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Massachusetts’ Top Court Clarifies What is a Corporate “Deadlock”
October 12, 2017
The Massachusetts Supreme Judicial Court, the final court of appeal in Massachusetts, recently identified the factors a judge must evaluate to conclude a “deadlock” exists among the directors or shareholders of a Massachusetts corporation. The existence of a deadlock allows dissident shareholders to petition a court for judicial remedies including the dissolution of the corporation. Directors, officers and shareholders of Massachusetts corporations should understand what a deadlock means to a judge. They also should understand the range of remedies a court may order to address a deadlock.
Massachusetts corporate law, like that of all states, contemplates that the directors and officers of a company may be so at loggerheads that they cannot continue to manage the business. Massachusetts corporate law therefore allows under two circumstances 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” to file a petition for dissolution of the company. Those circumstances are (1) that “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” and (2) that “the shareholders are deadlocked in voting power and have failed, for a period that includes at least two consecutive annual meeting dates, to reelect successors to directors whose terms have expired, or would have expired upon the election of their successors, and irreparable injury to the corporation is threatened or being suffered.”
Until recently, the SJC had not explained in any practical terms what defines a deadlock, allowing a judge to grant a petition for dissolution. In Koshy v. Sachdev, decided on September 14, 2017, the SJC established a four-part test to determine the existence of a deadlock. The case presented a prototypical case of deadlock in a closely-held company with two, equal shareholder/directors. Neither shareholder had the power to appoint a third director. Importantly, no agreement existed specifying any mechanism for breaking an impasse between the shareholders or requiring, for example, a buyout of one or the other.
The two shareholder/directors had a long history of conflict over the direction of the company, including whether it should be sold or continued as a separate entity. As with most such disputes, who started the fight, whether one or the other had breached his fiduciary duties, and who was interfering with the success of the business were hotly contested issues. The trial judge concluded a deadlock did not exist and refused to dissolve the corporation. The SJC concluded the opposite and directed the trial judge to consider what remedy should be used to break the deadlock, up to and including dissolution of the corporation.
The SJC ruled that a court must consider, at minimum, the following questions to determine whether a deadlock exists.
- Are there "irreconcilable differences between the directors of a corporation" such that "corporate paralysis" exists? This requires a "stalemate" concerning the "primary functions [of the corporation such as] payroll, client services, hiring and retention of employees, and corporate strategy."
- How large is the company? The SJC noted that a small, closely-held corporation is more likely to encounter these kinds of stalemates.
- Did one of the parties "manufacture[ ] a dispute in order to engineer a deadlock"?
- How much "distrust and antipathy" exists between the shareholders?
Having determined that a deadlock among the directors exists, a court must then consider whether a "true deadlock" exists. Is there some mechanism available to resolve the deadlock? If a stockholder or a group of stockholders has the power to remove or to add a director to resolve the deadlock at the board level, a true deadlock would not exist. A court would then have no power to issue an order breaking the deadlock. Similarly, if a shareholder’s agreement sets forth a way to resolve a conflict at the board level (e.g., through a repurchase of one party’s shares thus allowing the other shareholder to remove a dissident director), that mechanism would have to be utilized rather than the remedy of a judicial dissolution.
In the case the SJC considered, no agreement and no special voting powers existed that would have allowed one shareholder or the other to resolve the deadlock. Accordingly, a "true deadlock" existed.
The final question a court will be required to consider is whether some "irreparable injury is threatened or being suffered." This can be such things as harm to "reputation, goodwill, customer relationships, and employee morale." The SJC also found that factor to be established in Koshy v. Sachdev.
The SJC held that the appropriate remedy need not be dissolution. A trial judge may use his or her equitable powers to fashion a less extreme remedy, such as a forced buyout, sale of the company as an ongoing entity, or presumably even a change in the bylaws of the corporation to require the appointment of a neutral, third director.
Some of the important takeaways from this opinion are the following:
- When forming a new Massachusetts corporation with equal shareholders, do you want to plan for a continual need for consensus (equal numbers of directors or super majority voting), leading to the possibility of an irreconcilable deadlock, or do you want to plan that the board will be able to break an impasse through, for example, a majority vote of an odd number of directors?
- If a deadlock at the board level could exist (for example, where a corporation has an equal number of directors or, if an odd number of directors, where enough directors are conflicted and unable to vote), should the shareholders be able to break the deadlock and if so, how should they do it?
- Should the corporation’s organizing documents or its shareholder’s agreement require the buyout of dissident shareholders (e.g., a call option by the corporation or one group of shareholders or a put option by the dissident shareholders if a deadlock arises) if a deadlock arises among the directors?
- Do you want to require a dispute resolution mechanism other than a traditional litigation (for example, mediation followed by arbitration) to resolve a deadlock?
If you have any questions, please contact Dustin F. Hecker.
This Alert is provided for information purposes only, and does not constitute legal advice. According to Mass. SJC Rule 3:07, this material may be considered advertising. ©2017. Posternak Blankstein & Lund LLP. All rights reserved.