Managing Litigation Risk During the Business Lifecycle, Part 7: Deadlock, Dissolution and Business Break-ups

In the lifecycle of a closely held company—whether a limited liability company, a small corporation, or a joint-venture partnership—there are critical transitions that expose a business and its owners to considerable litigation risk. Among the most challenging are deadlocks among owners and the dissolution or break-up of the company. In this seventh installment of PilieroMazza’s blog series, “Managing Litigation Risk During the Business Lifecycle,” we discuss steps businesses should take now to avoid costly stakeholder deadlocks and explore how to manage associated litigation risks with detailed governance documents and proactive planning. Visit this link to access Parts 1-6 in this blog series.

What is Deadlock?

Deadlock occurs when the owners of a company are unable to agree on a critical business decision that prevents the company from carrying on its ordinary business. In a limited liability company or closely held corporation, the governing documents may include unanimous approval requirements or evenly divided voting rights that allow dissidents to prevent action and deadlock the business. When a deadlock continues, a company cannot move forward with key operations such as financing, acquisitions, or various governance matters.

In the absence of deadlock guidelines in a company’s governance documents, the primary remedy available is to seek redress through the judicial system, resulting in legal fees, potential reputational damage and further delay in the company’s ability to act.

Dissolution & Break-Ups

If deadlock persists, some owners may decide to exit, sell, or dissolve the company or seek judicial dissolution. Most state’s provide a statutory basis to petition a court for dissolution of the company when it is “not reasonably practicable” for the business to continue in accordance with its governing document. If the court grants dissolution, the company must wind up its affairs, which include settling outstanding debts, liquidating assets, distributing any remaining funds to owners, and filing a certificate of dissolution with the state. In addition to judicial dissolution, the court may order less drastic remedies to resolve the deadlock, like permitting certain owners to exit or sell their interests or appoint a custodian to temporarily manage the company’s operations.

These actions often trigger further disputes over valuation, governance rights, contract interpretation and exit mechanisms, all of which are costly to litigate. While this is a solution to the deadlock, it likely isn’t the most efficient.

Proactive Strategies to Mitigate Risks Associated with Deadlock and Dissolution

The best protection against deadlock disputes is proactive and detailed governance documents. Some of the key steps to reduce litigation risks related to deadlock and potential dissolution include:

1. Establish detailed decision-making provisions up front: Clearly define decision-making rights and voting thresholds.
2. Add clear tie-breaking provisions: Include a detailed deadlock resolution clause specifying mechanisms like forced buy-out terms or the appointment of a neutral advisor in the event of a dispute.
3. Include clear dispute resolution provisions: Provide pathways to resolution in the company’s governing documents such as mediation or arbitration that a member can seek prior to litigation.
4. Embed well-defined exit and valuation mechanisms: Include precise buy-sell provisions, triggers, and valuation methodologies to ensure a smooth transition if a stakeholder wishes to exit or if disputes necessitate separation.
5. Provide orderly winding-up or sale mechanics: Specify mechanisms for winding up the company to ensure certainty.
6. Ensure transparency: Keep track of the company’s financial and other key documents and allow members and shareholders regular access to the financials, board minutes, and decision-making procedures to help prevent claims of unfair treatment.

Conclusion

Member deadlock presents closely held companies with substantial challenges. By embedding clear governance provisions, deadlock resolution mechanisms, structured exit and buyout options, and alternative dispute resolution frameworks, businesses can reduce the risk of costly litigation and protect stakeholder value. Although deadlocks may not always be avoidable, proactive drafting not only provides guidance and protection for the company and its management but also supports the company’s long-term operational success.

For questions about member deadlock or strategies to reduce litigation risk, please contact  Todd Reinecker, Abby Baker,  Staci Alexander, Matt Healy, Kirby Rousseau, or another member of PilieroMazza’s Litigation & Dispute Resolution or Corporate & Organizational Governance practice groups.

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