Terminated managers normally pack up their desks. Now, they may also be able to cash in their chips. In a recent case1 two sacked managers of a private company obtained orders that forced the majority shareholder to buy back their equity at fair value. Private Equity firms should consider the significance of this decision when putting in place a management equity package.
Wain and Murchie (Drapac Managers) were managers of Drapac Group, founded by Michael Drapac. From 2004 to 2006 the Drapac Managers acquired equity interests in certain companies and trusts of the group, along with other executives. No formal shareholders agreement was entered into, however Drapac and the executives discussed the proposed terms of such an agreement over a number of years.
The relationship between the Drapac Managers on the one hand and Drapac on the other soured during 2009. Wain was subsequently terminated in October 2009, whilst Murchie resigned in December 2009, claiming his employment was untenable. Both brought proceedings for declarations of oppressive conduct, and orders that Drapac or the Drapac Group acquire their equity interests.
The law – oppressive conduct
The scope of and remedies for oppressive conduct are set out in the Corporations Act. Section 232 provides, in part, that a court may step in if the conduct of a company's affairs is commercially unfair to a member – that is, oppressive to, unfairly prejudicial to, or unfairly discriminatory against, the member. Section 232 also provides that a person can be affected by commercial unfairness in a capacity other than as a member – for example, as in this case, as an employee. A court can make any order it considers appropriate, including an order for the purchase of shares or (as a last resort) winding up.
The Victorian Supreme Court found that there was oppressive conduct towards the Drapac Managers. With respect to Wain for example, after their relationship had broken down, Drapac used his power as the majority shareholder to terminate Wain and unfairly exclude him from management. No offer was made by Drapac to acquire the Drapac Managers' equity. In the Court's view the fact that their equity was "trapped" when they would no longer be part of the management team "bore all the hallmarks of oppression".
The Court ordered Drapac and a company he controlled to acquire the equity held by the Drapac Managers at fair value.
Does this decision impact on private equity?
This is one of those areas of the law in which the courts are at
pains to stress that each case must be assessed on its own facts,
however frustrating that might be in predicting how the law might
apply in the future.
Notwithstanding, the case puts "leavers" from MBOs or MBIs firmly at the centre of those scenarios under which exclusion from management may constitute oppressive conduct. The Court characterised the Drapac Group as a "quasi-partnership", an arrangement under which persons contribute their capital based on mutual confidence and on the understanding that they will take part in the management of the company.
Although the investment structure in the Drapac case was not a private equity investment as such, almost all private equity investments would be treated as quasi-partnerships for these purposes. Further, the size of a manager's shareholding is not determinative – the Court rejected a submission that Murchie's shareholding of 3.5% was too low to constitute a quasi-partnership.
Would the outcome have been different if a shareholders agreement was in place? Perhaps. If a clause in such an agreement provided that, if a manager loses their job, their shareholding would continue pending a decision by the board to buy back their shares, the court may have upheld the clause. However, the Courts prefer to focus on the conduct of the majority shareholder and the commercial reality of that conduct on the leaver, rather than the underlying agreement. In a prior case2, the NSW Supreme Court placed little significance on the provisions of a shareholding agreement that enabled the oppressed shareholder in that case to sell shares to third parties, as the shares would probably not be saleable to anyone other than the majority shareholder at something like fair value (if at all).
How does the case affect private equity investments?
- The most obvious consequence is caution in drafting the leaver provisions of a shareholders agreement. PE firms might normally wish to have the right, but not the obligation, to acquire the shares of a leaver. This is particularly so for a "bad" leaver, who may use the sale proceeds to capitalise a competing business. In such cases, PE firms should recognise the risk of an oppression claim if the equity of a leaver becomes trapped.
- For an employee who is a minority shareholder, the case does not set a high threshold to establish that conduct is oppressive. The Court found that Wain's termination of employment was not based on proper grounds. Even more remarkably, Murchie's continued employment was found by the Court simply to be "untenable". Clearly, a breakdown in personal relations can be one of the factors that leads to oppression, even if part of the reason for such a situation is the conduct of the manager.
- The Courts have recognised the difficulty in determining "fair value". For example, what is the relevant date to determinate fair value? Are the appropriate records available as at this date? Is "fair value" the value the shares would have had but for the oppressive conduct? Notwithstanding, courts have wide powers to remedy oppression, and may override any valuation provisions contained in shareholders agreements if oppression is found.
- It is conceivable that a leaver could attempt to use the oppression remedy when a buy back is already underway – to force a change in the buy back price, from say cost to fair market value.
- Finally, certain equity arrangements may assist in limiting or hindering an employee's claim of oppression as a shareholder. Such arrangements may have other limitations though in establishing a management incentive package, so PE firms should balance these against the risk of an oppression claim.
1 Wain & Ors v Drapac & Ors  VSC
2 Tomanovic and Anor v Global Mortgage Equity Corporation Pty Ltd and Anor (2011) 84 ACSR 121
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.