Disagreements between shareholders can be a healthy thing, leading to creative solutions through the reaching of compromises. Differences can involve issues as diverse as how a company should be managed and controlled, and the direction and strategy it is taking. However, if differences become entrenched, the result can be potential deadlock and the loss of the ability to make important decisions, which can be severely damaging to a company and its shareholders.
One way of resolving this potential problem is though the incorporation of Deadlock provisions within shareholders’ agreements, investment agreements or articles of association.
What is deadlock?
The situation of deadlock is tightly defined, with qualifying conditions usually set out in shareholders’ agreements. These are generally situations which go beyond a mere single ineffective vote by shareholders.
Usually, a number of votes on the same issue must be made over a period of time, with the outcome being consistently indecisive. Such delay would generally give shareholders time to compromise on or find other ways of resolving the issue.
Deadlocks can also occur when other dispute resolution methods have been tried and failed, for example, when shareholders’ agreements provide for mediation to find an amicable solution if an issue is not resolved after two general meetings.
Deadlock provisions are a way of forcing a decision in such situations, as they are often so severe for one side that the threat of their use is enough to force the acceptance of a compromise. Due to their extreme nature, the circumstances in which they can be used are usually limited to matters significantly affecting business operations.
Common types of deadlock clauses
Although deadlock clauses can be found under a plethora of terms, they all boil down to a change in controlling interest, via one party selling their shares to the others to facilitate the taking of decisions on important matters by the remaining shareholders and are all generally types of conditional termination provisions. Common examples of deadlock clauses in shareholders’ agreements include:
Shotgun / Russian Roulette
Such clauses allow one shareholder to make an offer to buy out the other shareholder for a certain price and under certain terms and conditions. The other shareholder may then either accept such offer or buy the shares of the offeror for the same price and under the same terms and conditions (assuming there are two equal shareholders).
In this type of deadlock clause, each shareholder sends a sealed bid for the others’ shares to an independent and neutral third party. The third party then opens all bids at the same time and the highest bid wins, with the winning shareholder required to buy the others out at that price.
An auction is similar to a shotgun mechanism as the offering shareholder may have the opportunity to pay a price of their choice, including a premium. However, an auction differs from a shotgun approach, in that it lacks adverse consequences for shareholders making low bids, as the outcome simply depends on the highest bid.
The absence of appropriate clauses to resolve deadlocks before they occur can come at a high price. With such clauses, if there is severe disagreement, there are various ways of seeking exit from the company or resolving the problem such as using drag along clauses. Given the genuine possibility of deadlock among shareholders and the existential threat this can pose to a company’s ongoing viability, shareholders should ensure the shareholders’ agreement contains robust and precise provisions on procedures designed to resolve these matters.
By Dominik Karkoszka Senior Associate, and Adam Czarnota, Associate, Kochanski & Partners