Drag along rights enforceable

The decision in  William McCausland v Surfing Hardware International Holdings Pty Ltd ACN 090 252 752 [2013] NSWSC 902 (9 July 2013) is a reminder that drag along clauses in shareholders agreements are enforceable – if used appropriately.

This article highlights the extent of the issues and the complexity of factors which can affect the legal position of the parties in such situations.   In circumstances such as this a plaintiff will please multiple causes of action.

The judgment  of Slattery J was 402 pages of text containing some 1138 numbered paragraphs and graphics.  The issues were not confined to the drag along clause but involved an interpretation of the nature of the employment contact of the founder, the payment of a success fee and the circumstances surrounding his termination.  To a large extent, the facts outlined in detail by Slattery J’s would appear to make a good basis for a John Grisham novel.

Background to the case

Mr William McCausland (McCausland) and two others founded a surfing hardware business known as “Fin Control Systems”.  After the parting of the original two partners, (Mr Mountford and Mr Bennett) the interest in the company was held in two entities known as Surfing Hardware International Holdings  (Holdings) and Surf Hardware International Pty Limited (Hardware).

Following the sale of two co-founders’ interests, Macquarie Bank (Macquarie) and Crescent Capital Partners Ltd (Crescent) acquired a 61% share in the overall business with McCausland maintaining a 30% interest.   The remainder was held by a minority investor Mr Boscher (Bosher).  The parties entered into a shareholders agreement (SA) which contained a drag along provision at clause 12:

Clause 12 is provided at paragraph 160 in the full judgment of Slattery J as:

“12. Drag Along

12.1 Third party offer

If the Company or any Shareholder receives an offer from a bona fide buyer for the Share Capital (Third Party Offeror), it may serve notice, on behalf of the Third Party Offeror, (Offer Notice) on:

(a) in the case of the Company serving the Offer Notice, all Shareholders; and

(b) in the case of a Shareholder serving the Offer Notice, all other Shareholders and the Company, specifying:

(c) the proposed purchase price for the Share Capital  (Price);

(d) the proposed settlement date (Settlement Date)

(which must be a date which is at least 25 Business Days after the date of the Offer Notice);

(e) the name of the Offeror; and

(f) any conditions attaching to the offer.

12.2 Drag Along Rights

If the Shareholders decide, by passing a resolution  approved by those Shareholders holding (whether directly, by proxy or other authority) at least 60% of the total votes attaching to all ordinary Shares on issue in the capital of the Company, to accept the offer contained in the Offer Notice, the board must give a notice (Drag Along Notice) to each Shareholder:

(a) stating the decision of the Shareholders to sell all of the Share Capital on the terms contained in the Offer Notice;

(b) advising the Share Capital will be sold, on behalf of the Shareholders, on the Settlement Date to any alternate purchaser, which is any or some Shareholders, if the offer may by such Shareholder(s) is clearly (determined by the board in its sole and exclusive discretion) on the same or better terms than the terms contained in the Offer Notice (as determined by the board), then to the Offeror or any alternate purchaser, which may be any or some Shareholders, on the same or better terms than the terms contained in the Offer Notice, as determined by the board in its sole and exclusive discretion.

12.3 Obligation to complete

If Drag Along Notices are served, then:

(a) so that completion of the sale may occur on the Settlement Date, no Shareholder will be entitled to serve a Transfer Notice under clause 11; and

(b) on the Settlement Date, each Shareholder must deliver title to all of its Shares, free from all encumbrances, to a purchaser nominated by the board pursuant to clause 12.2(b).

12.4 Attorney

Each Shareholder and the Company hereby severally and irrevocably appoints any three Directors jointly as its agent and attorney with power to complete the sale as contemplated in this clause 12, including the power for any three Directors together to execute all necessary documentation to complete the sale on behalf of that Shareholder.”

Various disagreements between McCausland and management resulted in Macquarie and Crescent wanting to server their relations with McCausland.  McCausland rejected an offer to be bought out by a minority investor.  Further Crescent exercised their rights under the drag along provision in clause 12 to effect the compulsory sale of  McCausland’s shares.  It was alleged that the shares were sold well below market value.

What is a Drag Along clause?

Clauses 11 and 12 of the agreement dated 20 December 2002 governed the sale of shares by existing shareholders and when a third party offers to buy shares. Clause 12 dictated what should happen when a third party makes an offer for shares in the company and the mechanism of drag along rights.

Drag along rights are commonly included in shareholder agreements.  The clauses generally allow a majority shareholder to compel a minority shareholder to sell their shares to a bona fide third party if an offer for all of the shares in the company is received.   The majority shareholder can ‘drag along’ or force the other shareholders to also sell their shares in the company to that third party.

The relief sought

The issue was that the shares were sold at an undervalue – $0.67 and not $1.46 as it was alleged.

The proper interpretation of the drag along clause

The judgment addresses two aspects of the drag along clause in there procedural mechanisms and the meaning of a third party starting at 572.

In what appears on its face to be an example of a failure to make a consequential amendment in a commercial contact, clause 12.1 provided that “if the Company or any Shareholders receives an offer from a bona fide buyer for the Share Capital (Third Party Offeror)…”

Perhaps the ratio of the case is at paragraph 577 when Slattery J says:

“Clause 12 holds many indications that a clause 12.1 offer must be from a non-shareholder. Its language describing the bona fide buyer for the Share Capital as “a Third Party Offeror” is not to be ignored. Leaving aside the heading to clause 12.1, the description of the buyer as a “Third Party Offeror”, is language inapt to describe an existing shareholder, such as Crescent.“

It was later accepted at paragraph 614 that an existing shareholder could not make “an offer… for the share capital” within clause 12.1 and that Cresent was not a “bona fide” buyer for share capital.

The oppression argument

It was alleged that the course of actions by the defendants was oppressive pursuant to section 232 of the Corporations Act 2001 (Cth).

The matters to support the allegations as pleaded included:

• that Mr McCausland was excluded from management;
• that false allegations were made against him;
• that the parties conspired against him;
• that the defendants acquired the McCausland’s shareholdings at an undervalue; and
• that the Plaintiffs reserved their rights to identify any further particulars which they determined to be oppressive.

The alleged oppressive conduct was identified at paragraph 641 of the judgment.

Slattery J then goes on at paragraph 643 to discuss the relevant principles of oppression as contained in sections 232 and 233.  The issue to be determined “in balancing the interests of the company as a whole against minority interests that directors of a company have acted so as to unfairly prejudice the interests of that minority” citing Jenkins v Enterprises Gold Mines NL (1992) 10 ACLC 136 and 6 ACSR 539.

Despite the accepted facts it was stated at paragraph 655 that few of the McCausland’s eight headings of alleged oppressive conduct satisfied the tests for oppression.  That said, the Plaintiff’s contract and oppression claims succeeded.

The Court ordered after an extensive analysis of the valuation mechanisms that the market value of the shares was $1.02 as at 2 September 2004 and they were subsequently entitled to the difference between $0.675 and $1.02

Take aways about drag along clauses

• At the time of drafting a shareholders agreement it is critical that rights, obligations and exit options are clearly defined;
• Any collateral agreements such as Employment Agreements or Contracts for  Services are drafted and signed;
• Don’t proceed without finalising all contractual terms of all agreement as the passage of time will only make matters worse;
• Shareholders must carefully consider the inclusion of drag along clauses;
• If a drag along provision is wrongfully applied it is  likely to amount to a breach of contract resulting in damages being awarded to the affected party;
• Directors must consider their conduct as a whole to avoid any future question of oppression.

Links and further references

Cases

William McCausland v Surfing Hardware International Holdings Pty Ltd ACN 090 252 752 [2013] NSWSC 902 (9 July 2013)

Candoora no 19 Pty Ltd v Freixenet Australasia Pty Ltd & Anor (2008) VSC 367  – Fair value of shares

William Buck (WA) Pty Ltd v Faulkner [no 6] [2013] WASC 342 (24 September 2013) – Oppression

Legislation

Corporations Act (Cth) 2001 s232

Further information

If you need advice on preparing a shareholders agreement, or utilising a drag along clause, contact us for a confidential and obligation-free discussion:

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.

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