Drag along provisions enforced by the High CourtPrint publication
A drag-along provision in a shareholders’ agreement has been enforced by a recent High Court decision and the shareholder in question ordered to transfer his shares.
Where there are several shareholders in a company, a shareholders’ agreement is commonly used to regulate the relationship between the shareholders and to govern how the company is to be run.
Most shareholders’ agreements contain a drag along provision. A drag along is a mechanism by which the majority of the shareholders can force the minority to transfer their shares if a buyer is found for the company. Typically, the agreement will set out that if a certain proportion of shareholders agree to the sale, then the remaining shareholders have to transfer their shares as well. The figure can be anything but is usually between 51 per cent. and 90 per cent.
Although a drag along is a common clause in a shareholders’ agreement, the effectiveness of the provision has rarely been tested in court. In Cunningham v Resourceful Land Limited and others EWHC the court had to decide whether a minority shareholder could refuse to comply with the drag along provision.
A group of five individuals became shareholders in Resourceful Land Ltd (RLL) and entered into a shareholders’ agreement. The drag along clause stated that if the original three shareholders wanted to transfer their shares in good faith to an arm’s length buyer, they could require the remaining two shareholders to sell their shares too. The agreement also contained the wording which allowed the stock transfer forms to be signed on their behalf if they refused to do so.
Funding for the business was obtained from Privilege Project Finance Limited (Privilege). When further finance was required, Privilege agreed to provide it in return for an equity stake in RLL. In order to achieve this, it was agreed that Privilege would incorporate a new subsidiary to buy the shares in RLL from its shareholders and, in exchange, issue those individuals new shares in the subsidiary.
The three original shareholders of RLL agreed to this plan but the other two didn’t and so a drag along notice was served on the minority shareholders requiring them to sell their shares. When they still refused the transfer was completed under the provisions of the drag along. One of the dragged shareholders then challenged the drag along in court and applied to be reinstated on the register of members. His application was based on three arguments:
- the word ‘sale’ in the shareholders’ agreement meant a sale for cash. It didn’t include a share for share exchange and so the drag along couldn’t be used
- the sale was not in good faith
- the sale was not on arm’s length because the RLL shareholders were obtaining shares in the buyer.
The High Court however disagreed and upheld the use of the drag along.
The court found that the word ‘sale’ could include a non-cash sale because elsewhere in the clause the words ‘or any other consideration’ were used and therefore the wording was deliberately wide. It also found that the sale was carried out in good faith. Crucially the court found that it was the mental state of Privilege that was important not whether or not the sale itself was in good faith. The fact that Privilege had agreed to treat all the shareholders equally was evidence of good faith. Finally, the judge held that the sale was on arm’s length because there was no connection between the buyer and the sellers at the point that the sale was agreed. It was irrelevant that they were connected after completion.
This decision should be welcomed by institutional investors who often rely on drag along provisions as a means of exiting from an investment. The High Court has confirmed that the provision, as long as it is drafted correctly, can be used to force a sale.