Shotgun Clauses: the Importance of “Shooting” First
A shareholders’ agreement is often the appropriate legal tool for a new project or business partnership. Such a union is usually compared to a marriage contract, rightly so, since the shareholders’ agreement, like said marriage contract, aims to provide the new “partners” with clear corporate governance rules.
But often the different partners, just like newlyweds, are excited by all the opportunities that come with this union and forget to provide for important elements of their “partnership contract”.
Firstly, one of the issues for discussion – and perhaps even the most important – is how shareholders may dispose of their shares. Indeed, unless otherwise provided, a shareholder may sell his shares to anyone, which can results in a number of consequences for the company or its co-owner. Who would want to have a new partner forced onto them, a stranger to the company’s way of doing business that now wants to get involved in its business decisions?
Therefore, there should be a restriction on the transfer of shares in order to maintain the private ownership of the company and avoid the involvement of an unwanted third party. By making sure to include this when the shareholders’ agreement is being drawn up, the diligent shareholder ensures that the company will benefit from a greater stability and will be in compliance with legislative requirements regarding shared capital, thus maintaining certain tax advantages.
Secondly, the shareholders should provide for the possibility of forcing the buyback of their shares. Indeed, in addition to the traditional clauses providing for the allotment of shares and restrictions on employment at the end of the partnership, shotgun clauses will commonly be found in shareholders’ agreements, which can read as follows:
“CLAUSE: If one of the partners, party hereto, wants to sell his stake in the company (shared capital) or wants to buy the stake of the other party hereto, he (hereinafter the Offeror) must send to the other partner (hereinafter the Recipient) a notice indicating his offer to sell his stake in the shared capital of the company or his offer to buy the Recipient’s stake for the price and at the terms and conditions specified in his written offer to the Recipient. The Recipient shall, within thirty (30) days of the receipt of the offer, jointly exercise any of the following options:
i. in the case of an offer to sell, the Recipient can accept the terms of the offer and thereby decide to acquire the Offeror’s stake in the company. In the case of an offer to buy, the Recipient can accept the terms of the offer and sell its stake in the company to the Offeror;
ii. the Recipient can counter the terms of the offer and must therefore commit to offer to sell his stake in the company to the Offeror, if the latter had offered to sell his stake, or he must commit to buy the stake of the Offeror, if the latter had offered to buy the stake of the Recipient, all for the same price and at same conditions stated in the offer. The Offeror shall accept and follow through with the terms of counter offer;
iii. where the Recipient has not communicated his intention to accept or scounter the Offeror’s offer within the given deadline, he is presumed to have accepted the terms of the offer pursuant to paragraph (i) of this section;
Any offer, acceptance of an offer or counter offer under this section shall be made by written notice and the other partner must give an acknowledgment of receipt to the sender within three (3) days of receipt.
The following conditions shall be essential to any sale of the stake of a partner in the partnership under this section:
i. the purchase of the stake of one of the partners is considered valid only if accompanied by a certified check for an amount of at least twenty five percent (25%) of the total amount of the offer,
ii. all offers must provide a payment deadline and the terms for the payment of the balance of the purchase price, as well as the applicable interest rate.”
Shotgun type clauses, often called “boomerang”, “baseball” or even “Russian roulette” clauses, involve the sale or purchase of the shares of the various business partners. Thus, a shareholder can offer the other to sell him his shares, and if he has the necessary liquidity, he will have to buy the shares. However, if he doesn’t have the required funds, he will be obliged to offer to sell the shares he owns to the offering shareholder, at the same price and according to the same terms set forth in the initial offer.
In other words, it becomes clear that such a clause allows a partner with a better financial position to be able to demand the departure of another shareholder, who, not being able to buy the shares of his partner, risks losing all of his interest in the company and will be in an uncomfortable position.
This clause can be used strategically by a shareholder to make an offer with conditions he knows he will be able to fulfil, while knowing that his partner will, in turn, have difficulty meeting them. For example, he might want to specify that all employment contracts must be respected and while he is a full time employee with a generous salary, the other partner is not.
A non-compete covenant could also be included in this clause, which would be more restrictive than the terms already provided in the shareholders agreement. Indeed, this type of commitment has been declared valid by the Court of Appeal, even in cases where the duration of such a clause is very long, for example 10 years1. It could have no impact on shareholders wishing to withdraw completely from business, but would be a big disadvantage for those who want to continue working in the same field.
Of course, the exercise of this contractual right must respect the rules of good faith and cannot result in an abusive exercise. However, we must recognize the objective pursued by such a clause, which is to facilitate the quick and efficient departure of a shareholder when internal problems threaten the viability of the company. Speed and ease of execution are the two main advantages sought after by the person relying on it.
The exercise of the right to invoke a shotgun clause requires nevertheless the use of caution and an appraisal of the financial and personal circumstances of the business partner. Indeed, it is important to evaluate the position of this partner in order to determine the asking price for the shares. The drafting of such clauses should therefore be done with great care and it would be wise to anticipate situations where the sale of a shareholder’s shares is triggered automatically rather than simply providing for a formal commitment of the latter to sell them.
Such a commitment can often complicate the sales process and result in a legal challenge demanding time and money from both “former” partners. An automatic transfer of shares, in the form of a sale from one to the other, is preferable in that it causes the immediate termination of the shareholder status and allows the company to continue its operations without facing a judicial deadlock in terms of corporate governance. We must therefore exercise great diligence and thoroughness when a party is interested in using such a clause.
However, on some occasions, especially when the partnership is in trouble, there could be value in being quick on the trigger and “shooting first”, figuratively speaking of course!
With the precious collaboration of Mr. Raphael Allard, law student at École du Barreau du Québec.