How to Avoid Corporate Conflict Between Shareholders

How to Avoid Corporate Conflict Between Shareholders

Practical Guide for Business Owners in Russia and CIS

Mainstream

Avoiding corporate conflict means avoiding a situation in which business becomes a battlefield and its value plummets. The main task is not to win the dispute, but to ensure that the dispute never arises.

Corporate conflict between shareholders almost always ripens long before the first lawsuit. It is based on unspoken expectations, lack of clear rules and imbalance of interests. When the parties are guided by gentlemanly arrangements, sooner or later someone feels cheated and a devastating scenario is set in motion.

Effective prevention is based on three tests:

• Is there a legally binding balance of rights and responsibilities?
• Whether the mechanism for making key decisions, including stalemates, is working.
• Whether the exit of each partner from the business is determined in advance - planned, forced or emergency.

If these three issues are not resolved before the joint venture begins, any irritant – differences in dividends, different visions of strategy, personal conflict – can escalate into a full-blown corporate war.

When there is a risk of a corporate conflict

The risk of corporate conflict becomes real if:

• business with partners on equal or close shares;
• The majority shareholder systematically ignores the interests of minority shareholders.
• There is no shareholder agreement or corporate agreement;
• decisions are made behind the scenes without formalized procedures;
• Partners differ in their vision of strategy, reinvesting profits or going out of business.
• one of the participants ceases to actively participate in the management, but retains a share;
• a change of generations, the entry of heirs or the divorce of one of the shareholders;
• The business attracts an external investor or fund;
• The group of companies is structured in several jurisdictions, including Russian and foreign;
• One of the partners actually withdraws assets or creates a parallel business.

The mistake most owners make

Many entrepreneurs start a business with the following questions:

How do we distribute the shares?

That's the wrong first question.

The right question is:

How are we gonna break up if something goes wrong?

It is the answer to it that determines the rules of the game in a normal situation. When partners know exactly what scenario awaits each other in the event of a deadlock, withdrawal or breach of obligations, the very ground for destructive conflicts disappears. Conflict does not begin when a lawsuit is filed, but when one of the shareholders says: “I didn’t expect everything to turn out like this.”

Step 1. Check and structure business ownership correctly

Before signing any agreements, key questions about the structure need to be answered:

• Who is the real beneficiary? Is there a person behind a partner with whom you are not ready to share your business?
• Is the share of the real contribution? Contributions can be money, assets, customer base, intellectual property or management competencies.
• What corporate form was chosen? LLC or JSC in Russia, foreign holding, trust, partnership - each form gives a different level of protection.
• Does the current structure create a dead end? 50/50, 33/33/33, 40/40/20 shares without special mechanisms almost guarantee deadlock.
• Where will assets be stored and contracts concluded? Russian or foreign jurisdiction, offshore, holding company – the applicable protection instruments depend on this.

If the structure is already created and the conflict is brewing, it is necessary to analyze the possibilities of its adjustment: Options, convertible instruments, preferred shares, quasi-treasury shares or shares owned by the company itself.

Step 2. Agree on strategic vision and the “rules of the game”

Partners often discuss product, market, and investment, but avoid uncomfortable topics. They are the triggers for future disputes. Before starting a business, you need to record a common understanding in writing:

• Business purpose: Growth, dividend yield, preparation for sale, legacy?
• Roles and employment: Who is the financial investor and who is the financial investor? Under what conditions does the partner receive remuneration as a manager?
• Reinvestment of profits: What percentage is allocated to development and what is allocated to dividends?
• Attracting external capital: What are the conditions under which shares are eroded, is there a priority right?
• Prohibition of competition: Is the shareholder entitled to another similar business?
• Key staff policy: Option programs, phantom stocks, entry of new partners.

Such a vision agreement (often spelled out as a memorandum of understanding) is not always directly binding, but in the event of a dispute it is powerful evidence of the parties’ original intentions and helps interpret the provisions of the corporate contract.

Step 3. Enter into a corporate agreement (shareholder agreement)

In Russia and CIS countries, the main tool for conflict prevention is a corporate contract (Article 67.2 of the Civil Code of the Russian Federation, for LLC - a contract on the exercise of participants' rights). A shareholder agreement is used for the JSC. In foreign structures - shareholders' agreement.

The corporate contract allows:

• to fix the voting procedure on key issues;
• establish a special quorum and majority for strategic decisions;
• provide for the right of veto for minority shareholders on certain issues;
• limit the alienation of shares;
• establish mechanisms for forced redemption (call option) and sale (put option);
• provide for penalties for breach of contract.

Without such a contract, the parties are guided by dispositive rules of law that rarely meet real commercial agreements. The dispute then boils down to a formal struggle for control of a legal entity, rather than restoring a balance of interests.

Step 4. Establishing a Corporate Governance System

Even an ideal contract will not save you if decisions are made in the company without a formalized procedure. It is necessary:

• Regularly hold general meetings with proper notice and agenda.
• Record all decisions in writing – protocols, decisions of the sole participant, orders.
• Distinguish the competence of the governing bodies: That decides the general meeting, that the board of directors, that the general director.
• Establishing a board of directors with independent members with multiple partners or investors reduces the risk of deadlock.
• Provide access to information on the financial condition of the company for all shareholders (art. 91 C.C., art. 50 of the Federal Law "On LLC").

Practice shows that: If a minority shareholder cannot obtain basic accounting statements for months, he begins to suspect abuse, and the conflict flares up rapidly.

Step 5. Settlement of financing and dividend policy

The most common disputes are about money: where the profit is spent, why dividends are not paid, on what conditions the partner can demand additional contributions.

The corporate contract and charter should include:

• The procedure for determining the net profit available for distribution.
• The minimum percentage of profits allocated to dividends.
• Terms and limits of additional issue or additional deposits.
• Consequences of not contributing: reduction of the share, exclusion, option to buy at a discount.
• Rules for granting loans to participants and their return.
• Procedure for coordination of large transactions and transactions with interest.

When dividend policy is transparent and documented, shareholders do not perceive the absence of payments as a personal betrayal, they see objective indicators and pre-known rules.

Step 6. Provide mechanisms for resolving deadlock situations (deadlock)

Deadlock occurs when equal-opportunity parties block each other’s decisions. Typical example: 50/50 and disagreements on the budget.

Tools for exiting deadlock:

• Russian roulette: One partner offers a price, the second chooses to sell his share at this price or buy out the share of the initiator.
• Texas shooting: Both partners file closed bids for the price, the higher bidder wins.
• Mediation or expert permission: Referral of the dispute to an independent expert or mediator whose decision is mandatory or recommendatory.
• Staircase escalation mechanism: The issue is passed from the operational managers to the shareholder representatives, then to the supreme body with the right to vote.
• Temporary manager for the period of stalemate.

The mechanism must be established before a conflict arises. Once the impasse has already arrived, it is almost impossible to agree on rules for resolving it.

Step 7. Establishing rules for the withdrawal and fair valuation of shares

Any shareholder should understand how and at what price they can go out of business. The lack of a transparent exit mechanism leads to one partner feeling locked up and the other feeling blackmailed.

The corporate contract should include:

• Premium Purchase Right (ROFR) and the procedure for its implementation.
• The right to joint sale (tag-along) for minority shareholders.
• The right to demand adhesion (drag-along) for majority shareholders when sold to a strategic investor.
• Procedure for determining the fair value of the share: independent assessment, formula, pre-agreed multiplier.
• Scenarios of forced expulsion: breach of contract, loss of key employee, bankruptcy, divorce, death, loss of business reputation (bad leaver / good leaver).
• Calculation procedure: One-time payment or installment, sources of funds.

The more detailed the scenarios are, the less space there is for a dispute about an “unfair price.”

Step 8. Ensure information rights and transparency

Information asymmetry is one of the main causes of corporate wars. The majority shareholders who control management often restrict minority shareholders’ access to documents, creating the illusion of concealing abuses – even if they do not exist.

Minimum standard of transparency:

• Regular quarterly reporting for all shareholders;
• access to primary documentation in the company’s office;
• the right to initiate an audit;
• disclosure of transactions with interest;
• Information on management remuneration and key contracts.

In a corporate contract, it is possible to expand the scope of information rights in comparison with the legislative minimum, as well as establish responsibility for their violation.

Step 9. Implement early warning and dispute resolution mechanisms

Conflict does not come on suddenly. It is almost always preceded by signals: delays in providing information, disruption of meetings, unilateral actions of management, aggressive correspondence.

An effective prevention system includes:

• Mandatory pre-trial settlement with a clear schedule of meetings and escalations.
• Holding regular strategic sessions with the participation of all shareholders - at least once a year.
• Appointment of a “contact person” from each party to promptly remove misunderstandings.
• Involve an early stage corporate ombudsman or independent consultant.

The goal is to prevent disagreements from turning into a public corporate dispute, after which even formal reconciliation rarely restores trust.

Step 10. Regularly review and update agreements

Business is changing, and agreements from a decade ago may no longer reflect reality. Conflict prevention requires regular review of:

• Annual review of key terms of the corporate contract.
• Update of the assessment of shares and the mechanism of their redemption.
• Changes to the structure of the business: The emergence of a new investor, entering new markets, changing key employees.
• Audit of the corporate structure for tax, sanctions and legal risks.

A document that is not revised has evolved over time from a tool of protection to a source of conflict.

What to include in the corporate contract: key elements

Common Mistakes in Shareholder Relationships

1. Rely on verbal agreements and personal relationships: Today’s trust does not guarantee tomorrow’s consent. The absence of written rules turns any conflict into a “word vs. word” dispute.

2. Even a 1% share gives the right to information, contest transactions and lawsuits. A small shareholder can paralyze a business.

3. Equal distribution of shares without resolution mechanisms of deadlock is a time bomb.

4. When one partner wants to exit, a price dispute becomes inevitable and destructive.

5. Standard corporate contract from the Internet rarely takes into account the specifics of the business, the composition of participants and jurisdictional features.

6. Not to keep protocols and not to follow corporate procedures.Even with full consent, the absence of formal decisions opens the way for challenge.

7. If a partner simultaneously works in a business, his rights as a shareholder and duties as an employee should be separately fixed.

8. Divorce, inheritance, illness of one of the shareholders can unexpectedly enter into the capital of a third party not bound by previous agreements.

Shareholder checklist: 20 Questions for Conflict Prevention

1. Who are the real beneficiaries of all the shares?
2. Does each partner’s share match their actual contribution?
3. Is there a corporate agreement/shareholder agreement?
4. Does the charter reflect actual agreements?
5. Whether the partners' roles are defined: Active and passive investors?
6. Is there a clear way to decide on key issues?
7. Is there a mechanism for resolving deadlocks?
8. Is there a dividend policy?
9. Are there any additional funding rules and sanctions for non-payment?
10. Are there competition bans and regulations for parallel business?
11. Is the procedure for exiting the business and evaluating the share determined?
12. Are the powers of the general meeting, the board of directors and the general director separated?
13. Does the shareholders have access to financial statements?
14. Is there a mandatory pre-trial dispute settlement procedure?
15. Is there a mechanism for transferring a share in the event of death, divorce, bankruptcy?
16. Are sanctions and currency restrictions taken into account if the structure is international?
17. Is the management responsible for losses?
18. Is there a regular audit, financial and legal?
19. Are the agreements updated in view of changes in business?
20. Do all parties understand where and how disputes will be resolved?

What a strong preventive system looks like

A strong corporate conflict prevention system operates on five levels:

1. Structural level The right choice of jurisdiction, organizational and legal form, distribution of shares and control mechanisms.

2. Individually developed corporate agreement, covering all scenarios: from operations to emergency exit.

3. Procedural Level: Formalized and enforced corporate procedures, regular meetings, protocols, disclosures.

4. Regular strategic meetings, mechanisms of escalation, culture of discussion of disagreements before their transition to the legal plane.

5. Periodic review and audit of structures and agreements, analysis of changes in legislation, practice and business environment.

Only the combination of all five levels gives real stability. A contract without procedures is paper. Procedures without a contract are a good wish. Communication without structure is a temporary truce.

FAQ

It is possible, but it is necessary as soon as possible to formalize them in a corporate agreement or a shareholder agreement. The longer a business operates on oral rules, the more likely it is that one party will “remember” the arrangement differently.

What to do if we are already at a 50/50 impasse?We need to urgently consider a negotiated settlement involving a mediator or an independent expert. At the same time, the possibility of using the deadlock mechanism, even if it is not prescribed, through the conclusion of a settlement agreement or restructuring should be analyzed. Legal war in such a situation destroys business faster than any compromise solution.

Does the corporate contract work in Russia? Yes, the institution of the corporate contract is fixed in the article. 67.2 of the Civil Code of the Russian Federation and is actively used. There are peculiarities for LLCs and JSCs, but in general, courts recognize and enforce the conditions, including in terms of options, voting procedure and liability.

Is it possible to protect a minority shareholder without a corporate contract?Basic protection is provided by law: The right to information, the right to challenge transactions, to request audit. But effective protection of interests is possible only through an agreement, which explicitly spells out quotas, the right of veto, the procedure for withdrawal and dividend policy.

The heir or former spouse receives a share and becomes a full participant, without being bound by previous gentlemen's agreements. It instantly changes the balance of power. You can protect yourself through the inclusion in the charter and corporate contract of rules on the transfer of shares only with the consent of the other participants, options for redemption, trusts, marriage contracts.

Is it necessary to conduct a corporate dispute in Russia if the business is here? If the holding structure includes a foreign company, the dispute can be resolved in international arbitration (LCIA, ICC, SCC, etc.), which often gives greater flexibility and predictability. The choice of forum should be made before the conflict and enshrined in the agreement.

Prevention ceases to work when the parties have moved from protecting interests to destroying the opponent – criminal statements, raider attacks, public discrediting began. At this stage, it is not the prevention, but the strategic protection and resolution of acute corporate conflict that is required.

Related services

• Corporate conflicts, shareholder disputes and protection of business owners’ interests
• Corporate Law and M&A in Russia and CIS
• Structuring of business and joint ventures
• Shareholder agreements and corporate contracts
• Protection of minority shareholders and investors
• International Arbitration and Dispute Resolution
• Due diligence and corporate investigations

Related material

• How to resolve corporate conflict without losing business
• Shareholder agreement: step-by-step
• How to protect minority shareholders in Russian LLC
• Deadlock: How partners can break the deadlock
• Structuring of joint business: key-errors
• How to assess the share when leaving the business
• Inheritance of shares and shares: How to maintain control
• Corporate Contract vs Articles of Association: What is more important and how to combine

Conclusion

Corporate conflict between shareholders is not an accident, but the result of accumulated inconsistencies. The main tool for preventing it is not trust or personal relationships, but a legally verified system of rules prescribed before the dispute begins.

Strong prevention is based on three bases: Proper ownership structure, comprehensive corporate contract and operating corporate governance procedures. Added to this are deadlock resolution mechanisms, predetermined exit costs, and a culture of transparency.

In Russian and international structures, it is not the one who wins the court. The winner is the one who creates conditions in which the court is not necessary.