For the shareholders involved, the period of disagreement on matters that require their vote is often stressful, resulting in their spending valuable time at loggerheads with each other. Ultimately the bickering shareholders may cause the business to run into financial difficulty. For this reason, investors insert a deadlock resolution clause which reads something like this:
“In the event that the shareholders or the directors of the company, as the case may be, are unable to reach a decision on any reserved matter, a deadlock (“Deadlock”) shall be deemed to exist. Upon the occurrence of a Deadlock, either Party shall be entitled to immediately serve a written notice (“Deadlock Notice”) to the other Party declaring a Deadlock. On the serving of the Deadlock Notice, the Parties shall discuss and negotiate in good faith to resolve the Deadlock amicably. The Parties shall take all necessary steps to ensure that day-to-day functioning of the Company is not affected during the period that the Deadlock exists. In the event that the Deadlock is not resolved by the Parties within a period of 30 (Thirty) days from the Deadlock Notice, unless an extension of time is mutually agreed to by the Parties, the Parties shall appoint a sole arbitrator who’s decision in resolving the Deadlock will stand final and binding.”
A well-prepared shareholders agreement will usually have a deadlock resolution clause that will set out the framework within which shareholders and investors intend to resolve an impending dispute. A considered shareholders agreement, with the appropriate dispute resolution and deadlock provisions, can mean the difference between resolving the problem or the untimely demise of the business – usually to all parties’ detriment.
In the absence of these provisions it should be noted that unless one party has acted unlawfully or in breach of contract, the parties may not have effective recourse to the courts to settle the dispute; indeed the courts have been increasingly reluctant to appoint a liquidator as a means of addressing issues between shareholders. In any event litigation is likely to be very expensive and time consuming and, again, it is very likely to have an adverse financial impact on the business.
Apart from the above mentioned there are a number of mechanisms that can be adopted to resolve deadlock – the mechanism which should best be adopted for any particular business is dependent on several factors including the type of business, company structure and relative financial strength of the shareholders. The most common deadlock breaking mechanisms include the following (or combinations or variations of these):
- An “Auction” – in an auction the initiating party will notify the other(s) that it wishes to acquire their shares. The receiving party will then normally have a certain period within which to decide if it intends to sell its shares or buy the initiating party’s shares. If the other party also wishes to buy, both parties will then participate. This mechanism will only work equitably if the parties are of similar financial strength.
- “Buy Out” – This involves a mechanism where one shareholder can be quickly bought out by the other parties. While such a mechanism is quite uncommon as a means of breaking deadlock (and is more likely linked to the non-performance by a party if its obligations under a shareholders agreement, which non-performance typically gives the “non-defaulting” parties the right to acquire the “defaulters” shares) it can still be effective in certain circumstances. If this mechanism is used it will also be necessary to include an efficient means of establishing the price for the other party’s shares – this is more easily ascertained by reference to a pre-determined formula, rather than involving an independent valuation which will be more time consuming.
- “Put and Call” Options – A “Put” option enables a shareholder to require another shareholder to purchase its shares at a certain price. A “Call” option on the other hand allows a shareholder to compel the other shareholder(s) to sell their shares. “Put and Call” Options are probably not such an effective option for a company comprising shareholders of equal stakes. However, “Put” options in particular may be advantageous for a minority shareholder who perceives that the happening of certain events may weaken its position. Conversely a call option may be favoured by a majority shareholder who wants to take a certain course of action which may otherwise be impeded by a minority shareholder. The key to “Put” and “Call” option arrangements working well is clearly specifying when and how the option may be exercised, and agreeing on the price at which the option may be exercised at the outset.
- Liquidation – For some businesses, the parties may wish to provide for a regime that requires the shareholders to liquidate the company in the event of deadlock and to share the costs and expense of so doing. Liquidation however may not be an attractive option if a large element of the value of the business is “goodwill” and dependent heavily on its continuing as a going concern.
Whatever the mechanism chosen, it is also important to clearly define what constitutes a “deadlock” and a clear definition of reserved matters that require investor’s affirmative vote.
Whilst there are pros and cons with each of the different deadlock provisions, it is imperative to select the mechanism which the shareholders believe is appropriate in the circumstances, questions of “what if…?” can be beneficial at the preparation stage of the shareholders agreement and can provide a useful framework for the parties to understand their respective objectives and how an impasse can be managed going forwards. In summary, it is by far preferable to invest the time upfront to consider the terms of a shareholder agreement, in particular to select a deadlock breaking mechanism to ensure that should circumstances change, a resolution can be reached quickly and to allow the company to move forwards without the distraction of a prolonged dispute which can be both emotionally and financially draining.