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Shareholder deadlocks: Promoting resolution through unanimous shareholders’ agreements

Charlie Kim and Matthew McGuigan
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This story was originally published by Law360™ Canada, (www.law360.ca) a division of LexisNexis Canada.

By Charlie Kim, Matthew McGuigan and Sébastien Tuli


Disagreements between business partners in owner-managed corporations are inevitable. While these disagreements are often resolved at the business level, there are times when owner-managers cannot reach a consensus and are deadlocked on any given decision. For this reason, unanimous shareholder agreements (USAs) often provide for dispute resolution mechanisms. These mechanisms can resolve deadlocks in one of two ways: (i) by promoting resolution and maintaining a continuous relationship between the business partners; or (ii) by providing an exit mechanism and ending the relationship between the business partners.


This article highlights common dispute resolution mechanisms that are often incorporated into USAs.

Casting votes
If a corporation is managed by an even number of directors, then there is the potential that decisions of the corporation will be deadlocked. If frequent, such deadlocks can paralyze the corporation.

A casting vote is an additional vote awarded to one of the directors in the event of a deadlock. The casting vote is sometimes awarded to the owner-manager who is the founder, holds a majority of the shares or is involved in the day-to-day management of the corporation. However, depending on the number of directors, a casting vote can ultimately give decision-making authority to the director with the casting vote. While this may be appropriate in certain circumstances, it may nevertheless deter collegiality and diversity of opinions in the decision-making process.

Independent directors
Owner-managers have a specialized expertise in the product or service that the corporation offers,but do not always carry business management expertise. To prevent deadlocks with respect to business decisions, USAs can provide for the appointment of an independent director with extensive business management experience.

The inclusion of an independent director will: (i) prevent deadlocks by changing the composition of the board to an odd number of directors; and (ii) ensure that decisions are made impartially with a view to the best interest of the corporation. The USA should, however, set out a clear process for selecting the independent director to prevent disputes between the owner-managers that could a risein the selection process.

Arbitration
Arbitration is a common type of provision included within USAs to resolve deadlocks. Binding arbitration can help limit the adverse effects of disputes as it allows for a final resolution by an independent decision-maker. All shareholders in the dispute are bound by the decision, resolving any deadlock that has occurred. Additionally, binding arbitration provisions serve as a contractual agreement to not pursue disputes in court, which can be a costly endeavour and are resolved in the public eye. Contrarily, binding arbitration tends to be more efficient and private.

Despite the benefits of arbitration provisions, some business decisions are not arbitrable. In most business situations, there is no right or wrong answer, and business experts can have differing opinions on what is best for the corporation, as there are many stakeholders to consider. As such,while arbitration provisions can be effective in determining legal and contractual interpretation disputes, they are not necessarily appropriate for business decisions with multiple plausible solutions and paths forward.

Sealed bids and shotgun provisions
Certain deadlocks may be so severe or arise so frequently that it is not in the best interest of the owner-managers or the corporation for the parties to continue in business together. In these situations, the owner-managers may determine that it is best to part ways.

A sealed bid is a type of buyout provision that can be used when deadlocks arise. This dispute resolution mechanism requires each shareholder to submit a sealed bid to purchase the other shareholders’ shares. These bids are submitted to an independent third party. Based on criteria that are established in the USA, the independent third party makes a determination as to which sealed bid is the winning bid, requiring the shareholder who submitted the winning bid to buy out the other shareholder(s).

Similarly, a shotgun provision is another type of buyout provision. “Shotguns” are triggered when one shareholder offers to buy out the shares of the other shareholder at a specified price per share. The responding shareholder then has the option to either sell their shares to the offerer, or to buy the shares of the offerer at the same price per share.

Sealed bids and shotguns provide several advantages. First, they provide a mechanism whereby the owner-managers may part ways without winding up the corporation. Second, these mechanisms encourage cooperation among the owner-managers, given the extreme nature of cutting ties. However, there are instances where sealed bids or shotgun provisions may not be appropriate. For example, if financial disparity exists between the owner-managers, sealed bids and shotguns can be weaponized by the owner-manager with greater financial strength. In this instance, this owner-manager can use the threat of a sealed bid or shotgun to bully the others into succumbing to their position.

Winding up
Finally, the most severe deadlock provision is one that results in the winding up of the corporation. This type of mechanism can be triggered in the most extreme scenarios where the owner-managers are deadlocked with no possibility of reconciliation. A winding-up provision not only serves as a mechanism through which the parties may part ways — it really marks the end of the business.

In instances of financial disparity, owner-managers with less financial strength may prefer the inclusion of a winding-up provision, as they can alleviate the risks noted with sealed bids and shotguns. However, the inclusion of a winding-up provision poses the risk that any owner-manager may trigger the provision at any time. Business owners enter into business with the intention of operating the corporation long-term, through the good times and the bad. Therefore, the constant risk that the winding-up provision will be triggered upon any disagreement may spook potential business partners from entering into business together.
 

Drawing on over 15 years in business law in Ontario, Charlie Kim is a Partner in the Business & Transactions Group at Robins Appleby LLP. He counsels private equity firms, business owners, and lenders, and is active in the Korean Canadian Lawyers Association. He has authored legal articles on shareholder rights and corporate governance.

Matthew McGuigan is an Associate in the Business & Transactions Group at Robins Appleby LLP, where he practices as an Ontario lawyer. He advises on mergers and acquisitions, financing, and shareholder arrangements in Canadian and cross-border contexts. With a dual JD/HBA from Western and Ivey, Matthew applies a strong business lens to legal solutions and contributes to industry publications.

At Robins Appleby, we have been providing legal advice for over 70 years to entrepreneurs, businesses, financial institutions, and foreign companies operating in Canada. Located in Toronto's financial district, our firm is trusted by clients to help solve critical, time-sensitive issues. We offer a wide range of legal services including business and transactions, affordable and social housing, litigation and dispute resolution, commercial real estate development, tax law, employment law, and estate planning.

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