Drag along rights are pre-negotiated rights in a shareholders agreement and / or may also be contained within a company’s Articles of Association, giving majority shareholders important commercial flexibility.  Drag along provisions are important to the company as a whole, as a tool enabling the majority shareholders to retain control of the company by forcing minority shareholders to accept a third party offer to buy their shares.

The question is, how should drag along rights clauses be interpreted in practice?  The High Court has given useful guidance which companies will find useful to know.  In this case, the Court enforced the drag along rights in favour of the majority shareholders.

Three shareholders set up two companies for the purposes of developing and operating an anaerobic digestion plant. There were two further shareholders.  The first company bought the land on which the business operated, and the second company was the operator. 

Under the drag along provisions in the shareholders’ agreement, the minority shareholders would be expected to sell their shares in the company on the same terms if the three majority shareholders wanted sell their shares to a third party in good faith and where the transaction was taking place on an arm’s length basis.  If the minority shareholders refused to sell, the three majority shareholders could sign the stock transfer forms (to transfer the minority shareholders shares to the purchaser on their behalf).

A third party wanted to invest in the second (operating) company, but as a condition for the investment, all of the shares of the company which owned the land were to be transferred to the investor’s subsidiary company.  It was effectively a share-for-share exchange, as the investor would give the shareholders shares in the subsidiary company (i.e. there would be no cash consideration for the transaction).

A minority shareholder objected to the transaction arguing that the share exchange breached the drag along provisions as it was not a ‘sale’. They also argued that the majority shareholders were in breach of their duty of good faith under the shareholders’ agreement.

The Court disagreed: non-cash consideration, as in this case of a share-for-share exchange, satisfied what was interpreted as being broadly drafted wording in the drag along provisions of the shareholders agreement.   The effect of the drag along provisions were to allow the majority shareholders to transfer their shares in return for a shareholding in a different company (the investor’s subsidiary). 

Importantly, the Court confirmed that the test for interpreting drag-along clauses is the usual test applied in certain other commercial agreements.  Effectively, it is what a reasonable person with all the background information reasonably available to the parties at the time of the agreement would have understood the wording to mean. Furthermore, the Court decided that the transaction did take place on an arm’s length basis which also went in the majority shareholders’ favour.

What does this mean?
Drag along clauses have an important role to play in a company’s commercial arrangements, preventing minority shareholders from holding the company to ransom.  They give majority shareholders necessary flexibility to enable them to conduct their commercial activities, and attract new funding for the good of the company.

Businesses should appreciate that such a clause based on this recent case is likely to be interpreted as any other commercial contract clause. Where there is any ambiguity, the court will look at its natural meaning – even if the commercial outcome is unusual or unexpected.

In light of this recent decision it is important to ensure that your drag along provisions clearly set out the intentions of the parties to assist with avoiding a dispute.

How can we help?
If you have any concerns about your drag along rights and provisions, or any other terms in your shareholders’ agreement, your company’s Articles of Association or any other commercial agreements, then contact the expert corporate and commercial solicitors at Herrington Carmichael.

Please contact Melissa Deutrom on 0118 989 9712 and Alex Canham on 0118 989 9717

This reflects the law at the date of publication and is written as a general guide. It does not contain definitive legal advice, which should be sought as appropriate in relation to a particular matter.