Parting Ways in Family Businesses

Introduction

Companies in which shares or authority to manage is held by members of a family are considered to be “family businesses”. Family members can hold shares that control the company, as well as retain management authority. Having a family business means opportunity, security and income for family members. For this reason, it is important to keep the shares and/or authority to manage them within the family and establish continuity for future generations. In family businesses, family and commercial relationships can be intertwined; sometimes family businesses may face the risk of being terminated due to alienation and family animosities. Therefore, it is important to foresee policies for transfer of shares in line with family values and goals.

Within the scope of the articles of association, family constitutions and shareholders’ agreements, special mechanisms may be designed for the needs of family businesses. Many subjects may be included in these documents, from family values to corporate governance principles, from share transfer to dispute resolution mechanisms. These legal documents allow the creation of various mechanisms to maintain the shareholding structure and control of a family over the company in case of commercial conflicts among family members. If such conflicts do occur, the termination of joint stock companies for just cause under the Turkish Commercial Code (“TCC”), and share transfer limitations come into play. This newsletter will elaborate on share transfer limitations and introduce a decision of the Court of Cassation that reveals its approach regarding family businesses and termination for just cause.

Share Transfer Limitations

A successful entrepreneur is generally the starting point of a family business, but over time, other family members often get involved in the company. Such companies are shaped by family traditions, and grow to be an important income for the families. The continuity of these companies, which provide financial security to the family, becomes crucial. On the other hand, as a result of personal animosities, family members may prefer to cease their shareholding relation to the company over time and family businesses may face the danger of alienation. For this reason, it is important to regulate share transfers in order to preserve the family-specific structure.^[1]

Restrictions regarding share transfer may be included in the articles of association,^[2] the shareholders’ agreement^[3] and the family constitution.^[4] The legal restriction stipulated by Article 491 of the TCC, and the contractual restrictions foreseen under Article 492 of the TCC and the articles following in terms of registered shares, are noteworthy for family businesses as well. Accordingly, the transfer of registered shares may be subject to the approval of the company, and share transfer may not be approved if to do so would violate an important reason set forth under the articles of association. The important reasons are conclusively listed under Article 493/2 of the TCC, and the unique characteristics of the group of shareholders is considered to be an important reason. In this context, share transfers to those competing with the company may be subject to company approval; share transfers only to founding family members may be allowed.^[5] Thus, share transfers to undesired third parties can be prevented by such limitations.

There are also mechanisms that can be included both in family constitutions and shareholders’ agreements to protect shareholding structures pertaining to a family. These are first refusal,^[6] pre-emptive, call option, put option, drag along and tag along rights. These mechanisms are applied to realize share transfers to desired third parties.

First Refusal Rights

First refusal rights can be implemented in different ways: a shareholder willing to transfer his shares may be obliged to notify of his intention to transfer his shares and negotiate with first refusal right holders, or the first refusal right holders may be assigned priority for offer and the shareholder who intends to transfer his shares may be obliged to offer his shares to them.[7]

Pre-emptive Rights

Pre-emptive rights are applied as a precaution against the danger of alienation. They provide right holders an opportunity to purchase shares which are to be sold to a third party, so that the characteristics of a group of shareholders is maintained. Pre-emptive rights create a new legal status and they are considered to be a conditional right of purchase. This condition for the exercise of the right depends on the execution of an agreement through which the shares in question are transferred to a third party.^[8]

In family businesses, transitions between generations are especially likely to lead to deadlocks within the management. The equal division of shares following the death of the founding shareholder, and the equal contribution of capital between two siblings are examples of such occasions. In these cases, differences of opinion may easily render the company’s decision-making mechanism dysfunctional. As a precaution, shareholders may be given the right to sell their shares and other shareholders may be obliged to purchase those shares. Conversely, shareholders may be given the obligation to sell their shares and the other party may receive the right to buy them.^[9] These options are referred to as put options and call options, respectively. The exercise of such rights is conditional and depends on the existence of certain conditions foreseen under the shareholders’ agreement or family constitution.

On the other hand, a tag along option grants the right holder the opportunity to sell his shares under the same conditions with another shareholder who has the intention to sell his shares. Meanwhile, a drag along option grants the right holder the option to force other shareholders to sell their shares under the same conditions provided that the right holder decides to sell his shares to a purchasing third party. Tag along options generally intend to protect the interests of minority shareholders; while drag along options are exercised to facilitate the sale of a company.^[10]

On the other hand, a shareholding relationship may become unbearable due to poor management, hostilities between family members, or the failure to generate and/or distribute profits. For such cases, a lawsuit for the dissolution of joint stock companies for just cause regulated under Article 531 of the TCC may be appropriate.

The Termination of Joint Stock Companies for Just Cause

Where just cause arises based on Article 531 of the TCC, shareholders representing at least ten percent of the capital and five percent in public companies may request the termination of the company from the relevant court. This article functions as a protection mechanism against poor management.^[11] Pursuant to this article, instead of the termination of the company, the court may also decide on the squeeze out of the claimant shareholders upon the payment of the real price of their shares on the date nearest to the decision, or on another acceptable solution. The court enjoys considerable judicial discretion. It is important to note that the TCC contains a presumption in favor of the continuity of companies. Therefore, courts tend to decide on the termination of a company as a last resort,^[12] preferring other solutions, such as squeezing out the claimant shareholder.^[13]

Termination of a joint stock company for just cause holds significant importance for simple shareholdings, and family businesses. However, Article 531 of the TCC does not incorporate a definition of just cause or examples of just cause. Instead, the article leaves it to precedent and academic commentary^.[14] In fact, some authors do not consider personal disputes among shareholders as just cause for terminating a joint stock company.^[15] While personal disputes among shareholders requires close inspection, the approach of the Court of Cassation differs for family businesses. In a recent decision, the Court of Cassation stated that, as a rule, personal characteristics of shareholders should not play a role in business operations. However, depending on the characteristics of the individual case and company type, the Court of Cassation established that even in joint stock companies, which are equity partnerships, personal reasons may be considered as justifiable reasons for a decision for the termination of the company, to squeeze the claimant shareholders out of the company, or for another appropriate solution.

In the aforementioned decision of the Court of Cassation,^[16] the claimant asserted that the company (a family business) acted in violation of the articles of association. The claimant also asserted that company resources were used in a way that would harm shareholders. As evidence for this claim, he alleged that he had been alienated by the other shareholders, disguised profit transfer was performed by not distributing profits and granting board members unreasonably high financial rights and that board members who had served in previous years were released while the claimant was unjustly not released. In addition, he claimed that there was a criminal case for insult against another shareholder, that family relations were distorted and the majority shareholders exploited these poor relations, and therefore, continuation of the shareholding relationship was unbearable. Lastly, he argued that no profit has been distributed for a long time for various reasons. Accordingly, the claimant requested the termination of the company based on just cause, or the squeeze-out of the claimant upon the payment of the real price of the shares owned on the date nearest to the decision, or another appropriate solution. The court of first instance stated that termination should be a last resort and that the continuation of the company was essential. When the allegations of the claimant were evaluated, the court ruled that the conditions for termination for just cause had not occurred, and therefore, conditions for the squeeze out of the claimant from the company did not exist. Thus, the claim was rejected. The decision was challenged before the Court of Appeal but the request of appeal was rejected based on the merits.

The Court of Cassation, on the other hand, emphasized that the company in question was a family business and stated that the contention between the shareholders as well as the insult incident between the claimant and another shareholder that was brought before the criminal court would constitute just cause when dealing with a family business. In this respect, it concluded that the alignments formed among shareholders and the alienation of the claimant following the insult incident before the criminal court, in its entirety, constituted just cause for termination. Accordingly, the Court of Cassation reversed the decision of the Court of Appeal.

Conclusion

Family businesses mean financial security and income for families. For this reason, it is important to establish a strategy for share transfers within the articles of association, the family constitution and shareholders’ agreements against alienation. Such documents serve the purposes of managing personal enmities and poor management within family businesses, and ensuring the establishment of a functioning corporate structure for future generations. Commercial and family relationships may intertwine with family businesses, and maintaining shareholding relations may become unbearable over time. For these reasons, Article 531 of the TCC is a protection mechanism for disputing shareholders, especially minority shareholders, against the majority.