Memorandum of Incorporation Versus a Shareholders Agreement: Some Important Considerations.

  1. Introduction

  • In the context of South African company law, a memorandum of incorporation (MOI) and a shareholders agreement (SHA) are similar documents in that both seek to govern the manner in which a company is run, albeit with subtle differences.[1]
  • In terms of the Companies Act 71 of 2008 (Companies Act), the purpose of a MOI is to “set out rights, duties and responsibilities of shareholders, directors and others within and in relation to a company…”. Although not defined in the Companies Act, a SHA is an agreement which sets out how a private company should be operated and regulates the various shareholders rights and obligations.[2]
  • The promulgation of the Companies Act has fundamentally changed the form, content and application of the constitutional documents of a company and SHA’s.[3] In terms of the Companies Act 61 of 1973 (Old Act), a company’s constitutional documents consisted of its memorandum of association and articles of association.[4] Further in terms of the Old Act, these documents had to be registered at the Registrar of Companies and were therefore public documents open to inspection.[5] Conversely, a SHA was merely a private contract between the shareholders, enforceable between them and served the purpose of regulating important aspects of the company.[6] Such SHA’s would often include a clause stating that where there was a conflict between the SHA and the articles of association, that the SHA would prevail.[7] As the Old Act was silent with regards to such conflict, the SHA would triumph over the constitutional documents of a company.
  • This position has, however, been amended significantly in terms of the Companies Act. As will be discussed below, the Companies Act sets out a documentary hierarchal order, which favours the MOI. The adverse result is that in many instances, the shareholders of a company will enter into a SHA, only to find out subsequently that some of the provisions which they agreed to are null and void as they are in conflict with the MOI and/or the Companies Act.
  • The following article will provide an overview of the laws pertaining to the relationship between a MOI and SHA, the relevance of SHA’s under the Companies Act and drafting considerations in relation to SHA’s.

 

  1. The Law

  • As a starting point, it is necessary to look at the relevant provisions in the Companies Act that deal with conflicts between a MOI and a SHA. Section 15(7) of the Companies Act states that a SHA must be consistent not only with the Companies Act, but also with the MOI of a company. As a result, the MOI ranks above a SHA.[8] To the extent that a SHA or any provision thereof is inconsistent with the Companies Act and/or the MOI of the company, then such SHA or the relevant provision thereof is void to the extent of the inconsistency.[9] It is also important to note that a SHA may not be used to alter any ‘alterable provisions’ of the Companies Act, as such provisions may only be altered by the MOI.[10] ‘Alterable provisions’ are those provisions of the Companies Act which may be negated, restricted, limited, qualified, extended or otherwise altered in substance or effect in accordance with the wishes of the members, but only to the extent that it is done so in the MOI.[11]
  • The application of section 15(7) of the Companies Act has been addressed in two notable cases. These include the cases of Verso Financial Services (Pty) Ltd v Burger and others[12] and De Freitas v Chamdor Meat Packers.[13]
  • In terms of the Verso case:
  • the shareholders of a company were in the process of negotiating a new MOI (in accordance with the requirements of the Companies Act), when the majority shareholders appointed four additional directors to the board of the company.[14] Such appointments were in compliance with the articles of association, but contravened the SHA;[15]
  • it is of contextual importance to note that Schedule 5 of the Companies Act provided for a two-year transitional period (ending on 1 May 2013) during which companies could file amendments to their articles of association, in order to bring them in line with the Companies Act. During this transitional period, if a company’s existing articles of association were in conflict with the Companies Act, the articles of association would prevail.[16] Furthermore, during the transitional period, a SHA would prevail over both the MOI and the Companies Act, where there was any inconsistency. However, after the transitional period, and in accordance with section 15(7) of the Companies Act, the MOI had to be consistent with the Companies Act and a SHA had to be consistent with both the MOI and the Companies Act.[17] If a company failed to amend its articles of association before the end of the transitional period, then such articles would apply only to the extent that they were not in conflict with the Companies Act;[18]
  • the minority shareholders objected to the appointments arguing that as they were still negotiating the new MOI (and in particular the provisions dealing with the appointment of directors), that the relevant provisions of the SHA should apply;[19]
  • the court held that the position after the transitional period had ended was that the Companies Act and the MOI trump the shareholders agreement.[20] In coming to this decision, the court had to assess if the provisions of the articles of association relied on by the majority shareholders in appointing the directors were in compliance with the Companies Act.[21] Here the court found that as the Companies Act contains an unalterable provision that mandates at least 50% of the directors to be elected by a majority of shareholders, the majority shareholders were permitted to elect the additional directors, notwithstanding that the shareholders agreement has a different regime regarding the composition of the company’s board.[22] As the articles of association did not conflict with section 66(4)(b) of the Companies Act, and given that the articles now trumped the shareholders agreement after the lapse of the two year grace period, the election of the additional directors was in order, despite such election being inconsistent with the provisions of the shareholders’ agreement.[23]
  • In terms of the De Freitas case:
  • five shareholders of a company approached the court to declare a shareholders agreement (dated 2002) of full force and effect, and that such shareholders agreement and not the MOI of the company (adopted in 2012), takes precedent in respect of the relationship between the shareholders inter se and the company.[24] The shareholders of the company had resolved (at a quorate meeting, albeit not with all of the shareholders present) to adopt the new MOI and cancel the SHA.[25]
  • the issue to be decided by the court was whether or not the adoption of the new MOI amended or set aside the terms of the pre-existing SHA, that are contrary to those contained in the MOI.[26] In considering section 15(7) of the Companies Act, the court held that where a company adopts a MOI by special resolution, it will effectively amend any existing SHA, to the extent that it is inconsistent with the Companies Act or the MOI.[27] Furthermore, the court found that the existence of a non-variation clause in a SHA would not render a lawfully adopted MOI invalid.[28] Here the court held that even if the shareholders agreement was not terminated in its entirety, shareholders could not rely on any provisions in the shareholders agreement that conflicted with the Companies Act or the MOI.[29]
  1. Is a Shareholders Agreement still Relevant?
  • It is clear from the above that the promulgation of the Companies Act has made significant inroads into the practical benefits of SHA’s.[30] Under the Old Act, a SHA was key to the governance of a company and its members as it was used to supplant various provisions of a company’s articles of association.[31] Given that a MOI now trumps the Shareholders Agreement in terms of the Companies Act, as confirmed by the Verso and De Freitas cases, this paragraph aims to answer the question of why a SHA is still necessary and relevant, if at all. In other words, why not include all relevant provisions governing a company and its members in a MOI, to the exclusion of a SHA? This, in essence, would negate any risk of the provisions in a SHA being declared null and void and therefore provide more assurance and guidance to the company, the board and the shareholders.
  • Notwithstanding that a SHA is not as effective as it once was, it still has a number of advantages:
  • first, it is a private document.[32] It is not filed with the CIPC and is not available for public inspection;[33]
  • second, it is governed by the law of contract i.e. the Companies Act does not extend to SHA’s.[34] As a result, a SHA is useful in covering provisions that do not fall within the scope of the Companies Act or MOI. Such provisions generally include, but are not limited to: (i) the issued share capital of the company; (ii) shareholder loans; (ii) the sale of the issued shares; (iv) come-along provisions; (v) tag-along provisions; (vi) deemed offers; (vii) good faith; (vii) breach; (ix) disputes; and (x) confidentiality. It is not necessary to deal with each of these provisions in this article. Suffice it to say, they are important regarding the regulation of the relationship between the shareholders and the company. That is not to say such provisions cannot be included in a MOI. All that is required in this regard is that they do not conflict with the Companies Act.[35] Furthermore, such provisions will be binding on the shareholders and the company.[36] However, given the nature of private companies and the fact that information in this day and age is of great economic and commercial value,[37] it is highly unlikely that shareholders will be willing to make information available where there is no legislative requirement to do so. Conversely, it is preferable for parties to a private agreement to ensure that information disclosed between them and/or governing their affairs be kept confidential and be used only for purposes of the agreement.[38]
  • In light of the above, it is evident that all relevant provisions relating to the relationship between the shareholders inter se and the company can, in fact, be incorporated into the MOI. However, this is not always preferable as the MOI is a public document. One of the main reasons incorporators elect to incorporate a private as opposed to a public company, is, as the name suggests, to create a sense of privacy and confidentiality amongst its members. As a result, the members will be reluctant to disclose private information where it is not a legislative requirement. Therefore, a SHA is important to cover all of the relevant provisions that govern the relationship between the shareholders inter se and the company, whilst maintaining the privacy associated with private companies.
  1. Drafting tips relating to SHA’s
  • As mentioned earlier, a MOI and SHA are similar in that both documents serve to govern the manner in which a company is run. As a result, the MOI and SHA will often contain overlapping provisions. These generally include but are not limited to: (i) the business of the company; (ii) the endorsement of and safekeeping of share certificates; (iii) directors meetings; (iv) shareholders meetings and (v) distributions.
  • With regards to these provisions, and in light of the above, it is extremely important that those overlapping provisions contained in the SHA do not conflict with the MOI and the Companies Act. There are essentially three ways of ensuring such compliance:
  • first, they can simply be removed from the SHA. As the MOI trumps the SHA, they should be included in the MOI as opposed to a SHA. There is no real purpose of duplicating them in the SHA;
  • second, if the shareholders are resilient in ensuring that such provisions be included in both the SHA and the MOI, then those provisions in the SHA must, to the greatest extent possible, mirror those in the MOI;
  • finally, the provisions may be included in the SHA and merely linked to the MOI. For example, if the parties wish to include a shareholders meeting provision in the SHA, the SHA can simply state “the requirements for a meeting of the shareholders is set out in the MOI.”
  • By following such advice, parties can be rest assured that the MOI and SHA speak to one another and will avoid any potential conflict in the future.

 

  1. Conclusion

The promulgation of the Companies Act had a profound effect on the relevance and importance of SHA’s. This stems from the fact that the MOI trumps the SHA and any provisions in a SHA which are inconsistent with the MOI will be declared null and void to the extent of such inconsistency. Notwithstanding this, a SHA remains both relevant and important as it serves to incorporate provisions that fall outside of the scope of the MOI and the Companies Act but which are still important to the relationship between the shareholders and the company, whilst maintaining the privacy and confidentiality associated with private companies. When setting up a new private company with more than one shareholder, advisers should insist on the parties entering into a SHA. However, in doing so, they must ensure that the SHA falls in line with both the MOI and the Companies Act.

[1] Schwenn Inc. “Why do I need a Shareholders Agreement and MOI” (2018) para 1.
[2] DKVG “Commercial Law: Shareholder’s Agreements in a nutshell” Para 1.
[3] C Leclercq “New Companies Act MOI Deadline: What’s the Fuss?” para 1.
[4] FHI Cassim et al Contemporary Company Law (2012) page 123.
[5] Section 63 of the Old Act.
[6] Cassim op cit note 4 page 139.
[7] Schwenn Inc. op cit note 1 para 5.
[8] Cassim op cit note 4 page 139.
[9] Section 15(7) of the Companies Act.
[10] Cassim op cit note 4 page 140.
[11] Section 1 of the Companies Act.
[12] Case no. 9600/2013.
[13] [2015] JOL 33940 (GJ).
[14] [2015] JOL 33940 (GJ) para 3.
[15] [2015] JOL 33940 (GJ) para 12.
[16] Schedule 5 item 4(4)(a) of the Companies Act.
[17] Schedule 5 item 4(3A) of the Companies Act.
[18] Schedule 5 item 4(a) of the Companies Act.
[19] Case no. 9600/2013para 13.
[20] Case no. 9600/2013 para 26.
[21] Case no. 9600/2013 para 20.
[22] Case no. 9600/2013 para 24.
[23]  Case no. 9600/2013 para 29.
[24] [2015] JOL 33940 (GJ) para 2.
[25] [2015] JOL 33940 (GJ) para 5.
[26] [2015] JOL 33940 (GJ) para 3.
[27] [2015] JOL 33940 (GJ) para 27.
[28] [2015] JOL 33940 (GJ) para 28.
[29] [2015] JOL 33940 (GJ) para 32.
[30] Cassim op cit note 4 page 139.
[31] Ibid.
[32] Cassim op cit note 4 page 138.
[33] Ibid.
[34] Section 15(6) of the Companies Act.
[35] Section 15(1)(a) and (b) of the Companies Act.
[36] Section 15(6)(a) and (b) of the Companies Act.
[37] D Hutchison et al The Law of Contract in South Africa (2012) page 415.
[38] Ibid.

Author:            Darren Anderson
Position:          Senior Associate

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