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Are minority shareholders persuaded into sale by majority shareholders?

Gateley Legal

Arrangements between shareholders are often drafted to include “drag along” provisions, a mechanism by which majority shareholders can require minorities to join in a sale to a third party.

Since most third party purchasers are only interested in acquiring 100% of a company, drag along provisions ensure that a troublesome shareholder cannot block a potential sale or hold the majority to ransom. Private equity investors will almost always require management teams to sign up to drag along provisions so that the investor can realise its investment in due course.

Amending articles to include drag provisions

But what if your documentation doesn’t include drag along provisions? Amending a company’s articles of association only requires approval from the holders of 75% of the shares, so can a majority insert drag provisions into a company’s articles of association and have them bind a minority who is against the amendment?

To be valid, the power of a majority to amend articles which then bind a minority has to be exercised fairly and in the best interests of the company as a whole. This is a subjective test: provided there are reasonable grounds on which the majority could consider the change to be in the company’s best interests then the amendment will be valid. It is up to the minority to show that the amendment was not genuinely believed by the majority to be in those best interests.

In context…

In a recent case the court applied this test and found an amendment to the articles was indeed in the best interests of the company and therefore a minority shareholder could be forced to sell his shares against his wishes. Ironically, the case involved a dispute between the shareholders in the high profile private equity firm Charterhouse – a firm which probably thought it would be relying on drag along provisions to force the management of one of its investee companies to sell, rather than having to use them to sort out its own shareholdings.

The problem for Charterhouse was that over time a disparity had arisen between the holders of its shares and the active members of its investment team as executives had left but had been allowed to retain their shares. Evidence was heard that this misalignment of interests was a significant issue in the private equity industry and would be an impediment to Charterhouse raising a new fund.

A green light? 

So, is this decision a green light for inserting new drag along provisions into articles to overcome an off-side minority shareholder? Well it is certainly to be welcomed in clarifying that in some circumstances this is a course of action which will be upheld. But there are some specific factors which mean that it may be of limited use when considering subsequent cases. In particular:

  • the misalignment between the company’s shareholders and its management team was causing Charterhouse significant problems. Whilst the rationale for any MBO is generally the alignment of ownership and management, expert evidence indicated that this was particularly relevant in the private equity industry. In other industries or sectors the consequences of such a misalignment may not be so severe;
  • the drag in this case was effectively aimed at a number of non-continuing shareholders (although in fact most of them accepted the buyer’s offer without needing to be “dragged”). Whilst the buyer was a vehicle formed by some of the existing shareholders, this was not a case where a drag was being used as a mechanism to remove a lone troublesome shareholder, with all the remaining shareholders continuing in business together without him. The reorganisation was necessary in order to secure the long-term stability of the company when it was agreed that a sale to another buyer, or a cash injection from another investor, was unlikely. The case may be less persuasive in a situation where a company has alternative viable options for its future; and
  • most significantly, the existing documents to which the dissenting shareholder was a party actually already contained drag along provisions and the court viewed the changes made to the articles as a “tidying up exercise”. A drag along provision was therefore one of the bases of the commercial bargain between the original shareholders and the dissenting shareholder and he was not in a position to complain about being forced to sell his shares at a price accepted by a majority of the other non-continuing shareholders.  The case may therefore be of little help where the parties wish to insert drag along provisions where none have previously existed.

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