Our article addresses shareholders agreements under Turkish law, explaining their legal nature, their difference from the articles of association, their relative effect, voting agreements, pre-emption, drag along and tag along rights, deadlock provisions, exit mechanisms and the sanctions for breach.
A company founded by two partners in great harmony may, a few years later, take on an entirely different shape when one of them sells its shares to an unexpected third party. Or an investor puts serious capital into a company only to discover that, being in the minority, it has no say at all in critical decisions. In another scenario, two equal partners fail to agree on a fundamental matter and the company becomes completely deadlocked. What these pictures have in common is that the partnership relationship has been left solely to the articles of association and that the parties' real expectations have never been reduced to writing anywhere. The shareholders agreement exists precisely to fill this gap. Regulating in detail the partners' rights and obligations towards one another, their say in management, the restrictions on the transfer of shares and the routes out of the partnership, this agreement is a document that should be prepared when the company is founded but is most often neglected. This article comprehensively examines the legal nature of the shareholders agreement, its relationship with and difference from the articles of association, the consequences of its relative effect, its typical provisions and the sanctions available in the event of breach.
1. The Concept of the Shareholders Agreement
The shareholders agreement is a contract concluded between the partners of joint stock or limited liability companies. The basic aim of this agreement is to determine the partners' relationships with one another, their understanding as to the management of the company and the arrangements concerning the fate of the shares, in a manner far more flexible and detailed than that offered by the articles of association. The parties to the agreement are, as a rule, the shareholders of the company. The agreement may be concluded so that all shareholders are parties to it, and equally it may be established with a limited party structure in which only two or some of the shareholders are parties and the others are not included. In practice, recourse is had to this agreement most often in three situations; at the foundation stage of the partnership in order to clarify the parties' expectations, upon an investor's entry into the company in order to secure the investor's rights, and in family companies in order to protect intergenerational transition and the integrity of the shareholding. In all three situations the agreement serves as a road map preventing from the outset a significant part of the disputes that may arise in the future.
2. The Legal Nature of the Agreement
The shareholders agreement is not regulated in the Turkish Commercial Code. For this reason the agreement is in the nature of an atypical contract, meaning one not regulated in the law, and is subject to the general provisions of the Turkish Code of Obligations. The basis of the agreement is freedom of contract, one of the fundamental principles of the law of obligations; the parties may freely determine the content of the agreement, provided it is not contrary to the mandatory provisions of the law, to public policy, to personality rights or to general morality. In terms of its legal nature the agreement is an obligation-creating transaction with at least two parties, capable of imposing reciprocal or unilateral obligations and of giving rise to an obligation of instantaneous or continuous performance. In doctrine it is also argued that the shareholders agreement establishes an ordinary partnership relationship between the parties; for the parties undertake to act together in pursuit of a common aim. As to form, the agreement is subject to no condition; it may even be established orally. However, making it in writing, for ease of proof and clarity of provisions, is recommended in practice without exception and it is almost always drawn up in writing.
3. Its Relationship with and Difference from the Articles of Association
A correct understanding of the shareholders agreement passes through grasping its relationship with the articles of association. Although these two documents regulate the same partnership relationship, they differ fundamentally in legal nature and effect. The articles of association are the company's constitutive document; they are registered with the trade registry, announced in the trade registry gazette and, thanks to this registration, constitute an institutional regulation with absolute effect that may be asserted against third parties as well. By contrast, the shareholders agreement is not registered, is not announced and is an agreement with relative effect producing effect only between the parties who sign it. The practical consequence of this two-layered structure is this; the articles of association must remain within the limits permitted by the law and are narrow in terms of content, whereas the shareholders agreement allows for far broader and more detailed arrangements. Another important advantage of the shareholders agreement is confidentiality; whereas the articles of association are open to everyone, the content of the shareholders agreement is known only to the parties. That sensitive understandings between partners do not appear in a publicly accessible document is among the most important reasons why this agreement is preferred in practice.
4. Relative Effect and Its Consequences
The most critical feature of the shareholders agreement is that it has relative effect. Relativity means that the agreement is binding only between the parties who sign it and does not directly bind the company's legal personality or third parties. This principle has exceedingly important practical consequences and this is the point on which error is most frequently made in practice. The first consequence is that the agreement cannot be asserted against the company; the company is not bound by an agreement to which it is not a party and cannot refrain from recording transactions contrary to the agreement. The second consequence is that it is not possible for third parties to breach the agreement; even if a third party is aware of the existence of the agreement, the obligations arising from it do not bind it. The third consequence is that, in the event of a transfer of shares, the rights and obligations arising from the agreement do not pass automatically to the new shareholder; the transferee is not bound by it unless it separately becomes a party. For this reason, well-drafted agreements contain provisions making it mandatory for the transferee to accede to the agreement in the event of a transfer of shares. These consequences of relative effect make it essential to understand correctly the limits of the agreement and to establish mechanisms that close those limits.
5. Voting Agreements and Management Rights
One of the most common provisions of shareholders agreements is undertakings relating to the exercise of votes. These provisions, also termed voting agreements, aim to ensure that the shareholders act together on designated matters and that general assembly resolutions are adopted in the direction agreed in advance. These arrangements are used in particular to enable a minority shareholder or an investor to have a say disproportionate to its capital holding. Among the typical arrangements relating to management rights are granting a minority shareholder the right to representation on the board, giving it a veto right on certain critical matters, and agreeing that some decisions be taken by a qualified majority. The matters made subject to a veto right are generally headings directly affecting the company's future, such as mergers and acquisitions, amendment of the articles of association, capital increases, borrowing in significant amounts, the disposal of core assets and liquidation. However, the relative effect of these undertakings shows itself here too; the vote of a shareholder voting contrary to its undertaking is deemed valid before the company and the general assembly resolution adopted does not become invalid for this reason. The sanction for breach of the agreement remains at the level of damages and liquidated damages. For this reason it is of vital importance that voting undertakings be supported by deterrent liquidated damages clauses.
6. Pre-emption and Priority Rights
The preservation of the shareholding structure is one of the basic aims of shareholders agreements. The first mechanism serving this aim is the right of pre-emption. The right of pre-emption provides that, where a shareholder wishes to transfer its shares to a third party, these shares must first be offered to the other shareholders on the terms offered to the third party. The other partners may exercise this right and purchase the shares, and the entry of an outsider into the partnership is thereby prevented. This mechanism is a fundamental instrument preventing alienation in the partnership and protecting the relationship of trust between the existing partners. Another mechanism operating in a similar manner is the priority right granted to existing partners on the issue of new shares; this right prevents the dilution of existing partners' shares in the event of a capital increase and gives them the opportunity to preserve their proportions in the capital. The workability of these rights depends on the procedure being clearly regulated in the agreement; the content and form of the notice to be given by the partner wishing to transfer, the period allowed for the other partners to respond, how the price will be determined and on what terms the transfer will become free where the right is not exercised must all be set out in detail.
7. Tag Along and Drag Along Rights
The two most characteristic provisions of shareholders agreements are the tag along right and the drag along right. The tag along right is directed at protecting the minority shareholder. Thanks to this right, when the majority shareholder sells its shares to a third party, the minority shareholder also has the opportunity to join the sale on the same terms and to transfer its shares. Without this arrangement, the minority partner faces the risk of being left alone with a new majority partner it does not know and does not trust. The drag along right, on the other hand, protects the majority shareholder in precisely the opposite direction. This right gives the majority partner wishing to sell its shares to a third party the power to compel the other shareholders to sell their shares on terms no less favourable. The reason for the existence of this mechanism is practical; a buyer most often wishes to acquire the whole company and the presence of a small partner who would remain in the minority may prevent the sale. The drag along right overcomes this obstacle and preserves the possibility of exit. For both rights to operate effectively, the triggering events must be clearly defined, the notice periods determined and the obligation of equivalent terms expressly stated.
8. Transfer Restrictions and Lock-up
Shareholders agreements also frequently contain provisions providing that shares shall not be transferred for a certain period. This arrangement, known as lock-up, is used particularly at the foundation and growth stages of the company in order to secure that the founding partners and key persons remain with the company. From an investor's point of view, the founder of the company in which it has invested selling its shares and departing within a short period is a serious risk; a lock-up provision eliminates this risk. Similarly, restrictions may be regulated providing that shares may be transferred only to certain persons or on certain conditions. However, there is a critical limit here arising from relative effect; a transfer of shares made contrary to contractual provisions restricting transfer retains its validity and may be asserted against the company. That is, a transfer contrary to the agreement is not deemed legally invalid; the breaching partner merely comes under liability for damages and liquidated damages. In order to overcome this important limit, recourse is had in practice to complementary methods; institutional instruments such as inserting a transfer-restriction provision into the articles of association, pledging the shares or annotating the transfer restrictions on the share certificates strengthen the contractual restriction.
9. Deadlock Provisions and the Resolution of Blockage
Particularly in companies with two equal partners, one of the greatest risks is that the partners fail to agree on a fundamental matter and the company becomes unable to take decisions. This situation, known in practice as deadlock, may effectively halt the company's activity and cause the parties grave losses. Deadlock provisions are regulated in shareholders agreements in order to manage this risk. These provisions determine in advance the course to be followed in the event of deadlock. At the first stage a process of negotiation and of seeking a solution at senior management level is generally provided for. Where this process does not produce a result, mechanisms bringing about a change of hands in the shares come into play. The best known of these is that one partner makes an offer to the other to purchase its shares at a certain price and the other party is obliged to choose either to sell at this price or to purchase the offeror at the same price; this mechanism is regarded as balanced in that it compels the offeror to give a realistic price. Alternatively, solutions such as the valuation of the shares by an independent expert and their transfer at the price determined, or even the liquidation of the company, may be provided for. Regulating these provisions from the outset prevents the parties from being left helpless at the moment of deadlock.
10. Call and Put Options
Option provisions enabling shares to change hands upon the occurrence of certain conditions are also widely used in shareholders agreements. A call option gives the holder the power to purchase the other partner's shares according to principles agreed in advance when the determined conditions occur. A put option gives the holder the opportunity to sell its shares to the other partner and to compel the other party to purchase. These mechanisms are tied in particular to specific triggering events; cases such as one of the partners materially breaching the agreement, acting contrary to the non-compete undertaking, leaving its position at the company, death or loss of capacity are typical triggers. For option provisions to be functional, it is essential that how the price will be determined be clearly regulated; methods such as a fixed price, a formula, an independent valuation or a calculation on a given multiple may be used. Leaving the price mechanism uncertain renders the option provision inoperable in practice and turns it into a fresh source of dispute. Defining the triggering events in a manner leaving no room for doubt is equally important.
11. Non-Compete and Confidentiality
One of the essential elements of shareholders agreements is undertakings that the partners will not compete with the company. This undertaking carries vital importance particularly as regards partners who take an active role in management and who have access to the company's trade secrets, customer relationships and technical knowledge. A non-compete undertaking may be provided for both throughout the period in which the agreement is in force and for a certain period after the partner departs by transferring its shares. For a post-departure non-compete undertaking to be valid, it must remain within reasonable limits as to duration, geographical area and field of activity; a disproportionate non-compete undertaking may be deemed invalid or limited on the ground that it endangers the person's economic future. Alongside the non-compete undertaking, provisions relating to keeping information about the company and the partnership relationship confidential are also regulated. Since claiming damages in the event of breach of these undertakings is most often difficult, in practice these provisions are almost without exception tied to liquidated damages. Determining the liquidated damages at a level that is deterrent but not excessive is important both for the functionality and for the validity of the provision.
12. Breach of the Agreement and Sanctions
The sanctions available in the event of breach of the shareholders agreement are directly connected with the relative effect of the agreement and are for this reason limited. That the breach does not invalidate the transaction before the company is the most fundamental problem in practice; a transfer of shares made contrary to the agreement remains valid and a vote cast contrary to it produces effect as regards the company. Accordingly, the routes available in the event of breach remain essentially within the framework of the law of obligations. The first route is damages; it is requested that the breaching party compensate the loss suffered by the other party. However, proving the loss here is most often difficult and this difficulty may render the route of damages ineffective. For this reason the second and, in practice, far more effective route is liquidated damages; the liquidated damages provided for in the agreement may be claimed without the need to prove loss and serve the real deterrent function. The third route is a claim for specific performance; particularly where the performance of a specific transaction has been undertaken, the court may be asked to have this undertaking carried out. Fourth, contractual mechanisms such as the exercise of option rights against the breaching party may be brought into play. Structuring this architecture of sanctions from the outset when drafting the agreement provides effective protection at the moment of breach.
13. Dispute Resolution
Disputes between shareholders most often concern sensitive commercial information, the internal functioning of the company and personal relationships between the partners. Owing to this character, the method of dispute resolution must be chosen with care. In practice an arbitration clause is widely preferred in shareholders agreements. The basic advantage of arbitration in this field is confidentiality; the public nature of proceedings before state courts may lead to the disagreement between the partners and sensitive information about the company being disseminated publicly, whereas arbitration eliminates this risk. The second advantage is speed; partnership disputes dragging on may paralyse the functioning of the company. The third advantage is expertise; the resolution of the dispute by arbitrators versed in company law and commercial practice increases the accuracy of the decisions. In companies with a foreign partner, a further advantage of arbitration is that awards may be recognised and enforced in the international arena. When drafting an arbitration clause, the arbitral institution, the seat, the language, the number of arbitrators and the applicable law must be clearly determined. An incomplete or contradictory arbitration clause may cause the process to become blocked at the moment of dispute.
14. Mistakes Frequently Made in Practice
Certain mistakes are frequently repeated in shareholders agreements. The first mistake is not making the agreement at all; regarding this document as unnecessary in the atmosphere of harmony at the foundation stage of the partnership prepares the ground for intractable disputes years later. The second mistake is using templates obtained from the internet without considering the company's concrete situation; a text not adapted to the shareholding structure, the sector and the parties' real expectations is inoperative. The third mistake is disregarding the relative effect of the agreement and assuming that its provisions also bind the company; whereas the company is not bound unless it is a party. The fourth mistake is failing to observe consistency with the articles of association; the arrangements in the shareholders agreement must, so far as possible, be supported by institutional instruments such as transfer restrictions in the articles of association. The fifth mistake is not making it mandatory for the transferee to accede to the agreement in the event of a transfer of shares; this omission may cause the agreement to lose its function upon a single transfer. The sixth mistake is leaving price and valuation mechanisms uncertain. The seventh mistake is not providing for liquidated damages at all or determining them at an ineffective level; in that case the deterrent force of the agreement is largely lost.
15. Conclusion and Practical Recommendations
The shareholders agreement is one of the most effective legal instruments as regards the sound conduct of the partnership relationship and the prevention of disputes. The basic considerations in this field may be summarised as follows. The agreement is atypical and is prepared within the framework of freedom of contract under the Turkish Code of Obligations; it offers a broad field of movement in terms of content, but the limits of mandatory provisions and general morality cannot be exceeded. The agreement has relative effect; it binds only those who sign it, does not bind the company or third parties, and this limit must be observed in the design of every provision. Transfers of shares and votes cast contrary to the agreement retain their validity before the company; for this reason deterrence must be built through liquidated damages. When regulating pre-emption, tag along, drag along, lock-up and option provisions, the triggering events, notice periods, price mechanism and obligation of equivalent terms must be written in a manner leaving no room for doubt. In structures with two equal partners, deadlock provisions must always be provided for. It must be made mandatory for the transferee to accede to the agreement upon a transfer of shares, and the arrangements must so far as possible be supported by institutional instruments in the articles of association. Finally, an arbitration clause must be seriously considered for the confidentiality and speed it provides. Most importantly, this agreement must be prepared when the partnership is being established, that is, in the period when the parties are still in harmony; negotiating this document after a dispute has arisen becomes almost impossible.
The shareholders agreement is closely connected with the other fields of company law and commercial contract law. Our article on the liability of board members in joint stock companies, which addresses the liability of those serving in company management, and our analysis of choice of law and jurisdiction agreements in international commercial contracts, which examines the determination of the applicable law in structures with foreign partners, address the matters connected with shareholders agreements.
For advisory services on the preparation and negotiation of shareholders agreements, partnership structuring, investor entry, the design of exit mechanisms and the resolution of partnership disputes, you may contact us at info@guzeloglu.legal.