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What is a ‘drag along’ clause?

What is a ‘drag along’ clause?

Corporate Solicitor Matthew Collings explains the benefits of “drag along” provisions in a company’s Articles of Association or Shareholders' Agreement.

The dissent of a minority shareholder may not be a serious problem in the general day to day running of a company but if the disagreement between the majority and minority shareholders relates to whether or not to sell the company, it could prevent the sale from proceeding even if the majority want it to happen.

The solution can be the introduction of "drag along" provisions in a company’s Articles of Association or Shareholders' Agreement.

What is a drag along clause?

A drag along clause enables the majority shareholders of a company (typically over 75%) to compel the minority shareholders to accept an offer from a third party to purchase the whole company.

Put simply, the provisions enable the majority shareholder to ‘drag’ the minority shareholder along to the deal they may be opposed to.

Why are drag along clauses used?

While a dissenting minority shareholder may not be an issue in the general running of the business, the vast majority of prospective buyers of a business will want to purchase all of the shares and will be put off if they cannot gain 100% control.

Drag along provisions make the company more attractive to potential buyers, as they assure the buyer that that any sale will proceed without a minority shareholder vetoing it.

However, any attempt to force a shareholder to sell their shares by enforcing drag along provisions will be carefully scrutinised by the courts.

As drag along provisions are an important tool for majority shareholders, great care must be taken when drafting them, otherwise the majority shareholders may experience issues in enforcement or could face a claim from the minority for unfairly prejudicial conduct.

Drafting enforceable provisions

If drag along provisions are disputed by the minority, the main issue the Court will consider is whether they are being exercised in good faith. The test in this case is one of reasonableness.

Recent case law has evidenced a number of useful examples of well drafted provisions which were considered to be reasonable and enforceable, and why.

It is important to demonstrate reasonableness, and to provide that the minority shareholders will be entitled to sell their shares on exactly the same terms as the majority shareholders. It therefore follows that the minority shareholder is not being ‘undersold’, and will have difficulty claiming unfair prejudice if the sale is on a genuine arm’s length basis.

The flip side of this is that a transaction not at arm’s length (or at an undervalue) could be challenged as being unreasonable and risks the drag along provision being held to be unenforceable.

It is also wise to avoid limiting any reference to consideration payable for the shares to cash only. The High Court recently upheld provisions which dragged a minority shareholder along to a sale of shares where the consideration was not cash, but rather the issuing of shares in another company.  Fortunately, those provisions allowed payment to be cash ‘or any other consideration payable for shares’ and so were enforceable. The use of such wording should therefore be deliberately wide and flexible to help facilitate more complex transactions and give the selling shareholders more options.

What if existing Articles do not include drag along provisions?

Don’t worry – If your existing Articles are silent on the issue, you can consider passing a resolution to amend.

A minority shareholder (with less than 25% of the shares in the company) will usually be unable to prevent the change, but the consent of the minority to the change is always the preferred option.

Can I challenge a drag along provision?

Generally speaking a well drafted provision is likely to withstand challenge, so it is important to take legal advice on the introduction of drag along rights.

Recent case law has also demonstrated that the Courts will take a pragmatic approach. If there is no evidence of bad faith or improper motive from the majority shareholders, the provisions may (even if defective) be enforceable.

One could argue that just because a majority shareholder approves a deal, it does not mean it is in the best interests of the company and the minority shareholders. For example, a retiring majority shareholder who wants to cut and run may accept a less favourable deal in the interests of time, and there may be scope to argue unfair prejudice if the minority shareholders really are being dragged along with a bad deal which suits the majority, but not the minority. Each set of circumstances will be judged on the facts.

Key points to remember

  • When drafting a drag along clause, be sure to set out that the dragged along party will receive the same value as approved by the majority shareholders in an arm’s length transaction to a bona fide third party. In the event of a dispute, this increases the chance that a court will find it is fair and enforceable.
  • Ensure that provisions are drafted as widely as possible to give greater flexibility. For example, do not try to specify every kind of consideration the company may accept in return for shares – a catch all such as ‘any other consideration’ is advised. This will give more freedom when it comes to structuring deals.
  • For existing companies that do not have any reference to drag along provisions in their articles, you should consider passing a resolution to amend your articles to include this, or to include them in a separate Shareholders’ Agreement.  That way, any exit approved by the majority shareholders cannot be jeopardised by the minority.

Our Corporate team regularly act for shareholders in relation to drafting or amending existing Articles and Shareholders’ Agreements. For more information please contact Matthew Collings here.

About the author

Published: Friday 12th October 2018
Categorised: Commercial Client, Corporate Law, Legal Services in Newcastle, Penrith, West Cumbria

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