The Business Divorce Law Report
- Deadlock is more than an inability to make a decision. It is an inability to act under circumstances that present the real threat of harm to the business.
- Deadlock is triggered by the shareholders’ inability to elect directors.
- When there are no alternatives to prevent harm to the business, like a buy-sell agreement, a Court is likely to find that the shareholders or directors are deadlocked.
For the closely held corporation, deadlock may be the result of a dispute among the shareholders, or among the directors in circumstances that the shareholders cannot fix by electing new directors. Whether a court is asked to find deadlock under an applicable corporations statute or as part of a common-law remedy, deadlock is rarely found in circumstances in which there is no threat of significant or irreparable harm.
In this article, we will consider some of the circumstance in which courts have been asked to declare that a deadlock exists among the directors and/or shareholders of a corporation – often in a closely held corporation they are one and the same – and to fashion a remedy. Most often the principal remedy in the
case of a “true deadlock” is the dissolution of the corporation, which entails the liquidation of the entity. Courts rarely impose such an extreme remedy on a viable business entity, so such remedies as the sale of a minority interest, sale of the entity as a going concern or other types of injunctive relief are far more common.
A Series Examining Deadlock Among the Owners of Closely Held Corporations, Limited Liability Companies and Partnerships
Corporations statues vary in the statutory remedy for deadlock or oppression. The Model Business Corporations Act (MBCA), on which many state corporations codes are modeled, provides for the judicial dissolution of a corporation when the shareholders are unable to elect directors or when the directors are deadlocked in the management of corporate affairs; the shareholders cannot break the deadlock; and there is either the potential for irreparable harm to the corporation, or the “business and affairs of the corporation” cannot be conducted to the advantage of the shareholders. MCBA § 14.30. The model act also provides a court with broad powers to appoint a custodian to manage and/or wind up the affairs of the corporation. MCBA §§ 7.48; 14.32.
Statutory or Common Law Deadlock
Delaware law, which offers a somewhat different model, provides for the appointment or a custodian or receiver, but does not expressly authorize a court to order dissolution of the company. Rather, Delaware law permits the appointment of a custodian or receiver to manage the affairs of the corporation and provides that a receiver may be given the same powers as a receiver appointed to wind up the affairs of an insolvent corporation. Dissolution will likely not be available under Delaware for deadlock unless it is coupled with significant and intentional wrongdoing by one of the parties.
The approach under New York’s Business Corporations Law is to permit a petition for dissolution, but requires the action be brought by holders of at least one-half of the voting shares, unless there has been a failure to elect directors, in which case any shareholder can bring the petition. See BCL § 1104. Similar provisions are found in many states, including New Jersey, where I practice, Massachusetts, Illinois and California.
True Deadlock is Required
A recent decision interpreting Massachusetts statutory provisions on deadlock provides a comprehensive discussion of the phenomena of deadlock. The Supreme Judicial Court of Massachusetts in Koshy v. Sachdev (opinion here) held that the trial court had erred in finding that the ongoing dissension, lack of trust and inability to vest control of the entity in a majority constituted deadlock under the Massachusetts Corporations Code and might justify dissolution or some lesser remedy such as a forced sale by one of the owners
The litigants in Koshy v. Sachdev were former friends who had worked together at a prior company and who had formed their own business, Indus Systems, Inc. in 1987. Indus provided computed aided design (CAD) services. In 1999, it was awarded a contract with the federal Government Services Administration that permitted the purchase of Indus’ CAD services without competitive bidding. The business then grew quickly, but the two owners, each with a 50 percent share, disputed the direction of the corporation on strategic, operational and financial issues. In a 2011 dispute over the distribution of $1.4 million in retained earnings, Kochy was locked out of the business.
Although both principals returned to the business, they continued to be unable to agree on a number of issues important to the corporation. The trial judge held that the parties were not deadlocked, however. The Supreme Judicial Court reversed.
Statutory Elements of Deadlock
At issue was Mass. G.L. c. 156D § 14.30, which provides for involuntary dissolution on petition of at least 40 percent of the combined voting power of all shares if the directors or shareholders are deadlocked. The relevant statute provides:
The superior court located in the county set forth in section 14.31 may dissolve a corporation:
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(2) upon a petition filed by the shareholders holding not less than 40 per cent of the total combined voting power of all the shares of the corporation’s stock outstanding and entitled to vote on the question of dissolution, if it is established that:
(i)the directors are deadlocked in the management of the corporate affairs, the shareholders are unable to break the deadlock, and irreparable injury to the corporation is threatened or being suffered.
The statute requires “true deadlock,” which is a matter of law. Whether the deadlock warrants dissolution, the Court held, is a matter for the trial court’s discretion. The Court then went to hold that four factors are relevant to determining whether a deadlock exists:
- Whether irreconcilable differences that have result in corporate paralysis;
- The size of the corporation — deadlock is more likely to occur in small or closely held entities, for which there often is no market for its shares;
- Whether is appears that one party has engineered the dispute to create deadlock for strategic means;
- The extent of distrust and antipathy between the shareholders;
The court found that all of the factors indicated the existence of a deadlock and went on to examine the second statutory element, the irreconcilability of the deadlock. In this case, the 50/50 equity interests and absence of any mechanism, such as buy-sell agreement that could be invoked in the event of deadlock, made clear that the relationship between the two owners constituted deadlock under the Massachusetts statute.
In our next post, we will examine deadlock as the basis for dissolution or sale of a business under common law principles, as part of a court’s inherent authority to fashion equitable remedies.