This article has been written by Sharen Joel, pursuing a Diploma in General Corporate Practice: Transactions, Governance and Disputes from LawSikho.
it has been published by Rachit Garg.
Table of Contents
Shareholders’ agreement is an agreement between the owner of the share and the company and/or between the shareholders as well. It elucidates the correlation that exists between the shareholders and the company. The agreement contains provisions to safeguard the interest of majority and minority shareholders in the company. It outlines the rights, obligations and liabilities of the shareholders. Shareholders’ agreement encompasses preemptive rights, the right to drag along and the right to tag along in respect of the sale of the company’s shares. These rights ensure that shareholders’ interests are secured and even create an option for the shareholders to make their way out of the company if required. The present article is a piece dealing with the two rights of drag and tag belonging to the shareholders and their scenario with respect to India.
Right to drag along
The right to drag along is specifically provided to the majority shareholder. It is also known as the “Come-along clause” in shareholders’ agreements. The majority shareholder is one who owns more than 50% of the share in the company. Whereas, the minority shareholders are the ones who own less than 50% of the shares in the company. Right to drag along allows the majority shareholder to sell his shares and compel the minority shareholder to deliver the shares at the same price and terms to the third party. This right warrants the flexibility and liquidity to the majority shareholder. The minority shareholder is dragged into selling the shares held by him on the pretext that the majority shareholder is trading.
Right to drag comes into play in almost all kinds of sale transactions, mergers or acquisition deals, or deals relating to changes in the ownership of the company. The right to drag along ensures that the sale of the company is not obstructed by the minority shareholders. It ensures that no piece of the share is left behind. Drag-along rights are mostly encompassed in agreements of private companies and subsumed when the private company changes into a public. When the company goes public the previous shareholder’s agreements cease to exist and new drag along rights need to be incorporated in the agreements if applicable.
Though the drag along rights provision undermines the minority shareholders’ right to make a choice and retain their shares, it guarantees that they are not being exploited by trading their shares at unfavourable rates and conditions and the terms are uniform for all shareholders. Even investors prefer to invest in companies with the right to drag along provisions in their agreements.
Advantages of the right to drag along
- Right to drag along makes sure that the sale of the company is not blocked by minority shareholders.
- Though the right to drag along is for the benefit of the majority shareholders, it also proves beneficial to the minority shareholders as they get to sell their shares on the same terms and conditions as the majority shareholders.
- Drag along clause is important in the shareholder agreement when it comes to inviting investors in the company. Investors are likely to invest in companies with drag along clauses to mitigate the future risk from minority shareholders.
Disadvantage of the right to drag along
The major drawback of drag along rights is that it forces minority shareholders to sell their shares even if they are not willing to sell. Right to drag along promotes forced sale transactions and is arbitrary to the interest of minority shareholders, thereby making the minority shareholders lose their prospective future gains.
When is the right to drag along triggered
Right to drag along can be triggered in varied sale transactions. Generally, drag along rights are triggered in mergers and acquisitions, the sale of the company’s securities, the sale of valuable assets of the company and other transactions as specified in the Articles of Association. The right to drag along can also be triggered when the majority shareholder holding 51% or more holds in the company wants to sell his share.
Key consideration while negotiating the right to drag along
- Firstly, while incorporating drag-along rights in shareholders’ agreement, the terms majority and minority shareholders must be well defined according to the company’s Article of Association or bye-laws. It is necessary because there are different classes of shareholders depending upon the company’s structure and shareholding pattern.
- Secondly, drag along can also be incorporated in a manner in which the minority shareholders are provided with a predefined time period for buying out shares of the majority shareholders.
- Thirdly, when there is no single majority shareholder and several persons altogether holding more than 50% shares in the company agree to sell the company then they can drag the minority shareholders along with them. However, in case of splitting up of the company, it is essential to consider the drag along clause in the shareholder’s agreement.
- Drag along rights are a suitable option for companies in their initial years as it ensures stability and undue complexity in cases of transfer of ownership.
Right to tag along
The right to tag along is provided for the benefit of minority shareholders. It allows them to sell their shares at the same price and conditions as the majority shareholder. When the majority shareholder is selling their shares, the minority shareholders can exercise their right to tag along and join the majority shareholder in the sale. It is lucrative for the minority shareowners as they are at risk of being exploited when the majority shareholders decide to sell shares, thereby leaving them high and dry. Without the right to tag along, the actual price minority shareholders will suffer a loss as most buyers want to attain greater power in the company.
The tag along rights are available mostly in startups and private companies. Tag along rights ensure a secure way out for the minority shareowners. The tag along rights provides a higher valuation of the shares held in minority. Investors are most likely to avoid investing in companies with tag along provisions as it only benefits the minority shareholders and gives them sufficient control in the transactions of the company.
Advantages of the right to tag along
Tag along rights benefit the minority shareholders in getting the same deal as the majority shareholders when the majority shareholder enters into a sale transaction. It provides them financial protection as they get to sell their shares at the same price as that of majority shareholders. Tag along right provides minority shareholders with a safe exit from the company. These rights give control to the minority shareholders to some extent.
Disadvantages of the right to tag along
The substantial disadvantage of the right to tag along is that it prevents majority shareholders from investing in the company. Big investors avoid investing in companies that offer tag along to their minority shareholders as it gives considerable power to the minority shareholders in the company affecting the decisions of the majority shareholders.
Moreover, tag along rights also affect the sale of the company when the potential buyer is reluctant to change the terms and conditions of the sale transaction to please the minority shareholder and is unwilling to buy their shares.
When is the right to tag along triggered
Right to tag along can be triggered in case of promoters selling their shares and investors want to become a part of the sale transaction and also want to exit the company. However, like drag-along rights, the process for triggering tag-along rights may change depending on the parties’ goals.
Key considerations while negotiating the right to tag along
Whether the tag-along right should be applied is a frequent topic of discussion:
- Solely for the sale of all the shares held by the majority shareholder, or to any sale of shares by the majority shareholder with the express tag-along right to apply to the minority shareholders proportionately based on their respective shareholding percentages in the joint venture.
- The majority shareholder might achieve a nearly total economic exit by selling a sizable majority position (albeit not all of its holdings) in the first option, which could put minority shareholders in danger of the tag along provisions being triggered.
- It’s frequently argued whether minority owners who use their right to tag along should be required to make the same array of representations and warranties as the selling majority shareholder.
- There is a case to be made that the exercise of the tag-along right is within the control of the minority shareholders (unlike the situation under a drag-along right), and therefore if the minority shareholders are to receive the same price per share on exit, they should control the exercise. Minority shareholders may understandably seek to minimise the level of contractual assurances given (on the basis that the sale process is effectively controlled by the majority shareholder).
Right to tag along vs. right to drag along
The Companies Act of 2013 does not specifically mention the right to tag and drag along. They are provided in the company’s bylaws and shareholders’ agreements. Co-owners are generally required to give notice to other shareholders before entering into any transactions. The difference between the two rights is stark. The two rights differ on the following points:
- Accessibility: The tag along right is available to minority shareholders whereas, the drag along right is given to majority shareholders.
- Impact on investments: Investors favour companies offering drag along arrangements, as it emphasises the flexible structure. On the other hand, investors try to avoid the companies that give the right to tag along to the minority equity holders.
- Secure withdrawal: Right to drag along ensures the exit of the majority shareholder without being derailed by minority co-owners. Right to tag along permits the minority shareholder to exit with the majority shareholder and sell their shares by tagging with the majority equity holder.
- Beneficiary: The right to drag along is usually advantageous for the majority shareowner and the right to tag along benefits the majority shareowner. But that does not necessarily imply that the right to drag along exploits the minority shareholders, it ensures that they get the same benefits as majority share owners in any transactions.
- Status: The status of the drag and tag along rights is settled in regard to the public company. As both rights can be enforced in a public company. But the position in the context of a private company still needs to be clarified. The lack of any settled provision creates uncertainty.
- X owns 60% shares of ABC Pvt. Ltd. and wishes to sell the shares to the PQR Pvt. Ltd. X negotiated the terms of the sale with PQR Pvt. Ltd. and it was decided that PQR Pvt. Ltd. wants 100% of the equity of the company.
According to the shareholder’s agreement of X, being a majority shareholder he can exercise his right to drag along and drag all the other co-sharers into the sale. Provided that the other co-sharers are being offered the same deal with the same terms and conditions.
- Rajiv, the majority shareholder of Titus Pvt. ltd. went bankrupt and wants to sell his part of the share. According to the shareholder of the company, the minority shareholder can exercise their right to tag along if the need arise, although it is not mandatory on the minority shareholder that they have to sell their shares. Kabir after knowing the deal that Rajiv is getting for his part of the shares and knowing completely well that the company is running at loss, decides to exercise his right to tag along and sell his share along with Rajiv.
India’s position with respect to right to drag and tag along
- Section 58 of the Companies Act, 2013 states that the parties are free to enter into individual agreements with each other. SEBI has somehow cleared the situation to vide its notification dated 3rd October, 2013. In clause (C) of the notification, it stated that companies are not required to take prior permission in contract arrangements for preemptive rights (which include the tag along rights and drag along rights).
- In Vodafone International Holdings BV v. The Union of India, (2012), the Supreme Court of India stated that the right to drag along, right to tag along and preemptive rights are binding on the parties even if they are not mentioned in the Articles of Association of a company. The condition precedent is that the shareholders’ agreement must be in consonance with the Articles of Association and not violative of anything mentioned in it.
- The Supreme Court in an appeal filed in Bajaj Auto Ltd V. Western Maharashtra Development Corporation Ltd, (2015) held that shares are movable property and the shareholders have the right to enter into individual agreements and while doing so, he is merely exercising their property rights. Therefore, the agreements entered by shareholders with others in regard to the sale and transferring or preemption of the shares are not restricted.
The right to tag along and the right to drag along is not specifically defined or provided anywhere in the Indian legislation and is subjected to a lot of confusion and misunderstanding. However, these two rights are indispensable in any shareholders’ agreement. They are propounded with the motive to ease the transfer of shares and also secure the exit options. The judiciary’s view is clear in terms of public companies. The right to tag along, drag along and preemption rights are available in public companies. But in absence of any written provision, this area remains grey for private companies. Section 58 of the Companies Act, 2013 is specific about public companies but the scope for private companies is non-existent. For that reason, it is at the disposition of the courts to decide from case to case, the applicability and availability of these rights. Before incorporating these rights, all aspects of the company should be kept in mind and only after due deliberation, they must be integrated into the shareholders’ agreement. All the conditions and requirements must be laid down in clear words and the situations in which these rights can be exercised and triggered, must be mentioned in the agreement so as to avoid confusion in the future.
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