Where several people invest in a company, they often put in place a shareholder’s agreement to regulate their relationship. Provided that such an agreement is drafted properly, regulating this matter in a contract (rather than in the company’s statute), will keep the arrangement confidential and not publicly available.
A drag-along clause has the purpose of forcing shareholders to sell their shares if a third party buys the company, essentially allowing the buyer to squeeze out a minority that does not agree with the sale. For this clause to work, the shareholders wishing to trigger the clause need to have a set percentage of shares, usually a controlling stake, although this percentage can vary.
A group of individuals incorporated two companies with the purpose of setting up a plant, one company (“REL”) for acquiring the land, and the other company (“RLL”) to run the plant itself.
The shareholders entered into a shareholder’s agreement stating that if three of them wished to transfer their shares in good faith to an arm’s length buyer, they could require the other two to sell their shares too, and that they would be able to sign the transfers on their behalf if they refused to do it.
REL approached Privilege Finance Ltd (“Privilege”) for funding, but soon requested more funds. Although Privilege agreed to provide further funding, in return they asked for an equity stake in REL which was practically achieved by incorporating a new subsidiary that would buy RLL shares from its shareholders, paying them with shares in its own capital, therefore making them shareholders alongside Privilege.
However, only three shareholders agreed to the deal, with the other two dissenting. The deal was nevertheless completed and a notice was served to the disagreeing minority based on the drag-along clause and thus forcing them to sell their shareholding.
One of the dragged shareholders complained, and filed at court asking for his name to be put back on RLL’s register of members, on the basis that:
- the word “sale” used in the shareholder agreement meant a sale for cash, whilst the deal was completed offering shares in the new subsidiary.
The Court found that besides the word “sale”, the agreement contemplated “any other consideration”, a word wide enough to include a non cash sale.
- the sale was not made in good faith because it arose from the need for funding, and the shareholders received a collateral benefit from it.
The Court found that the sale was in good faith, because Privilege had agreed to treat all shareholders in the same way, including the dragged ones, there was therefore no indication of bad faith.
- the sale was not at arm’s length, since RLL shareholders obtained a shareholding in the new buyer company.
The Court held that when the sale was agreed, there was no prior connection with the buyer, as the acquisition of an equity share in the subsidiary happened after the sale. This is because the sale was at arm’s length at the time it was agreed, not afterward.
This case is significant for a number of reasons. It is one of the few cases on contractual drag along clauses and shows that the Courts are willing to take a commercial approach to these types of clauses, looking at what a reasonable person with all the related knowledge would have understood the contract to mean, rather than interpreting them strictly.
This approach gives comfort to shareholders, who see drag along clauses as a way to facilitate an exit from an investment and shows that the insertion of such clauses in an agreement or in the company’s article is necessary.
However, in drafting contractual clauses it is important to consider the following:
- the threshold of shares required to trigger the drag along – too low of a threshold risks handing over control to a small group of people, while too high risks making the clause ineffective;
- specifying whether or not the clause applies to sales other than cash. In this case the clause was silent; however if the clause only provides for cash sales, a sale for equities won’t be upheld by the Court;
- a provision allowing someone to sign the forced sale of share, otherwise the seller would need to apply to the Court in order to be able to enforce the clause. The signatory can be the company, or the sellers themselves, as in this case. The best way to include this provision would be to include a power of attorney for this purpose in a shareholder’s agreement, separate from the company’s articles which would require the shareholders agreement to take the form of a deed.
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