Court Defines “True Deadlock”

by Farrell Fritz, P.C.
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Minority shareholder oppression and deadlock are the twin pillars of most business divorce litigation. Both are codified in the vast majority of statutes authorizing proceedings for judicial dissolution of closely held corporations and, to a lesser extent, limited liability companies. Both encompass infinite permutations of  behaviors — of both the well and ill-intended variety — among business co-owners that make any working definition of the two doctrines only marginally more useful than Justice Potter Stewart’s famous “I know it when I see it” definition of obscenity.

From my casual observations over the years, I’d say the courts probably have devoted far more attention to formulating and refining the standard for minority shareholder oppression, which is of more recent vintage than deadlock as ground for judicial dissolution and typically is not defined in the statutes. Oppressive conduct is evaluated in most states under one of three judicially-created formulations: majority conduct that defeats the reasonable expectations of the minority shareholder; breach of the fiduciary duty of good faith and fair dealing majority shareholders owe minority shareholders; and burdensome, harsh, and wrongful conduct constituting a visible departure from the standards of fair dealing majority shareholders owe minority shareholders in close corporations.

I’ve not encountered comparable attempts to formulate a deadlock standard, although one might think the term deadlock needs no judicial interpretation à la oppression. After all, the dictionaries tell us that deadlock is a state of impasse or inability to progress when two opposing factions with equal control can’t come to agreement on something. But the dictionary definition doesn’t get us very far in the context of judicial dissolution proceedings. For example, 50/50 owners in an otherwise well-functioning company could be deadlocked over what shape table to buy for their conference room; no one would suggest that deadlock of this sort would warrant a judicial death verdict for the company. And what about a feigned deadlock created by one faction in pursuit of a break-up, buy-out, or other strategic objective?

In my case-law travels I’ve come across decisions that catalog prior cases granting dissolution as illustrative categories of disagreement warranting dissolution, e.g., impasse over distributions or the hiring or firing of key personnel, but I’ve seen no attempt to fashion an overall framework for evaluating claims of deadlock, that is, until last month’s opinion in Koshy v Sachdev (read here) in which the Supreme Judicial Court of Massachusetts, in its first-ever effort to construe that state’s deadlock-dissolution statute, devised a four-factor test to determine whether a “true deadlock” exists.

Koshy involves a corporation formed in 1987 by two 50/50 shareholders called Indus Systems which describes itself as a leading provider of web-based facilities information systems. Starting in the late 2000s, the owners’ relationship began to deteriorate over differing views of the business’s optimal strategic direction, which bred other disputes over personnel, inter-company payments to an overseas subsidiary, and distributions.

Litigation broke out in 2011-12. First, Sachdev sued Koshy over a large distribution taken by the latter without Sachdev’s consent. Amidst further hostilities, Koshy brought suit seeking judicial dissolution of the company based on deadlock, alongside claims for breach of fiduciary duty by Sachdev who counterclaimed in kind.

In a post-trial ruling, the judge rejected Koshy’s dissolution claim and dismissed the remaining claims and counterclaims for breach of fiduciary duty. Koshy appealed and the case was transferred to the Supreme Court on that court’s own motion.

The Supreme Court’s Four-Factor Test for “True Deadlock”

The Supreme Court in Koshy, acknowledging that it had not previously construed the state’s corporate dissolution statute, tasked itself with fashioning a test for what the commentary accompanying the statute’s enactment called “true deadlock.” It proceeded to identify four factors.

First, whether “irreconcilable differences between the directors of a corporation have resulted in ‘corporate paralysis'” defined as “a stalemate between the directors concerning ‘one of the primary functions of management'” (quoting from a 1966 decision by Maine’s Supreme Court).

Second, “the size of the corporation at issue,” recognizing that deadlock “is more likely to occur in a small or closely held corporation” as to which the lack of a ready market for a shareholder’s stock “and the greater likelihood that a shareholder is reliant on the corporation for a salary, tends to increase the potential for deadlock and accompanying oppressive tactics.”

Third, whether “a party has manufactured a dispute in order to engineer a deadlock” in which event “a court should view the party’s claim with skepticism.”

Fourth, “the degree and extent of distrust and antipathy between the directors” where “mutual antipathy can transform what may begin as a run of the mill disagreement into irreconcilable conflict and stalemate where hostility precludes compromise.”

The Test Applied in Koshy

The court’s application of the four factors to the “undisputed” facts in Koshy led it to the “inescapable” conclusion that “the conflict between the parties constitutes a deadlock.” All four factors, the court wrote, supported a finding of deadlock:

Applying the first factor, the acknowledged facts underscore corporate paralysis with respect to a number of key matters. The parties have profoundly different opinions regarding both Indus’s daily operations and its future. They disagree on such basic matters as staffing needs, as well as dividend and tax distributions, and even more fundamentally, hold diametrically opposed views as to long-term corporate strategies and goals. The areas of disagreement between the parties appear to far outweigh the few areas of agreement. Over the past few years, the parties appear to have agreed only on the matter of employee raises and the need to hire a new salesperson. . . . The parties are diametrically opposed on nearly every issue of importance concerning Indus’s current operations and its future.

The second factor also argues in favor of deadlock. Since the parties each own fifty per cent of Indus, each has the ability to prevent the other from enacting any policy with which he disagrees, on any subject; their stalemate thereby effectively paralyzes Indus on all of the issues on which the two disagree. As to the third factor, we discern no indication in the judge’s findings that either party engineered the dispute in bad faith. Rather, the facts reflect a genuine disagreement between the parties concerning the most basic aspects of company policy.

Looking to the final factor, the parties do not contest the trial judge’s finding that they operate based on a relationship of mutual distrust and antipathy. The judge was well warranted in concluding that Koshy “views all of Sachdev’s actions as an attempt to freeze him out of the management of the company” and that “Sachdev questions all of Koshy’s actions.” The record is replete with personal insults, questioning of motives, and general acrimony between the parties. This mutual antipathy in a two-director corporation has prevented the parties from compromising and has inspired increasing levels of brinksmanship. Accordingly, we conclude that Koshy has met his burden to show that the parties are deadlocked….

Having found the existence of “true deadlock,” the court in Koshy next examined whether the shareholders had an available mechanism for breaking the deadlock, such as a buy-sell or mediation agreement, and finding that no such mechanism existed, and after also finding that the irreconcilable deadlock and “mutual antipathy” rendered the two shareholders “unable effectively to manage the company,” the court remanded the case to the trial judge for a determination of the appropriate remedy, be it dissolution or a lesser remedy such as a buyout or the sale of the company as a going concern.

Koshy‘s four-factor test doesn’t introduce anything especially novel to the vast body of deadlock dissolution cases in which courts examine some if not all of the issues identified by the Massachusetts Supreme Court. Koshy‘s formulation for detecting “true deadlock” nonetheless provides a useful analytic framework that goes beyond merely ticking off the types of disputes that previous courts have found to be symptomatic of deadlock justifying dissolution.

Finally, Professor Brian JM Quinn of the Boston College Law School filed an interesting amicus brief in Koshy in which he urged the court to take guidance from the Delaware Supreme Court’s recent decision in Shawe v Elting authorizing a sale of the highly profitable TransPerfect company based on the irreconcilable deadlock between its two owners. The Koshy opinion cited Shawe three times. You can read the amicus brief here.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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