Produced by Julie Garland-McLellan, Consultant at AltoPartners Australia and non-executive director and board consultant based in Sydney, Australia.

Contribution by Stephen Dallamore, Managing Director Search Partners International and current Global Chairman on AltoPartners

This edition of the newsletter was first published on The Director’s Dilemma website and the full newsletter is available for viewing here. To subscribe to future editions of the newsletter, click here

The Director’s Dilemma - September 2020

Our dilemma this month looks at cleaning up the mess left by an unscrupulous MD.

Zachariah recently accepted the role of Managing Director with a medium sized private company. The previous MD resigned when $400K of unauthorized withdrawals was discovered. She left the company with an increasing, unscheduled debt problem.

The now ex-MD owns around 12% of the shares, held through a trust, with a possible value of $200K. The board offered to extinguish the ex-MD’s debt if the shares are sold and 100% of the proceeds are paid to the company. They also agreed not to pursue the ex-MD for the remainder of the outstanding amount or to report her to the authorities. Deeds of separation have been signed and contain strong confidentiality provisions.

Now, one of the directors, who is a friend of the ex-MD, owns 40% of the shares, is an unsecured creditor, and also a key international vendor, has given notice he’s found a buyer for his shareholding and will invite the ex-MD to sell to the same buyer. Thus 52% of the equity is now going to an unknown party.

Zachariah’s concern is that this new shareholder will have a majority interest, effectively controlling the company and, if allied with the ex-MD, could make his role precariously uncomfortable. The Chair owns 15% of the shares and is the son of the founder. He is greatly loved by the other directors and chairs an inclusive meeting, but has no idea how to proceed under these circumstances.

What should Zachariah do?

Stephen’s Answer

This is a private company so the first thing Zachariah should do is scrutinize the shareholders’ agreement. Private companies are very chary about protecting their shareholding structure and it would be most unusual not to have a clause dealing with pre-emptive shareholder rights, which effectively gives the current shareholders right of first refusal.

Even if there are no takers, and the shareholder then offers them to an outside buyer, they can’t do so at a discounted rate, unless they have previously offered the same discount to the current shareholders.

Zachariah should approach the Chair, who has a vested interest in the company, and float the idea of a management buy-in, even if it means approaching an institution to fund a portion of the purchase or find a friendly purchaser (White Knight).

However, careful scrutiny of the shareholders’ agreement might also reveal a penalty clause in the event of fraud or misconduct. This normally means that those shares can be acquired at cost from the transgressor, and not at market value. As MD, he is also within his rights to check if the deeds of separation and confidentiality provisions pass a common-law test and whether they are in fact, enforceable in law.

Zacharia should also meet the proposed new shareholder and get a sense of who they are and what value they would add to the business. Finally, the Chair and MD should insist on some form of redress from the ex-MD in the form of a payment plan to return the unauthorized withdrawals, and in the event the former MD can’t meet this, then consider a bond against her existing assets.

Julie’s Answer

Zacharia is in a bind. He should get a legal opinion on the deed of separation and the shareholders’ agreement and/or constitution. The company agreed to accept the proceeds of the ex-MD’s share sale in lieu of complete reimbursement of the unauthorised withdrawn funds; does that supercede any shareholders’ agreement that might include constraints on the sale?

Control now rests with the incoming investor; Zacharia needs to meet and understand their position. He had the skills, qualifications and reputation to gain the MD appointment but must now prove it again. He should also get legal advice on his contract and how it may protect or compensate him if he is ousted.

A new majority shareholder has power to call a meeting and replace individual directors or the whole board. This could be followed by a decision to change to an MD the new board has chosen. Zacharia needs to be the best choice available. The best way to do that is by building a relationship and sharing with the investor his plan for reporting to the board, managing the debt, and establishing positive cash flows.

Zacharia is suffering his board’s failure to provide good governance. Better controls and oversight would have prevented the ex-MD stealing from the company. Moving quickly to agree on a ‘quiet exit’ has opened the door to a potential comeback or vengeful action.

It is important, when taking on a CEO or MD role, to look beyond the business and focus on the board. While he grapples with this problem Zacharia needs to also lay the foundations for building a better board in the future. Ethics and governance training is clearly needed.