What is a company constitution?
A company constitution is a document that generally specifies the rules governing the relationship between and activities of the company, its directors and shareholders. A constitution is a special form of contract as it binds the company, shareholders who initially agreed to adopt a constitution and any future shareholders, unlike other forms of contract that only bind those who are parties to it. A company’s constitution has effect as a contract between the company and each member (i.e. shareholder), a member and each other member and the company and each director and company secretary, under which each person agrees to observe the provisions of the constitution so far as they apply to that person. This only creates enforceable rights and obligations in relation to shareholders in their capacity as shareholders of the company, not in their personal capacity. It also does not create enforceable rights and obligations between the shareholders of a company and the company’s directors and/or company secretary. Consequently, a shareholder may be precluded from enforcing any provisions in a constitution that confer personal rights, which may include the right to be employed by the company, non-compete agreements and provisions designed to protect the interests of minority shareholders.
What does it mean to adopt a company constitution?
A company may adopt a constitution either on or after registration. The Corporations Act does not prescribe the rules that must be included in a constitution. A company’s constitution may modify the provisions of the Corporations Act that apply as replaceable rules and specify the replaceable rules that do not apply to the company.
A replaceable rule is a provision of a section or subsection of the Corporations Act that can be displaced or modified by a company’s constitution. The provisions of the Corporations Act that apply as replaceable rules are set out in section 141 of the Corporations Act. These rules deal with matters relating to officers and employees, inspection of books, director’s meetings, shareholders meetings and issue and transfer of shares. They apply to companies registered after the commencement of the Company Law Review Act 1998 (Cth) on 1 July 1998 and companies registered before 1 July 1998 that repeal or have repealed their constitution after that date. This includes many closely held private companies that currently operate in Australia. Although failure to comply with the replaceable rules does not constitute a breach of the Corporations Act, any replaceable rules that apply to a company have effect as a contract between the company and each member, a member and each other member and the company and each director and company secretary, under which each person agrees to observe and perform the rules so far as they apply to that person. Consequently, a shareholder of a company has a personal right as against each other shareholder to require compliance with any replaceable rules that apply in relation to the company. The existence of the replaceable rules could provide the opportunity for minority shareholders of closely held private companies to protect their interests against decisions by the majority that may have adverse financial consequences for them by enabling minority shareholders to negotiate the terms of their relationship with the other shareholders of a company through the adoption of a constitution that varies the replaceable rules.
Officers and employees – Corporations Act replaceable rules Management of a company
Section 198A of the Corporations Act provides that the directors are to manage the business of a company and may exercise all the powers of the company, except any powers that the Corporations Act or the company’s constitution requires the company to exercise at a meeting of shareholders. As a company has the legal capacity and powers of an individual and a body corporate, the power of the directors to manage the business of a company enables the directors to engage the company in a range of activities, unless the activities are restricted or prohibited by the company’s constitution. Vesting the power to manage the company in the directors is a long established principal of company law. Generally, this will be appropriate as shareholders do not have any obligation to act in the best interests of the company as a whole whereas the directors of a company must not improperly use information or their position for their own commercial advantage or to cause detriment to the company and must exercise their powers and discharge their duties with care and diligence, in good faith and in the best interests of the company as a whole. Where a company’s constitution confers on the directors the power to manage the company and does not otherwise prescribe how such powers are to be exercised then only residual powers will be left with the shareholders which means that generally they cannot override decisions of the directors, the directors can ignore any directions given to them by the shareholders and the shareholders do not have the power to authorise the company to commence litigation. A company’s constitution may amend the balance of power between directors and shareholders such that the shareholders are empowered to give directions to, or overturn decisions of, the company’s directors. However, any such provision needs to be carefully considered by a minority shareholder of a closely held private company. It would generally only be in the interests of a minority shareholder to agree to amend the balance of power between directors and shareholders if the power can only be exercised in circumstances where the shareholders unanimously agree that the power should be exercised. If unanimous agreement of the shareholders is not required then there is a risk that a self-interested majority shareholder could make decisions that have adverse financial consequences for minority shareholders and aggrieved minority shareholders may need to commence legal proceedings in order to protect their interests.
Appointment, removal and remuneration of directors
There are a number of replaceable rules in Part 2D.3 of the Corporations Act that deal with the appointment, removal and remuneration of directors of a company. The appointment of a director is permitted by an ordinary resolution of shareholders, pursuant to section 201G, or by a majority of directors, pursuant to section 201H. A director may be removed and a replacement appointed by an ordinary resolution of shareholders, pursuant to section 203C. The remuneration of directors and reimbursement of their expenses in connection with company business may be determined by an ordinary resolution of shareholders, pursuant to section 202A. These provisions are important in closely held private companies as the directors in such companies are generally either shareholders or related parties of shareholders of the company. Although a constitution may make special provision for the appointment, remuneration and removal of directors, sections 201G, 201H and 202A are generally incorporated in private company constitutions. The power of shareholders under section 203C to remove and appoint directors is often substituted with, or supplemented by, a provision that gives a similar power to a majority of directors. In order to protect their interests against decisions by the majority that may have adverse financial consequences for them, minority shareholders of closely held private companies may negotiate a constitution which:
- includes sections 201G, 201H and 203C, subject to an overriding power of each shareholder to appoint and remove a director as their representative; or
- does not include sections 201G, 201H and 203C, but empowers each shareholder to appoint and remove a director to represent their interest in the company.
Representation on the board of directors of a closely held private company is particularly important to minority shareholders as it is likely to:
- provide them with a means by which they can receive a return on their investment in the company without having to rely on receiving dividends (i.e. by receiving directors’ fees);
- protect them against the risk of not receiving any return on their investment in the company (e.g. if the level of remuneration paid to directors results in there being no dividends);
- enable them to exercise some control over the management of the company.
Even if board representation does not provide any control over the management of the company or a return on investment in the company, it should provide a forum in which a minority shareholder could raise concerns regarding the management of the company, enable them to access any information relating to the affairs of the company and thereby minimise the risk that decisions are made that may have adverse financial consequences for them.
Directors’ and shareholders’ meetings – Corporations Act replaceable rules
The Corporations Act provides that the quorum for a meeting of directors is two (2) directors, unless otherwise determined by the directors (section 248F), and the quorum for a meeting of shareholders is two (2) shareholders (section 249T). Where a quorum is present for a meeting the Corporations Act provides that:
- a resolution of directors must be passed by a majority of votes cast by directors entitled to vote on the resolution (section 248G);
- each shareholder has one vote on a show of hands and one vote for each share they hold on a poll (section 250E);
- the chair of both a meeting of directors and a meeting of shareholders has a casting vote, pursuant to sections 248G and 250E respectively.
The quorum and director and shareholder voting provisions of the Corporations Act do not protect the interests of minority shareholders of closely held private companies. If these provisions are adopted without amendment then they may provide the opportunity for the majority to constitute a quorum and pass resolutions at directors and shareholders meetings, which may have adverse financial consequences for minority shareholders. In closely held private companies where minority shareholders are not represented on the board of directors and section 250E is not amended then it is unlikely that the interests of minority shareholders will be protected against decisions that may have adverse financial consequences for them. However, the interests of minority shareholders of closely held private companies may be protected if:
- sections 248F and 249T are varied to require all directors and shareholders to be present at the relevant meetings to constitute a quorum; and
- in circumstances where a minority shareholder is represented on the board of directors, if sections 248G and 250E are varied to require resolutions of directors to be passed unanimously by all directors and resolutions of shareholders to be passed unanimously by all shareholders.
Where a unanimous resolution is required by a company’s constitution a casting vote is unnecessary. However, the absence of a casting vote provision and/or the inclusion of a requirement that all decisions made by the directors and shareholders of a company must be made unanimously may expose the company to deadlocks and provide no mechanism to resolve them in a timely and cost effective manner, which is not in the best interests of any of the shareholders of a company.
Issuing and transferring shares in a company – Corporations Act replaceable rules
The Corporations Act includes a number of replaceable rules that govern the issue and transfer of shares in a company. Section 254D requires the directors of a proprietary company to first offer shares of a particular class to existing shareholders of that class before issuing further shares, unless otherwise authorised by an ordinary resolution of shareholders. Sections 1072A, 1072B and 1072D concern the transmission of shares on death, bankruptcy or mental incapacity of a shareholder. These provisions have limited application and as a consequence do not protect the interests of the shareholders of a company. Section 254D only applies to the issue of new shares in a proprietary company and does not extend to the transfer of existing shares by any of the shareholders of a company. Sections 1072A, 1072B and 1072D only provide for another person to be recognised as the holder of shares in the event of the death, bankruptcy or mental incapacity of an existing shareholder, they do not require the shares to be transferred to existing shareholders. Where a constitution adopts these replaceable rules without amendment there may be changes in shareholdings of a company such that the continuing shareholders have no control over the parties with whom they share ownership of the company. However, by extending and/or modifying the application of these replaceable rules the shareholders of a company should be able to exercise some control over the parties with whom they contract as shareholders of the company. For example:
- the application of section 254D could be extended to require an existing shareholder to first offer to sell their shares to the other shareholders (before offering their shares to any third parties) in circumstances where they no longer wish to be a shareholder of the company (e.g. due to retirement or for any other reason);
- the application of sections 1072A, 1072B and 1072D could be modified such that on the death, bankruptcy or mental incapacity of a shareholder they (or their legal personal representative) are required to offer to sell their shares to the other shareholders, rather than those shares being transmitted to their legal personal representative or another person otherwise entitled to be registered as holder of the shares.
Generally, it will not be appropriate for such provisions to be included in a company’s constitution as they may confer personal rights on the shareholders of a company, which are unenforceable if they appear in the constitution.
Inspecting company books – Corporations Act replaceable rules
Section 247D of the Corporations Act provides that the directors, or an ordinary resolution of shareholders, may authorise a shareholder to inspect the books of the company. The books of the company include the company register, financial reports or records, documents and any other record of information. The scope of section 247D is limited as the books of the company do not include minutes of directors meetings and other documents that may evidence how decisions of directors are made. Further, if a constitution provides that the replaceable rules do not apply to a company and a provision similar to section 247D is not inserted in the constitution then a minority shareholder may have to make an application to the court under section 247A for an order that the shareholder be authorized to inspect the books of the company. Section 247D may be varied in a company’s constitution to enable minority shareholders to access:
- the books of the company by giving notice to the company, rather than requiring inspection to be authorized; and
- minutes of directors meetings and other documents that may evidence how decisions of the directors of a company are made, not just registers kept under section 173 and minute books kept under section 251B.