Triple D Threat: Deadlock, Dissolution and Draconian

Let’s say you start up a company with a good friend. You each own 50% of the stock (or, membership interest in the case of a limited liability company). You design and sell a successful product. Everything is going great—until suddenly, it isn’t. The business is fine. But your relationship with your co-owner is not. Maybe you disagree on retaining an employee. Maybe you disagree on pricing a new product. Maybe you disagree on if and how the business should expand. You both have a strong conviction about the way the business should be running, and those convictions do not align. Then, the disagreements start to negatively impact the business. You can’t seem to move forward. What are your options to break the stalemate?

Equal ownership has its benefits and risks. The obvious benefit is that you came into the business with your co-owner. Neither of you wanted to take a back seat—and you didn’t. Instead, you worked together, supported each other, and shared the initial costs and responsibilities.

But, of course, a 50-50 ownership structure has one big risk (among others): the situation described above, where the co-owners have a failing out that locks up the corporation. In a 50-50 ownership structure, neither owner can act without the other’s approval. E.g., Koshy v. Sachdev, 477 Mass. 759, 763 (2017). The need for unanimity can lead to a stalemate tying up the company’s resources and mobility. Put simply, “[t]he two-man nature of the business intensifies this potential for deadlock.” Rowley Auto Parts, Inc. v. Bontos, 25 Mass. L. Rptr. 607, 2009 WL 2356687 (Mass. Super. 2009). And “minor” issues between owners can create a deadlock which the shareholders— who are typically the same people as the directors and key employees—cannot break. Constantine v. Lawnicki, 22 Mass. L. Rptr. 745, 2007 WL 2429721 (Mass. Super. 2007).

The relationship between co-owners in a two-person corporation is also characterized by especially broad fiduciary duties. Massachusetts courts have applied the general law of partnership duties to close corporations and LLC. This means shareholders in an evenly split close corporation owe one another a “strict” fiduciary duty to act with “‘utmost good faith and loyalty.’” Donahue v. Rodd Electrotype Co. of New England Inc., 367 Mass. 578, 593 (1975) (citation omitted). “They may not act out of avarice, expediency or self-interest in derogation of their duty of loyalty to the other stockholders and to the corporation.” Id. But where “the alleged wrongdoer can demonstrate a legitimate business purpose for his [or her] action, no liability will result unless the wronged shareholder succeeds in showing that the proffered legitimate objective could have been achieved through a less harmful, reasonably practicable, alternative mode of action.” Zimmerman v. Bogoff, 402 Mass. 650, 657 (1988). Where you and your co-owner are both acting sincerely, with a focus on the best interests of the corporation (in your view), a breach of fiduciary duty claim is unlikely to succeed. Without having this option to reign in your co-owner’s conduct, your remedies at law are few.

With proper planning, you can try to contract around a dispute in the first place by using a shareholder agreement. Such agreements are enforceable in Massachusetts and can cover a wide range of matters. See Mass. Gen. Laws Ann. ch. 156D, § 7.32. Among other things, a shareholder agreement can make clear which shareholder, director, or officer may make business decisions in a specific area. Thus, you and your co-owner could assign responsibilities early on. For example, you handle marketing, while your co-owner handles accounting. If your agreement provides that your assignments include hiring, pricing, and related decisions within that area, it should preclude the opportunity for deadlock.

Moreover, your agreement should contain a dispute resolution mechanism. This can take several forms—and even have different options, depending on the type or scope of the dispute. As one example your agreement can identify a neutral third-party that both shareholders trust, who is willing and able to act as referee in the event of deadlock. Alternatively, it can set up conditions for turning to mediation or arbitration. In the event of a deadlock and increase in animosity, the agreement should contain buyout directions, to allow you and your co-owner to split up but keep the business going.

But what happens if you don’t have a shareholder agreement? Massachusetts law provides deadlocked 50-50 shareholders with limited recourse. Under Section 14.30, a shareholder of 40% or more of the corporation’s shares may petition for judicial dissolution of the company, when “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.” Mass. Gen. Laws Ann. ch. 156D, § 14.30. The judge has discretion to grant dissolution or another remedy such as appointment of a receiver or custodian. See id.; see also Koshy v. Sachdev, 477 Mass. 759, 771-72 (2017); Mass. Gen. Laws Ann. ch. 156D, § 14.32.

In the leading case interpreting this statute, the two co-founders of a computer-aided design company developed a fundamental difference of opinion regarding the future of the company after experiencing considerable success. Koshy, 477 Mass. at 761. “This difference in viewpoints bred growing distrust,” which manifest in disagreements on everything from paying vendors to retaining employees. Id. at 762. Their relationship deteriorated into litigation for breach of fiduciary duty. Koshy also sought dissolution under Section 14.30. Id. After a bench trial, the judge ruled against Koshy on all claims. Id.

The Supreme Judicial Court reversed and remanded the dissolution claim. The court found the parties were in “true deadlock.” Their animosity and distrust rendered them essentially unable to make corporate decisions. As a close corporation, they were the only two directors and share- holders—there was no one else to break the deadlock. Moreover, the court noted that shareholders may have a contractual mechanism to break a deadlock, such as a buy-sell agreement or agreement to use alternative dispute resolution. But Koshy and Sachdev had no such agreements. Id. at 766-69. The Court found that the company was threatened with an irreparable injury because Koshy and Sachdev’s “impasse regarding nearly every major corporate decision has cast a cloud on [their company’s] future.” Id. at 770.

Turning to the remedy, the Court noted that dissolution is discretionary under Section 14.30 and concluded that the statute “also authorizes lesser remedies, such as a buyout or the sale of the company as an ongoing entity.” Id. at 771. The Court remanded for consideration of the remedy. Id. The lower court found that in this case dissolution was a “draconian” measure because the business was a going concern.

Koshy reinforces the importance of planning for conflict in the early stages—before 50-50 shareholders reach the point of deadlock. And while deadlock may seem preposterous in the early days of business, it is not uncommon, as Koshy demonstrates. See also, e.g., Rowley Auto Parts, 25 Mass. L. Rptr. 607; Constantine, 22 Mass. L. Rptr. 745. Conflicts that start small but snowball can arise due to changes in the market or in personal or family circumstances. Even success can breed conflict. In Koshy, the company was doing well, but that very success led to the co-founders’ deadlock. Your best option might be to look ahead and work around the problem before it begins.

In the absence of having such an agreement, Koshy identifies a few judicial options for breaking a deadlock: the 14.30 dissolution, but also a request for judicially ordered buy-out or sale of the business as an ongoing concern. 477 Mass. at 771. But these options may not be attractive to an active co-owner and co-founder who would still wish to engage in the business after breaking the deadlock. If this is your situation, you may have only one reasonable solution: to work it out with your former friend and co-owner. And while this may seem impossible, your co-owner faces the same risk of losing ownership or control because of judicial intervention. If this is your situation, it will be necessary and invaluable to find a great lawyer to negotiate on your behalf with your co-owner—or to represent you before a neutral third-party referee, if the two of you can agree to such a person.

At Pakrooh Law, P.C. we emphasize evaluation of each situation taking into consideration the applicable laws and facts, the economic and psychological circumstances of the parties, and our client’s ultimate objective. We understand that corporate deadlocks – even simple disagreement between business partners, – can be extremely frustrating and costly, with serious implications on the distribution of profits, corporate control and governance, and even the future of your own company. It is our intention that this blog provide you with some perspective of Massachusetts law on business disputes and corporate deadlocks. We are privileged to have guided other business owners through their challenging times and are prepared to counsel and represent you too. We look forward to helping you.

If you find yourself amid a deal or a business dispute, you may need to turn to attentive counsel to protect you. Pakrooh Law, P.C. regularly deals with contracts and business disputes, and we are fully prepared to give the counsel and guidance that you need.