Case law: Court gives guidance on interpretation of 'drag-along' rights in company shareholders' agreements
Company shareholders who agree to 'drag-along' clauses in a shareholder agreement that allow a shareholder's shares to be taken away from them in certain circumstances, should construe their obligations according to the usual rules for interpreting commercial agreements.
This update was published in Legal Alert - September 2018
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Shareholders in a limited company can include 'drag-along' provisions in a shareholders' agreement and/or their articles of association which say that, if the holders of a certain percentage of the company's shares (usually a majority) want to dispose of them to a third party, the other shareholders also have to dispose of their shares to that third party - on the same terms.
In a recent case, shareholders set up two companies. One owned the land from which the business operated (the landowning company), and the operating company ran the actual business.
A shareholders' agreement in relation to the landowning company contained drag-along provisions saying that if the three original shareholders wanted to sell their shares in the company to a buyer in good faith in an arm's length transaction, the other shareholders also had to sell their shares to that buyer on the same terms. The agreement allowed the three original shareholders to sign transfer forms on behalf of the other shareholders if they refused to do so.
The operating company later needed further funding from an investor. The investor agreed to provide this but only on condition that all the shares in the landowning company would be transferred to a subsidiary of the investor, to be set up for the purpose. In return for transferring their shares, the shareholders of the landowning company would be issued with shares in the subsidiary, but would receive no cash. This is known as a share-for-share exchange, because shareholders effectively exchange their shares in one company for shares in another.
The three original shareholders agreed to the deal, and told the other shareholders they had to transfer their shares to the subsidiary too, under the drag-along provisions in the shareholders' agreement.
One of the other shareholders objected. When a transfer form was signed on his behalf, and his shares in the landowning company registered in the new shareholder's name, he asked the court to rectify the register to reinstate his name in it on grounds the transaction breached the shareholders' agreement. He claimed that:
- A share-for-share exchange was not a 'sale', and the drag-along provisions only applied in the event of a sale
- The transaction was neither in good faith nor at arm's length as it resulted in fresh funding for the operating company. As the three original shareholders of the landowning company were also shareholders of that company, they enjoyed a 'collateral benefit' from the transaction
The court disagreed on all counts. It applied the usual legal test used to interpret the wording of commercial agreements, that is, the objective test of what a reasonable person in possession of all background information reasonably available to both the parties at the time the agreement was entered into would think that wording meant. It refused to apply a different test simply on grounds that the drag-along provisions meant a shareholder could have their shares taken away from them. On that basis, the court ruled that:
- While the main drag-along clause in the shareholders' agreement did use the word 'sale', the clause allowing a transfer form to be signed on their behalf if a 'dragged along' shareholder would not sign one themselves also included the words 'or any other consideration'. This wording was 'deliberately wide', and covered a share-for-share exchange where no cash changed hands, so the drag along rights applied
- The investor had acted in good faith having treated all shareholders equally in the transaction, including those 'dragged along' under the shareholders' agreement
- The transaction had been an arm's length one because there had been no 'prior connection' between the three shareholders and the investor before it was agreed
The court therefore refused to rectify the landowning company's register of members.
- Those entering into shareholder agreements, or agreeing to clauses in articles of association, that allow a shareholder's shares to be taken away from them should understand that the usual rules for interpreting a commercial agreement will still apply - which may mean the drag-along rights operate even if the transfer of the shares is not achieved through a sale, but some other means, such as a share-for-share exchange
Case ref: Cunningham v Resourceful Land Limited  Ch D
Disclaimer: This article from Atom Content Marketing is for general guidance only, for businesses in the United Kingdom governed by the laws of England. Atom Content Marketing, expert contributors and ICAEW (as distributor) disclaim all liability for any errors or omissions.
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