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					REGIJA BORENIUS Client Seminar 15 March 2005 SHAREHOLDERS AGREEMENT – DRAFTING FOR SUCCESS Notes for presentation of Lauris Liepa.

Structure of the presentation: 1. Necessity of the SA and the conditions for application, 2. Structure and principal contents of SA, 3. Practical implementation of SA 4. Typical problems/ shortfalls of SA application, 5. Summary.

Part One. Introduction. Shareholders agreement (SA) is widely used instrument in commercial practice, in particular for the undertakings with foreign capital. The main purpose of SA is to structure the relationship of two or more participants (The Partners) in an undertaking (The Company). In case the Partners are long-term strategic partners, no SA may bee necessary, unless specific issues of the relevant undertaking demand attention. Such issues may be: particular duties of the participants, in particular, in relation to the timeframe of the stages of the development of the Company, financing, sale of the shares of the Company (put and call options) or alike. The term “Shareholders Agreement” encompasses variety of meanings from different areas of law. SA may include such autonomous concepts as agreement for setting up a joint venture (elements of incorporation agreement), non –competition agreement, technology sharing, etc. 1

We will not attempt to concentrate to such specific issues, technically covered by the term “shareholders agreement”, however actually being part of specific regulation, although a number of them may serve as a good example of the essence of the SA e.g. documentation related to financing of the Company and related status of venture capital institution as a shareholder in the company or agreements between shareholders – former creditors in the company under rehabilitation, determining e.g. standstill of their creditor’ s claims. Notable that not many undertakings use SA, in Latvia statistically only minority of Companies have SA.

Prerequisite to it’s application may be specific status of shareholders as well as demands for the business of the company.

1. Option One: shareholders are equals and have a shareholding pari passu. The purpose of SA is to protect their balance and the agreement is central to that effort, e.g. two or more undertakings traditionally being competing entities enter the new market to set up a business. This is particularly important when shareholders commit themselves to management of the Company.

2. Option Two: one shareholder requires specific conditions, protection. e.g. when public body (the state or municipality) is a shareholder. This is particularly sensitive to the corporate agendas with a political element, e.g. by privatization of public asset the state remains as a minority shareholder and still maintains a control of performance of obligations of the strategic investor.

3. Option Three: the specific status of the company. The Company’s business demands specific approach of the shareholders. An appropriate example be an IT company, where research and set-up phase may require further continuous shareholders attention and support.

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Part Two. Structure. One general comment on the technique of drafting of the SA. The agreement may be very detailed and complex in cases, where the anticipated business will be specific, or to put it bluntly, when shareholders do not particularly trust each other. However, in jurisdictions, where corporate law is the most developed, it is typical to lay out only the most important issues of the joint venture requiring special description. Thus we may present a “check-list” of issues that are most common in the shareholders agreements.

The structure of SA may include such material components as:

1) Company business and Governance Purpose of the company may be defined in the SA. In Latvia this becomes an acute issue since the company business activities are no longer a mandatory chapter in the Articles. Rules of composition of the institutions and exercise of the daily management and control may be generally described by the SA. One of the modern trends (post the many vocal corporate scandals) is to paste the basic rules of corporate governance within the SA. It has been notable that major foreign investors have attempted to secure proper business practices, at least defining the guidelines in their anticipated common business with the local partners. Not to say the least, these rules of SA also may serve as guidelines for the designated areas of the Company’s business, to be further elaborated by the company’s institutions. Some shareholders are trying to bind non-competition arrangements within the SA, this area shall be carefully

2) Capital structure and financing Shareholders may mutually commit to grant a specific amount and/or proportion of the equity investment and/or subordinated capital loans. 3

It is typical to have a binding commitment on maintenance of the equal proportion of the capital allotment, e.g. joint obligation to increase the capital, maintaining the initial proportion of investments. Shareholders may define various types of securities, to be issued by the Company. Depending on their investment strategies, the shareholders are allotted different kinds of shares, e.g. preferred shares for the venture capital equity investor or non-voting shares for the subordinated lenders. As to the financing strategy, Shareholders outline their vision of the source of funds for business. Partners may agree on rules for the new entrants – diminution of the proportion or emission of special kind of instruments, e.g. bonds. Shareholders may also express their intention in relation to their aims of distant future, such as arrangement of the IPO.

3) Decision making procedure, voting on specific issues Since no corporate documentation provides for option to document informal consultancy (consensus) procedure, SA is ideally placed to describe the procedure of the decision making. Parties may elaborate special technique of consulting each other on material issues to be voted by the company shareholders and the agenda and guidelines for institutions. A couple of problems may surface here. The latest trends of good corporate governance are demanding that individuals forming corporate institutions are independent and shall not be bound to/ by any suggestions, recommendations of a “proper voting”. These trends are included in the regulations for financial institutions in Latvia. Another potential trap is the protection of the minority shareholders. It is important though that major shareholders respect the rules of protection of the minority shareholders, in case they are left outside the SA. The ultimate point of concern here is the applicability and enforceability of sanction mechanisms in case one of the shareholders acts contrary to the arrangement of SA, we will deal with this a moment later.

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4) Share encumbrance and transfer Partners are usually trying to secure their joint participation during the whole lifecycle of the Company. To ensure this permanence, the SA may contain various hurdles in selling the shares. Typical clause in the SA is commitment to limit the possibilities of share sale to third parties or even encumbrance via pledging the shares. Thus the statutory right of the first refusal for the exiting partners is cemented contractually. No doubt – also in this instance we shall refer to the enforceability problem – third parties may not be aware of any negative covenant or restriction, bound contractually and not available for the public examination. Latvian Commercial law however places the burden of responsibility to the business partner – one must carefully examine the party of the anticipated transaction. However this rule may apply only to the document of the public domain.

5) Distribution of dividends Similarly with the equity investment policy, or perhaps even more importantly is to define the policy of dividend distribution. A capital-intense business may force shareholders to retain their dividends undistributed for the first years of the Company life. SA is the only paper where such commitment may be arranged between the shareholders.

6) Dead-lock and exit rules One of the principally beneficial reasons to have SA is the chapter related to dead-lock solution issues and provisions for their avoidance / resolution. Variety of possible mechanisms are boiling down to the core principle – any disagreements even when there seemingly is no exit, still may be resolved by pre-arranged mechanisms. Parties either concentrate on techniques of settlement of discrepancies via specific mediation procedures or bodies of mutual trust (e.g. Chamber of Commerce) or discuss the exit rules for one of the Parties. It inevitably may be the case that only the Exit scenario may save the Company form further deadly clashes. It is hardly possible to discuss the exit between the clashing parties; it certainly helps that exit rules are defined long before. 5

7) Valuation of the Company For this purpose company valuation is a key to any exit scenario. Describing the exit route, the next clause will be devoted to Company valuation by an independent expert. Either the expert is selected and identified in the SA or, what is the most typical situation, rules for the Company evaluation are defined. Valuation may be carried on various precepts (on a going concern, or asset-based, or future), that is advisable to be precisely reflected in SA.

8) Other issues SA may cover a whole range of other issues important for cooperation of the Partners. The most typical will be Non-competition clause, access to information by Shareholders, transactions of the Company, Confidentiality provisions, etc.

Parties may use their creative imagination to enrich the contents of any template SA, proposed by theirs lawyers. Usually the SA are at their best when the partners have suffered at least one business failure and are

Part Three Application. SA may be applied as an everyday instrument for running of the Company. Usually though it is useful as a guideline for elaboration of more detailed rules of operations and management, and SA is left as a general guideline. Thus SA may be rather used “in times of war” than in times of peace, i.e. whenever shareholders face difficulties of managing the joint operations. As outlined, several issues of SA then become critical. Such points of special interest for parties effectively are: Composition of decision making bodies, governance, dead-lock and exit rules.

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Potential problems/ shortfalls: 1. Enforceability of the SA? – practical sanction mechanism may be impossible due to the fact, that ultimately the defaulting shareholder will retain the Company shares until the effective judgment of the court forcing to exit, and will continue playing a [usually very nasty] role in the Company’ s business.

2. Prevailing effect and validity of SA or Articles of Association? The parties may agree, and will always draft, that the SA is effectively prevailing over any other corporate documents. Here the problem will appear in case the SA is contradicting mandatory provisions of the corporate law. In such case, no doubt, the SA will be overruled by the legally effective documentation.

3. Binding effect of the commitments towards third parties? Alternatively the problems may appear in case third parties have acted in good faith, albeit in breach of the SA. No doubt, they will be pardoned, but shareholders will have to reconsider their arrangement. One of the most acute problems is effect of shareholders prohibition to pledge the shares, not available for public inspection.

4. Availability of SA for examination by third parties? Parties are usually trying to secure their arrangement under the confidentiality siege. It is important to reconsider in advance the items to be placed under the confidentiality clause.

5. Shall all the company shareholders be part of the SA? May the new shareholders refuse to sign in? What shall the Partners do, in case the new shareholder is unwilling to join the SA? The simplest answer is – take it or leave it. The praxis however often guide us the opposite direction: interest towards the new entrant is so high that parties agree to modify or even dismantle the SA.

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6. Minority shareholder problems? The SA shall always be drafted with a cautious look on the minority protection rules. There are several court cases at present in Latvia, when disrespect towards the minority shareholders may push the principal owners to pay a heavy price.

7. Competition law impact? Precedent suggests a situation when a shareholder is found to be in breach of the competition law prohibitions only because of ugly drafted SA, dating back to early nineties. This is a useful reminder to businesses to constantly improve the documentation and always look at the case –law for the fresh interpretation of ever changing regulation.

Part Five. Summary. Noting the critical aspects described above, we believe, that SA is an effective tool to improve relationship between the Parties in the company, and, if drafted thoughtfully, SA shall be the best guide to avoid possible future problems in the Company before they surface.

We advocate preparing SA, which does not copy the rules of the Commercial law, we neither see a necessity to copy the Articles of Association, while reflecting in SA the most important issues of the Partners concern.

Q&A

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