Should Shareholders Agreements deal with the potential for deadlock?

Should Shareholders Agreements deal with the potential for deadlock?

The potential for a shareholder deadlock is the inevitable consequence of how shareholdings and shareholders agreements are commonly structured – deadlocks do not happen by accident. The question is how (if at all) the agreement should cater for the possibility of a deadlock and a process for shareholder deadlock resolution.

A number of alternative solutions have emerged as common ways to deal with this situation. Which one of these might work for your business and company will depend on several factors, including the nature of the business, the identity and number of shareholders and their relative shareholdings.

What is a shareholder deadlock?

A shareholder deadlock is essentially a failure by shareholders to approve a proposed course of action by the company which, under the agreement between them or the company’s articles of association, requires their joint approval.

The deadlock could arise in a number of different ways, including:

● reserved matter deadlock: the shareholders failing to approve a matter which, under the shareholders agreement or articles of association, requires their consent as a reserved matter

● shareholder deadlock: the shareholders failing to pass a resolution which, under the Companies Act 2006 or the articles of association, requires shareholder approval

● board deadlock: the directors failing to pass a board resolution for a matter which requires board approval

A company with two shareholders, each of whom holds 50% of the issued shares, is particularly susceptible to a deadlock arising.

So also is a company with two or more minority shareholders but where the shareholders agreement or articles of association contains mechanisms which create the potential for a deadlock. These might be:

● reserved matters requiring the approval of minority shareholders or a defined minimum percentage of all shareholders

● equal representation and/or voting rights at board level

● requirement for specified directors or shareholders to vote in favour and form part of a majority for a board or shareholder resolution to be validly passed

● requirement for specified directors or shareholders to be present for a board or shareholder meeting to be quorate

How should the shareholders agreement deal with the potential for deadlock?

Shareholder deadlock definition

The first stage is to define what constitutes a deadlock. This could be defined as:

● the failure to approve any matter which requires joint approval, whether as a reserved matter or a board or shareholder resolution

● the failure to approve just reserved matters or specified reserved matters

The agreement may also contain:

● a process for matters to be tabled at more than one meeting

● a minimum period to have passed before a deadlock will be treated as having arisen.

Consider also including an undertaking that no shareholder will act to create an artificial deadlock, though this could give rise to a potential dispute in the future as to whether a deadlock has arisen.

Alternative shareholder deadlock mechanisms

We have summarised some of the more common deadlock resolution mechanisms and the pros and cons of each one.

“Gin and Tonic clause”

If the shareholders are companies in a joint venture company, one method of potentially resolving a deadlock is to include a gin and tonic deadlock clause. This provides for the matter to be elevated for discussion between the parties’ CEOs or other nominated senior management positions (over a “gin and tonic”). The rationale for this is that the CEOs will not be involved in the detail and implementation of the joint venture company’s operations and may be able to take a more detached view of the situation. Also, the personnel from each side who are engaged in the joint venture company’s business will not want matters to be unnecessarily escalated to their bosses so will do what they can to avoid this happening.

The downsides of this type of clause are:

● before the deadlock has arisen, it is possible (or even likely) that the CEOs have already been involved in the thinking and decision-making process

● any resolution requires the agreement of the CEOs in any event

● it only works for corporate shareholders or businesses with several layers of management. If one of the CEOs is already personally involved in the joint venture (for example, as one of the nominated directors) then a gin and tonic clause probably achieves nothing

Reference to third party expert determination

One possible solution which is often raised is for the deadlock matter to be referred to an independent third party for expert determination, with the shareholders then being bound by the expert’s decision.

Whilst this is artificially attractive, it is not often used in practice as a methodology for resolving shareholder deadlock situations.

Reasons for this include:

● the matter in dispute is often not something to which is suitable for expert determination or to which there is only correct answer

● what type of expert should be used – a lawyer, an accountant, a corporate finance adviser?

● parties will not want to be bound by an expert’s determination of what may be simply a commercial decision or choice

● this does not prevent future deadlocks from arising or bring an end to the shareholding relationship

Sale of one shareholder’s shares

If the deadlock cannot be resolved, it is often preferable for one shareholder to be bought out by the other shareholder. This will bring an end to their commercial relationship and reflect that it has broken down.

The key issues are however:

– which shareholder should be buyer and which should be seller

– what should the price be

A number of ways of determining these issues have been developed. The adopted mechanism will depend on factors including whether the company has equal shareholders or majority and minority shareholders.

Majority and minority shareholders

If the company has a majority and one or more minority shareholders, the majority shareholder may always require that it is the buyer of shares and not the seller. The ways to achieve this include:

Majority shareholder call option

The majority shareholder has a call option to purchase the minority shareholder’s shares at fair value or by reference to a pre-determined formula.

Minority shareholder put option

The minority shareholder has a put option to require the majority shareholder to purchase the minority shareholder’s shares at fair value or by reference to a pre-determined formula.

The downsides of these mechanisms are the potential for one shareholder to manipulate the situation by creating a deadlock to acquire or sell shares. The then fair value may also not be a true reflection of the long term value of the company and the shares being sold.

Equal shareholders

If the company has equal shareholders, the sale processes include:

“Russian roulette clause”

One shareholder (A) triggers the process by stating a price at which it is willing to sell its 50% shareholding to shareholder B. B must then either choose to purchase A’s shares at that price or to sell B’s shares to A at the same price.

The jeopardy which is hinted at by the title “Russian roulette” is that shareholder A does not know whether it will be the seller or buyer of shares. However, this is designed to ensure that A nominates a fair price as this could be the price at which either A’s shares are sold or A is required to purchase B’s shares.

“Texas shootout clause” or “Shotgun clause”

This is an exotic way of describing a more straightforward process in reality – each party submits a sealed bid for the other party’s shares and, whichever bid is higher, is the purchaser of the other’s shares at the bid price.

The downsides of both processes include:

● it requires one shareholder to purchase and fund the purchase of the other’s shares

● the perception that a financially stronger shareholder will be able to use the clause to its advantage (perhaps by nominating a low price, knowing that the financially weaker shareholder will not be able to match it)

● it does not take into account services or assets which one shareholder provides to the business and these no longer being available to the company

Sale of the entire company

One way of avoiding one shareholder from taking advantage of its comparatively strong financial position when compared to other shareholders is to include a process for the entire company to be put up for sale and sold to a third party. The shareholders are bound to accept the highest offer received.

To avoid one shareholder frustrating the sale exercise, often the process involves the appointment at the outset of a corporate finance or other adviser to market the company for sale and find buyers.

The downsides of this approach are:

● the potential for one shareholder to frustrate the process, notwithstanding the legal wording of the agreement

● the sale of the company potentially at a time when it has not yet realised its full value or when market conditions are poor for a sale

Liquidation

As a “nuclear” option, one alternative is for an unresolved deadlock to result in the compulsory liquidation of the company, resulting in the end of the company’s operations and potential loss of investment by the shareholders. The rationale for including this as the ultimate deadlock-breaking mechanism is that the shareholders will act in their commercial interests to avoid this occurring, so will be encouraged to find their own solution rather than allowing the company to be wound up.

No mechanism

Often, having considered the alternatives, parties may decide that they do not like any of the potential alternative deadlock breaking mechanisms and would prefer not to deal with potential deadlock in their agreements.

The thinking behind this is that none of the alternative solutions are perfect, it is impossible to predict what might cause a deadlock and you do not know what the market conditions or specific circumstances of each shareholder may be at the time in the future when a deadlock has arisen. Having no mechanism to resolve the deadlock will incentivise the shareholders to come up with their own resolution at the time to avoid loss of value and investment.

The disadvantage of this conclusion is that there is no way of resolving a future deadlock. This increases the possibility of a deadlock remaining unresolved and could potentially increase the likelihood that litigation is the only route for a resolution to the dispute. Unfair prejudice proceedings under the Companies Act 2006 are exceedingly damaging to the business and relations between shareholders, as well as being very expensive in legal fees.

Paper Rock shareholders agreement templates

Our selection of template shareholders agreements contain a number of different mechanisms for resolving deadlocks. 

Each template is written in plain English and is accompanied by clear explanatory guidance on the document and its use.  For more details, visit Shareholders Agreements.

PaperRock offers affordable, legal document templates, written by experienced and expert lawyers, trusted by businesses across the UK and elsewhere. No hidden charges or trial sign-ups to complete your document. Subscribe or buy, the choice is yours.

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