2016 was another strong year for M&A in Israel, with 93 deals in the Israeli high-tech sector alone. The annual proceeds of $10b represent a 12% increase over those of 2015 – itself a record year.
With a robust market, continued development, and with IPO activity at a relative low, M&A transactions continue to be the leading means for growth in the Israeli high-tech sector. An important tool to guarantee that an M&A deal will be successfully completed is the “drag along” mechanism (also known as “bring along”). In general terms, the drag along mechanism allows a majority of shareholders to initiate a sale or change of control in the company and force the minority shareholders to participate in the transaction. This right is based on the premise that a minority shareholder should not be able to prevent a majority shareholder from selling the company and achieving liquidity, upon terms desired by the majority shareholders. Given the potential for the drag along mechanism to significantly ease the deal approval process, its provisions should be given careful consideration.
In Israel, a drag along is often effected by adoption of contractual drag along provisions by and among the shareholders of the company, although Israeli law provides statutory drag along provisions under Section 341 of the Israeli Companies Law 1999-5759 (the “Companies Law”).
Section 341 of the Companies Law offers a statutory drag along mechanism. However, it is still unclear under Israeli law (including case law) whether Section 341 constitutes an exclusive route that enables drag along rights over the minority shareholders, or whether it offers an alternative or even a default, against which a company may create parallel contractual rights in its Articles of Association.
Under the arrangement authorized in Section 341, an offeror who acquires at least 80 percent of the shares, or a class of shares, of a company may force the non-selling minority shareholders to sell their shares on the same terms as the majority shareholders. For the sake of calculating the 80 percent, the controlling shareholder of the offeror or anyone acting on behalf of the offeror, or the controlling shareholder of the offeror, are not taken into account. The 80 percent threshold may be raised or lowered pursuant to the company’s Articles of Association. However, unless altered through an amendment to their Articles of Association, companies formed prior to February 1, 2000 have a forced sale threshold of 90 percent.
According to Section 341, a shareholder opposing the sale may appeal to the courts in order to prevent the compulsory sale. The law also dictates a three-month timeframe for the drag along process: the purchase offer must be accepted within two months, and following those two months the minority shareholder has one month to appeal to a court. However, it remains unclear under Israeli case law whether such timeframes can be altered though the company’s Articles of Association.
The question of the timeframe is an important one, because adhering to the agreed-upon set of actions may be critical if the matter ends up in court. In this respect it is worth noting the recent case of Halpin v. Riverstone National, Inc., heard by the Delaware Court of Chancery. The drag along mechanism in question required that early notice be provided to the company’s minority shareholders. In this case, however, the minority shareholders were only notified of the deal after the fact. Thus, the court found the drag along mechanism unenforceable – clearly an undesirable outcome for the shareholders who wished to trigger the drag along. While the question of whether or not shareholders of Israeli companies may agree upon timeframes different from those provided in Section 341 remains unanswered, it is clear that at minimum, they should adhere to the agreed-upon triggering requirements, lest they risk a court voiding the procedure and most likely canceling the deal.
Drag Along Provisions:
In practice, drag along provisions are commonly embedded in Articles of Association of Israeli companies, the specific terms of which can vary widely from one agreement to the other, and which are invariably based upon the shareholders’ respective interests and priorities, as well as the company’s needs.
When drafting drag along provisions, it is important to pay careful attention to their specific terms, as these can heavily influence their effectiveness. Naturally, majority and minority shareholders have opposing interests vis-à-vis many of the main issues. Whether or not a proposed transaction can in fact trigger the drag along mechanism will depend upon whether the form of the transaction is covered by the provision. Provisions will commonly include language referring to a merger or sale of all or substantially all of the company’s shares or assets. At minimum, 50% of company ownership should be sold in order to trigger the mechanism, but the percentage could be much higher and still be effective, for example when the minority shareholders own a relatively small percentage of the company in question. Dynamics between the majority shareholders are also at play, and drag along provisions will commonly include a threshold percentage for the majority shareholders who need to agree to sell their shares, to effectively give each major shareholder a veto over the proposed transaction.
Majority shareholders would naturally prefer the drag-along process to be brief, while minority shareholders would prefer a more extended process. As mentioned above, it is unclear whether Israeli companies may implement drag-along timeframes which diverge from the three-month timeframe set forth in Section 341. In practice, however, drag along provisions are often silent on the matter of timeframes, allowing for an uncontested process to proceed quickly, but ceding to the legal minimum if a minority shareholder decides to exercise legal measures.
Attention should also be paid to the form of consideration received in the deal (which could be limited to cash or liquid securities, but could also include illiquid securities or other assets), and to its allocation. Generally consideration is distributed pro rata, or if the company has more than one class of shares, in accordance with the liquidation preference. However, there are variations to take into account, for example whether or not contingent payments such as future earn-outs are considered part of the consideration available for distribution, or if shares with a more senior liquidation preference will also receive preference in terms of the type of consideration they receive in the transaction.
The success of a drag along mechanism rests upon its ability to guarantee the compliance of minority shareholders. Typically, such shareholders will undertake in advance to give customary representations and warranties with regards to their share ownership and agree to the covenants made by the shareholders in the contemplated transaction. Conversely, minority shareholders will want to protect themselves by limiting to the bare minimum the representations and warranties which they will be required to give in the event of a drag along, and to ensure that they are treated the same as the majority shareholders in the transaction documents, otherwise the drag along will not come into effect. To guarantee the timely conduct of a potential drag along sale, shareholders may agree to appoint a seller representative funded by an escrow fund. In some cases, minority shareholders may even agree to sign an irrevocable proxy or power of attorney that will become effective upon a qualifying transaction, which enables the majority shareholders to enforce their drag along right even when the minority shareholder is unwilling to abide by the agreed-upon mechanism.
In conclusion, drag along provisions are common and useful, featuring in the Articles of Association of many companies. Although that the relationship of such bespoke provisions with the provisions of Section 341 has yet to be seriously tested in Israeli case law, in practice they live successfully in parallel, to the benefit of countless companies and their shareholders.