The High Court has upheld a drag-along provision in a shareholders’ agreement and ordered a shareholder to transfer his shares in the company in question.
Where several persons invest in a company, they will often put a shareholders’ agreement in place to govern how the company is to be run and to regulate their relationship. Provided the shareholders’ agreement is drafted properly, by setting these matters out in a contract (rather than the company’s constitution), the arrangements will not be publicly available.
A drag-along (or “drag”) is a mechanism that forces shareholders to transfer their shares if a buyer agrees to buy a company. Essentially, it is a mechanism to squeeze out a minority that opposes a sale. In order for the drag-along to apply, a buyer will need to agree a sale with shareholders holding a specified level of shares or voting rights. Typically, this percentage is a controlling stake, such as 51%, 66% or 75%, but it could be any level.
What happened here?
In Cunningham v Resourceful Land Limited and others, a group of individuals incorporated two companies with a view to setting up an anaerobic digestion plant. One company (RLL) would acquire the land to house the plant, and another (REL) would run the plant itself.
The individuals entered into a shareholders’ agreement in relation to RLL. That agreement stated that, if three of the individuals (the three original shareholders) wanted to transfer their shares bona fide (i.e. in good faith) to an arm’s length buyer, they could require the other shareholders to sell their shares too and could sign transfers on their behalf if they refused to do so.
REL procured project finance from Privilege Project Finance Limited (“Privilege”). When it became clear that REL was running out of money, it approached Privilege for further funding. Privilege agreed, provided it received an “equity stake” in return.
To achieve this, Privilege would incorporate a brand-new subsidiary. That company would then buy the shares in RLL from its shareholders and, in exchange, issue those individuals new shares in its own share capital, making them shareholders alongside Privilege.
The three original shareholders agreed to this plan and signed an agreement with the new company. The other two shareholders, however, did not. The original shareholders served a drag-along notice on the remaining two, requiring them to sell their shares to the new company.
The transfer was completed under the drag-along clause. Afterwards, one of the dragged shareholders complained and applied to the court for his name to be put back on RLL’s register of members. He advanced three arguments:
- The word “sale”, used in the drag-along clause in the shareholders’ agreement, meant a sale for cash. However, the price on the sale in this case was paid in shares, not cash, meaning that the drag could not have applied to it.
- The sale was not made “in good faith”, because it arose from the need for further funding and the selling shareholders received a “collateral benefit” from it.
- Finally, the sale was not on “arm’s length” terms, because RLL’s shareholders were obtaining a shareholding in the new buyer company.
What did the Court say?
The Court disagreed.
Although the drag-along clause itself referred only to a “sale”, the clause in the agreement that allowed the sellers to sign a transfer on behalf of the individual used the words “or any other consideration”. The Court said this wording was “deliberately wide” so as to extend to a non-cash sale.
It also found that Privilege had acted in good faith. Importantly, the question was not whether the sale itself, viewed objectively, was in good faith, but rather the mental state of Privilege when it entered into it. In this case, Privilege had agreed to treat all of RLL’s shareholders, including the dragged shareholders, the same, and so there was no suggestion of bad faith.
Finally, the judge said that the sale had been on arm’s length terms. There had been “no prior connection” between Privilege and the selling shareholders before the sale was completed. The fact that they had agreed to acquire shares in the new company before the drag was completed did not make them connected parties. The shareholders’ agreement required the buyer to be at arm’s length when the sale was agreed, not when it was completed.
The court therefore refused to amend RLL’s register of members.
There are relatively few cases on contractual drag-alongs, so this judgment is helpful in understanding how a court will view them.
There have been concerns that courts will interpret drag-along clauses strictly, as they involve forcibly acquiring someone’s property. If that is the case, the court did not feel restricted by that approach in this case. Instead, it took the orthodox approach of identifying the parties’ intentions by looking at what a reasonable person with all the background knowledge would have understood by the contract.
This will provide significant comfort to major shareholders, particularly institutional investors, who regard a drag as a means of facilitating an exit from an investment. The court’s willingness to uphold the forced sale in this case shows that drag-along clauses are far from pointless.
However, if including a drag in a contract or a company’s articles, there are still certain key things worth remembering:
- Think carefully about the threshold for triggering the drag-along. Too low a threshold may hand control of the company over to a small cabal, whilst too high a threshold may make the mechanism difficult or effectively impossible to invoke.
- Make it clear whether the drag applies to sales other than for cash. Here, the agreement was silent in the drag-along clause itself. However, if the clause specifically refers to a sale for cash, a court will not allow it to be used to force (say) a share-for-share exchange.
- Include a clause allowing someone to sign the share transfers on behalf of the dragged shareholders if they refuse to comply, or else the selling shareholders will need to apply to the court to enforce the drag. This could be the company itself or (as in this case) the sellers. To ensure maximum flexibility and enforceability, it is best to achieve this by including a power of attorney for this purpose in a shareholders’ agreement separate from the company’s articles. This will require the shareholders’ agreement to take the form of a deed.