By: Chas Waters
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.
Founders, family members, and other owners of private companies often think that equal ownership of their company is the fairest way to allocate shares. No owner wants to cede control to another shareholder, leaving themselves in a weakened position. Owners are focused on making their company successful and reluctant to divert time and energy to potentially divisive discussions typically handled in shareholder agreements (for corporations) or operating agreements (for limited liability corporations). Why discuss owner death or disability, buy/sell agreements, methods of dispute resolution or share pricing between owners, when the owners are nowhere near contemplating such matters? This case graphically lays out the reasons for discussing and reaching agreement on these subjects early in co-ownership relationships, and the potential consequences for failing to do so. The decision provides guidance for companies in Massachusetts whose owners fail to heed this advice and helps manage the consequences.
In Koshy, for twenty years two close friends (plaintiff and defendant) built and operated the company they founded and owned together. Over time, fundamental differences arose between them relating to the future direction of their company, and whether to distribute or invest the company’s substantial retained earnings. The relationship deteriorated with actions such as unilateral check-writing, personnel hiring/firing, and mutually unacceptable buyout offers. In 2012, the plaintiff filed the lawsuit claiming irreconcilable deadlock in the operations and management of the company under the Dissolution Statute. Despite the overwhelming evidence of deadlock, the trial court judge placed too much significance on the company’s profitability, and failed to find either a deadlock or irreparable harm. Moreover, the trial court ruled that dissolution under the statute was a “draconian” remedy.
The Massachusetts Supreme Judicial Court, which has the ultimate power to make decisions of law in Massachusetts, disagreed. It found that:
- Irreconcilable differences between directors had resulted in corporate paralysis – that is, a stalemate in a primary management function of the business.
- This was a privately-owned business with evenly divided ownership, and without a ready market for ownership interests.
- There was no evidence that one party manufactured a dispute in order to engineer a deadlock and, thus, force dissolution or ownership change.
- The degree of antipathy and distrust between the deadlocked parties precluded compromise to break the deadlock, and there was no agreed-upon mechanism for breaking the deadlock.
The Court then considered whether the irreconcilable deadlock caused or threatened irreparable harm to the corporation. The SJC made clear that “irreparable harm” is not limited to financial harm, and that a deadlock can present a threat of irreparable harm to a company which is presently profitable and performing well. It found that the inability to effectively manage the corporation (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. Again establishing new law, the SJC held that the statutory remedy of involuntary dissolution 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. As a result, it sent the case back to the lower court to consider the appropriate remedy.
This case represents a cautionary tale for all owners and directors of private businesses. It is critical to develop and craft solutions for disputes, should they arise, that are timely and fundamentally fair for all sides. After a deadlock occurs, dispute resolution is exponentially more difficult. However, as a result of Koshy, guidelines now exist for those Massachusetts businesses who have not implemented dispute resolution provisions, and that can break a deadlock without destroying the business.
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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 email@example.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.