At a Glance
- The Constitution is a public document mandated by the Corporations Act, while a Shareholders Agreement is a private contract.
- Shareholder Agreements provide superior protection for minority shareholders and specific exit strategies.
- In the event of a conflict, a well-drafted Shareholders Agreement usually prevails over the Constitution.
- Relying solely on "Replaceable Rules" leaves significant legal gaps for proprietary companies.
- Proper documentation prevents the "deadlock" scenarios that often lead to expensive litigation.
The Dual Pillars of Company Governance
In Australia, the governance of a proprietary company is generally governed by two main instruments: the company’s Constitution and a Shareholders Agreement. Under the Corporations Act 2001 (Cth), a company can choose to be governed by its own Constitution, by the "Replaceable Rules" set out in the Act, or a combination of both.
However, the Constitution is often a "one-size-fits-all" document. It focuses on the mechanics of the company, such as how meetings are called, how shares are transferred, and the powers of directors. It does not typically address the nuanced relationship between founders, such as what happens if one shareholder wants to leave, or how a deadlock in voting should be broken. This is where the Shareholders Agreement becomes indispensable.
Why a Shareholders Agreement is Critical
Protection of Minority Interests
Under standard statutory rules, majority shareholders hold significant power. A Shareholders Agreement can introduce "reserved matters" that require unanimous or 75% approval, ensuring that minority owners have a say in fundamental changes like issuing new debt, changing the nature of the business, or selling major assets.
Control and Management
While the Constitution dictates the appointment of directors, a Shareholders Agreement can grant specific shareholders the right to appoint a board representative. This ensures that those with significant equity have a direct voice in the strategic management of the company, rather than relying on a general vote.
Exit Strategies and "Drag-along" Rights
One of the most common points of friction occurs when a majority shareholder finds a buyer for the company, but a minority shareholder refuses to sell. In the case of Gambotto v WCP Ltd, the High Court established strict limits on the ability of a majority to compulsorily acquire shares via constitutional changes. A Shareholders Agreement solves this by including "Drag-along" rights, where minority shareholders contractually agree to sell if a bona fide offer is made for the whole company, and "Tag-along" rights, which protect minorities by ensuring they can join a sale on the same terms as the majority.
Statutory Constitutions vs. Private Agreements
A Constitution is lodged with ASIC and is, to some extent, a public-facing document. It defines the company’s "rules" for the outside world. Conversely, a Shareholders Agreement is a private contract between the parties. This privacy is highly valued by Australian businesses that wish to keep their internal dividend policies, valuation formulas, and non-compete restrictions confidential.
Furthermore, it is standard practice to include an "Inconsistency Clause" in the Shareholders Agreement. This clause stipulates that if there is a conflict between the Agreement and the Constitution, the Shareholders Agreement shall prevail. This gives the parties the flexibility to override statutory defaults to suit their specific commercial needs.
Practical Case Example: The Danger of Deadlock
Although Vujnovich v Vujnovich is a New Zealand decision, its reasoning on shareholder deadlock and the “just and equitable” winding-up principle is often referred to in comparative discussions of shareholder oppression and corporate winding up in Australia. Three brothers operated a business through companies where they were equal shareholders. They fell into a "deadlock" where they could no longer cooperate. Because they lacked a robust Shareholders Agreement with a clear dispute resolution or buy-out mechanism, the only remaining legal path was a court-ordered winding up of the company on "just and equitable" grounds.
This resulted in the destruction of the company's going-concern value and massive legal fees. Had the brothers possessed a Shareholders Agreement with a "Shotgun Clause" or an independent valuation and buy-out process, the dispute could have been settled commercially without liquidating the business.
A Lawyer’s Perspective: The "Replaceable Rules" Trap
Many small to medium enterprises (SMEs) in Australia rely on the "Replaceable Rules" found in the Corporations Act to save on setup costs. We often see this lead to disaster. For instance, Section 203C of the Act provides that shareholders in a proprietary company may remove a director by resolution. However, it does not provide the sophisticated protections required when that director is also a founder with significant intellectual property or sweat equity. Without a Shareholders Agreement to link a director's removal to a mandatory share buy-back, a company can find itself in a position where an ousted director remains a hostile shareholder for years.
Key Takeaways
- Relying on the Constitution alone is insufficient for multi-shareholder companies
- Shareholders Agreements provide privacy and commercial flexibility
- Exit mechanisms like "Drag-along" and "Tag-along" clauses are essential for future liquidity
- Inconsistency clauses ensure the private agreement takes precedence over the public constitution
- Early documentation is significantly cheaper than court-ordered liquidation
Frequently Asked Questions
Does every Australian company need a Constitution?
A company can rely on the "Replaceable Rules" in the Corporations Act, but most choose a formal Constitution to provide clarity and modify certain default rules to better suit their business structure.
Can a Shareholders Agreement override the Corporations Act?
No. While it can override the Constitution or Replaceable Rules, it cannot override mandatory provisions of the Corporations Act 2001 (Cth), such as those regarding insolvent trading or director duties.
What happens if a shareholder refuses to sign a new agreement?
A Shareholders Agreement is a contract, meaning it generally requires the consent of all parties to be bound. This is why it is best to have the agreement signed at the company's inception or during a new share issue.
Are Shareholders Agreements legally binding in Australia?
Yes, they are enforceable contracts. If a party breaches the agreement, the other shareholders can seek remedies such as injunctions, specific performance, or damages.
Can the agreement prevent a shareholder from starting a competing business?
Yes. Unlike a Constitution, a Shareholders Agreement often includes "Restraint of Trade" clauses that prevent shareholders from competing with the company or poaching staff for a certain period after they exit.
How We Can Help
We provide expert guidance on corporate governance to ensure your business foundation is secure, including:
- Drafting tailored Shareholders Agreements that reflect your specific commercial goals;
- Reviewing and updating existing Constitutions to ensure compliance with the Corporations Act;
- Advising on minority shareholder rights and protections;
- Structuring buy-sell provisions and exit strategies to prevent future litigation;
- Resolving shareholder disputes through negotiation and mediation before they reach the courts.
