Drag-along Rights and Appraisal Remedies in Stockholders Agreements

Practical Law Legal Update 4-523-5341 (Approx. 6 pages)

Drag-along Rights and Appraisal Remedies in Stockholders Agreements

by Practical Law Corporate & Securities

Published on 26 Mar 2015 • Delaware

A discussion of drag-along rights and appraisal remedies after the Delaware Court of Chancery's decision in Halpin v. Riverstone National, Inc.

Unique among most provisions of a stockholders agreement, the drag-along right only benefits the majority stockholder. The drag-along allows a majority stockholder who wishes to initiate a change of control of the company (subject to any right of first refusal or right of first offer, as applicable) to force the minority stockholders to participate in the transaction. This right is based on the premise that a minority stockholder who has a smaller amount at risk should not be able to prevent a majority stockholder from selling the company and achieving liquidity.

The obligation to participate in the transaction contemplates several different actions. If the deal is structured as a sale of stock, each stockholder who is subject to the drag-along agrees to sell a pro rata portion of all classes or series of capital stock held by them and being sold in the drag-along sale. If the transaction is structured as a merger, each stockholder who is subject to the drag-along agrees to vote in favor of the merger.

Implicit in the covenant to vote in favor of the merger is an agreement by the stockholder to refrain from exercising his appraisal rights. Appraisal rights are a statutory remedy available to a stockholder who opposes a merger, allowing him to petition the court to determine the fair value of his shares. (Although they are usually associated with public M&A transactions, appraisal rights are equally available in private transactions.)

To preserve his right to seek appraisal, the stockholder must not vote in the transaction's favor. Hence, the covenant in the stockholders agreement to vote in favor of the merger necessarily amounts to a waiver of the appraisal remedy. However, to protect the majority stockholder against an argument that waivers of statutory remedies should not be merely implied, many stockholders agreements make explicit that the participating stockholders also waive their appraisal rights. This is the approach taken in Practical Law's Standard Document, Stockholders Agreement (Multi-party; Private Equity), a model agreement for a sponsor-friendly buyout or similar private equity investment. Section 4.05(b)(ii) of the agreement, describing obligations of the minority stockholders, states the following:

"(ii) If the Drag-along Sale is structured as a sale of all or substantially all of the consolidated assets of the Company and the Company Subsidiaries or as a merger, consolidation, recapitalization, or reorganization of the Company or other transaction requiring the consent or approval of the Stockholders, then notwithstanding anything to the contrary in this Agreement, each Drag-along Stockholder shall (A) vote (in person, by proxy or by written consent, as requested) all of its voting securities (including any voting Shares) in favor of the Drag-along Sale (and any related actions necessary to consummate such sale) and otherwise consent to and raise no objection to such Drag-along Sale and such related actions and (B) refrain from taking any actions to exercise, and shall take all actions to waive, any dissenters', appraisal or other similar rights that it may have in connection with such transaction." (Emphasis added.)

Contractual Right to Waive Appraisal

The ability to contractually waive the appraisal remedy has not typically been thought of as controversial, but a recent Delaware Court of Chancery decision raises the possibility that this is not an obvious matter. In Halpin v. Riverstone National, Inc., the minority stockholders of a corporation that underwent a change of control approved by the written consent of the corporation's 91% stockholder raised this issue (C.A. No. 9796–VCG, (Del. Ch. Feb. 26, 2015)). The stockholders were party to an agreement with a drag-along provision that required the minority stockholders to vote in favor of any change-of-control transaction proposed by the majority stockholder. Despite the voting obligation, the minority stockholders petitioned the court for appraisal of their shares, contending (among other arguments) that a common stockholder cannot waive his statutory right to appraisal ahead of time in return for consideration that is to be set later by the controlling stockholder.

In its opinion, the Court of Chancery acknowledged that this was an issue of first impression. The court explained that it is settled that holders of preferred stock can contractually waive their appraisal rights, because the rights of preferred stockholders are largely contractual (In re Appraisal of Ford Hldgs., Inc. Preferred Stock, 698 A.2d 973 (Del. Ch. 1997)). However, the relationship between common stockholders, on the one hand, and the board of directors and controlling stockholder, on the other, is mainly governed by the common law of fiduciary duties. This factor prevented the court from reaching the same conclusion as it did in Ford Holdings regarding preferred stock.

Without answering this question, however, the court concluded that the minority stockholders were not bound by the drag-along provision, because the controlling stockholder had failed to properly exercise it.

Failure to Adhere to Contractual Requirements Undermines the Drag-along Right

In Halpin, the company notified its stockholders that:

Eleven days prior, its controlling stockholder CAS Capital had provided its written consent under Section 228 of the DGCL for the company to enter into a merger agreement.
The merger agreement had been signed the next day.
The merger had closed three days after that.

However, under the company's stockholders agreement, for a majority stockholder to exercise its drag-along right, the stockholder was required to provide notice to the minority stockholders before entering into the change-of-control transaction. The relevant section of the agreement stated:

"[I]f at any time any stockholder of the Company [...] owning a majority or more of the voting capital stock of the Company (hereinafter, collectively the 'Transferring Stockholders') proposes to enter into any [Change-in-Control Transaction], the Company may require the Minority Stockholders to participate in such Change-in-Control Transaction with respect to all or such number of the Minority Stockholders' Shares as the Company may specify in its discretion, by giving the Minority Stockholders written notice thereof at least ten days in advance of the date of the transaction or the date that tender is required, as the case may be. Upon receipt of such notice, the Minority Stockholders shall tender the specified number of Shares[...] In addition, if at any time the Company and/or any Transferring Stockholders propose to enter into any such Change-in-Control Transaction, the Company may require the Minority Stockholders to vote in favor of such transaction, where approval of the shareholders is required by law or otherwise sought, by giving the Minority Stockholders notice thereof within the time prescribed by law and the Company's Certificate of Incorporation and By-Laws for giving notice of a meeting of shareholders called for the purpose of approving such transaction[...]" (Emphasis added.)

As drafted, the provision required the majority stockholder to provide notice to the minority stockholders of the proposed transaction before agreeing to the transaction if it were to force the minority stockholders to tender their shares or vote in favor of the transaction. Because CAS Capital had failed to provide this notice, the court considered the drag-along right to have been forfeited. The minority stockholders were therefore free to seek appraisal of their shares.

The notice requirement in this scenario might seem somewhat insignificant in light of the fact that CAS Capital owned 91% of the common stock and could squeeze out the minority stockholders without their approval. This sense that a foot fault on the notice provision should not completely nullify the drag-along right animated CAS Capital's argument that the implied covenant of good faith and fair dealing should rescue the drag-along right. By this line of thinking, the minority stockholders understood that the purpose of the drag-along right was to go along with any merger initiated by CAS Capital and to waive their right to appraisal. To the extent that the merger ultimately consummated did not precisely match the technical requirements of the stockholders agreement, CAS Capital argued that the implied covenant should "fill the gaps" and require the minority stockholders to accept the merger consideration.

CAS Capital used the phrase "fill the gaps" out of an understanding that the function of the implied covenant is "best understood as a way of implying terms in the agreement, whether employed to analyze unanticipated developments or to fill gaps in the contract's provisions" (Dunlap v. State Farm Fire and Cas. Co., 878 A.2d 434, 441 (Del. 2005)). However, the court rejected the argument, emphasizing that the stockholders agreement did not contain any gaps that needed filling. Rather, the parties, who were sophisticated and charged with recognizing that a merger could be approved by written consent under Section 228, negotiated a drag-along right that would not apply if CAS Capital gave notice after the merger had been consummated. (The court added in a footnote, while emphasizing that saying more was not necessary to find the implied covenant inapplicable, that there is a substantive distinction between providing notice before and after the merger, because prior notice gives the minority stockholders a chance to seek redress from the court in case of an oppressive merger).

Practical Law's model stockholders agreement, like the agreement at issue in Halpin, similarly requires notice before the change-of-control transaction in order to exercise the drag-along right. Section 4.05(a) states:

"Participation. At any time prior to [the consummation of a Qualified Public Offering/[INSERT DATE]], if [the Investor (together with its respective Permitted Transferees)/one or more Stockholders (together with their respective Permitted Transferees) holding no less than a majority of all the [issued and outstanding Class A Common Stock/Shares on a Fully Diluted Basis]] (such Stockholder(s), the "Dragging Stockholder"), proposes to consummate, in one transaction or a series of related transactions, a Change of Control (a "Drag-along Sale"), the Dragging Stockholder shall have the right, after delivering the Drag-along Notice in accordance with Section 4.05(c) and subject to compliance with Section 4.05(d), to require that each other Stockholder (each, a "Drag-along Stockholder") participate in such Drag-along Sale[...]" (Emphasis added.)

In light of the decision in Halpin, majority stockholders must be zealous about providing notice and following all instructions of the stockholders agreement to avoid the risk of forfeiting the drag-along right.

For more on drag-along rights and stockholders agreements generally, see these Practical Law resources:

Drag-along Rights and Appraisal Remedies in Stockholders Agreements | Practical Law