The Business Divorce Law Report
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Owners of a closely held business, be it a corporation, limited liability company or partnership, may enter into contracts that are triggered when the principals have become deadlocked.
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Anti-deadlock provisions may provide for the appointment of an independent director, for alternative dispute resolution, or for the compelled sale of an equity interest.
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The owner of a business that invokes the terms of an anti-deadlock provision, particularly when the sale of interest is involved, is likely to be subject to duties of loyalty and care.
After a closely held business becomes deadlocked, it is extremely difficult to push the parties toward some mechanism that might either break the deadlock or preserve the current management system, or event let the parties separate themselves on mutually agreeable terms.
A Series Examining Deadlock Among the Owners of Closely Held Corporations, Limited Liability Companies and Partnerships
Human nature stands in the way. The parties likely have financial and emotional positions that they are unwilling to compromise. These may range from the ability to control some aspect of the operations of the business to the payment of dividends or bonuses.
Lawyers and their clients try to address the potential for future deadlock with these contractual provisions that are known by a number of descriptions, such as buy-sell agreements, shotgun
provisions, put-call terms. In the world of closely held limited liability companies, corporations and partnerships, a buy-sell agreement that is triggered by a deadlock is the pre-nuptial agreement of business divorce.
In this and the following post, we examine these contractual provisions that are used to break deadlocks. We consider first the scope of anti-deadlock provisions, when they may be invoked and whether they are subject to judicial controls. In a following post, we will look at buy-sell agreements in more detail and, in particular, shotgun language that is intended to keep a forced sale on terms acceptable to both parties.
The Importance of Anti-Deadlock Provisions
Are these contractual solutions effective? Again, human nature being what it is, the anti-deadlock contractual provisions can themselves become a point of contention. Nonetheless on the whole, contracts that describe how the closely held corporation, limited liability company or partnership will address a paralyzing deadlock are likely to be enforced by courts and serve their purpose well.
In fact, as we have seen in considering disputes involving deadlocked entities, the absence of such a contractual agreement is a factor that is given significant weight by courts weighing a request for an involuntary dissolution of a business. If the parties have not planned for the predicament, the court may see no other alternative.
The result of a judicial resolution to a dispute that the parties might have resolved themselves may be less desirable than their own agreement As a chancery judge once told my client and his estranged business partner, “I will make a decision here, but the overwhelming probability is that any decision I make will not be as good as one that you might have come up with yourselves.”
Buy-Sell Agreement Triggers in Closely Held Businesses
A key aspect of a buy-sell agreement is that it keeps the business “in the family,” as opposed to a liquidation or sale. In looking at anti-deadlock provisions, however, they may be described, there are two critical aspects. The first is how the provision may be triggered. The second is the nature of the remedy, in most cases how a sale of someone’s interest will be managed, particularly who will pay and how much. These provisions will appear in the sale of shares of stock in a close corporation, a limited liability company interest or a partnership.
An anti-deadlock provision may require that it be invoked by one of the parties, or it may be self-executing. In a leading case discussing the applicability of such a buy-sell agreement, Universal Studios v. Viacom, the Delaware Chancery Court considered whether prohibited competition by one of the parties to a joint enterprise required one of the parties to invoke a “shotgun” buy-sell provision in which the parties lose control of the valuation of the business, and ordered a dissolution of the business.
More commonly, however, a buy-sell agreement is triggered by one of the parties making a demand on the other over some issue on which the business has become paralyzed by deadlock. Language such as the following is relatively typical in these provisions.
If the Members are unable to agree on a matter and the lack of agreement materially impairs the continued operation of the Company’s business, any Member or group of Members acting jointly (Offering Members) may submit a written offer to all of the Members (Remaining Members) who are not part of the offering group. The offer shall set forth the price that the Offering Members have determined to be the fair value of the total interests of all Members in the Company and a pro rata allocation to the respective interests of each of the Members.
The definition of “material” may be a point of dispute when there is a buyout offer made. The non-offering party — particularly if the offering party has superior financial resources — may argue that the buyout provision was triggered in bad faith to force an unmerited sales or a sale on unfair terms.
The issue of when the failure to agree rises to the level of deadlock is an issue that we have considered previously. See Deadlock in the Closely Held Business, a part of our series on deadlock. The courts uniformly consider deadlock to be actionable when it has paralyzed a business or is financially damaging to the business. The factors that are likely to come into play include the following:
- Is the trigger real? In other words, is there a bona fide deadlock that might warrant granting a petition for dissolution?
- Did the party invoking an anti-deadlock provision of an agreement unfairly cause the deadlock? If the party that invokes the anti-deadlock provision is in some way culpable, there may reason to look at the validity of the trigger? It will be difficult to enforce the provision if it is triggered by a crisis that one side invoked unfairly.
- Are there circumstances that suggest that one side is trying to gain an unfair advantage? Unequal resources, lack of access to key information or a crisis that seems to have been created may all point to a trigger that is being invoked unfairly.
Contractual Provisions to Break Voting Deadlocks
In some circumstances, all that is needed is a tie-breaker. There are those cases in which the managers, directors or partners are evenly divided and there is an issue that cannot be resolved through negotiation. It may be a one-off situation, such as the renewal of a line of credit, or it may be a decision that brings the business to an end, such as a vote to merge or sell the assets of the business, dissolve or issue a new equity interest.
In other cases, the issue may be more fundamental to the business. Some examples are a fundamental dispute about the direction of the business, the admission of a new member, the appointment of a manager, or other ongoing actions that require the members to be able to act.
A court generally has the ability to appoint an independent director of a corporation or an independent manager of a limited liability company to break a deadlock. However, courts are reluctant to make the court-appointed neutral a permanent aspect of the management of the company. Rather than make itself a permanent arbiter of the operations of the business, a court is more likely to find that it is not reasonably practicable to continue with such an inability to make decisions.
A contractual agreement to bring in an independent party to break a deadlock may be included in an operating agreement, by-laws, shareholder or partnership agreement. However, for the same reasons as with courts, they are unlikely to provide more than a limited, temporary solution.
An example is the operating agreement adopted by Inspirion Delivery Sciences, LLC, which was the subject of a lawsuit in Delaware Chancery Court in Acela Investments, LLC v. DiFalco. The parties had adopted a provision to the operating agreement that provided for the use of a designated representative to avoid a vote, or inability to vote, by a conflicted manager. Ultimately, the issue of when and how the designated representative functioned became a central aspect of a deadlock that led to a court order that the company be dissolved.
While the appointment of an independent person to break a deadlock may provide a temporary solution, its value is likely to be limited to single issues, such as the approval of a loan or purchase. Even then, the triggering of the independent vote is likely to be a sign of a larger governance problem.
Mandatory Alternative Dispute Resolution in the Event of Deadlock
Another approach that is related, but not quite the same as, the appointment of an independent director is a provision that requires mandatory mediation or arbitration of disputes that deadlock the company. This approach will permit resolution of a specific issue by a third party, but invoking it may be a harbinger of more difficult times to come.
It is not uncommon that a core document, such as the operating agreement for a limited liability company or a shareholder agreement for a corporation, will have provisions that require that disputes be submitted first to mediation and ultimately resolved through private arbitration rather than the courts. Alternative dispute resolution in these circumstances, however, presumes that one party has been wronged by the other, as opposed to irreconcilable business differences.
A contractual agreement to mediate in the event of a deadlock, however, is something different. In the Acela Investments opinion discussed above, the core business dispute was on an operational matter, the selection of a manufacturing facility and business partners. In that respect, the dispute was different than the circumstances that often lead the parties into litigation. There was no allegation of an actionable wrong such as misappropriation or competition. The manner in which the two sides tried to implement and enforce the agreement led to litigation, not unlawful conduct.
Mediation, in these circumstances, could save the business, and a competent mediator is often capable of forging a consensus among parties that cannot recognize their common interests.
Arbitration, on the other hand, is likely to be less effective. I have seen various agreements that include a provision requiring arbitration in the event of a deadlock, but have never seen one implemented independently of a corporate governance litigation in which the issues were much larger. The parties may arbitrate the involuntary dissolution of the enterprise or the expulsion of a member, but the use of an arbitrator to break a deadlock is problematic at best.
Buy-Sell Agreements May Trigger Fiduciary Duties
Shareholders, limited liability company members and partners may have a right to pursue their own economic interests, even in some circumstances when it means that others in the business will not benefit or be damaged. This right of self-interest, however, can be subject to significant limitations. Triggering or enforcing a buy-sell agreement may be subject to fiduciary duties of loyalty and care or may be in breach of the parties’ implied covenant of good faith and fair dealing.
Adhering to the strict letter of the agreement may not be sufficient when the effect is unfair to the other owners of the business. Courts will look at the exercise of a contractual right in many circumstances to determine whether one side is seeking an unfair advantage over the other. Two key considerations that arise frequently in disputes of this type, whether a majority owner has the ability to dictate a course of action over minority owners. This is often the case in mergers and asset sales when minorities are compelled to sell. A second issue is whether one of the parties is attempting to deprive the other parties of the benefit of their ownership in the business. This is the core issue in oppressive shareholder and oppressive member litigation.
A court is likely to consider whether there is a bona fide deadlock, look at the materiality of the dispute and consider whether the business is paralyzed by disagreement. When one side is in a better position to benefit from the remedy, particularly when a compelled sale of interests are involved, the judge may feel compelled to intervene.