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Enforcement of drag-along provisions
In a recent case (Cunningham v. Resourceful Land Ltd and others  EWHC 1185 (Ch)), the Chancery Division of the High Court upheld the application of drag along provisions in a shareholders’ agreement and held that the transfer of the claimant’s shares in accordance with such provisions had been valid. This article will consider key aspects of the decision and identify relevant take-away points.
The court case
The claimant was party to a shareholders’ agreement (SHA) relating to Resourceful Land Ltd (RLL) together with four other shareholders. RLL was incorporated with the purpose of holding the land on which an anaerobic digestion plant would be operated. The operations of the plant itself were to be undertaken by another company, Resourceful Earth Limited (REL). REL, which had obtained finance for the project from Privilege Project Finance Limited (Privilege), began to run out of money in March 2017. Some of the directors of REL requested further funding from Privilege, without which the project could not complete. Privilege agreed to provide additional monies, but on the basis it would receive an equity stake in the project. It was proposed that Privilege incorporate a new company, Wortside Limited (Wortside), which would purchase all the existing shares in RLL from its shareholders in exchange for newly-issued shares in Wortside. Three of the shareholders (Syndicate Shareholders) supported the transaction proposed by Privilege, but the remaining two shareholders did not.
The SHA contained drag along provisions in clause 8 which stipulated that where the Syndicate Shareholders wished to transfer their shares in RLL to a “bona fide arm’s length purchaser” the Syndicate Shareholders had the option to require all the other shareholders to “sell and transfer” all their shares on the same terms to the third-party purchaser. Clause 8.6 provided that if the dragged shareholders failed to execute transfers of their shares then, upon the company receiving the purchase monies “or any other consideration” payable for the shares, the Syndicate Shareholders were permitted to execute the transfers on their behalf.
The Syndicate Shareholders entered into a sale and purchase agreement, selling all their shares in RLL to Wortside, following which they served a drag along notice on the remaining two shareholders. The transfer of the shares held by the two remaining shareholders was completed pursuant to the provisions of clause 8 of the SHA. The claimant challenged the transaction by bringing a claim to rectify the register of members, seeking to replace Wortside’s name with his in respect the relevant shares, on the basis that:
- the word “sale” in clause 8 of the SHA was only intended to cover a sale of shares for cash and not shares, and therefore the drag along provisions had not been applicable to the transaction;
- the transaction had not been bona fide or undertaken in good faith, as it arose as a condition of further funding, the Syndicate Shareholders received a collateral benefit and it had been undertaken in “great haste” and was intended to take advantage of RLL; and
- the transaction was not on arms’ length terms, as the shareholders of RLL obtained an interest in Wortside (the purchaser).
The High Court dismissed the claimant’s claim and upheld the application of the drag-along provisions. The Court reasoned as follows:
- clause 8 was not to be interpreted as only applying to a sale of shares for cash. In particular, the words “or any other consideration” were deliberately wide and permitted a non-cash transfer;
- Privilege had not acted in bad faith and was a bona fide purchaser as required under the SHA. Privilege had agreed to treat all the shareholders (including the dragged shareholders) on an equal basis. There was no evidence of a side deal or special inducement for the Syndicate Shareholders. There was also no evidence that Privilege had, or had intended to, take advantage of the RLL Shareholders; and
- clause 8 required an arm’s length purchaser at the time the sale was agreed and not at or following completion. There was no prior relationship between the Syndicate Shareholders and Privilege, other than a commercial relationship between Privilege and REL. Wortside only obtained an interest in RLL as a result of the transaction and, prior to that, had no interest in or connection with RLL.
Key take-away points
There are relatively few cases on the enforceability of drag along provisions. Therefore, the decision of the High Court is encouraging for shareholders who seek to rely on drag along provisions in shareholders’ agreements or articles of association. The Court adopted a pragmatic, commercial interpretation of the drag along provisions in order to facilitate a transaction that was obviously in the best interests of the company and its shareholders as a whole. Nevertheless, there are some learning points for parties/lawyers seeking to draft, negotiate or rely on drag along provisions:
- Courts called upon to enforce drag along provisions will, in the first instance, seek to interpret the provisions by reference to what a reasonable person with relevant background knowledge would have understood the language to mean. Therefore, it is important for the language to be as clear as possible on what is permissible under the provisions. For example, it should be clear whether a dragged shareholder can be paid in non-cash consideration. Other common consideration structures, such as deferred consideration, loan-notes, earn-out and escrows should also be expressly permitted (if that is the intention of the parties);
- where relying on drag along provisions, it is important to review the provisions carefully to ensure compliance. Any Court called upon to assess whether the process in the provisions has been followed correctly is likely to scrutinise the conduct of the dragging shareholders closely; and
- in addition to compliance with the wording of the relevant provisions, equitable and fair treatment of all shareholders (including the dragged shareholders) is always likely to be a key consideration of any Court (although it is acknowledged in this case the Court considered these matters on the basis of the wording in the SHA). Nevertheless, a transaction in which all shareholders are treated equally, and which is in the best interests of the Company and the shareholders as a whole, is likely to be less vulnerable to subsequent challenge.