- In In the matter of Pioneer Energy Holdings Pty Ltd (Pioneer Case), the NSW Supreme Court held that a compulsory share transfer of a party’s shares for $1 arising from that party’s breach of a shareholders’ agreement was a penalty on the basis that the consequence (being the loss of the defaulting party’s entire investment) was not proportionate to the loss to the non-defaulting party resulting from the breach. This decision was despite the inclusion of a clause to the effect that the compulsory share transfer (and a related cash payment) represented a genuine estimate of the non-defaulting party’s loss.
- The outcome in William McCausland v Surfing Hardware International Holdings Pty Ltd ACN 090 252 752 (McCausland Case) showed that, when drafting a shareholders’ agreement, it is important to clearly set out the parties’ rights and obligations, including in relation to pre-emptive rights and exit options for shareholders. In particular, if the parties agree that an existing shareholder may initiate a drag-along process by making an offer, this needs to be clearly drafted and the mechanics of the process must support this intention.
The Pioneer Case – Key Facts
- Blue Oil Energy Pty Ltd (Blue Oil) and Morgan Stanley Capital Group Inc (Morgan Stanley) entered into a shareholders’ agreement as the shareholders of Pioneer Energy Holdings Pty Ltd (Pioneer). Under the agreement, the parties were required to contribute a fixed sum as initial funding and increase their contributions if required by Pioneer’s board.
- If Blue Oil failed to pay its portion of initial funding, Morgan Stanley could require Blue Oil to transfer all of its shares to Morgan Stanley for $1 and pay Morgan Stanley $2 million. The shareholders also acknowledged that the option to require the share transfer and the $2 million payment was a genuine estimate of the loss and expense Morgan Stanley would incur if Blue Oil failed to satisfy its funding obligations (Blue Oil Default Clause).
- The board of Pioneer resolved to increase the initial funding budget and Blue Oil did not pay the amount it was required to contribute. Although Morgan Stanley had not purported to exercise its option, a separate dispute arose in respect of one of Pioneer’s subsidiaries and orders were made for the determination of, among other issues, whether the option and related cash payment was a penalty.
The Pioneer Case – Decision
The court held that:
a clause is likely to be a penalty if:
- the amount stipulated as the remedy is extravagant and unconscionable by comparison with the greatest loss arising from the breach, and
- it provides advantages significantly greater than those which would flow from a genuine pre-estimate of damage or if the remedy is out of proportion to the likely damage, and
- while the parties may have intended for the Blue Oil Default Clause to provide incentives for prompt payment, the clause was still a penalty as Blue Oil’s loss of the whole of the value invested was not proportionate to its breach.
The Pioneer Case – Key takeaways
- A clause prescribing payment upon default should be constructed to ensure the amount payable seeks to reflect the loss that will be suffered.
- Requiring the same payment on a compulsory share transfer irrespective of loss suffered may be construed as a penalty.
- An express agreement that a payment is a genuine estimate of the loss is not conclusive.
The McCausland Case – Key Facts
- McCausland was a co-founding shareholder of a surfing hardware business. Macquarie Bank (Macquarie) and Crescent Capital Partners (Crescent) acquired 61% of the business (Company) leaving McCausland with approximately 30%. The remaining shares were held by minority investors. McCausland, Macquarie and Crescent entered into a shareholders’ agreement containing a drag-along provision.
- Various disagreements resulted in the parties wanting to sever their relations. Following a rejection by McCausland to be bought out by a minority investor, Crescent exercised the drag-along provision by making an offer for all of the shares in the Company requiring McCausland to sell his shares.
- The drag-along process could only be initiated by an offer from a bona fide buyer for 100% of the shares in the Company.
- Following the sale, McCausland disputed the exercise of the drag-along provisions.
The McCausland Case – Decision
The court held that Crescent had not validly exercised the drag-along rights because:
- the agreement required the bone fide buyer to be a ‘Third Party Offeror’ and therefore, as an existing shareholder, Crescent could not be a bone fide buyer under the terms of the agreement, and
- the agreement required the offeror to make an offer for 100% of the shares in the Company therefore, as an existing shareholder, Crescent could not satisfy this test without first selling all its shares.
- McCausland was awarded damages on the basis of the difference between the market value of his shares at the date of breach of the shareholders’ agreement and the price at which they were acquired under the drag-along provision.
The McCausland Case – Key takeaways
- Parties to a shareholders’ agreement must ensure that their intentions are reflected in the drafting of the mechanics of drag-along provisions.
- An improper exercise of drag-along rights may trigger a breach of a shareholders’ agreement resulting in damages being payable to a dragged shareholder.