When a third-party purchaser offers to acquire a company, the majority shareholders may be willing to sell their shares, while one or more minority shareholders refuse to participate. This can create difficulties where the purchaser is only interested in acquiring the entire company and does not wish to retain the existing minority shareholders.
In practice, this issue becomes even more significant where there are multiple minority shareholders. A minority shareholder may seek to negotiate a higher purchase price or more favourable terms, or simply fail to complete the transaction within the agreed timetable. Such delays may jeopardise the proposed acquisition or cause the purchaser to withdraw altogether.
A properly drafted drag-along right addresses this problem by allowing the majority shareholders to compel the minority shareholders to sell their shares together with them on the same terms.
How Do Drag-Along Rights Work?
A drag-along right is commonly included in a shareholders’ agreement. It allows shareholders holding an agreed percentage of the company’s shares, typically the majority shareholders, to compel the remaining shareholders to sell their shares to a third-party purchaser.
For example, if Shareholder A owns 80% of a company and Shareholder B owns the remaining 20%, a purchaser may only be willing to acquire the company if it can obtain 100% ownership. Where a valid drag-along provision exists, Shareholder A may compel Shareholder B to sell its shares to the purchaser at the same price and on substantially the same terms.
In this way, drag-along rights enable the purchaser to acquire the entire company without being prevented by a minority shareholder who does not wish to sell or disagrees with the sale price. This reduces the risk of minority holdouts delaying or frustrating an agreed transaction by ensuring that all shareholders sell their shares on the same terms and complete the transaction within the agreed timetable. This provides greater certainty to both the selling shareholders and the purchaser.
Enforceability of Drag-Along Rights
The enforceability of drag-along rights under Malaysian law was considered in PKNS Holdings Sdn Bhd v Nusa Gapurna Development Sdn Bhd & Anor [2014] 1 LNS 519. In that case, the majority shareholder entered into a share sale agreement with a third-party purchaser and subsequently issued a drag-along notice requiring the minority shareholder to participate in the sale.
The High Court upheld the drag-along mechanism contained in the shareholders’ agreement and held that the minority shareholder was contractually bound to comply with the valid drag-along notice issued by the majority shareholder. The Court held that, once the contractual requirements for exercising the drag-along right had been satisfied, the minority shareholder could be compelled to participate in the sale. In reaching its decision, the Court emphasised that commercial agreements should be enforced according to their agreed terms and declined to rewrite the parties’ bargain.
The decision demonstrates that properly drafted drag-along provisions are generally enforceable under Malaysian law, provided that the contractual conditions and procedures for exercising the right are strictly complied with. It also highlights that the effectiveness of a drag-along right depends on the clarity of the shareholders’ agreement, as the Court will enforce the parties’ bargain rather than imply additional protections that were not agreed.
Conclusion
Drag-along rights are an important mechanism for facilitating (or compelling) the sale of the entire company. By reducing the risk of minority holdouts, they provide greater certainty for both existing shareholders and prospective purchasers that an agreed transaction can be completed.
However, as the PKNS decision illustrates, the effectiveness of a drag-along right ultimately depends on careful drafting and strict compliance with the agreed contractual procedures. Businesses should therefore seek legal advice when negotiating and drafting drag-along provisions to ensure that the clause is enforceable, consistent with the shareholders’ commercial intentions, and capable of operating effectively when an exit opportunity arises.
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This article was written by Shawn Ho (Partner) with the assistance of Sonia Lim (Intern) from Donovan & Ho’s corporate practice.
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