This article has been written by Anuj Mishra, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution; and has been edited by Oishika Banerji (Team Lawsikho).
It has been published by Rachit Garg.
There are various types of agreements, and once written, they can be used in a variety of contexts. When agreements are clearly written, the parties can better understand them and avoid misunderstandings. A shareholder’s agreement is a contract between a company and its shareholders. It defines shareholders’ rights and responsibilities, as well as clauses governing the company’s management and powers. This contract between the shareholders governs the conduct, rights, responsibilities, liabilities, and obligations and duties of each shareholder. To protect the interests of shareholders, regulations are in place to ensure that any transfer of shares takes place only with the consent of the parties involved. But not all safeguards are available to all shareholders. Drag-along and tag-along clauses are frequently found in shareholder agreements; one safeguards the interests of majority shareholders, the other those of minority shareholders. As a result, in order to protect his position and the investment, an investor needs certain rights to be outlined in the shareholding agreement. This article discusses the important aspects to consider while drafting a tag along rights clause in a shareholders agreement.
An overview of the shareholder’s agreement
The shareholders of a private limited company are granted rights under the company’s Articles of Association (or “AOA”) and the Companies Act of 2013. In general, private limited companies’ AOA gives shareholders access to a wide range of rights. These clauses are referred to as “pre-emptive rights.” The main goal is to prevent existing shareholders from being forced to accept a new shareholder they do not want. Usually, the remaining shareholders may buy the departing shareholder’s shares:
- According to their current shareholdings (barring any provisions in the agreement that specify a particular shareholder or shareholders as having priority);
- At a premium not less than the price paid by any prospective third-party buyer.
In addition to the points made above, the “drag along” and “tag along” clauses are a prime illustration of how to balance the rights of a majority shareholder and a minority shareholder. These rights are argued to be a crucial component of any term sheet or shareholders’ agreement involving the transfer of equity shares. The rights mentioned above are established during investment negotiations between the majority shareholder and minority shareholders of a company. Contractual terms like “drag along” and “tag along” have no place in the Companies Act, 2013. Similar concerns have been raised in Vodafone International Holdings BV v. Union of India (2012).
The principle of majority rule forms the foundation of shareholder democracy. To avoid oppressing the interests of the minority, the power of the majority must be restrained within a reasonable range. To maintain the balance of power, the Companies Act of 2013 grants certain rights to minority shareholders. The shareholders agreement may provide them with additional protections, luring regular investors to invest in the business.
The importance and key clauses of a shareholders’ agreement
The shareholder’s agreement is necessary as it defines the relationship between the different shareholders with their rights and commitments in the Company’s management, as have been stated previously as well. Being a key document in relation to a company’s affairs, it must always be in alignment of the company’s AOA. The most essential clauses that should be included in the shareholder’s agreement have been provided hereunder:
- Participation in critical decisions: The role of the investors must be clearly defined in the agreement under this clause.
- Pre-emptive rights and anti-dilution: Willingness of existing shareholders to invest further gives birth to this clause.
- Right of first refusal: This clause is a protective one for shareholders who object to transfer of shares.
- Drag-Along and Tag-Along Rights: This clause being the essence of this article serves as a protective belt for minority groups of shareholders who are crowded with unwanted co-owners as a consequence of selling of holdings by majority shareholders.
- Exit or termination clause: This clause deals with the aspect of a shareholder leaving the company under different scenarios.
- Dispute resolution: A dispute resolution clause is considered to be the last resort but is the safest way of disposal of any issues that arise.
Tag along rights clause
When a majority shareholder decides to sell their shares, tag along clauses protects minority shareholders from being left behind. Selling 10% of a company to a minority shareholder would be challenging because most buyers prefer to purchase the entire company. As a result, minority shareholders might be compelled to sell their shares at a price that is significantly below market value or has no connection to it. Minority shareholders without tag along rights may find that their shares are worthless or worthless.
For example, Shyam is a startup’s minority investor. The business is doing well, but one of the majority shareholders is leaving and selling their shares to a third party. Shyam is hesitant to stay on as a new majority shareholder takes control. As a result, Shyam leverages the tag along clause in their shareholders agreement to negotiate the same terms in a sale with a third party buyer, enabling her to leave the business as well.
When a situation occurred that was beyond Shyam’s control, the tag along clause gave him options. To protect their interests, informed investors typically insist on including tag along obligations in the shareholders’ agreement. Nevertheless, significant shareholders frequently consent to include exceptions to a tag along rights clause in their agreements. It is in the minority shareholders’ best interests to make some concessions in their direction because it keeps the major shareholders engaged and motivated.
Benefits of a tag along rights clause
- They protect the interests of minority shareholders because they are clauses in contracts. They ensure that their interests are protected in the event of a company sale.
- It enables the minority shareholder to profit from a compelling deal crafted by the majority shareholder, who has more clout during negotiations.
- For each of their shares, the minority shareholders receive the same consideration as the majority shareholder. This tag’s terms are also the same as those of the sale by the majority investor.
- It provides greater liquidity to minority shareholders.
- The rights that primarily benefit the minority shareholders are known as tag along rights, also known as “co-sale rights.”
- Even though the sale of private equity shares is strictly controlled, majority investors have the resources and expertise to make it happen. The option to take advantage of this is given to the minority shareholders.
- Tag along rights ensure that minority shareholders are treated equally with majority shareholders, despite the fact that they heavily favour majority shareholders by keeping them “locked in” to the business.
Enforceability tag along rights clause in India
In most contracts involving a merger, amalgamation, takeover, or any funding series, drag along and tag-along rights are required. Many types of transactions, such as mergers, acquisitions, or takeovers, as well as any other change in company control, trigger drag along and tag-along rights. According to the company’s ownership structure and the shareholders’ bargaining power, the majority shareholder’s percentage may change. It is usually between 51% and 75% of the total shareholding. Section 58 of the Companies Act of 2013 provides for the indirect enforcement of tag along rights clauses as it states that “to the extent that it relates to the transfer of securities, any agreement between two or more parties shall be enforceable as a contract’’.
As a result, “tag along” clauses can be considered purely contractual in nature. Only the terms of a contract, not an act, give rise to them. The two landmark judgments that have been discussed hereunder are a reflection of the enforceability of tag along rights clause in India.
V.B. Rangaraj v. V.B. Gopalkrishna (1992)
In the landmark case of V.B. Rangaraj v. V.B. Gopalkrishna (1992), it was a settled law that the ‘shareholders agreement’ cannot be said to be outside the purview of the Article of Association of a company and therefore rights mentioned in the agreement must be in conformity with those mentioned under the AOA. Thus, the extent of the rights in the shareholder’s agreement are ipso facto restricted and clarified by their nature. Their existence is affected if the same goes beyond the foundational scope of AOA of a company.
Vodafone International Holdings BV v. Union of India (2012)
The above discussed concept was attached with greater clarity in another landmark decision of Vodafone International Holdings BV v. Union of India (2012). The Supreme Court had opined in this case that the judgement delivered in the case of V.B. Rangaraj v. V.B. Gopalkrishna (1992) is meant only for private limited companies. Further, in cases of public limited companies, the situation stands different. Whereas, the case for a public limited company is different. A shareholder’s agreement mentioning rights like drag along and tag along is applicable even if they are not confirmed by the article of association of the respective company, in cases of public company. This can happen only if the rights are getting enforced for the company’s benefits. Thus, to conclude, in India, it is clear that tag along and drag along rights are enforceable, provided they are in conformity with the AOA of the concerned company. And when it comes to public companies, they are applicable only if used in good faith.
The legal status of drag along and tag along rights is extremely ambiguous. For these rights to be applied, the scenario must be crystal clear. Furthermore, these rights must be in accordance with the company’s ‘Articles of Association’. It must be stated in the company’s AOA that these rights are applicable and valid if they are mentioned in any agreement. Given the aforementioned, there would be no use in having an AOA since it would need to contain every clause from the shareholders’ agreement. It is advisable to include shareholders’ agreement clauses in AOA either by insertion or by reference until the Apex Court provides a clear explanation. Furthermore, it is evident that rights like first refusal, put/call options, and tag-alongs are enforceable in India.
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