Drag Along Rights: Interpreting Them Correctly
How should a company interpret ‘drag along’ rights set out in their shareholder agreements? Businesses will find useful recent guidance set out by the High Court as to how to interpret them appropriate.
A drag along clause confers on the majority shareholders the right to accept an offer from a third party to buy their shares, and force the minority shareholders to accept the offer. It effectively forces minority shareholders to take part in the sale of the company.
What’s the background?
A shareholder took action against a company1. Three shareholders set up two companies to develop and operate an anaerobic digestion plant: one company was the legal owner of the land; the other operated the business from that land. In the shareholders’ agreement for the company that owned the land, the drag-along provisions required that if the three shareholders (the syndicate shareholders) decided to sell their shares to a third party in good faith to an ‘arm’s length’ buyer, the others had to sell their own shares on the same terms. Furthermore, if the other shareholders refused to do so the original shareholders had the right under the terms to sign the transfer forms on their behalf.
In due course, a third party agreed to provide investment to the operating company on condition that all the shares in the other company were transferred to the third party’s subsidiary company. However, the three original shareholders would receive shares in that subsidiary, and no cash (it was a share-for-share exchange).
Unfortunately, one of the other two shareholders objected to transferring his shares to the subsidiary under the drag-along provisions, but the sale proceeded anyway under the drag-along clause. He argued that the sale had been in breach of the drag-along provisions in a shareholder agreement, and in breach of the syndicate shareholders' duty of good faith under that agreement.
The appropriate test for interpreting the drag-along clause was the usual test for any commercial agreement. This requires considering objectively what a reasonable person with all the background information reasonably available to the parties at the time of the agreement would understand the wording to mean.
The shareholder’s claim failed, and he could not be put back on the register of members of the company. His argument that a share-for-share exchange was not a ‘sale’ was rejected – the wording of the clause was wide and included “any other consideration”, including non-cash consideration. Its effect was to allow the syndicate shareholders to transfer the shares in return for a shareholding in a different company.
The Court also found that the investor/buyer had acted in good faith. There was no prior agreement between it and the syndicate shareholders, and the transaction was at arm’s length.
What does this mean?
Companies and company shareholders need to know that the usual rules for interpreting commercial agreements also apply to clauses in company articles and shareholder agreements, including drag-along provisions. This case also shows that drag-along rights can operate (depending on the wording of the provision) without a cash consideration, such as a share exchange. The good news for companies is that it allows a welcome measure of flexibility, permitting them to freeze out minority shareholders for the good of the company as a whole.
It’s not such good news for minority shareholders who may prefer a cash exit.
1 Cunningham v Resourceful Land Limited [2018] Ch D
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