DRAG ALONG vs. TAG ALONG RIGHTS

Profile of the Author: Madhav Gawri is a 4th Year Law Student in Vivekananda Institute Of Professional Studies and has been working with Niti Manthan for more than two years.

INTRODUCTION

A venture capitalist has to secure his interest first. His or her primary motive is to help the company grow initially and create a market presence. After the initial growth, a venture capitalist or a habitual investor would look to sell the company for a considerable amount to a larger entity than them. Moreover, the Articles of Association of the company and the Company Act, 2013, stops the majority shareholder from exiting to protect the interest of the other shareholder. Therefore, the biggest investor has to secure his exit options from the company. Keeping this in foresight, the investor pushes the other investors and shareholders of the respective company to agree and relinquish their rights. At the same time, the venture capitalist can sell his or her shares at a considerable price without any hindrance. Therefore, to remove these possible hindrances and speed bumps in the future, the concept of drag-along rights and tag-along rights is embedded in the shareholder's agreement or the share purchase agreement.

DRAG ALONG RIGHTS

It is the majority of shareholders' right to drag along the minority shareholders to sell their shares and ownership of the company to the buyer, in which the majority of shareholders have agreed to sell their share. Therefore, the minority shareholders are not left with any other option, but not to comply with the selling of the share. This right is generally created from the prior agreement which the majority and minority shareholders had signed. This agreement can be in the form of shareholders' agreement or share-purchase agreement. On the bright side, the majority shareholder would be selling his share for a considerable amount, and he or she would not be taking a loss. Therefore the minority shareholders get the same deal, same price, and some conditions as majority shareholders.

TAG ALONG RIGHTS

Minority shareholders hold these rights. The tag-along rights protect the minority shareholders by giving them the option of joining the transaction and selling their shareholding in the same transaction as the majority shareholder. This right obligates the majority shareholder to include the holdings of the minority shareholder and then negotiate to sell it.

WHEN ARE THESE CLAUSES NEEDED?

Drag along, and tag-along rights are generally required in those contracts where the nature of the transaction is merger, amalgamation, takeover, or any funding series. For example, a tech start-up CEO wants to retain more than 50% shares of the start to maintain the majority owner of the company. He includes a drag along with clause in the agreement with the venture capitalist, who is a minority shareholder in the company. By doing this, the CEO of the company has protected himself by retaining the majority shareholding. Moreover, he can exit the company by completely selling it to a potential buyer through the application of drag along with clause. This provision prevents any future scenario where the minority shareholder wants to undermine the sale of the company.

Regarding tag-along right, it can happen so that the investor sees more potential in the company than the promoters and founders itself. Therefore, the investor may include a tag-along clause where he might have an option either to sell or to continue with the company itself. Tag along clause may be drafted in such a way that if the promoters or the founders want to sell the company and their respective shareholders, then the monitory shareholders have the option to buy them off, and completely take over the company.

FACTORS OF FORMATION OF DRAG ALONG AND TAG ALONG RIGHTS

The specification and details of the drag along and tag along rights may vary from agreement to agreement. These rights affect majorly, both the parties, majority, and minority shareholders. Therefore, numerous factors affect the formation of rights. These factors are:

DRAG ALONG AND TAG ALONG RIGHTS: TRIGGERED

Drag along, and tag-along rights are triggered in many types of transactions, like mergers, acquisitions or takeovers, or change in control of the company in any other form. The majority shareholder's percentage may vary depending on the company's ownership mix and the shareholders' negotiating strength. It is generally between 51% - 75% of the shareholding.

The legal position of drag along and tag along rights are very confusing. The scenario must be crystal clear for the application of these rights. Moreover, these rights must be following the ‘Articles of Association’ of the company. It must be mentioned in the AOA of the company that these rights are applicable and valid if mentioned in any agreement. Then they are not outside the purview of the company. It is settled that the ‘shareholders agreement’ cannot be outside the purview of the article of association. Therefore, the right mentioned in the shareholder agreement should be confirmed by the articles of association.[1] The concept was cleared in another judgment granted by Supreme Court, where it was overserved that the V.B. Rangaraj clarified the situation for a private limited company. Whereas, the case for a public limited company is different. In a public company, a shareholder's agreement mentioning rights like drag along and tag along is applicable even if they are confirmed by the article of association of the respective company. But the action and execution of these rights should only be allowed when used for the company's benefits.[2]

Therefore, in India, it is clear that tag along and drag along rights are enforceable if it is confirmed by the article of association in a private limited company. They are prima facie applicable in case of a public limited company if used in good faith and for the benefit of the company's users.

To accommodate this thought of law and concept, SEBI had notified a guideline providing a change of thought in itself. It provided that there is no need for prior permission from SEBI to enforce and utilise the clauses of drag along and tag along. The articles of association must only confirm them.[3]

EXAMPLES OF TAG ALONG AND DRAG ALONG CLAUSES

Bristol-Myers Squibb Company and Celgene Corporation entered into a merger agreement. The prior had proposed to acquire the latter in a cash and stock transaction valued at approximately $74 billion. After the proposed transaction, Bristol-Myers Squibb acquired around 69% of shares, and converted Celgene shareholders accounted for the remaining 31%.

In this deal, the Celgene shares were delisted. The minority shareholders were required to comply with the terms of the deal and were not eligible for special considerations. Had Celgene’s shares not been delisted, drag-along and tag-along rights could have become more of a factor. In some situations, such as this, majority shareholders may negotiate special share rights under an alternative class structure that may not be available to minority shareholders due to the implications of drag-along rights.

CONCLUSION

Drag along and tag along rights are very exclusive and special rights that are created and included in a contract exclusively. These rights are formulated so they either may protect the majority shareholders exit option in the form of drag along rights or protect the minority shareholder's exit option in the form of tag-along rights. The formulation of these rights must be done in such a while considering every possible factor. Moreover, the legality and applicability of these rights are clear in India. The article of association of a private company must allow the application of these rights, whereas, in a public company, the transaction must be in good faith and beneficial to the users of the company. The drag along and tag along rights are very important, and both the majority shareholders and minority shareholders should focus on these rights while formulating them.

[1] V.B. Rangaraj v. V.B. Gopalkrishna (1992) 1 SCC 160

[2] Vodafone International Holdings BV v. Union of India (2012) 6 SCC 613

[3] ‘SEBI Notification No. LAD-NRO/GN/2013-14/26/’ (SEBI, 2013) accessed 20 August 2020.