Businesses are complex organizations involving several individuals who pool in their knowledge, capital and other resources and work together to achieve the business objectives. At times, however disputes arise. Conflicts of interests while making business decisions as well as differences in outlooks, visions and opinion can, at times, result in the business activities to come to a standstill. These situations are known as Deadlocks. The author has attempted to analyze certain facets of Deadlocks and their resolution by a four pronged approach, firstly, the author has examined what a Deadlock is and the need for Resolution Clauses, secondly, the author has highlighted the Resolution Processes that are commonly accepted in Corporate Governance, thirdly, the advantages and disadvantages of having a Deadlock Clause and fourthly, the methods of avoiding deadlocks.
Deadlock and Deadlock Resolution Process
Conflicts of interests while making business decisions as well as differences of outlook, vision and opinions have a role to play in disputes. At times, when a resolution is introduced in a crucial or critical matter and the same cannot be passed putting the affairs of the business at stake, dispute resolution mechanisms fail and arbitration cannot be resorted to on technical and subject-matter basis. Such a situation is commonly known as a Deadlock. It is defined as a state of inaction resulting from the opposition of two unrelenting forces or factions.[1] It is a term used in corporate law to denote the blocking of corporate action by one or more factions of shareholders or directors when they disagree with some aspect of the corporate policy.[2] These situations are of irreconcilable differences, where neither of the shareholders have a majority and a conflict arises over management of the business. Such situations are extremely harmful to the business and can lead to severe financial losses if not addressed and resolved appropriately. Deadlocks can arise at Board Level and at Management Level. This article addresses deadlocks at the Board Level.
Colossal efforts are put in, to make a business successful. Businesses at their earlier stages do not see a lot of conflicts in decision making. However, established businesses are a whole different ball-game, differences arise at several levels. The markets evolve; situations change, priorities change and conflicts arise in what is to be viewed as the future for the business. Regardless the source, if the end is that a decision cannot be reached at (especially when agreements require voting by vote-in-majority or supermajority voting and no decision can be taken for the business to move from thereon in any direction), there is a deadlock. Without a proper resolution process in place, deadlocks can prove to be lethal and end in standstill and/or eventual liquidation.
Deadlock resolution process involves stages such as identification of a situation as deadlock, recognizing the available mechanisms to resolve the deadlock, recognizing the most favorable resolution process (ideally, the process mentioned in the Shareholders Agreement) after taking into account factors such as the company or business’ structure, the capital availability and the quantity of knowledge about the actual value of the business and in whom it resides. The optionality of using these resolution processes and their scope is generally limited by a Deadlock resolution clause which. A Deadlock Clause becomes important in order to identify the Deadlock and in promptly putting in place the predetermined mechanisms to resolve it.
Common Deadlock Resolution Clauses
On recognition of a Deadlock, any of the deadlocked shareholders should ideally issue a notice to the other such shareholders informing about the same. On being informed of the presence of such Deadlock, there should be a meeting of all the shareholders either physically or electronically, a series of meetings (if required) and efforts should be taken to come to a solution or a compromise. Once sufficient time-lapses and deadlock is still not resolved, the methods mentioned below can be resorted to. The Casting Vote of the Chairman should be considered. This is typically done through the Articles of the business. This system developed from the practice of House of Commons, Casting vote is vested with the Chairman in order to resolve a deadlock. This right is not inherent but conferred through the Articles. The shareholders could also appoint an Independent Non-Executive Director. At the shareholder level, the company may also issue a Golden Shares to an outsider. In the event the last two alternatives are chosen, several dynamics must be taken into account such as identifying a suitable impartial person with fitting business expertise and the cost of referral to an outsider.[3]
Anglo-American processes providing expeditious and easier exits at reasonable price are often incorporated as clauses to efficiently work out deadlocks. These are known as Shootout Clauses. A Russian Roulette Clause typically provides that, the Shareholder initiating the resolution process offer to the other shareholder, its entire shareholding at a specified price to be accepted within specified time; the other shareholder can either accept this offer and acquire the shareholding of the initiating shareholder or sell all of its own shares to the initiating shareholder at the initiating offer’s price. In case of disagreement on selling at the price, this clause can permit escalation of price and even counteroffers until a suitable price is reached at. This solution typically leads to huge exits and favors shareholders with a stronger financial position. If a party lacks the financial ability to purchase the shares, then it will be at a significant disadvantage, the weaker shareholder runs the risk of being taken advantage of and being bought out at a lower price knowing about the inability of the weaker party to compete. In the author’s opinion, Texas Shoot-out (also called Dutch Auction Clause)[4] is the fairest of the exit clauses. Each shareholder provides sealed bids for the shareholding of the other deadlocked parties and these bids are submitted to an independent third party (e.g. notory, mediator). These bids are then opened simultaneously and the highest bid shall be obligated to buy the shares of other shareholders.
The fear of having to exit the business at short notice and on the other hand having to incur heavy expenses to buy-out may increase the willingness of the shareholders to resolve deadlock amicably. The lack of certainty as to the outcome is expected to bring in fairer prices as neither the party know whether its stance would be as a buyer or seller. Case law on the validity of shoot-out clauses is rare in India, however, bleakly it exists in the United States. These two clauses are considered valid in the United States and also in Germany, so long as they are fair and not violating the fiduciary duty of the members towards each other.[5]
Under a Vanilla Put Option one shareholder is obliged to sell its shares to the other shareholder and under Call Option one shareholder is obliged to buy the other shareholder’s shares.[6] Put Option may be beneficial to a minority shareholder whereas Call Option may be beneficial to a majority shareholder.[7] The Shareholders Agreement typically sets out the method for valuation of the shares. This solution favors the shareholder who is prepared to take initiative as he can decide whether he wants to buy out or be bought out[8] but, on the downside, the valuation mechanism may not produce a price for the shares they like. This clause can be misused unless reserved matters are properly construed in the Agreement. In order for its successful use, the agreement should be well crafted to include exactly when and how the option can be exercised and agreeing on the price at which the option may be exercised at the outset.
While an Arbitration or Expert Resolution may seem ideal for deadlocks which are more or less of factual nature, in issues of simple differences of opinion (which is almost always the case) on conducting the business and taking it forward, such method might not in actuality, be available. Alternative Dispute Resolution can work where both shareholders wish to find amicable resolution with the assistance of an Independent facilitator to come to an accord on how to take the business forward. This would fail in absence of goodwill between parties.
If the company has sufficient profits or cash, the company can Buy-Back its shares from shareholders who wish to exit the deadlocked Company. In this process, the remaining shareholder is not required to raise additional funds as the Company uses its own profits and case. On the other hand, a shareholder looking to exit can seek a third-party buyer if the Company’s Articles do not prevent such sale.
In the author’s opinion if the deadlock does not involve emotions, the best way to resolve a deadlock would be escalation to a level above, which further depends upon the operating structure of the business. If the company is within a Group, it would be prudent for the deadlock to be Escalated.[9] Such a procedure may be effective as managers at higher levels may be able to appreciate the broader strategic picture.[10] Again, the availability of this option remains only when there are levels of management above those directly involved.[11]
Finally, when all measures fail to resolve the deadlock, Voluntary Liquidation may be resorted to. This is the last resort where none of the parties is in a position to buy the others out and the parties are unable to effect a trade sale of the company to a third party. The shareholders may prefer to agree in advance how the company’s assets are to be redistributed to them if there is a surplus on liquidation.
Advantages and Disadvantages of Deadlock Resolution Clause
A considered shareholders agreement, with the appropriate dispute resolution and deadlock provisions, can mean the difference between resolving the problem (perhaps by the swift exit of one shareholder) or the untimely demise of the business - usually to all parties’ detriment.[12]
It has to be noted that deadlocks can be extremely challenging and the uncertainty and leadership tension puts the business in a tricky situation. It would be best to agree upon a process at the time of drafting the Shareholders or Operators Agreement as the case may be. If no remedy for deadlock exists, the same has to be resolved by the Courts, more often than not, the outcome of this tends to be a forced sale wherein the risk lies as to the failure to realize the maximum financial value and also as too, dissolution of the company. Besides, in absence, of such clauses, the parties may not even have effective recourse to the Courts to settle the dispute unless there has been an unlawful act or a contractual breach or other breaches. In order to avoid such drastic results such as erasure of the business as a whole, deadlock issues should be carefully determined at the onset of the business and resolution processes should be mapped out after taking into account the form and structure, the capital of the company, the knowledge of parties and employees. Codification of a mutually agreed upon deadlock remedy and delineation of detailed steps to be taken to recognize deadlocks and to resolve it is for the best interests of the business.
Of the very few downsides is the danger that the presence of such a clause may be used by one party to manipulate and engineer a deadlock and resolution procedure to favour him/her (usually one with better financial resources).[13] Another downside is that legal proceedings are lengthy and the outcome is not always predictable.
Avoidance
Deadlocks are not completely avoidable; the best way to deal with them is to divide the voting rights carefully in a manner such that despite several permutations and combinations taking into account all possible contingencies with an aim to never reach a 50-50 position.
Another step would be a well-drafted deadlock resolution clauses in the Shareholders or the Operators Agreement as the case may be. Such clause should not only provide the resolution procedure to be undertaken in case a deadlock arises but also clearly demarcate what a deadlock would be.
At times, parties prefer to deal with deadlocks as and when they arise in order to not be bound by any or either of the above processes. This, however, may not be the best way to tackle the deadlock when it arises, as parties may not be able to decide how to go about the fix.
An ideal Deadlock resolution clause should typically contain two parts, first, comprising of ways to resolve the deadlock amicably, providing options such as meetings, escalation of the issue to designated representatives (senior/top management) and second, providing options for an exit when deadlock cannot be resolved amicably. The best chance at avoiding a deadlock is to define carefully the duties and responsibilities of members and divide in a manner suitable for the business or the company in the long run whereby by all combinations, majority or casting vote can be reached and have a Chairperson of the Board afforded with an additional or casting vote. The curtailed list of reserved matters for deadlock should be ideal and should include only those matters which are of fundamental nature and utmost importance (such as merger, joint ventures, expansion of business, approval of business plan, capital expenditure beyond a threshold) which may have a bearing on the business, growth prospects of the company and/ or the objectives of the members or of the promoters of both or as the case may be.[14]An exit option should be avoided; instead escalation and external expert intervention and meetings should be promoted.
Following is an illustration of a Deadlock Clause with provision for Texas Shoot-out, Escalation and Casting Vote of Chairman:
“For the purposes of this clause, Deadlock shall be deemed to have occurred in either of the following situations:
(a) the entire board is comprised of an even number of directors
(b) at a meeting at which all directors are present,
Equal number of votes cast for and against any proposed action by the Board on any material matter regarding the Company or its operations as under Clause _ of this Agreement, the shareholders agree to discuss all matters fully and completely and to use their best efforts to co-operate and resolve the issue in the best interests of the company. If the Deadlock persists for __ week(s), any of the shareholders shall have the right to issue a Deadlock Notice to all other deadlocked parties…”
“If pursuant to issuance Deadlock notice, __ week(s) have passed and the Deadlock has not been effectively resolved, the ____ shall arrange for appointment of an Independent third party (qualifications to be prescribed) and thereafter arrange for a meeting within __ week(s) wherein each deadlocked shareholders shall be present and ready with Sealed Offers to purchase shares of the other deadlocked shareholders, such Sealed Offers shall be submitted to the Independent third party appointed. Third Party shall then within __week(s) declare the highest bid and provide for sufficient time to adhere to the Offer.
Provided, this clause will be available to the deadlocked shareholders only if they have previously escalated the issue for decision of higher management to no avail
Provided further, the Casting vote of Chairman can be considered even at the time when the issue is in consideration of the Independent third party.”
Conclusion
The dictums of Courts of Law in the United States of America and Germany have been in favour validity of such clauses provided they aren’t inherently unfair and violate the principles of fiduciary duty. Besides, in incorporating these clauses, especially ones involving buying of shares, care should be taken that the same is permissible under the various regulatory regimes (e.g. foreign investor or even national institutions and categories of investors have investment caps, exceeding such limits would not be permissible); competition laws and the applicable Company Law (the 1956 or 2013 Act as the case may be)
While there are upsides to a pre-determined deadlock clause, there are downsides to it too, however, it would be wiser to inset a Deadlock Clause. In the authors’ opinion, two faceted solution is required to avoid standstills in businesses, firstly, the Articles should be drafted carefully, dividing the voting rights in a manner such that despite several combinations and contingencies, a deadlock situation would not arise and secondly, drafting carefully, the list of reserved matters and laying down the precise resolution process, the business may want to opt for.
[1] https://definitions.uslegal.com/d/deadlock/
[2] Ibid.
[3]https://www.bbmsolicitors.co.uk/Briefing-Sheets/the-company-divorce-how-to-get-through-deadlock.html (last visited on 22nd May, 2018).
[4]https://legalsolutions.thomsonreuters.com/law-products/news-views/corporate-counsel/untangling-the-corporate-knot (last visited on 22nd May, 2018).
[5] Holger Fleischer & Stephan Schneider, Shoot-Out Clauses in Partnerships and Close Corporations – An Approach from Comparative Law and Economic Theory, Max Planck Private Law Research Paper No. 11/13. (https://www.peacepalacelibrary.nl/ebooks/files/339410493.pdf).
[6] https://cavell.co.nz/articles/2014/disputes-and-deadlock-between-shareholders (last visited on 22nd May, 2018).
[7] Availability of these options shall also be based upon the caps and restrictions on the investors and/or sectors involved.
[8] http://www.northwoodreid.com/Art.5050deadlock.html (last visited on 22nd May, 2018).
[9] https://www.bbmsolicitors.co.uk/Briefing-Sheets/the-company-divorce-how-to-get-through-deadlock.html (last visited on 22nd May, 2018).
[10] Ibid.
[11] Ibid.
[12]https://cavell.co.nz/articles/2014/disputes-and-deadlock-between-shareholders (last visited on 22nd May, 2018).
[13]http://www.lindermyers.co.uk/resolving-disputes-in-shareholders-agreements-by-using-deadlock-clauses/(last visited on 22nd May, 2018).
[14]http://www.mondaq.com/india/x/635334/Shareholders/Deadlock+Resolution+Mechanism+In+Joint+Venture+Agreements (last visited on 22nd May, 2018).