Company Constitutions vs Replaceable Rules: Governance for Directors

What is a Company Constitution?

A legally binding agreement between your company and its internal members that defines rules related to internal governance, business activities and rights and obligations of its internal members.

It is submitted as part of a company’s incorporation process.

A company constitution has the following components:

• Name and type of company

• Decision-making and board member selection structure

• Nature and extent of liabilities of company members

• Details of company shareholders

• Business objectives and activities of the company

• Rules and regulations pertaining to share issuance, board resolutions and director duties

Moreover, having a defined constitution in your company documentation may empower your company to perform certain actions that are not defined with the relevant company legislation in your jurisdiction.

For instance, it enables your company to acquire shares from existing shareholders and restrict transfer of shares.

Why is Company Constitution Important for Business Today?

A company constitution enables your company to:

• Pre-define rights and obligations of stakeholders, along with company’s policies and processes

• Ensure a balance of power between shareholders and directors, especially in cases of evident gaps in control

• Retain control over your company as it grows and provide flexibility and certainty in governance

Why is it Important for an Event Tomorrow?

A company constitution is important for an event tomorrow, as it helps:

• Benchmark the existing processes and regulations of your company against your competitors

• Evaluate details on share capital, policy on share transfer and issuance and stake owned by your shareholders

• Resolve any potential disputes related to ownership of shares, internal processes, management or compliance

• Assess the relationship between your company and shareholders

• Understand what rules exist that may impact on the ability to achieve or process to implement a proposed transaction

Pros of Addressing Company Constitutions

• Improvement in decision-making ability of your company by defining roles and powers

• Reduction in internal disputes as process of appointment and removal of directors is pre- defined

• Flexibility to modify or replace rules and regulations that are provided for as standard under the relevant company legislation in your jurisdiction

Cons of Not Addressing Company Constitutions

• Lack of clarity in how to deal with particular situations

• Board of directors may lack the required powers to address certain matters that are not common but important to your company

• Increased difficulty in protecting the rights of minority shareholders

The Law

Section 134 of the Corporations Act 2001 (Cth) (Corporations Act) provides that a company’s internal management may be governed by a constitution, the replaceable rules as set out in that Act, or a combination of both.

The term “constitution” is defined in s 9 to mean:

• a company’s constitution, which (where relevant) includes rules and consequential amendments that are part of the company’s constitution because of the Life Insurance Act 1995; or

• a managed investment scheme’s constitution; or

• in relation to any other kind of body:

  • the body’s charter or memorandum; or

  • any instrument or law (other than the Corporations Act) constituting, or defining the constitution of, the body or governing the activities of the body or its members.

The rules that a company adopts to govern the internal management of the company may be referred to as corporate governance rules.  These rules may be in the form of the company’s constitution or the “replaceable rules” as set out in the Corporations Act.

Under s 136, a company adopts a constitution:

• on registration (each initial shareholder agrees in writing to the terms of a constitution before the application is lodged); or

• after registration (if the company passes a special resolution adopting a constitution or a court order is made that requires that the constitution be adopted).

A company may modify or repeal its constitution or a provision of its constitution, by special resolution (refer to s 136(2)).

Replaceable rules

The general principle is that for an agreement to be binding there must be consideration.  Nominal consideration is sufficient to make a simple contract binding.  Under s 140 the constitution of a company and the replaceable rules are a statutory contract.  Unlike a public company (s 117), a proprietary limited company does not need to register its constitution.

Section 140 of the Corporations Act provides that the constitution and the replaceable rules are contracts between the company and each member, each director, each company secretary.  Non-compliance with a company’s constitution or any applicable replaceable rules is not, in itself, a contravention of the Corporations Act.  However, if a company is in default of its obligations to a member under its constitution, the member would ordinarily have a personal contractual right to remedy the breach.  This may include declaratory and injunctive relief to enforce company compliance or damages against the company for non-compliance.  Replaceable rules are applicable to a company unless the company adopts a constitution that expressly excludes or overrides the operation of the replaceable rules.

As a general rule, replaceable rules can apply to any company, including a proprietary company that is or was registered after 1 July 1998.  However, a proprietary company cannot use the replaceable rules if the same person is both its sole director and its sole shareholder. A company, including a proprietary company, may also include in its constitution, a reference to replaceable rules that does not otherwise apply (see s 135).

The sections of the Corporations Act that may apply as replaceable rules are set out in a table form in s 141.

Where a shareholders agreement sits beside the constitution

A company constitution and a shareholders agreement do different work. The constitution binds the company and every member under section 140 of the Corporations Act 2001 (Cth), it is lodged with ASIC where the company chooses to adopt one, and it can be altered by special resolution of the members. A shareholders agreement is a private contract between the shareholders, and often the company as well. It is not lodged, it is not public, and it is usually drafted so that it cannot be changed without the agreement of every party to it.

That difference is the reason most closely held companies use both. The constitution carries the governance machinery. The shareholders agreement carries the commercial bargain between the people who put the money in.

A shareholders agreement commonly covers matters a constitution does not. Reserved matters that require unanimous or supermajority consent. Pre-emptive rights, drag along and tag along rights on a sale. Deadlock resolution. Funding obligations and what happens when a shareholder will not or cannot contribute. Board composition and who each shareholder may appoint. Restraints of trade, confidentiality and the treatment of a shareholder who leaves the business. Dividend policy and valuation method on an exit.

Where the two documents conflict, the outcome depends on drafting. The constitution governs the company’s internal affairs as a matter of statute, so a shareholders agreement that purports to override it can leave the parties with a contractual remedy against each other and no ability to stop the company acting. Well drafted pairs include an inconsistency clause and an obligation on the shareholders to exercise their votes to amend the constitution so that the two documents agree.

Constitutions and shareholders agreements: common questions

What is the difference between a shareholders agreement and a company constitution?

The constitution is a statutory contract binding the company and all members, alterable by special resolution. The shareholders agreement is a private contract between the shareholders that usually requires unanimous consent to change. The constitution governs how the company operates. The agreement governs the bargain between the owners.

Do you need both a constitution and a shareholders agreement?

A company with a single shareholder rarely needs both. A company with two or more shareholders who have contributed unequal amounts, or who hold different roles in the business, generally does. The replaceable rules and a standard constitution say nothing about deadlock, exit or reserved matters.

Which document prevails if they conflict?

Neither prevails automatically. The constitution binds the company itself, so an act permitted by the constitution is not void merely because the shareholders agreement forbids it. The remedy lies against the shareholder in breach. Drafting an inconsistency clause into both documents is the way to settle the question in advance.

Is a shareholders agreement lodged with ASIC?

No. It is a private contract and is not lodged or made public. A constitution adopted on registration is held by the company, and a copy is lodged with ASIC in the circumstances the Corporations Act 2001 (Cth) requires.

Can a shareholders agreement be changed later?

Only in the way the agreement itself allows, which is usually by the written consent of every party. That is the point of the document. A shareholder who could be outvoted on a constitutional amendment cannot be outvoted on the agreement.

Constitutions, shareholders agreements and the resolutions that give effect to them are drafted by GRM LAW’s corporate and commercial lawyers.

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For more information, please contact Gavin McInnes on 07 3367 8681 or gmcinnes@grmlaw.com.au.

 The information contained in this article is general in nature and cannot be regarded as anything more than general comment. Readers of this article should not act on the basis of this comment without consulting one of GRM LAW ‘s legal practitioners who will consider their particular circumstances.

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