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25th April 2016

The limitations of drag-along - Arbuthnott v Bonnyman [2015]

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What are drag-along clauses?

Drag-along clauses are often included in a company’s articles or in a shareholders’ agreement for the benefit of the majority shareholder(s). They allow a company’s majority shareholder(s) to offer the entire equity of the company to a potential buyer, rather than being limited to offering only his own shareholding, by forcing the minority shareholders to be dragged along by the majority by requiring the minority to sell their shares to the same buyer.

There is often a disproportionate difference in market value between an entire shareholding compared with a mere majority shareholding in that same company. Most trade buyers want complete control of companies they acquire, and would not contemplate the acquisition of only a majority of the shareholding, due to the complications which might arise from the continuing existence of minority shareholders. Such minority shareholders may be hostile to the acquisition and they may seek to delay or frustrate a buyer’s plans to reorganise the company or merge it into other operations.

For this reason, majority shareholders (and particularly institutional investors) demand drag-along clauses so as to ensure, where necessary, they could liquidate their investment for maximum profit by offering the whole company for sale, regardless of any opposition from the minority shareholders.

How is a drag-along clause triggered?

Drag-along clauses will include trigger mechanisms which specify what proportion of the shareholders must agree to a sale before the remaining shareholders are dragged along. The trigger threshold may be set at any level the parties agree. An investor, purchasing a majority of a company’s shares and with a strong bargaining position, may be able to demand a clause which permits them to trigger the drag-along without the agreement of any other shareholder.

Are there any limitations on the use of drag-along clauses?

The use of drag-along clauses often leads to a substantial number of alienated and disaffected minority shareholders whom are opposed to a sale of their shares, but find that they have no recourse under the shareholders’ agreement or articles of association.

A minority shareholder in this position is likely to find that his only option is to petition the Court under s.994 of the Companies Act 2006 on the grounds that the sale would be “unfairly prejudicial” to him. However, as with most company law, the courts have historically been extremely reluctant to interfere with the outcome of the freely negotiated shareholders’ agreement (or articles), drawn up by the parties.

In the recent case of Arbuthnott v Bonnyman [2015] the majority shareholders received a management buyout offer which they were keen to accept, but on which could not proceed due of the refusal of the claimant minority shareholder to sell his shares. To get around the problem, drag-along provisions were inserted into the relevant company’s articles (without the consent of the claimant), which then permitted the majority to sell the company and force the claimant to participate. The claimant believed the sale price to represent a substantial undervaluation of his shares and issued a petition under s.994.

The Court held that a term could be implied into the articles that, as sophisticated financial professionals, the majority would not accept a sale price which they did not honestly consider to be fair and reasonable. The burden of proof lies with the petitioner. In the Arbuthnott case, the claimant was unable to show that the majority did not hold such a belief, although this new implied clause may have a significant impact on future cases.

Ordinarily, a majority seller will wish to realise maximum profit from the sale and would not sell his own shares at an unreasonable undervalue, but there may be circumstances when the majority may fall foul of this requirement.

Consider, for example:

a majority shareholder who is suffering cash-flow difficulties and who wishes to make an urgent sale, accepting a substantial price reduction in order to realise a quick profit; a majority shareholder who is also a shareholder of, or otherwise has an interest in, the buyer, and who is willing to accept a low sale price because he is effectively on both sides of the transaction; or a majority shareholder who has failed to take reasonable steps to value his own shares and does not appreciate the true value of his shareholding, bringing into question the position where the majority hold an honest but unreasonable belief about the sale price.

Minority shareholders being dragged along by majorities such as those described above may have good grounds to complain to the Court. It remains to be seen how the Court will apply this implied term in such circumstances.

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