Court and jurisdiction
Supreme Court of NSW – Equity Division – Slattery J
William McCausland was a co-founding shareholder (McCausland) of a surfing hardware business established in the 1980s. In 2002, the business’s two other co-founders sold their interests.
Macquarie and Crescent acquired 61% of the new, restructured and recapitalised business (SH), leaving McCausland (and his wife) with approximately 30%. The remaining share capital was held by other minority investors including Mr Boscher. McCausland entered into a shareholder’s agreement (Shareholders Agreement) with these new shareholders. The Shareholders Agreement contained a drag-along provision in clause 12 (see attached).
Between 2002 and 2004, various disagreements between McCausland and management resulted in Macquarie and Crescent wanting to sever relations with McCausland (and vice versa). McCausland rejected an offer to be bought out at $1.10 per share by Mr Boscher who had been attracted to invest by Macquarie and Crescent.
Following the failure to acquire McCausland’s shares through the Boscher proposal, Crescent exercised the drag-along provision in the Shareholders Agreement by:
- making an offer for all the shares in SH;
- obtaining approval from the requisite majority of shareholders (60% vote); and
- compulsorily requiring McCausland to sell his shares.
Following the compulsory sale of shares, McCausland disputed, among other things, the exercise of the drag-along provisions.
Three key issues considered in this judgment in respect of the Shareholders Agreement are:
- whether an existing shareholder can be a ‘bona fide buyer’ of the ‘Share Capital’ under the drag-along provision in the Shareholders Agreement,
- whether such existing shareholder will be in breach of the Shareholders Agreement if they purchase shares under the drag-along provision, and
- how damages are assessed and measured when a shareholder has sold their shares under a drag-along provision.
Can an existing shareholder be a ‘bona fide buyer’ of the ‘Share Capital’ under the clause 12 drag-along provision in the Shareholders Agreement?
Clause 12 of the Shareholders Agreement outlines a two-phase process:
- the drag-along process may be initiated “[i]f the Company or any Shareholder receives an offer from a bona fide buyer for the Share Capital” (Share Capital is defined in the Shareholders Agreement as ‘all of the Ordinary Shares on issue’); and
- if a 60% majority of shareholders decide to accept the offer to acquire the share capital at a shareholders meeting, the other non-accepting shareholders are required to decide whether to make a competing offer ‘on the same or better terms than the offer’ (or drag along).
Slattery J held that only an offer from a non-shareholder can initiate the clause 12 drag-along provision, noting that the drafting in clause 12 contained many such indications, including:
- language describing the bona fide buyer for the Share Capital as a ‘Third Party Offeror’ is not to be ignored;
- the issue of agency, whereby notices are served ‘on behalf of the Third Party Offeror’ – his Honour noted that a person cannot be an agent for himself;
- in the case of a shareholder-shareholder offer, this would require the shareholder serving the offer on his own principal (and this is not a businesslike construction); and
- the term ‘bona fide’ means ‘genuine and not fake’ – Crescent was bona fide in every sense except in terms of being ‘for 100% of Share Capital’ because a shareholder-Offeror cannot answer this description, without first selling all its shares.
Is an existing shareholder in breach of the Shareholders Agreement if they purchase shares under the drag-along provision?
Slattery J held that the step of requiring McCausland to transfer shares to the purchaser on behalf of the Crescent consortium at $0.675 per share resulted in a loss to McCausland. His Honour noted that this step was a breach of the Shareholders Agreement as it was a transfer of shares not complying with the provisions of the Shareholders Agreement.
McCausland’s failure to seek injunctive relief to prevent the transfer of shares did not waive the breach of the Shareholders Agreement.
McCausland was awarded damages calculated as the difference between the market value of McCausland’s shares and the price at which they were acquired under the drag- along provisions of the Shareholders Agreement.
In calculating the value of McCausland’s shares, his Honour accepted a capitalisation of earnings method of valuation (proposed by McCausland’s expert) over the DCF method of valuation (proposed by Crescent’s expert), as the business was relatively mature, had a proven track record and had expectations of future profitability, allowing maintainable earnings to be established with a reasonable degree of confidence.
When drafting a shareholders agreement, it is crucial to clarify rights and processes in relation to pre-emptive rights and exit options for shareholders. For example, 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; and
if a drag-along provision is exercised improperly by a shareholder-offeror, the shareholder-offeror may be in breach of the shareholders agreement and be liable for damages if losses are incurred by a dragged-along shareholder.