Despite being a common law creation, ‘drag along’ and ‘tag along’ clauses have gradually come into practice in Romania. Due to the recent years’ strong economic progress and the growth of some economic sectors (e.g. the IT market) institutional investors, such as venture capital investors, private equity investors, even business angels (individual investors who provide capital for businesses) have appeared. For them an exit from their investment is particularly important. There are many ways to withdraw from an investment, but this article will focus on the drag along and tag along clauses. These clauses are considered universally valid, regardless of jurisdiction and I will try to determine how they fit into the Romanian legal system.
As some terms are different in each legal system, I shall refer to both the members of a joint-stock company and the ones of a limited liability company as ‘shareholders’, while the ownership components will be called ‘shares’ in both cases. However, to differentiate the intricacies between these distinct companies I will highlight what type of company I am referring to in each paragraph. After a structural overview I will illustrate the drag along provisions, the similarities and differences between the former clauses and the tag along provisions, and I will present my conclusions in the end.
2. Drag along provisions
2.1. Function and legal nature
The drag along clause, also called the ‘joint exit clause’ (Săuleanu, 2008, p. 48) or the ‘exit solidarisation’ clause (Decision No. 1113/A, 2014), is an important provision that can protect the interests of the majority shareholders. If the majority shareholder receives an offer to divest the shares, he can only sell them together with the minority assignee (Săuleanu, 2008, p. 48). In other words, the controlling shareholder(s) might ‘drag’ the other shareholders into a joint sale of the entire company. If the controlling shareholder manages to find a buyer for the entire company, minority shareholders might be forced to join in the sale, even if they do not agree. These provisions are sometimes associated with certain pre-emptive clauses, so that minority shareholders have the right to buy the entire company instead of being forced to work with another entity (Henry, 2017).
The majority shareholder who relies on his drag along right must offer the minority shareholders the same price, terms and conditions as any other seller would (Investopedia I, 2017). These provisions usually occur in the case of a merger or an acquisition of the company, since they help to remove the minority shareholders and sell the full value of the company.
The drag along clauses are agreed upon during the negotiations between the controlling shareholder(s) and the minority ones. Their key function is to prevent a minority shareholder from blocking the sale of the company against the will of the majority shareholder (Investopedia I, 2017). However, there is a risk of abuse on the side of the shareholder who exercises his drag along right. For example, he may be acting in bad faith, setting a very low price for the shares with the buyer, precisely to defraud the other shareholders and share the benefits with the buyer. Therefore, as a rule, the parties determine the minimum price for the shares to be sold (Ciobanu, 2012, p. 254). Another way of preventing such abuse is the following: if the notified shareholders are dissatisfied with the offered price, that price can be fixed by an independent third party (Article 1662 para. (1) of the Romanian Civil Code). The price determined this way will be the one for which shareholders may be forced to sell their shares (Ciobanu, 2012, p. 254). Although drag along rights are more likely to protect the controlling shareholder(s), minority shareholders can often benefit from them as well. As they determine that the price, terms and conditions are homogeneous for all the shareholders, the minority can achieve favourable sale of their shares under terms that were otherwise unfavourable (Johnson, 2017).
Regarding the clauses’ legal nature in Romania, some authors concluded that they are similar to the option agreement (Ciobanu, 2012, pp. 254-257), an opinion I agree with. The option agreement is regulated in the Romanian Civil Code in Articles 1278 para. (1) and 1668 para. (1). It is a convention in the case of a sale whereby the promisor remains bound to his own declaration of will – the prior consent to the sale of a good – with the beneficiary being able to accept or refuse it. If it is accepted, the sales contract is concluded. This declaration is considered an irrevocable offer. As for the similarities between the drag along clauses and the option agreement, there is the shareholders’ consent to the sale of the shares in case of the drag along right’s exercise by the majority shareholder, i.e. the beneficiary of this right (Ciobanu, 2012, p. 255). The identity of the third-party buyer will be known by the minority shareholders only upon notification by the controlling shareholder. In terms of differences, we have the conclusion date of the sales contract, as well as the parties between which the contract is concluded. Regarding the former, the moment of the sale’s conclusion is not when the beneficiary of the drag along right exercises it, but when the sales contract with the third-party buyer is finalised (Ciobanu, 2012, p. 255). Concerning the latter, once the drag along right is exercised, the sales contract shall be concluded between the minority shareholders and the third-party buyer, not between the minority shareholders and the controlling shareholder (Ciobanu, 2012, p. 255). If the agreement establishing the drag along rights is an option agreement, according to the legal literature we are dealing with an early manifestation of the shareholders’ consent to the sale of their shares. The exercise of the drag along right by the beneficiary will cause the shares of the minority shareholders to be included in the sales contract concluded with the third-party buyer. Therefore, the inclusion of these minority shareholders in the sales contract would not seem to be necessary due to the ex ante formation of their consent. However, I believe that it is appropriate for the minority shareholders to become parties to the sales agreement ‘[…] in order to avoid any potential claims regarding the validity of transferring the right of ownership over the shares’ (Ciobanu, 2012, p. 255).
2.2. Joint stock companies and limited liability companies
Before analysing the tag along provisions, we need to examine the effects of drag along clauses in the case of joint-stock companies compared to limited liability companies, from the perspective of the transfer of the shares’ ownership. Regarding joint-stock companies, Article 98 para. (1) of Law 31/1990 highlights that both materialised and dematerialised nominative shares are transferred by a statement made in the shareholders’ register, signed by the assignor and the assignee (or by their agents). For the first type of shares, the transfer must also be indicated in the title itself and signed by the parties. The parties can provide the articles of incorporation for other forms of transfer as well, e.g. the drafting of a sales contract, so the entries in the shareholders’ register no longer have a rights-generating effect. One may infer that there is a problem if the parties do not sign both the sales contract concluded between the controlling shareholder and the third-party purchaser and the shareholders’ register of the company. Some practical solutions are (Ciobanu, 2012, pp. 255-256): mortgaging shares held by the signatories of the drag along convention for the benefit of the majority shareholder, thus constituting a guarantee of compliance with the obligations deriving from the drag along clause; empowering a third party (by agreement of the parties) to fulfil the formalities of signing in the shareholders’ register on behalf of the sellers when exercising the drag along right and the conclusion of the sales contract between the controlling shareholder and the buyer. The disadvantage of these conflict avoidance options is that the parties have to understand the proposed solutions ex ante. Therefore, if the parties were not so diligent and did not provide for other options of transferring the shares’ ownership in the articles of incorporation, the rule of Article 98 para. (1) of Law 31/1990 shall apply, namely the registration of the transaction in the shareholders’ register. I concur with the opinion that for the controlling shareholder to capitalise on the drag along right, the beneficiary must file a lawsuit requesting a decision to substitute the sales contract. This also requires the company’s administrator to register the transaction in the shareholders’ register, whilst both the shareholder and the third-party buyer should make a claim for legal action, for opposability reasons (Ciobanu, 2012, p. 256). Of course, this claim is redundant if the company’s articles of association lay down that the transfer of ownership takes place with the conclusion of the sales contract. The exercise of the drag along right and the signing of the contract by the controlling shareholder and the buyer shall also cover the transfer of the minority shares.
As for limited liability companies, the first important aspect is the 30 days opposition period from the publication of the decision of the shareholders’ general meeting approving the sale of the shares in Part IV of the Official Journal of Romania – if there was no opposition –, or from the date when the decision to reject it was communicated – if such opposition has been expressed. More precisely, the transfer of ownership becomes effective only upon the expiry of the opposition period, as it is apparent from Article 62 para. (1) of Law 31/1990. Although the transfer is recorded in the company’s register – similar to joint-stock companies –, the registration does not have a rights-generating effect like in the previous case, as it is apparent from Article 203 of Law 31/1990. This means that there is no need for legal action to transfer the right of ownership, since waiting for the opposition period to end shall suffice. However, the sale must be approved by the general meeting of shareholders. This is the moment when the shareholders who do not want to sell usually vote against the sale. According to Article 79 of Law 31/1990, the beneficiary of the drag along clause does not have the right to vote in the general meeting, because his/her interests are contrary to the company’s. Hence, the transfer of ownership does not take place without the decision of the general meeting adopted by the entire assembly. The court cannot issue a judicial decision that substitutes a contract in this case (Ciobanu, 2012, pp. 256-257).
In view of the above, in the case of joint-stock companies, the exercise of the drag along convention can be done without the help of the courts if the parties have determined some appropriate means and set out in the articles of incorporation that the transfer of property happens with the conclusion of the selling agreement. The transfer’s display in the shareholders’ register is no longer required. In limited liability companies, the drag along rights cannot be enforced in the same way as in joint-stock companies, but I believe the solutions presented in the legal literature (Ciobanu, 2012, p. 257) are adequate, i.e. the establishment of a mortgage on the shares held by the minority shareholders.
3. Tag along provisions
Such provisions consist of clauses that allow minority shareholders to join the controlling shareholder(s) if they find a buyer. The purpose is to ensure that minority shareholders are not left behind when a controlling shareholder decides to leave the company. Hence, these clauses are meant to protect the interests of the minority shareholders (Henry, 2017). They effectively force the controlling shareholder(s) to include the shares of others in the negotiations with third parties to facilitate the exercise of the rights derived from these clauses (Investopedia II, 2017). These rights enable minority shareholders to join a deal that a powerful shareholder (often a financial institution with considerable influence) is capable of making. The controlling shareholders, such as venture capital companies, often have a greater capacity to find potential buyers and negotiate payment terms. These clauses entitle minority shareholders to a better liquidity of their shares, since private equity is very difficult to sell and the majority shareholders can often facilitate purchases and sales on the secondary market (Investopedia II, 2017).
There are some similarities between tag along and drag along agreements. A notification is required from the promisor to the beneficiaries of the tag along right, with the obligation to provide them with all the details regarding the third-party purchaser, the price offered and the trade terms of the transaction (Ciobanu, 2012, p. 257). The beneficiaries may rely on the exercise of this right, so the majority shareholder will be unable to sell his/her shares without including the shares of the minority shareholders under conditions that are similar to the transaction of his/her own shares. Finally, the tag along right is also exercised by the beneficiaries through written communication addressed to the shareholder who is about to carry out the sale of the shares.
On the other hand, the rights and obligations deriving from the tag along convention are not the same as the ones derived from a drag along agreement. If the promisor decides to sell his/her shares in breach of his/her obligations under the tag along clause, the beneficiaries of the right will only be able to claim damages for the prejudice they have suffered (Ciobanu, 2012, p. 257). Regarding the selling agreement in the case of limited liability companies, members with tag along rights may oppose to the sale in the shareholders’ general meeting, effectively blocking the operation and safeguarding their rights (Articles 61 and 62 of Law 31/1990). In the absence of other specific legal mechanisms, the only option to ensure that these rights are respected by the promisor is the claim for damages (Ciobanu, 2012, p. 257).
While these clauses might seem quite straightforward at first glance, several legal issues surround them, which are sometimes difficult to understand. In the absence of explicit rules for drag along clauses and due to their prevalence in practice, we can evaluate this type of clause as an atypical option agreement concerning the sale of shares, a tripartite legal figure, with a special kind of timing. In the incipient phase, this clause appears to be a bilateral one – concerning the controlling shareholder and the minority shareholders only –, but after exercising the rights deriving from the clause, the effects become wider with the emergence of the third-party buyer in the equation.
While the drag along right is also regarded as an obligation to exit, the tag along right can be viewed as the correlative right to that obligation, as a right to exit. The right to exit requires a special legal mechanism, a tripartite legal figure which involves the same ‘actors’ as the exercise of the drag along right, but with a slight alteration in their ‘roles’: the controlling shareholder – the promisor –, the minority shareholder – the beneficiary of the tag along right –, and the third party – the buyer of all the shares involved in the legal equation.
It can be concluded that both drag along and tag along clauses protect, albeit in different manners, the minority shareholder(s). Hence, they can be viewed as exit for the investors from their investment and also as means of protecting the minority shareholders from possible abuse by the controlling shareholder(s). Either way, one cannot deny their more regular appearance and growing significance in the legal practice, especially in the context of profound globalisation. Therefore, these clauses should be known and grasped not only by legal practitioners but investors as well, taking into consideration that these provisions are means of safeguarding their investment.
By Vladimir Griga
This material was published in Lawyr.it Vol. 5 Ed. 3, September 2018, available only online.
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