21 Nov 2013
Court won't be dragged kicking and screaming into creative uses of "drag-along" rights
by Graham Taylor, Samy Mansour, Joanna Zhou
Drag-along provisions are not generally a mechanism for an existing shareholder to procure another shareholder's exit from the joint venture.
Drag-along provisions are contained in joint venture agreements, generally speaking, to enable majority participants to require minority participants to sell their shares to a third party purchaser. Is that all they can do?
A recent attempt to use them in a more creative fashion has been thwarted by the New South Wales Supreme Court (William McCausland v Surfing Hardware International Holdings Pty Ltd  NSWSC 902).
A surfboard joint venture gets choppy
Mr and Mrs McCausland held approximately 30% of the shares in SHI Holdings Pty Limited which developed and sold customisable surfboard fins. Mr McCausland was also an employee of the business. The Shareholders' Agreement said that if:
"the Company or any Shareholder receives an offer from a bona fide buyer for the Share Capital (Third Party Offeror)" it may serve an offer notice, on behalf of the Third Party Offeror on the company or all of the shareholders (as the case may be); and
the shareholders passed a resolution with at least 60% of the total votes accepting the offer notice,
the board of the company was obliged to require each shareholder to sell its shares to the relevant purchaser.
- "Third Party Offeror" was defined by reference to a "bona fide buyer for the Share Capital" without actually referring to a third party purchaser; and
- "Share Capital" referred to all of the shares in the company.
By 2004, various disagreements had played out between Mr McCausland and other managers of the company and his employment was terminated. A consortium (which included almost all of the other shareholders) also made an offer to buy all of the shares in the company and relied on the drag-along provisions, which resulted in Mr and Mrs McCausland's shares then being sold.
Court rejects creative use of drag-along provision
The McCauslands argued, amongst other things, that the sale of their shares breached the terms of the Shareholders' Agreement – only an offer from a third party for all of the shares in the company could trigger the drag-along provisions. An offer by an existing shareholder, by definition, could not satisfy this criterion.
The Court agreed– the drag-along clause was intended to be invoked by an offer from a non-shareholder. In particular:
- the offer could not be for all of the share capital of the company as required by the drag-along clause. "As a matter of ordinary language an offeror cannot accept its own offer. Another person must do that"; and
- the offer was bona fide in every sense other than the fact that it was not for 100% of the share capital – essentially, the consortium was not a "bona fide" buyer for all of the shares because it already held ordinary shares which it had no intention (or ability) to purchase under the offer.
What if a shareholder had used a nominee or related company to acquire the shares? Although the Court did not have to rule on this, it said that:
"it would be quite open to argue that [that purchaser] was not a "bona fide buyer for the Share Capital", as the term "bona fide" draws in broader judgments about the honesty or genuineness of the offer, not just the financial capacity of the offeror".
Drag-along provisions and planning an exit
Typically, drag-along provisions are included to facilitate the sale of all of the shares in a company to a third party purchaser.
Unless otherwise agreed upon by the parties, they are not a mechanism for an existing shareholder to procure another shareholder's exit from the joint venture.
The Court also suggested that even if a nominee or related company of a shareholder offers to acquire all of the shares, it is unlikely that that purchaser would be deemed to be "bona fide".
The key lessons from the case are:
- you must think about shareholder exit mechanisms at the time of drafting your agreement, not later;
- courts will analyse the intention behind a drag-along provision as well as its express language; and
- failure to properly draft, and appropriately interpret, drag-along provisions may result in an illegitimate exercise of purported rights under the drag-along clause.