A SHORT REVIEW ON DEADLOCK PROVISIONS

Definition

A deadlock arises from major disagreement respecting a fundamental corporate policy that cannot be resolved due to absence of majority vote or unanimity. This type of issues mostly occur in organizations with an even number of owners, especially those with two owners, may cause very serious troubles. In particular, the blockage of the shareholders on the management may ultimately cause the business to run intro financial difficulties and put the entities’ neck on the line. The event was typically described in Palmieri v. A.C Paving Co:

“There is an equal split or nearly equal split of shares and control; there is a serious and persistent disagreement as to some important questions respecting the management or functioning of the [organization]; there is a resulting deadlock; and the deadlock paralyzes and seriously interferes with the normal operations of the [organization].” 1

 In every business operation, each partner/shareholder is entitled to:

-Right to know about the business operation

-Right to be included in the management

-Right to participate in collective decisions

According to the Law in most countries, ordinary business decisions can be taken with majority vote of the shareholders however, extraordinary issues can require unanimity of the shareholders.

The process of resolving deadlocks can be highly time-consuming and expensive in consideration of involving the services of lawyers, witnesses and judges Moreover, the resolution of business deadlock in unincorporated entities may end up with dissociation of joint owners or the dissolution of the business association. The completion of the dissociation or dissolution involves the buy-out of the dissociated owner’s shares, where the asset valuation fully carries a critical aspect.

Asset Valuation

In the event of the dissolution of the business association, the asset valuation plays highly

1 Palmieri v. A.C. Paving Co., (1999) 48 B.L.R. (2d) 130 (B.C.S.C.)

important part in determining the buy-out price. It is also considerably necessary in order to complete the transfer of the assets, which also may be very deceptive in case of the Partnership or LLC is tied to the;

-Skills and knowledge of the employees

-Business methods and corporate culture

-Intellectual property

which are often intangible and not necessarily reflected on the financial statements.

Despite all of these facts, asset valuation of the business association can still be considered as one of the most difficult and complex part of the dissolution and also merger & acquisition transactions as well. Thereof, it is regarded as the best idea that the most accurate knowledge about the value of the business venture may be located in the minds of the business owners.

 General Resolution of Deadlock in accordance with Turkish Commercial Code

In consideration of Turkish commercial code regarding the business deadlock arisen in company management, there is no specific provision regulated in order for resolving the relevant matter.

In case of the board of directors of the company not functioning or somehow deadlocked for a long time, it may be conducive to dissolution of the company in accordance with Article 531 of the Turkish Commercial Code. Upon the application made by the eligible shareholder, the court may rule for necessary measures (i.e appointing trustee) and would adjudicate on the case after hearing the board of directors. Pursuant to Article 531, a claimant may demand the dissolution of the company from the court with just cause. Yet, the court is not fully obliged to decide on termination of the company but instead, the court may rule in favor of the squeeze-out of the claimant upon the payment of per share value in the earliest time or also may rule on another suitable and expedient solution.

Nevertheless, it is still a time-consuming and expensive process, which also may consequence with financial difficulties for the company ultimately.

That is why, the implementation of typical deadlock provisions in the shareholders agreement before the deadlock occurs, may be the best alternative method instead of resolving before courts.

 Common Deadlock Provisions

Deadlock provisions are clauses (or series of clauses) implemented in shareholders’ agreement or joint venture agreements, which accurately regulate how disagreements on essential matters shall be resolved in relation to the business management.

Naturally deadlock provisions appear with respect to different manners and with different types of transactions in each domestic legal system. However, the typical characteristics of the provision will be as follows:

-Certain key issues are determined as matters, which are commonly related to taking  a

resolution and the management of the business.

-In order to be said that the deadlock has arisen, the provision shall determine a certain number of meetings of the board of directors.

-The provision may/shall contain an alternative mediation solution before getting in irreversible methods.

-In case of the failure of all amicable solutions, the termination provision shall automatically take the action.

  1. Shotgun Provision

Shotgun provisions are the most common type of clause that often used to in the shareholders’ agreement or joint venture agreements in order to break a deadlock. It basically provides that, one of the parties may notify the other party its offer to sell to the other party all of its shares at a specific price. Once the Shotgun provision has been triggered, other party is compelled to either buy the shares with that price or sell its share at the same price. This type of clauses is also know as “Russian Roulette.

A typical example has been taken from the operating agreement of the Omnibus Financial Group:

“If for any reason any Member (‘the Electing Member’) is unwilling to continue to be a member of [the LLC] if another Member (‘the Notified Member’) is also a member of [the LLC], then the Electing Member may give the Notified Member written notice stating in such notice the value of a 1% Membership Interest (‘Interest Value’)  whereupon  the Notified Member shall, by written notice given to the Electing Member within 30 days from the date of receipt of the Electing Member’s notice, elect either to purchase the Electing Member’s interest in [the LLC] or to sell to the Electing Member the Notified Member’s interest  in  [the LLC].”2

According to some legal authorities, Shotgun provisions have several desirable properties.

Shotgun provisions lead to fair and equitable division of the assets, since the party making the offer may end up on either side of the transaction. When examining the Valinote   v.

Ballis case, the Judge states that “The possibility that the person naming the price can be forced either to buy or to sell keeps the first mover honest.”3

Shotgun provisions are considered as the expedient mechanism. On the contrary of the standard negotiations, only one party may unilaterally trigger the Shotgun provision and force the other party to the transfer of the shares. Once the provision is triggered, counter party shall respond the given notice within specific number of days either by selling or buying the shares. This fact also provides an exact solution for the parties, since it is clearly understandable that bargaining on the table with meaningful considerations seems barely impossible in the event of deadlock.

2 Valinote v. Ballis; No. 00 C 3089, 2001 WL 1135871 (N.D. Ill. Sept. 25, 2001)
3 Valinote v. Ballis; 295, F3d. 666 (Ill. 2002).

The Shotgun mechanism is mostly cost-efficient since the participation of third party is not required at all.

Shotgun provisions typically give the shareholders discretion over whether to trigger the clause, which basically may influence on negotiations and induce more equitable outcomes.

In addition, prohibition of competition may also be included with this provision, which makes it more restrictive the terms provided in the shareholders’ agreement. This type of supplementations is considered fully valid with relevant jurisdictions.4

It is also essential to mention that shotgun provisions should be drafted with precision and clarity to provide suitable protection to both parties. It might operate arbitrarily, if one of the parties is at financially superior position and may however manipulate the buy-out.

In regard to the validity of the “Russian Roulette” clauses, this clause can be considered as valid in principle in relation to a two-shareholder company. However this clause may also become retrospectively invalid, if the economic performance of the two involved shareholders diverges over time.5

  1. Shoot-out / Auction Provision 

This type of provisions is also considered as dramatic solutions in order to resolve the deadlock in a different way. Pursuant to shoot-out provisions, each party send a sealed all-cash bid by stating the price at which they are willing to buy out the other party. All bids are gathered in control of the independent third party (i.e notary) and both bids are then opened simultaneously, with the shareholder having made the higher bid being obliged to purchase the shares of the other shareholder. In other words, higher bidder is duly entitled to buy the others  share.

Another type of a shoot-out provision is also quite similar with above given process, however, this process contains offers and counter-offers that can continue through several rounds, with each bid required to exceed the previous highest bid by a specific percentage. Eventually the highest bid becomes final and binding for both parties.

The main advantages of such clauses can be considered as the velocity of the exit process and the guarantee of a reasonable and fair price for each party. The possibility of having to exit from the company in a short time period may also increase the willingness of the shareholders to reach agreement in the event of a deadlock.

Yet, the disadvantage of this type of provisions can be considered a the unpredictability and the lack of foreseeability Neither shareholder knows in advance whether the process will end in its exiting the company or becoming the sole owner.

4 Payette c. Guay Inc. 2013 CSC 45, Court of Appeal / France
5 20 December 2013 (Az. 12 U 49/13) Nuremburg Higher Regional Court / Germany

  1. %100 Buy-Out Provision

This type of clauses involves a mechanism that one of the shareholders is eligible to quickly buy out the other parties’ shares. This mechanism is used quite uncommon in order to break the deadlock but still can be effective in certain circumstances. In case of this mechanism implemented in the shareholders’ agreement, it will also be necessary to include an efficient means of establishing the price for the other parties’ shares.

  1. Arbitration Provision

Arbitration provisions provide both parties a solution imposed by an independent outside expert in case of any disagreement occurs. At that rate, all shareholders will equally share the cost of the expert. This clause can be considered as suitable only in factual or technical matters.

  1. Mediation Provision

Mediation is not considered as a strictly termination provision at all. Many deadlock provisions end by providing that the parties shall mediate until a solution is found but however, the parties are usually unable to mediate or bargain with meaningful consideration, thereof the deadlock is mostly resolved with dissolution of the company. Unlike the arbitration clause, the mediator has no power to impose a solution or make a decision.

 Validity of Deadlock Clauses in European Partnership and Corporate Law

When examining the case law on the validity of deadlock clauses (in particular: Shotgun and Shoot-out), it is rarely encountered relevant jurisdictions in Continental Europe in contrary to United States.

A first indication comes from a 2009 judgment ruled by the Court of Appeal in Vienna, which approved the inclusion of a “deadlock clause” in the articles of association of a close corporation and the entry of these articles into the commercial register. 6

According to the Court, this mechanism has sufficient “checks and balances” to  prevent  one of the parties taking advantage of the other party. Therefore, individual shareholders are protected from unreasonable disadvantage, meaning there can be no argument that shoot-out clauses should be invalid for being in breach of public   policy.

According to the German doctrine, Shotgun or shoot-out clauses are not considered as invalid restriction of the right to dissolve a partnership. At some point, deadlock provisions are examined whether they are complied with the general provisions of German Law. The issue regarding dissolution and the termination of the company by the shareholders were regulated in the Article 723 of BGB. According to the Article 723(3) it has been stated that

6 Vienna Court of Appeal, judgement dated 20.4.2009 – 28 R 53/09h, GesRZ 2009, 376

any agreement that is excluded or contrary to these provisions shall be considered null and void.

However deadlock provisions shall not conflict in any way with Article 723 (3) BGB since each partner is free to initiate the shoot-out.

 Conclusion

As it has been previously explained, deadlock matters can be very problematic and tricky for the companies and also for their shareholders. Future business partners usually fail to plan for the possibility that their working relationship will come to an end due to irreconcilable difference or how the assets shall be divided in case of divorce. Additionally, similar deadlock matters arise mostly in family-owned corporations, which may cause significant troubles afterwards not only in business point of view, but also on social basis. As a consequence, those issues mostly end up before local courts in order to resolve the deadlock but it is quite time-consuming and expensive which also may cause financial difficulties for the company. In order to reach an effective solution, deadlock clauses are commonly used in different legal systems, which also seem necessarily for our legal system at some point. Contractual stability shall become more efficient and effective unless the contractual provisions are complied with the mandatory provisions of the domestic legal regulations.

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