Deadlock Among Partners Can Be Used As Swords by Dissenters in State Court Lawsuits
Here’s a problem that cost the principals of a business entity—that was involved in trading equities using a Quant algorithm— plenty of money, but could have been avoided if the underlying contract was drafted to provide for a way out in the case of hopeless business deadlock. This problem arose principally due to the fact that when a 3 member firm added a fourth member, there was no review of the LLC Operating Agreement. So what happened here could happen in the context of a joint venture partnership between two entities, or it could happen in the context of four owner/operators of a business entity. The agreements might provide for dispute resolution techniques, but the big elephant in the room, which no one thinks about, is that despite all the underlying issues, there are State statutes pursuant to which there can be court-ordered dissolution of the business.
If you’re the general counsel of a company involved in a strategic partnership, take note. But I will describe the problem in the context of four owners of what was essentially a joint venture limited liability company. After a few years, there were some disagreements, and the 4 owner/managers found themselves divided into two factions, one faction wanted to dissolve the business (the “Dissolvers“), the other faction wanted to continue the business (the “Continuers“). There was no non-compete agreement governing the parties to the business, which was a trading firm. The underlying Agreement provided that all decisions were to be made unanimously.
In some cases, Dissolvers of an entity will be using “deadlock” as a ploy to dissolve so that they can continue the business under a new name, and get a business divorce from the others. In many cases, there is a non-competition clause contained in the original agreement, but sometimes that clause is not artfully drafted; it may provide that the parties may not compete with the entity after they leave the entity, but what about competing against each other?
So, despite issues such as breach of contract, breach of fiduciary duty, lack of good faith that encompassed the underlying dispute, one factor remained: there was a deadlock, and the Dissolvers made it known that under the terms of the State statute, the entity could be dissolved, without a hearing regarding the underlying issues regarding what prompted the deadlock. The other issues can be litigated in a separate action. In this instance, The Dissolvers filed a lawsuit in State court, asking the Court to dissolve the company due to deadlock.
Although the underlying issues could be litigated in a separate civil action, that was no balm for the Continuers. Civil litigation is expensive and time-consuming, and the Continuers wanted the Court to hear their arguments in the context of the dissolution lawsuit, and hoped that the Court would in this instance make a ruling not to dissolve the entity until it heard the claims made by the Continuers.
Unfortunately for the Continuers, there was no leeway for them to bootstrap their arguments into a lawsuit brought to dissolve the company pursuant to the deadlock statute. The Court had read all the submissions, and applying the letter of the law, that the company was not able to pursue its business due to the dispute among the four owner/operators, it dissolved the company and ordered the distribution of its assets in accordance with liquidation procedures.
Now, what could have been done to remedy the situation? Certainly, anytime there is an even number of parties, and equal voting power, a stalemate or deadlock can occur, especially in instances in which unanimous vote is required for company action. In many cases, the deadlock won’t affect the operation of the business, and can be worked out among the parties. However, in instances in which one set of parties is most interested in terminating the relationship, the provision calling for unanimous vote as a predicate to corporate action can be used as a sword, rather than a shield; that’s the situation described in this article. Also, if a non-compete clause doesn’t provide that the departing partner/employee cannot compete against the other partners/employer, as well as the entity, then the deadlock provision becomes attractive as a sword.
This is why it’s essential that voting agreements within these entities must be reviewed and drafted in a way to avoid deadlock. There can be clauses calling for majority of votes for certain issues, or super majority votes for other issues, and in some instances, such as dissolution of the company, or admission of another partner, the usual course is for unanimous vote. However, if there has to be a unanimous consent voting provision, the language of the Agreement can be tailored to review the provisions of the relevant State statute regarding deadlock, and language can be inserted into the Agreement so that if unanimous action is needed, there will be provisions which remove the dispute from the situations described in the relevant State deadlock statute. In the instance described herein, the Dissolvers were then able to start a new competing business, since their non-compete clause prohibited them from competing against the now-dissolved limited liability company. Even numbers of partners can bring uneven results.
