Pitfalls in Drafting Articles of Association

Pitfalls in drafting Articles of Association (Articles) It is exciting to start a new business and after months or years of planning and organizing, finally the dream is becoming a reality by incorporating an entity with the partners you trust. The target is to incorporate an entity as soon as possible and less time is spent in reviewing the wording of the Articles, until there is a problem and the partners are at headlocks. This short updater will bring to your attention the pitfalls to avoid in drafting Articles based on our experience. Enjoy! Quorum A quorum is important for both board and shareholders meetings. Most Articles provide that a quorum for either the board or shareholders’ meeting shall be two directors/shareholders. There are numerous problems associated with having two members as a quorum: (a) What happens when there is a deadlock?

(b) What if there are only two shareholders/directors and the other intentionally decides not to appear? (c) What happens if a particular member has the sole right to appoint or terminate a particular director but opts not to do so? Companies have been stuck and unable to proceed with passing key decisions because of such a provision. There are ways to avoid this pitfall: (a) Have a chairperson to the board appointed in advance, either for a lifetime or annually. If there are only two shareholders/directors, then the chairperson (who can also be a member of the board and attend shareholders’ meetings) should have a casting vote. This will sort a deadlock issue. (b) Always have quorum in odd numbers e.g. 3, 5 etc.

(c) To sort a deadlock in members’ meetings, either have shareholders in odd numbers, the chairperson should have a casting vote or use polling in voting as opposed to show of hands. (d) Articles should provide that, if the quorum is not met at the time the meeting is called, the meeting should be adjourned to another date and time. If the quorum of the adjourned meeting is not met within 30 minutes, then whoever is/are present shall form a quorum – this means that even if there is one director/shareholder at the adjourned meeting, such director/shareholder alone will form a quorum and be able to pass resolutions as may be necessary.

(e) For the Articles in which each member is entitled to appoint a director, to cater for the possibility that the relevant member may opt not to appoint a director in order to ‘freeze’ the board’s operations, the Articles should provide a timeframe within which each member shall appoint or terminate a director and failure to do so will entitle the other member(s) to appoint such director. Call & Forfeiture This provision in the Articles allows the company to require the shareholders(s) to pay up for their shares within a particular period of time. It is not mandatory for shareholder(s) to pay for their shares at the onset but the shareholder(s) can, on demand, pay up at any point in time – particularly when the company needs funds. Some Articles have these provisions which will prove challenging in the long run: (a) The company cannot call more than 25% of the shares at

the same time. This means that the company can only call 25% of the unpaid shares and wait couple of months before calling on the next 25% and so on. (b) The company must call on all shareholders to pay up and cannot some to pay up. (c) Call on shares must be pre-approved by all shareholders of the company. The above are just the few common wording of call and forfeiture provisions in most Articles registered in Tanzania. To avoid the challenges which will be brought by such provisions, it is important to: (a) Ensure that the company can call on all shares at the same time. (b) The company should have the discretion to call on any shareholder to pay up notwithstanding that there are others who haven’t paid up. (c) The call on payment of shares should be by majority vote. It is highly unlikely that the shareholder who is being called to pay up will be willing to comply.

Again under this part the issue of quorum becomes key. Use of technology for meetings Most Articles lack a provision which allows meetings of the board and shareholders to be held otherwise than by physical meetings. Technology advancement has allowed people to have meetings without having a physical meeting. Articles should allow the use of video conference or normal telephone calls to proceed with meetings. The location of the meeting is where the chairperson is located. Written resolutions This provision allows the members or directors not to have an actual meeting (whether physical or otherwise) rather the resolutions are approved in writing by all directors/shareholders. This is the easiest way to approve resolutions where all members/directors are on board without bothering to organize a meeting.

It is important to ensure that your Articles have a provision which allows for written resolutions in absence of actual board or shareholders’ meeting. Pre-emption rights Contrary to popular belief, pre-emption rights are not provided for in the Companies Act of Tanzania and it is not mandatory to have them in the Articles. However, it is common for most Articles to have such provisions so that the shareholders are informed and protected against having unknown members join their company. Whilst pre-emption rights do offer protection to the existing shareholders, such pre-emption rights if drafted wrongly can complicate the removal of a shareholder or the shareholder is prevented from leaving the company. A keen eye should be kept to ensure that the wording of pre-emption rights is well drafted to balance the interests of the shareholders.

Pricing of shares for transfer This is another pitfall which befalls the shareholder who wishes to transfer his shares. Most Articles contain a provision that when a shareholder wishes to transfer his shares, then the board of directors is given the exclusive mandate to facilitate the transfer of shares including determining the price for the shares. Such provision can have serious consequences to a shareholder who wishes to transfer the shares especially if that shareholder does not have control of the board. Ordinarily, shares are a private property of a person and the person should be free to determine the price he wants for his shares. However, if it is important to ensure that the company controls the transfer, particularly if there are pre-emption rights to be

observed, the best provision is to allow the auditors of the company to determine the market value of the shares to be transferred because the same figure will be considered by the revenue authority to determine the capital gains tax payable. Inheritance/ transmission of shares This provision is common in many Articles and it caters for when an individual shareholder dies, what happens to his/her shares as it would fall within his/her estate. It is a requirement under the Companies Act that each company should have not less than two shareholders and most foreign companies setting up locally appoint any person they can find to hold the 1 share whilst the remaining shares are held by the parent foreign entity. This is done on an urgent basis and the aim is simply to satisfy the two shareholders requirement and be able to register.

Once registered, it is forgotten and the individual remains as a shareholder. This individual could be (a) the lawyer who was hired to register the company; (b) was a director of the parent company; or (c) just some local person in order to attain the local content requirements which might be applicable. The issue arises when the individual dies and his family is becoming problematic i.e. believing that their deceased relative had equal share/footing in the company or the individual parts ways with the company in an antagonistic manner. An extra eye should be cast in this provision to ensure that, if the non-contributing individual shareholder dies, there is a way of limiting his family’s claim against the company. This can be catered for by clearly stating the procedure of compensating his family, if any and how the share will be ‘taken’ from his estate.

Whilst the Companies Act does not expressly prohibit holding of shares in trust, the best option might be to enter into an agreement with an individual shareholder that he has not contributed anything to the company and that he holds the share in trust of a third party. It goes without saying doing due diligence on any individual joining the company is critical. Extra ordinary general meetings Members of the company are bound to meet at least once every year in what is called an annual general meeting. However, there are other matters which may arise which require an urgent input/decision of the shareholders – hence the need to call an extra ordinary general meeting. Most Articles do recognise possibility of calling an extra-ordinary general meeting but do not go a step further to detail the notice period and how it can be issued.

It is very important for the Articles to provide on possibility of calling an extra-ordinary general meeting, who may call it, the notice period and how the notice should be issued. Considering that the extra ordinary general meeting is urgent in nature, the notice period should be as short as possible, means of issuing the notice should be as informal as possible i.e. unlike an annual general meeting which requires an actual written notice, the notice for an extra ordinary general meeting can be via email or text. It is recommended that either director or chairperson should be able to call the extra ordinary general meeting. Appointment & termination of directors Directors are the persons vested with exclusive powers to govern the day to day operations of the company. Directors determine the success or failure of any company. The key issue is, who appoints directors?

Is it the members or their fellow directors? Who terminates them? Under what grounds? Who determines the amount payable to them as salaries? Executive & non-executive directors? What about alternative directors? These should be clearly addressed in the Articles to bring as

much clarity as possible. Notices to shareholders & directors Articles need to be very clear of how to reach a particular director or shareholder. It is advisable that the Articles provide that each director and shareholder shall regularly or annually inform the company on its updated address for service of notices and if the director/shareholder fails to do so, whichever address the company has is the one which will be used to serve the director/shareholder with the required notice. When things fall apart in the company, address for serving a notice become critical because they can easily argue that they weren’t informed/no notice was issued etc. Appointment of senior officials It is very important to provide in the Articles the appointment of senior officials of the company. Who are the senior officials? Who appoints/terminates them? Their salary determination?

In most instances, the majority shareholder would like to have a final say on the matters involving senior officials of the company. Use or non-use of Table A The Companies Act has table A which suggests the wording of the Articles. It is not mandatory to adopt table A but some Articles do adopt table A. It is very common for the persons drafting or working on registering the company to simply allow the applicability of table A yet the members signing up for the Articles haven’t had the chance to review table A. Later it comes as a surprise that the members are bound by the provisions of table A yet they have never had a chance to review the said provisions and make whatever amendments they deem necessary. The simple referral to table A makes the job of the person hired to work on Articles easier pending a future doom.

What to do if you have the Pitfalls The good news is that, it is possible to amend the Articles to ensure that the pitfalls are removed. The process of amending the Articles involves presenting amended versions to the Registrar of Companies and if they comply with the requirements, the Articles will be registered and will replace the old Articles in their entirety. Our support for your business We are a law firm and readily available to assist in all your legal needs and beyond. Call us for a same day meeting and assistance. Please visit our website www.go2experts.co.tz to see our areas of practise and our previous informative updaters across various sectors.

Disclaimer The views expressed in this paper are those of the author only and should not be considered as an official interpretation, defamatory or interference of any legislation, laws or policies of any country including Tanzania. The contents of this paper should not under any circumstances be reproduced or used without our express written consent. It should not be considered as a legal advice to any of its recipient(s) and should not be relied upon without obtaining further legal advice. We accept no liability for any loss occasioned or suffered due to the contents of this paper.