The Massachusetts Supreme Judicial Court recently issued a decision in Koshy v. Sachdev that serves as a reminder to all Massachusetts business owners that dispute resolution provisions are a crucial part of any successful business plan that can prevent years upon years of costly litigation.
The facts involved are familiar to any business attorney: two friends start a business together and split everything 50/50, the business is successful for a number of years, over time small disagreements lead to growing mistrust, mistrust leads to bigger disagreements, those disagreements paralyze the business, and eventually a lawsuit is filed.
Here, after more than a decade of running a successful business together, the two shareholders began to have disagreements over the timing of payments to an affiliate. Soon, the shareholders could no longer agree on distributions, tying up more $1.4 million in retained earnings. Eventually, day to day operations suffered, culminating in the dramatic hiring, firing, and re-hiring of a sales representative by the now openly-combative business partners. Finally, after unsuccessful buy-out negotiations, things had become so acrimonious and intractable that one of the shareholders filed a lawsuit asking the court to dissolve the otherwise-successful business and split up the assets. That lawsuit, filed in 2012, went to trial in 2013 and then waited nearly two years for a ruling, which came in 2015. Now, after more than five years of litigation, no doubt hundreds of thousands of dollars in attorneys’ fees, and nearly a decade after the start of the dispute, the SJC has sent the case back to the trial court for more proceedings, and the two shareholders are still in business together.
From a legal perspective, the court’s ruling is the first to interpret the deadlock provisions of the Massachusetts Business Corporation Act (G.L. c. 156D, § 14.30 (2)(i)), and it set forth four non-exclusive factors that courts should consider when determining whether a deadlock exists between directors. Those factors include:
- Whether irreconcilable differences between the directors of a corporation have resulted in “corporate paralysis,” where “corporate paralysis,” means a stalemate between the directors concerning one of the primary functions of management.
- The size of the corporation at issue, with deadlock more likely to occur in a small or closely held corporation, particularly one where ownership is divided on an even basis between two shareholder-directors.
- Whether there is any indication that a party has manufactured a dispute in order to engineer a deadlock.
- The degree and extent of distrust and antipathy between the directors, with mutual antipathy transforming what may begin as a run of the mill disagreement into irreconcilable conflict and stalemate where hostility precludes compromise.
From a practical perspective, the ruling’s primary importance is to highlight how expensive it can be to neglect dispute resolution provisions in agreements between founders, particularly where ownership and control is split 50/50. It’s often difficult for founders at the start of their new venture to imagine a dispute scenario, but this decision throws into sharp relief that these scenarios can and do happen, and how a lack of planning can lead to breakdowns in relationships, years of fighting, and a mountain of costs, both through fees paid to attorneys’ and through simple waste and lost productivity when the business inevitably suffers.
The takeaway then, is that whether in a shareholder agreement or operating agreement, it’s crucial to the health of the business and the founders’ investment to have a provision that provides a binding resolution to a dispute in accordance with predetermined rules. These provisions can take many forms, including binding arbitration, a forced buy-out at a pre-determined price, or a buy-sell provision that provides a mechanism for the parties to set the price, but they should, at a minimum, take effect when a deadlock is encountered. It is also important that these provisions be reviewed as the company grows to make sure that the prescribed outcomes continue to match up with the founders’ expectations.