The New South Wales Supreme Court recently held(1) that a forced sale of shares to a consortium of existing shareholders under a drag-along clause in a shareholders' agreement amounted to a breach of the agreement. The court awarded damages in favour of the ousted shareholders.
This case involved the use of a drag-along mechanism in a shareholders' agreement to effect a compulsory sale of shares by the remaining founder of SHI Holdings Pty Limited to a consortium of existing shareholders.
The surfing hardware business conducted by the company was founded by three business partners, including William McCausland, in the 1980s. The business grew into a prominent Australian surfing brand. In 2002 two of the partners exited the business as part of a reconstruction and recapitalisation transaction.
Following completion of the transaction, McCausland and his wife together held approximately 30% of the issued share capital of the company. Of the remaining shares, approximately 22% was held by each of Macquarie Bank and Crescent Capital Partners, and the balance were held by a group of minority interests. As part of the transaction, the shareholders entered into a shareholders' agreement, which contained a drag-along clause.
It is common for a shareholders' agreement to include a drag-along clause. Such clauses generally operate where a shareholder wishes to sell its shares to a third party, but that third party is willing to purchase only 100% of the shares in the company. In those circumstances, the selling shareholder can 'drag along' or force the other shareholders to also sell their shares in the company to that third party at the same price and on the same terms.
A drag-along mechanism can benefit:
- majority shareholders, as it provides them with an efficient and simple method for realising their investment (often without having to comply with rights of first refusal); and
- minority shareholders, as it may assist them in achieving a higher price for their shares, given that investors are often willing to pay a premium where they can secure control of a company.
The drag-along clause in the shareholders' agreement provided that it was to be invoked "[i]f the Company or any Shareholder receives an offer from a bona fide buyer for the Share Capital [defined as all of the shares in the Company] (Third Party Offeror)".
The clause required that an offer notice be put to shareholders for approval by a special majority (ie, by shareholders holding at least 60% of the votes attaching to the ordinary shares in the capital of the company). If approved, the board was required to issue a drag-along notice, which mandated that each shareholder transfer their shares to the third-party offeror (subject to the receipt of a better offer from a shareholder, as determined by the board, in which case the shareholders would be bound to sell to that shareholder).
Breakdown in relationship
Following the change in ownership in 2002, ongoing disagreements occurred between McCausland and the company management, leading to an irretrievable breakdown in their relationship. McCausland's employment with the company was terminated, which triggered further conflict, particularly at board level as McCausland remained a director. The other shareholders considered that a final break from McCausland was necessary in order to avoid any material detrimental impact on the success of the company's business.
The company commenced a sale process whereby it invited offers for the sale of all the shares in the company. Negotiations with a number of third-party investors took place, but none of them put offers forward.
On the last day of the offer period, Crescent (one of the existing shareholders) made a bid to acquire all the shares in the company at A$0.67 a share. This was treated by the company as having engaged the drag-along mechanism. Ultimately, the McCauslands' shares in the company were compulsorily transferred to a consortium of existing shareholders led by Crescent, which submitted a better shareholder offer than the original offer, under the drag-along provisions, for A$0.675 a share.
The McCauslands claimed, among other things, that their shares had been wrongfully acquired in breach of the shareholders' agreement and sought to recover damages for the difference between what they considered to be the market value for the shares (A$1.46 a share) and the consideration paid to them for their shares (A$0.675 a share).
In particular, the McCauslands argued that:
- as an existing shareholder, Crescent could not engage the drag-along clause to make an offer for the whole of the share capital of the company, given that Crescent already held some of those shares; and
- Crescent was not a bona fide buyer, on the basis that its offer was part of a strategy designed to invoke the drag-along mechanism, rather than a genuine offer to purchase the shares.
Justice Slattery held that only an offer from a non-shareholder could initiate the drag-along mechanism in the shareholders' agreement in question. The judge noted that the drafting of the drag-along clause supported this finding in a number of ways, including that:
- a shareholder cannot make an offer to purchase "all" the shares in the capital of the company, because as an existing shareholder, it already holds some of those shares and cannot not make an offer to itself to acquire them; and
- language describing the bona fide buyer for the share capital as a 'third-party offeror' is not to be ignored.
The judge considered that the reference to a 'bona fide buyer' in the drag-along clause meant "genuine and not fake" or "good faith, without fraud". He held that Crescent's bid was bona fide in every sense in relation to the shares in the company that it did not already own, as it was a genuine buyer. However, Crescent could not be a bona fide buyer of all the shares in the company for the reasons noted above. Therefore, the judge held that Crescent's initial offer was not an offer that validly invoked the drag-along process.
The court held that the forced acquisition of the McCauslands' shares amounted to a breach of the shareholders' agreement, which resulted in a loss to the McCauslands. It awarded damages in favour of the McCauslands for the difference between what the court determined to be the market value for the shares (A$1.02 a share) and the consideration paid to the McCauslands for their shares (A$0.675 a share).
The court's judgment was made notwithstanding the fact that the McCauslands took no action to seek to restrain the sale of their shares before the forced sale.
Although the court did not have to determine this question, the judge issued comments in relation to a shareholder using a nominee or associate to make an offer in order to overcome requirements in a drag-along clause that the offeror be a non-shareholder. The judge considered that it would be quite open to argue that such an offeror was not "a bona fide buyer for the Share Capital", given that the phrase 'bona fide' encompasses broader connotations of honesty and genuineness of the offer, rather than just its financial capacity to proceed.
The decision highlights the importance for shareholders of giving careful consideration to the inclusion, and appropriateness, of pre-emptive rights and exit mechanisms (both mandated and voluntary) in a shareholders' agreement when acquiring less than 100% of the shares in any company.
For example, there would have been no need to rely on a drag-along clause to force the sale of the McCauslands' shares had the shareholders' agreement provided for the compulsory sale of such shares (or an option to purchase such shares) on the termination of McCausland's employment with the company.
These types of mechanism assist in avoiding disputes where parties no longer wish to work with each other, particularly where they clearly prescribe the terms on which the outgoing shareholder's shares will be acquired (including price and payment terms).
The decision also raised a number of further considerations:
- Where a drag-along clause is to be triggered by an offer to acquire 100% of the shares of a company, it is unlikely that an existing shareholder could validly invoke such process.
- Where a nominee or associate of a shareholder is used to overcome this restriction, difficulties may be encountered in satisfying any requirements that the offer be bona fide.
- Professional advice should be sought before signing a shareholders' agreement. There may be protections that can be built into the agreement for both minority and majority shareholders, including in the drag-along clause.
- Where it is agreed that existing shareholders can initiate a drag-along process, the shareholders' agreement should expressly provide for this.
- Where a drag-along clause is wrongfully applied to force the sale of shares, this is likely to amount to a breach of contract, giving an ousted shareholder a right to be compensated where the sale proceeded at less than market value.
However, interpretation will always turn on the facts of the individual case and the drafting of the shareholders' agreement in question.
For further information on this topic please contact Bianca Battistella at Piper Alderman by telephone (+61 2 9253 9999), fax (+61 2 9253 9900) or email (firstname.lastname@example.org). The Piper Alderman website can be accessed at www.piperalderman.com.au.