Deadlock Provisions in Shareholder Agreements – Avoiding Stalemate

A deadlock occurs when the shareholders of a company are unable to agree on a decision and neither side has a majority vote.

While not uncommon, deadlocks arising between shareholders can be time consuming, costly and cripple the operations of a business particularly when they relate to a critical business decision.

This highlights the importance of including deadlock resolution provisions in Shareholder Agreements which contain a mechanism for resolving a deadlock (which would otherwise lead to stalemate in the company’s operations and overall decision making).

Understanding Deadlock Provisions

A deadlock provision is designed to address situations where shareholders are unable to reach the required majority (i.e. 51% or more on one side). Its purpose is to alleviate circumstances where the company would otherwise be crippled by indecision in relation to a critical item of business as a consequence of the indecision.

Ordinarily, the first step of a deadlock provision will provide for an escalation of the issue. For example, if the required agreement is unable to be reached at two (2) separate meetings of the shareholders, the shareholders will have 48 hours to reach agreement. If the required agreement is still unable to be reached, the deadlock mechanism will be enlivened.

The deadlock mechanism will apply automatically where a deadlock occurs (i.e. a majority either for or against a resolution cannot be achieved, the deadlock provision will be enlivened).

Common Deadlock Mechanisms

The following options can be considered by shareholders to include as deadlock resolution mechanisms in their shareholders agreement:

1. Russian Roulette clause

This mechanism allows either shareholder to offer their shares for sale to another by issuing a formal notice. The recipient must then choose either to purchase the shares at the stated price or sell their own shares at the same price to the offering party. For example, Shareholder A issues a notice to sell their shares for $100, Shareholder B receives the notice. Shareholder B has the choice to either purchase Shareholder A’s shares for $100, or sell their shares to Shareholder A for $100. This clause is most appropriate when shareholders are in comparable financial positions, as it can otherwise be used to unfairly force out a less financially resourced party.

2. Texas Shoot-out clause

The Texas Shoot-out clause is similar to the Russian Roulette provision where the shareholders submit a sealed bid to buy out the other shareholder/s. Once all bids have been made, they are revealed together. Whoever is the highest bidder will be obligated to buy out the other shares at the bid price. This clause should only be used when shareholders are of similar financial capacity to ensure that there is no financial imbalance that in turn forces a shareholder out.

3. Chairperson Casting Vote

A chairperson deadlock clause appoints one shareholder (usually the chairperson for shareholder meetings) to hold a casting vote on the decision in the event of a deadlock. The casting vote will ultimately decide whether the resolution is passed or rejected. This provision is usually suitable when there are three or more shareholders.

4. Put option clause

This clause grants a shareholder the right to require another shareholder to purchase their shares at a predetermined price or market value.

5. Call option clause

In contrast to the put option, the call option allows a shareholder to compel another to sell their shares at a predetermined price or market value.

6. Arbitration clause

An arbitration deadlock clause requires a formal process where an independent third-party expert in the field is appointed as an arbitrator to resolve a dispute. The arbitrator will make a binding, legally enforceable decision on the dispute. The provision should include how the cost of the arbitrator will be shared. In most cases it is shared equally between the shareholders.

7. Mediation clause

A mediation clause is similar to the arbitration clause where an independent third party (not necessarily an expert) will help resolve the dispute. The mediator will do this by conducting a meeting with the shareholders and facilitate the discussions between the group with the hope that a mutually acceptable solution will be reached between the shareholders. Unlike an arbitrator the mediator is not able to impose a solution or make a decision on the shareholders behalf.  The provision should include how the cost of the mediator will be shared. In most cases it is shared equally between the shareholders.

8. Liquidation clause

The Liquidation clause is to be used as a last resort where it forces the company into liquidation when other attempts to resolve the deadlock have been unsuccessful. The cost of the liquidation is to be shared equally between the shareholders.

When entering into a new shareholders agreement or considering whether an existing shareholders agreement needs to be updated, shareholders should give consideration to whether a formal deadlock resolution mechanism should be included to avoid the company and any associated business becoming crippled by indecision.

If you are considering implementing a deadlock resolution mechanism into your shareholders agreement or require advice on the most appropriate mechanism for your business, the Corporate & Commercial Team at Coulter Legal can assist you.