The Company Divorce : how to get through deadlock

When entering into a new business arrangement whether through a shareholders agreement or joint venture agreement or simply subscripting for shares in a NewCo without ether of these documents in place (which is generally not advisable) it is easy to be swept up in the good times and the prospects of a new, successful and profitable company. It is harder in this state of healthy optimism to consider the end point. Just as ideally no one should enter into there marriage envisaging their divorce (pre-nups aside) there is always a reluctance to consider at the outset the possibility of the relationship breakdown which may easily occur between shareholders. This article aims to set out a few of the solutions deadlock situation ,some which act like pre-nups and seek to plan for a future problems and other are very the equivalent of divorce courts when talking through the issues has well and truly failed.

What is deadlock?

In a situation where parties each own 50% of the shares (or equal proportions of the shares if there are more that two parties) of a company, if they cannot agree on a certain course of action this is often described as deadlock. The structure of the company will usually reinforce the deadlock position, e.g.: – each party will be able to appoint an equal number of directors to the board – each party will have equal voting rights. Particularly in a small company situation where there are two directors who are both equal share- holders moving on from the point of deadlock can be difficult.

Is it better for an Agreement to stay silent on Deadlock?

When entering into any Agreement some parties may prefer not to specify in detail how any deadlock is to be resolved, relying instead on finding a solution as and when such a situation arises. One reason for this is the view that, if parties wish to settle a disagreement, they will do so, whereas, if they are not willing to compromise, the drafting of detailed deadlock resolution procedures will not force them to agree.

What are the options?

Including detailed deadlock resolution procedures in the agreement may focus the parties’ minds in the event that a disagreement arises, particularly where failure to resolve the deadlock will have serious consequences. Successful deadlock resolution procedures will encourage the parties to reach an amicable and speedy settlement of the outstanding issues. Common deadlock procedures include granting a casting vote to the chairman of the board, use of an outsider’s swing vote, esca- lation of the issue, and reference to mediation, arbitration or expert determination

Chairman’s casting vote

Deadlocks at board level may be unlocked by giving the chairman of the board of directors a casting vote. However, this arrangement isn’t ideal in a 50/50 company because it gives an advantage to the party who has/is appointed the chairman. Until 1 October 2007, the standard articles of association gave the chairman of the board a casting vote at shareholder meetings. The relevant provision was removed on that date because it was considered to be inconsistent with the provisions of the Companies Act 2006 which state that an ordinary resolution of the members of a company means a resolution that is passed by a simple majority. However, a saving provision was subsequently introduced which allows non-traded com- panies whose articles provided for a chairman’s casting vote before 1 October 2007 to retain or reinstate such provisions. Outsider’s swing vote If the parties are not willing to allow the chairman of the board to resolve a deadlock, they may be willing to provide for an impartial outsider to resolve deadlock situations. At shareholder level, the company may issue a golden share to the outsider or at board level ask an impartial non-executive director to make the decision. Whether the outsider is a director or a shareholder, there are a number of considerations which must be taken into account if this method is used, including identifying a suitable impartial person with appropriate business expertise, the costs of referral to an outsider (i.e. what payment will the outsider require), and whether deadlock resolution may be delayed by the time taken for the outsider to understand the issues

Escalation

This option really depends on what structure the company operates within. If the company is within a group and deadlocked it may be sensible for the deadlocks to be escalated to higher levels of management within the group. Such a procedure may be effective because it will concentrate the minds of the management team (as they will be unwilling to have to refer the matter higher up), and managers at higher levels may be better able to appreciate the broader strategic picture. However, this procedure is not likely to be effective where the parties have few or no levels of management above those directly involved.

Mediation, arbitration or expert determination

Referring a dispute to an external expert or arbitrator could unlock deadlocks at either board or shareholder level. However, such referrals may involve considerable time and expense and may not be appropriate where the deadlock arises for a business rather than an operational reason. Mediation may be used to assist the parties to resolve the deadlock themselves but will not provide a final resolution if the parties are unable to agree on a solution to the deadlock .If the parties are unable to agree on the resolution of a deadlock and none of the above methods are effective, options will usually be limited to a transfer of shares or voluntary liquidation of the company.

Transfers of shares

Standard put and call options are unlikely to work in deadlock situations as there is no party in default and the options would therefore be exercised by whoever served notice first. For this reason, two-party agreements often include a variation on put and call options known as Russian roulette. A typical Russian roulette provision works by one party (A) offering to buy the other party’s (B’s) interest in the joint venture at a price specified by A. B has a limited period of time to sell its interest at that price or, if it does not want to sell its interest, to purchase A’s interest at the same price. If B does not respond within the specified time, B may be deemed to have accepted A’s offer to buy its shares. Such provisions are designed to ensure that the price paid for the transfer of shares is fair and that the parties only resort to the use of the procedure if they are unable to continue to work together. However, these provisions usually only work situation and the arrangements are likely to favour the party that is financially stronger or more involved in the business. An alternative to Russian roulette which is sometimes used is Mexican or Texas shoot-out. This usually involves one party (A) offering to buy the other party’s (B’s) shares at a price specified by A. B is then entitled either to accept A’s offer or to reject A’s offer and state that it wishes to buy A’s shares at a price higher than that specified by A. A and B then make sealed bids or enter into an auction, and the person who bids the highest is entitled to buy the other out. This procedure is subject to the same objections as Russian roulette procedures but is also more open to exploitation, as a party who does not really want to buy the other party out could force the other party into paying a higher price than it initially offered. If neither party is in a position to buy out the other party, the parties may attempt to sell the whole company to a third party, failing which the company may enter into voluntary liquidation. However, in a multi-party agreement, it may be possible for one of the shareholders to transfer its shares and exit without affecting the ongoing operation between the other parties.

Voluntary liquidation

Voluntary liquidation of the company will usually be a last resort where none of the parties are 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. Voluntary liquidation involves the company being wound up and selling its assets and/or distributing them. If the company sells some or all of its assets, the shareholders may be entitled to make bids to the liquidator for assets that they want. Alternatively, 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. If the company is UK registered, one or more of the parties may alternatively apply to the court for the company to be wound up on just and equitable grounds. However, there is no certainty that the court would determine that the grounds for such a petition had been satisfied.

BBM Solicitors specialise in advising directors in both contentious and non-contentious matters (including transactional work). Contact: Jennifer Simpson (jms@bbmsolicitorsco.uk). This briefing note is current as at 1st May 2013 and is our understanding of the position described at that date. Legal advice ought to be taken before relying on its terms (particularly to ensure the law has not changed).