October 2016

By Robert W. Nunn

Tug of WarThis article discusses ways to avoid or deal with deadlock in the planning and organizational stages of a business.

In his short children’s poem The Zax, Dr. Seuss writes of a North-Going Zax meeting head-to-head with a South-Going Zax on the prairie of Prax. Stubbornly, neither will step aside, so they stand toe-to-toe for years as a new highway is built around them. Dr. Seuss provides us with a wonderful example of deadlock and its consequences if left unresolved.

Deadlock is inaction caused by the opposition of persons or factions. It is a common and often serious problem for privately held businesses. It can arise in many business circumstances but occurs most frequently in businesses with two owners (or groups of owners) having equal ownership of the business. The 50/50 ownership that seemed so appropriate when the business started can become a quagmire of irresolvable conflict which can damage or even destroy a business. Family businesses are especially vulnerable to the risk of deadlock because family interests can overlap and conflict with business interests and provide more opportunities for serious disagreement.

Deadlock Avoidance

Obviously the best way to deal with deadlock is to avoid it altogether. Some deadlock avoidance techniques are structural or transactional, and others are based on management techniques and interpersonal relationship skills. Most can be used with others.

Good Communication. The ultimate deadlock avoidance mechanism is the establishment of effective communication and alignment among the owners, managers and directors. If these key stakeholders can set collective goals and communicate among themselves in meeting those goals, conflicts which might arise will be minor and resolvable. If the stakeholders cannot align on a common set of goals, deadlock is much more likely. Foremost, therefore, the owners should establish a mechanism for regular meetings, open communications, collective goal setting, and other systems to assure that all of the needs and desires of all stakeholders are adequately addressed. This calls for management skills rather than legal techniques.

Concentration of Voting Power. Concentration of voting power in the hands of one person or one faction can avoid deadlock. This assures that deadlock is avoided because a single party has the power to compel a result. This sounds harsh, and often is. Minority owners may frequently find that losing in a conflict situation is preferable to prolonged deadlock. If one of the Zax had been forced to step aside, the result would have been better for both, even the one forced to yield.

Concentration of voting power does not necessarily mean transfer of ownership interests. Voting power can be concentrated through voting trusts, voting agreements, use of nonvoting interests to separate equity ownership from voting control, class voting, other bylaw or operating agreement provisions.

Uneven Number of Managers. Boards of directors are frequently structured with an uneven number to avoid deadlock. Establishing a board of three, five, or seven can go a long way to avoiding deadlock.

Independent Board. Another deadlock avoiding provision is to simply cede management to a group of outsiders. This approach has many concerns, including compensation, devising mechanisms to assure competence and diligence, and assuring that the goals of the owners are adequately addressed. Outside managers would presumably be selected because of expertise in the industry.

MAD. An extreme approach to deadlock avoidance is to build mechanisms that assure a bad result for everyone and, therefore, encourage avoiding deadlock. For much of the Cold War, the United States and the Soviet Union avoided nuclear war through Mutually Assured Destruction (“MAD”). Similar (non-nuclear) MAD provisions can be built into the structural documents of a business entity. In the event of prolonged deadlock, either party can compel that the business be liquidated. This doomsday approach is extreme but can still be preferable to prolonged deadlock.

Deadlock Resolution

If deadlock is not avoided, several mechanisms exist to resolve the deadlock once it arises. These mechanisms aren’t necessarily fair, but instead are based on the concept that deadlock is the worst outcome, and any resolution is preferable to deadlock. That might not always be true.

Negotiation/Mediation. The most obvious is negotiation among the parties. This is closely related to the communication function intended to avoid deadlock. If emotions are already running high, negotiation compelled by the operating agreement may help assure it occurs.

A variation on the negotiation concept is a facilitated mediation. A mediator can frequently bring parties together to a mutually acceptable resolution if the parties may not communicate among themselves to agree. A potential problem with mediation is agreeing on the mediator, but that is easier than negotiating a resolution of the deadlock itself. Skilled mediators can guide the parties to an agreement in a large percentage of cases.

Tie-Breaker/Contingent Director. A common technique for breaking deadlocks is to designate a trusted third party to decide if a deadlock arises. The tie-breaker is usually identified in advance, but this approach risks the tie-breaker is unavailable (death, disability, or otherwise) when the deadlock arises. Finding an individual trusted by all parties to be both impartial and skillful is challenging. Sometimes an expert in the field is designated to resolve the impasse.

The tie-breaker is not a member of the board and is involved for a single decision. A contingent director or manager becomes a full-fledged member of the board, with all the related powers and duties, if a deadlock occurs. The result is similar in the short term, but can be dramatically different in the long term.

One of the greatest difficulties with the tie-breaker or contingent director or manager approach is that the tie-breaker/contingent director, even though an expert in the subject or industry at hand, may not be adequately familiar with personal goals of all stakeholders. You might find yourself with a resolution that is textbook perfect, but inappropriate for the personal circumstances of the individuals.

Arbitration. Closely related to the concept of a tie-breaker is an arbitrator. An arbitrator acts much like a private judge, hearing the assertions of each party in an informal hearing and then making a determination binding upon the parties. Like a tie-breaker or contingent director/manager, the decision is turned over to a third party. A significant difference is that an arbitrator is a third party rent-a-judge who will make a determination based upon only the facts presented and has no further involvement with the company or fiduciary obligation to the company or its owners.

Chance. Deadlock can be resolved by chance, such as the flip of a coin or drawing lots. Allowing important business decisions to be made by chance seems cavalier, but can still be preferable to prolonged deadlock. Both Zax would have been better off had their impasse been settled with a flip of a coin.

One cut, the other choose. One way to divide a cookie between two children is to allow one to cut the cookie into two pieces and allow the other to choose which piece to take. The technique has application beyond baked goods. Some (but not all) businesses can be split up into two pieces. With the one cut, the other choose approach, one of the owners decides how the business is to be divided and the other decides which portion to keep. This technique won’t work well if the business is not capable of being divided.

Solomon’s Choice. A common deadlock resolution provision goes by several colorful names, including Solomon’s Choice, Texas Shoot Out, Shotgun, and Push-Pull. It works best with two 50% owners of relatively equal financial capacity and liquidity.

Under a Solomon’s Choice provision, Owner A offers to sell A’s stock to Owner B and, offers to purchase Owner B’s stock at the same price and on the same terms. Unless B accepts the offer and buys the stock of A, B must sell B’s ownership interest to A.

A Solomon’s Choice provision can protect the entity from the effects of an impasse between two owners. However, because the provision forces an owner to either buy-out the other owner or to relinquish his/her interest in the entity, its effect can be harsh and is often unacceptable to the parties. It is inappropriate when one owner has sufficient wealth and liquidity to purchase the other owner’s stock, but the other does not have sufficient financial means to exercise the option to purchase. This tactical advantage of liquidity may be reduced by including terms. The agreement could provide for a payout at a low interest rate over a long period, which would dilute the negotiating power of the wealthier owner.

Solomon’s Choice can also be fashioned to work with over two owners, but is more complex and less satisfactory in those circumstances.

Put Option. If one or more owners has an option to compel the purchase of their ownership interest, it will inspire a cooperative attitude of the other owners. This provision need not be mutual. The owner with a minority interest might may compel purchase of his/her ownership interest at appraised value. The put option functions as an “or else” if the minority interest is not kept happy.

Except for effective communication, none avoidance or deadlock resolution provisions are perfect, but each offers hope of avoiding the damage that can result from a standoff. With foresight and planning, your business can avoid the fate of the Zax.