CLIENT ALERT – New Massachusetts Case Law on Private Company Deadlock

CLIENT ALERT


The Supreme Judicial Court of Massachusetts issued a precedent-setting decision (Koshy v. Sachdev, SJC-12222 (September 14, 2017)) in favor of Sheehan Phinney’s client, an equal owner and director of a Massachusetts software company. The decision made new law in the area of private company shareholder disputes. The SJC interpreted for the first time the Massachusetts Corporate Dissolution Statute (a/k/a the “Deadlock Statute”), and found that a “true deadlock” existed in the company’s operation and management that required court intervention. It then ruled that “dissolution” is not the only remedy available, and decided that “lesser remedies” are implied by the statute, such as a court-ordered sale of the company to one of the owners or a third party.

The Court established a four-factor test for determining whether a deadlock exists (as required by the first prong of the statutory criteria for a “true deadlock”).

  1. Have irreconcilable differences between directors resulted in corporate paralysis – that is, a stalemate in a primary management function of the business?
  2. Is this a privately-owned business with evenly-divided ownership and without a ready market for ownership interests – thus, susceptible to deadlock and oppressive tactics associated with deadlock?
  3. Is there evidence that one party has manufactured a dispute in order to engineer a deadlock and, thus, force dissolution or ownership change?
  4. What is the degree and extent of antipathy and distrust between the deadlocked parties – do they preclude compromise to break the deadlock?

In Koshy, it was clear that a deadlock existed in the corporation – owned in equal percentages by its two founders. They were unable to agree on any major decision, from strategy to hiring, exhibited intense mutual antipathy and distrust over a period of years, and had a history of accusatory lawsuits against each other.

To determine whether the deadlock was irreconcilable, as required by the second prong of the statutory criteria for a “true deadlock,” the Court looked for the existence of a mechanism for breaking the deadlock, such as a Shareholder Agreement or Operating Agreement with a buy-sell or other dispute resolution provision. The Court determined there was none, and that the valuation provision contained in the company’s Articles of Incorporation was not applicable for resolving deadlocks.

The Court then considered whether the irreconcilable deadlock caused or threatened irreparable harm to the corporation (the third and final statutory criteria). In doing so, the SJC ruled that “irreparable harm” is not limited to financial harm, and that a deadlock can present a threat of irreparable harm to a company that is presently profitable and performing well. It found that the inability to manage the corporation effectively (and resort by the shareholders/directors to “management by litigation”) demonstrated a clear threat of irreparable harm to the corporation in the long term, and the existence of a “true deadlock.”

Having found the existence of a “true deadlock” as a matter of law, the Court considered the remedy. It reviewed the statutory remedy contained in G.L. c. 156D § 14.30, which provides that if a court finds the existence of a true deadlock it may dissolve the corporation. Here, faced with a profitable business, the lower court had found this remedy “draconian” and was expressly loathe to apply such a remedy to an ongoing concern. Again establishing new law, the SJC held that the statutory remedy of involuntary dissolution necessarily includes “lesser remedies” that permit the continuation of an ongoing concern, such as sale to a third party or buy-out of one party’s interests. Therefore, it remanded the case to the lower court to consider the appropriate remedy.

This case is important to both corporate and litigation attorneys. It underlines the need for shareholder agreements or operating agreements in the early stages of corporate existence that include thoughtful dispute resolution provisions. It also identifies the potential problems with evenly-divided company ownership, a common feature in family-owned businesses and other private companies. Finally, it provides new and expanded guidance on the interpretation of G.L. c. 156D § 14.30, and litigation analysis when disputes arise.

* * *

Charles A. Waters was the lead attorney for the plaintiff in Koshy. He is a Shareholder at Sheehan Phinney Bass & Green where he Co-Chairs the firm’s Litigation Group. Charles can be reached at cwaters@sheehan.com or 617.897.5644.

This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice.