The tag-along right and the drag-along right, which are used to protect a minority shareholder, stem from private equity investment agreements under the common law system. In practice, similar clauses are specified for more and more merger and acquisition (M&A) transactions. The tag-along right provides shareholders with the right to join a transaction where another shareholder of the company seeks to sell their stake in the company, while the drag-along right provides the shareholder who wishes to sell shares with the right to force the other shareholders to join the transaction, thus binding the shareholders together. The above two rights enhance the partnership-like relationship between the shareholders of a company without violation of the Company Law and other relevant laws of China.
The initial purpose of the tag-along right is to ensure that an institutional private equity investor has the right of withdrawal in case of change of the actual controller of the invested company. Such scope is now extended to ensure that when a shareholder wishes to transfer its shareholding, the other shareholder has the right of withdrawal if it neither wishes to exercise the right of first refusal, nor intends to continue the joint operation with new shareholders in partial acquisition or establishment of a new joint venture.
The initial purpose of the drag-along right is to ensure that such minority shareholders as institutional private equity investors may obtain higher values in transferring their equity interest in the invested company, as the value of the entire equity interest or the controlling interest in the company being transferred is normally higher than that of its minority interest. The same rule is applicable to the transfer of the equity interest held by a shareholder in partial M&A, and establishment of a new joint venture.
For example, if a shareholder (the transferor) intends to transfer, in whole or in part, the equity interest held by it in the target company, it shall first notify the other party (the non-sponsor party). In accordance with the tag-along right and drag-along right clauses between the shareholders, the following may occur after the non-sponsor party receives the notice:
(1) Exercise by the non-sponsor party of the statutory right of first refusal. If the non-sponsor party determinates to exercise its statutory right of first refusal and sends a notice of acceptance during the agreed period for such exercise, the transferor shall transfer its equity interest to the non-sponsor party.
(2) Exercise by the transferor of the drag-along right. If the non-sponsor party fails to exercise its right of first refusal during the agreed period, the transferor may, but is not obligated to, after the expiry of the agreed period for exercise of the right of first refusal, send a written drag-along notice to the non-sponsor party requiring it to dispose of, in whole or in part, the equity interest held by it in the target company to the proposed transferee under the same conditions. Upon receipt of the drag-along notice, the non-sponsor party shall, under the same conditions, transfer, in whole or in part, the equity interest held by it in the target company, to the proposed transferee. Considering the strictness of the drag-along clauses, there are generally certain additional limitations on triggering events. For example, the non-sponsor party shall transfer the equity interest in whole, or such transfer shall at least lead to the transfer of the control over the company.
(3) Exercise by the non-sponsor party of the tag-along right. If the non-sponsor party fails to exercise its right of first refusal during the agreed period, it may (but is not obligated to), after the expiry of the agreed period for exercise of the right of first refusal, send a written tag-along notice, requiring the proposed transferee to acquire, in whole or in part, the equity interest held by the non-sponsor party in the target company, under the same conditions as the transferor.
If the non-sponsor party sends a tag-along notice during the period for the exercise of the tag-along right, the transferor shall cause the proposed transferee to complete the acquisition of the tag-along equity interest of the non-sponsor party at the same time. If there are two or more non-sponsor parties requiring the exercise of the tag-along right, the contractual terms will generally specify that the parties exercising the tag-along right shall transfer to the proposed transferee, the equity interest held by them in the company, in proportion to their respective shareholdings.
(4) Transfer by the transferor on its own to the proposed transferee. If the non-sponsor party fails to send a notice of acceptance for exercising its right of first refusal during the agreed period, and thereafter any party fails to send a tag-along right notice or a drag-along right notice, the transferor has the right to dispose of its equity interest in whole to the proposed transferee.
In practice, the entity exercising the tag-along right is a non-sponsor party, and whether the tag-along right is exercised or not generally has no impact on the proposed transferee; in other words, subject to the total number of transferred shares remaining unchanged, the exercise of the tag-along right only affects the proportions of shares transferred by the shareholders.
A breach of the drag-along right clauses is more likely to happen. In that case, if the non-sponsor party fails to perform the drag-along right clauses, how will a binding judgment obtained by the transferor and the proposed transferee be enforced? Relevant judicial interpretations of the Supreme People’s Court specify that the people’s court may, in accordance with articles 35 and 36 of the Company Law, and subject to the consent of a majority of the shareholders, auction, dispose of or otherwise transfer the frozen investment interest or equity interest, held by a person subject to enforcement, in a limited liability company. Shareholders who disagree with the transfer shall purchase the shares to be transferred; failure to do so shall be deemed an agreement to the transfer and will not affect the execution.
In addition, if an effective legal instrument specifies a specific subject matter, enforcement shall be made against the original subject matter. In accordance with the above-mentioned judicial interpretation, in executing a judgment on a drag-along right case, the equity interest of the person subject to enforcement shall be first frozen by the people’s court, and then other shareholders shall be notified to exercise the right of first refusal under the same conditions, and subject to other shareholders waiving the right of first refusal, the court shall organize or supervise the transfer of the underlying equity interest to the proposed transferee.
Zhang Yichi is a partner at East & Concord Partners
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