When putting in place or reviewing shareholder arrangements (i.e. shareholder agreements and/or new articles of association) for private companies, the possibility of the death of a shareholder should be specifically considered.
The constitution of a private company often contains restrictions on the transfer of shares. Usually a shareholder will not be able to transfer his or her shares unless he or she has first offered them to the other shareholders. This mechanism is commonly referred to as “pre-emption rights”.
It is fairly usual to find that pre-emption rights will apply where a shareholder is leaving the company for whatever reason. Similarly, pre-emption rights can apply on a shareholder’s death but often the application of pre-emption rights on death does not provide a satisfactory outcome for all involved. In such circumstances, under the pre-emption rights, the personal representatives of the deceased shareholder will automatically offer the shares to the remaining shareholders. But there is no obligation on the remaining shareholders to purchase the shares. Moreover they may not have the financial resources to do so. As a result the personal representatives may find themselves in the difficult position of holding shares in a private company (often as a minority shareholder) which they cannot sell.
Cross options and life insurance
A possible solution is for the shareholders to take out cross life insurance policies, which are complimented by cross option agreements entered into by the shareholders. So, in the event of a shareholders death, not only will the life insurance policy provide the funds to the surviving shareholders for the purchase of the shares, but also the personal representatives can exercise an option for the remaining shareholders to purchase the shares (or the remaining shareholders can exercise an option for the personal representatives to sell the shares).
A cross option agreement also serves to ensure that the surviving shareholders do not simply retain the proceeds of the life policy and not buy the shares, or indeed that the deceased’s estate simply refuses to the sell the shares. A trust deed is also needed so that the proceeds of the life policy on the death of a shareholder will be payable directly to the surviving shareholders in order to provide them with the necessary funds to buy the deceased’s shareholding.
These arrangements mean that the personal representatives have a degree of control over the situation, by exercising the option they can make the sale of the shares happen. In many ways this is a preferential scenario when compared with the situation that relies on pre-emption rights as described above.
Private company shares usually attract 100% business property relief for inheritance tax purposes so that a deceased’s estate will not be subject to a charge for inheritance tax on the value of the shares. A binding contract made prior to death for the sale of the shares may well jeopardise that relief and therefore cross options have to be drafted carefully in order to avoid that risk.
Issues in practice
Independent financial advisers and banks can all suggest suitable life assurance products for this purpose and can usually provide outline and standard cross option agreements and trust documentation. The provider will recommend that independent legal advice is taken on these documents. Care needs to be taken, however, to ensure that such arrangements meet the objectives of the shareholders.
The company’s articles need to be checked to ensure that there is not some inconsistent provision which may prevent the operation of the cross options as planned. Frequently, for example, articles contain a provision enabling the directors to refuse to register a transfer.
The cross option agreement needs careful drafting to ensure that there can be a binding contract at the relevant time, that it will be consistent with the company’s articles of association and that inheritance tax business property relief is not prejudiced.