Deal Aware

Mergers & Acquisitions and Corporate Restructuring

Drag-along and Tag-along Rights in a SHA & their Enforeceability


Keywords: Drag-along rights; Tag-along rights; Shareholders’ Agreement

shareholder

Christina D'Souza is a III Year B.A. L.LB Student at Dr. Ram Manohar Lohiya National Law University (RMNLU)

INTRODUCTION

A “Shareholders’ Agreement” is an important legally binding contract between the shareholders and the company, and between the shareholders themselves. A Shareholder’s Agreement sets out a shareholder’s rights and responsibilities. The existence of “Drag-along right” and “Tag-along right” in a Shareholders’ Agreement is commonly found in modern day investment agreements. With the rise of globalization and cross-border investments, it becomes essential to understand the importance of these rights as classic exit-related provisions, which are widely used in international Merger & Acquisition deals but remain relatively underutilized in India. Perhaps because of this reason, the enforceability of these rights in India remains debatable.


DRAG-ALONG RIGHTS AND ITS RELEVANCE

Drag-along and Tag-along rights are relatively new to India and therefore, the legal enforceability of such rights is a concern for the foreign investors. For public limited companies, prior to 2013, these rights were practically unenforceable in India because Section 111A of the Companies Act, 1956 (‘the 1956 Act’) required shares of a company be ‘freely transferable’ and the invocation of these rights could have been construed as causing a restriction in the free transferability of shares. However, the doubts regarding the enforceability of the same were cleared by the Bombay High Court in Messer holdings v Shyam Madanmohan Ruia, which held that any contract or arrangement between two or more persons with respect to transfer of securities can be enforced like any other contract and does not impede the free transferability of shares at all.

Thereafter in 2013, the Companies Act, 2013 (‘the 2013 Act’) replaced the 1956 Act, but retained the requirement under new Section 58(2) (corresponding to Section 111A of the 1956 Act) that shares of a company be freely transferable. However, the newly inserted proviso to Section 58(2) made enforceable “any contract or arrangement between two or more persons in respect of transfer of securities”, meaning thereby that the shareholders now had the freedom to incorporate any restriction in the transfer of securities in the Shareholders’ Agreement, including Drag-along and Tag-along rights.

Even though the Drag-along and Tag-along rights may prima facie seem enforceable, it is not clear what should be the pre-conditions required to be satisfied for their enforceability. In the next part of this article, a discussion regarding the importance and existence of these pre-conditions will be made by learning how they are enforced in foreign jurisdictions. Moreover, till now, the enforceability of these rights has been discussed only in the context of a public limited company and in the next part, the context will change to a private limited company.

ENFORCEABILITY IN INDIA: PRIVATE LIMITED COMPANY

As far as a private limited company is concerned, enforceability of Drag-along and Tag-along rights remained in doubt. This is because neither the 1956 Act nor the 2013 Act even remotely talked about Drag-along and Tag-along rights in the context of a private limited company. Shortly after the 2013 Act was introduced, in order to elucidate upon the situation, the SEBI by way of its notification dated 03.10.2013 declared that contracts including Drag-along and Tag-along rights contained in the Shareholders’ Agreement need not seek SEBI’s permission in advance.

The notification was not issued in the specific context of either private limited companies or public limited companies. This can be construed to mean that the Drag-along and Tag-along rights are enforceable in India as long as they are incorporated by the shareholders in their Shareholders’ Agreement and Articles of Association. However, it must be noted that private companies derive this freedom only in the absence of any formal provision applicable to them in this regard. Absence of a formal provision raises certain questions,as would be evident in the subsequent paragraphs.

ENFORCEABILITY AROUND THE WORLD

Despite their widespread use, the enforceability of Drag-along and Tag-along rights has received little attention and 
relevant case law is also thin on this ground. Authors in common law jurisdictions like Australia, Ireland, Malaysia, the UK, and the US usually point out that there is no prohibition against these clauses and that in principle, they are enforceable.

In the United Kingdom, Drag-along and Tag-along rights are widely regarded as enforceable. These rights are formally recognized by the recent UK legislation in the Growth and Infrastructure Act, 2013. If the enforceability of these rights is challenged, the Court carefully scrutinizes these rights and through the test of reasonableness, it considers whether they are being exercised in good faith. In a recent case, the Chancery Division of the High Court upheld the application of Drag-along provisions in a Shareholders’ Agreement and made itself clear on the enforceability of these rights and held that these rights, if exercised in good faith, are enforceable.

Coming to the US, in so far as the Drag-along rights are concerned, case law seems to suggest that they are enforceable where they serve a reasonable corporate purpose. Failure to comply with the Drag-along sale provisions contained in the Shareholders’ Agreement will render the drag along rights unenforceable.

However, in Turkey, these rights come with practical constraints to enforcement because they are not regulated under the Turkish law and execution of these rights may thus be problematic. In case of a dispute between the shareholders, the courts will not render a specific performance decision, but instead will grant monetary compensation to remedy the Drag-along or Tag-along Rights related breaches.

A more peculiar situation can be observed in Brazil, where the concept of only Tag-along Rights is recognized. However, the position of law on their enforceability is quite dynamic. Initially, a Tag-along right for the minority shareholders was in place. However, a new law was enacted in 1977 amending the previous law which abolished Tag-along rights. The rationale behind this change was to facilitate the ongoing privatization program, allowing the Government to sell off its controlling stakes without sharing the control premium with minority shareholders. In 2011, another amendment was passed to partially reinstate tag along rights.

COMPARATIVE CONCLUSION

The need for protective rights like Drag-along and Tag-along rights in a Shareholders’ Agreement is indispensable. Establishing a company is an adventurous task. It is very important for the shareholders to include proper preventive measures while entering into a Shareholders’ Agreement to be prepared for future conflicts. With regard to the current status of these rights India, a need is realized for certain reforms with respect to both private and public limited companies.

As far as public limited companies are concerned, it is almost settled that Drag-along and Tag-along rights are enforceable. However, since public interest may be involved in such companies, to avoid a possible misuse of the Drag-along and Tag-along rights, certain restrictive guidelines must be issued so as to ensure that these rights are not misused by shareholders. For instance, an insight must be taken from the UK & the US regarding a bar to enforceability of Drag-along and Tag-along rights when they are not exercised reasonably and in good faith. This should ideally be done by a legislative exercise but judiciary’s prudence on the matter will also suffice.

Coming to the private limited companies, their situation in India is similar to the situation of companies in Turkey as discussed above, which is, there is a lack of an express governing law on the matter. Therefore, it is suggested that the Drag-along and Tag-along rights must be formally recognized in the specific context of private limited companies as well and be regulated by the Indian law.

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