under section 994 of the Companies Act 2006, a member (for example, a shareholder) of a company can petition the court for relief if the company’s affairs are being conducted in a way that is unfairly prejudicial to that person’s interests as a member.

There is no fixed list of actions or omissions that can amount to unfair prejudice. Examples can include excluding a shareholder who is also a director from the management of the company, allotting shares to dilute a minority shareholder’s interest, misappropriating company funds, failing to pay dividends in certain circumstances, and deliberately failing to comply with the company’s constitution.

The scope of behaviour that can amount to unfair prejudice is wider if the company is a “quasi-partnership". A quasi-partnership is a company where there is a relation of mutual confidence between the members and an understanding that they are entitled to be involved in running the company's business in a way similar to the partners of a partnership. Unfair prejudice may occur if a quasi-partnership’s affairs are run in a way that is inconsistent with that mutual understanding, whether or not that amounts to a breach of duty or the entity’s constitution.

The courts have very wide discretion to grant almost any remedy they think fit if unfair prejudice has occurred. The most common remedy the courts have applied is to require other members of the company (or the company itself) to acquire the injured party’s shares.

What did the court say?

The court agreed that there had been unfair prejudice.

A critical question was whether the parties had created a “quasi-partnership” between them. In this case, the court said that IAEP was a quasi-partnership, because all its shareholders were entitled to be directors and take part in its management. This was underscored by the fact that the parties undertook express duties of good faith to each other and agreed not to compete with each other.

This conclusion was not changed by the fact that the shareholders’ agreement contained a standard clause stating that the parties had not intended to create a partnership. It was evident that IAEP, as a company, could not be a partnership, but this did not mean there was no quasi-partnership.

This meant that the court was able to consider a wider range of conduct when deciding whether unfair prejudice had taken place. The judge reached the following conclusions.

  • By the time of the alleged failure to initiate negotiations between IAEP and SES, the opportunity to acquire the further Lines required to present the entire turnkey solution had disappeared, and so there was no real basis for negotiations for a sale to IAEP or a third party. Mr Dodson could not, therefore, have suffered any prejudice. (The court therefore declined to rule on whether the parties had breached their duties of good faith.)
  • Making the library available to CGI and SES at no cost, when the library had considerable value to IAEP, was a clear breach of fiduciary duty and amounted to unfair prejudice to Mr Dodson as a shareholder of IAEP.
  • Arranging for the turnkey services to be provided by CGI, rather than IAEP, was a “clear breach” of the business promotion and the non-compete clauses, which again amounted to unfair prejudice to Mr Dodson as a shareholder of IAEP.

What does this mean for me?

Unfair prejudice claims are very fact-specific. However, this is a good illustration of the court applying established principles when deciding whether unfair prejudice has occurred.

The case also shows the dangers of side-lining a founder from a business. Generally, shareholders have no right to take part in a company’s business and excluding a shareholder from doing so will not give rise to a claim. But where a business is set up on the basis that all shareholders will be entitled to a say in how it is run, preventing a shareholder from taking part may well give rise to unfair prejudice.

When looking to take a proposed course of action, therefore, companies, directors and significant shareholders should ask certain questions.

  • Would the proposed action breach any terms of the company’s constitution? If so, there is a greater risk of unfair prejudice. In this respect, it is important to remember that a company’s constitution comprises not only its articles of association, but also any special resolutions and, potentially, other agreements between the company and its shareholders, such as a shareholders’ agreement, investment agreement or joint venture agreement.
  • Would the proposed action amount to a breach of duty by the directors? Directors owe their statutory and fiduciary duties to the company itself, and normally it is the company which must sue for any loss. But if the breaches become part and parcel of the company’s conduct, they may well tip over into unfair prejudice and entitle an aggrieved shareholder to petition for relief.
  • Was the company set up on a mutual understanding that all shareholders would be allowed to take part in management? If so, acting contrary to that understanding risks exposing the company to an unfair prejudice petition, even if the company and directors are acting in full compliance with the company’s constitution and their statutory duties.
  • Will the proposed action actually cause any individual shareholders or group of shareholders damage or loss? If not, it will be harder for a shareholder to show that they have suffered any prejudice.