Drag along clause in shareholders' agreements

Tollers

1st October 2018

Legal Briefing

Tollers

IT is surprising how frequently co-shareholders in a company fail to consider or sign a shareholders' agreement regulating their relationship as shareholders. Pre-nup for business people is probably the most useful and succinct way to describe a shareholders' agreement, which resonates with business owners.

One issue that is addressed in all well-drafted shareholders' agreements is drag along clause, which is relevant to all companies with more than two shareholders and any company with both a majority and minority shareholder.

A drag along clause can be used by a majority of the shareholders to ensure that a minority shareholder or group of minority shareholders cannot prevent the sale of shares if a desirable offer comes along.

Another example would be where the majority shareholders wish to sell their shares to a third party, but the third party's offer is conditional upon them acquiring all of the shares in company and not just the majority's stake. Such a condition is very much the norm in share sale and purchase transactions. Once triggered, the drag along clause allows the majority shareholders to force or drag minority shareholders into participating in the share sale.

Drag along clauses are all well and good in theory, but they can throw up some complicated issues and by their nature, can be contentious because they compel a group of shareholders to do something that they may not otherwise voluntarily opt to do. Surprisingly, there are relatively few court decisions covering this area of company law.

The High Court recently delivered a decision in the case of Cunningham v Resourceful Land Limited and Others [2018] which saw a drag along clause upheld. This is a useful decision in helping to understand how courts will view drag along clauses in future.

In the case, two companies were incorporated in order to set up and run a bio plant. The shareholders' agreement stated that, if three of the shareholders agreed to transfer their shares in good faith to an arm's length buyer, they could force any minority shareholders to do the same (relatively standard wording).

The companies experienced cash flow difficulties, and in a bid to save the business the three main shareholders agreed to sell their shares, but the shares were to be purchased not for cash, but by way of new shares in the buyer. One minority shareholder objected to the use of a drag along clause. In its judgement, the court stated that the drag along clause was valid and effective, that the rights had been properly exercised and the shares were sold in good faith.

Concerns have been expressed that courts would interpret drag along clauses very narrowly because such clauses involve the forceful sale of minority shareholders' property. This case should allay those fears and give comfort to majority shareholders that, where a properly drafted agreement is in place, a minority will not be able to frustrate the majority from selling a company.

For more information on how the Corporate and Commercial Team at Tollers can assist you with shareholder matters, contact Tollers on 01604 258558 and a member of the team will be happy to assist. Find out more at www.tollers.co.uk.

Tollers