William McCausland v Surfing Hardware International Holdings Pty Ltd  NSWSC 902
Shareholders’ agreements commonly include what are known as “drag along” provisions. Typically the drag along clause enables a majority shareholder to force all of the other shareholders in the company to sell their shares to a purchaser who wishes to acquire 100% of the company. Not only does the drag along mechanism make it easier and cleaner for large shareholders to realize their investments, the drag along mechanism can also deliver greater value to all shareholders (including the minorities) because potential purchasers are likely to pay more per share if they can be delivered 100% ownership and control of the company.
While the general framework for drag along clauses is relatively standard, the details of each clause are usually closely negotiated and tailored. The clause may contain a range of protections for the minorities or it may be very one-sided in favour of the majority shareholders. One of the simplest and most common express requirements is that the offer to buy the company must at least be “bona fide”. A recent decision of the Supreme Court of New South Wales explores what this means. The decision also considers whether an offer by the majority shareholder (as opposed to an offer by an external third party purchaser) can be used to invoke the drag along process.
The recent case of William McCausland v Surfing Hardware International Holdings Pty Ltd  NSWSC 902 related to a surfing hardware business founded by three partners in the early 1980s. The small business flourished and grew into a multi-million dollar global enterprise. Its key products (the “Fin Control System” and “Gorilla Grip”) became prominent Australian surfing brands. Eventually two of the founders wished to retire whilst the other (Mr McCausland) wished to continue. The business was restructured in 2002 to help facilitate the exit of the retiring founders. As part of this restructure, several new investors (including Macquarie and the private equity firm Crescent Capital) became shareholders in the business. It was around this time that a shareholders’ agreement was entered into. The shares were held as follows: Macquarie (21.632%), Crescent (22.296%), McCausland (30.495%) and the balance was held by other investors.
Unfortunately, there was a significant clash of management style between McCausland and the other large shareholders. Eventually, the relationship irretrievably broke down. Mr McCausland’s ongoing employment with the company was terminated, but he continued to act as a director. The board was becoming dysfunctional. Something had to give. The drag along clause was seen as the solution.
The drag along clause was as follows: “If the Company or any Shareholder receives an offer from a bona fide buyer for the Share Capital (Third Party Offeror), it may serve notice, on behalf of the Third Party Offeror, (Offer Notice) on: (a) in the case of the Company serving the Offer Notice, all Shareholders; or (b) in the case of a Shareholder serving the Offer Notice, all other Shareholders and the Company”. The “Offer Notice” had to specify the price, settlement date, name of the offeror and any conditions attaching to the offer. Apart from a requirement that the settlement date be at least 25 business days after the date of the Offer Notice, the shareholders’ agreement did not require any minimum price or any other sale conditions.
Once an Offer Notice was issued it was then up to the shareholders as a whole to decide whether or not to accept the offer. For this purpose, the shareholders resolution needed to be passed by a special majority vote of at least 60%. If the resolution was passed, the board had to give a “Drag Along Notice” to each shareholder. Once a drag along notice was issued, each shareholder was obliged to transfer their shares to the purchaser. At this stage, there was a final opportunity for a shareholder to make an offer to buy the company. If such an offer was made and it was determined by the board to be “clearly” on the same or better terms than those contained in the original offer notice, then the shareholders were required to sell to that shareholder.
So What Happened?
The company commenced a sale process to sell all of the shares in the company. The company engaged KPMG as its financial adviser for the sale process. A number of potential purchasers were approached including Quiksilver, Billabong, Rip Curl, Salomon/Adidas and O’Neill, as well as venture capital funds. Crescent was also permitted to participate in the sale process.
As it eventuated, several of the major potential purchasers pulled out of the sale process. Others needed more time to decide whether to make an offer. The timetable for the sale process was extended by 2 weeks. At the conclusion of the sale process, none of the external purchasers had made a bid. On the final day of the sale process, Crescent made an offer to acquire the company at $0.67 per share.
The company treated Crescent’s bid as “an offer from a bona fide buyer for the Share Capital”. The drag along procedure was then invoked. Even though Crescent made the initial offer, a slightly higher alternative offer at $0.675 per share was made by a Crescent led consortium (which included Macquarie and several other shareholders) and it was this alternative bid which was finally endorsed by the board as being “clearly” superior to the original offer. This ultimately resulted in McCausland’s shares being sold to the Crescent led consortium for $0.675 per share.
McCausland later argued that the drag along process had been invalidly applied. He also argued that the sale process had been rushed and that Crescent had been given an unfair information advantage over external bidders in terms of when and how much financial information was made available. He sought, amongst other things, damages for the difference between the drag along price ($0.675) and what he submitted was the market value of his shares ($1.36).
McCausland’s main argument was that Crescent’s offer was not “an offer from a bona fide buyer for the Share Capital”.
He argued that:
- only an offer from a third party (i.e. someone who was not a shareholder) could make an offer to trigger the drag along process;
- since the “Share Capital” was defined as all of the shares in the company, it was not possible for an existing shareholder to make an offer to acquire all of the shares when some of those shares were already held by the shareholder; and
- even if Crescent’s offer was for all of the share capital, it was not “bona fide” because it was purely intended as a strategic step to invoke the drag along process, rather than a genuine offer.
What Did the Court Say?
The court held that Crescent’s offer was not a “bona fide offer for the Share Capital”. It agreed with McCausland that it was not an offer to acquire “all” of the shares in the company because, as an existing shareholder, Crescent could not make a valid offer to itself. It also found that the reference in the drag along clause to a “Third Party Offeror” was “inapt to describe an existing shareholder”.
The court interpreted “bona fide” as meaning “genuine and not fake” or “acting in good faith” or requiring “an honest and genuine approach to the task”. The question was whether Crescent was a person who genuinely intended to carry through with acquiring 100% of the shares in the company. If Crescent did not have that intention or had no financial capacity to complete the deal, it may not have been bona fide. The court noted that Crescent had undertaken relatively extensive financial and logistical preparations to make and proceed with the offer. Overall, the court concluded that Crescent’s offer was bona fide. However, because the offer was not from an external party or for all of the shares (see above), it was not valid for the purpose of invoking the drag along clause.
So why didn’t Crescent just set-up a newco or use a nominee or related body corporate to make the initial offer, rather than directly make the offer itself? Surely this would have addressed the requirement that the offer be from an external (i.e. non-shareholder) party? The court did not have to decide this point because this is not what Crescent did. However, it is interesting to note the court’s view that “it would be quite open to argue that a nominee of a shareholder was not a “bona fide buyer for the Share Capital”, as the term “bona fide” draws in broader judgments about the honesty or genuiness of the offer, not just the financial capacity of the offeror”.
Since Crescent’s offer was not effective to trigger the drag along process, all of the drag along steps subsequently taken were done in breach of the shareholders agreement. McCausland was awarded damages (albeit the court applied a slightly lower market value for his shares than the value he submitted).
The key points are:
- Drag along clauses should only be invoked if there is an offer from an external party. This means that an offer from an existing shareholder cannot be used to trigger the drag along process.
- Using a “newco” or nominee company to get around this requirement is unlikely to be “bona fide”.
- If a majority shareholder wants the right to make an offer which triggers the drag along process, then this should be expressly stated in the shareholders’ agreement.
- Allowing an offer from a majority shareholder to trigger the drag along process may result in an offer price which is neither independent, market value nor arms’ length. Therefore, minority shareholders should be cautious in giving a majority shareholder this right. Minorities should also consider other fall back protections e.g. minimum pricing, independent valuations or other evidence that the offer price is at least fair value.
- The case also highlights the need for shareholders’ agreements to include a wide range of exit mechanisms. In this case, it seems that the drag along clause was the only way to compulsorily acquire McCausland’s shares. Other possible mechanisms that could have been included are put and call options and other compulsory sale triggers (e.g. if a key person ceases to be employed by the company or if a deadlock cannot be resolved).
Getting the exit mechanisms right is absolutely critical to any shareholders’ agreement.