Corporate Deadlock – When Shareholders Seek the Courts’ Assistance in Forcing Buy-outs

Corporate deadlock is often cited as a reason why the court should invoke its powers and order the sale of one shareholder’s stock in minority shareholder litigation. While deadlock is a legitimate reason to bring a lawsuit seeking the court’s intervention, it is not a magic bullet that will automatically lead to the court ordering a buyout of one or more shareholders.

Deadlock is defined under the New Jersey Business Corporations Act and can be found under one of two circumstances. Deadlock can be found to exist when “the shareholders are so divided that they have not been able, for two consecutive meetings, to elect successors to directors whose terms have expired or would have expired if successors had been elected and qualified.” N.J.S.A. 14(a):12-7(1). The second manner in which deadlock may exist is if “the directors or other persons having management authority are unable to effect action on one or more substantial matters respecting the management of the company’s business.” N.J.S.A. 14(A):12-7(1).

The first deadlock provision may seem like an easy one to satisfy in closely held companies since many small companies do not hold formal shareholder meetings as required under the statute. The owners of small closely held companies are so focused on running the business that they forget about the formal requirements. Instead, since the shareholders in such companies generally work together closely and see each other practically every day, they make management decisions informally as necessary to operate the business and without formal meetings or corporate resolutions.

Such practices raise significant concerns because the failure to observe corporate formalities is one element of corporate operations examined in any case seeking to pierce the corporate veil and void the protection a corporation provides against personal liability of the shareholders, they are not fatal in a shareholder oppression case. The acceptance and participation in such practices can operate as a waiver of any objection to the failure to observe corporate formalities and create a defense to such a claim. Any new found desire to begin observing those formalities and documenting corporate actions may raise suspicion and exacerbate an already untenable situation.

The second definition of deadlock is not absolute; it is qualified by the language requiring that the deadlock cause an inability to take action on “substantial” matters. Thus, a disagreement about what color to paint the offices or what type of coffee to buy will not qualify as deadlock. The inability to agree that the company should have a distribution of profits or borrow money to fund legitimate working capital needs, however, would be a substantial matter and support a claim of deadlock.

Even if you can demonstrate to the court’s satisfaction that a deadlock does exist, that is not necessarily the end of your problems. The court is not required to order a sale of stock, but has other remedies available, such as the appointment of a provisional director. The court can appoint another director to the company temporarily for purposes of resolving the deadlock. In this way the company is able to resolve the deadlock and continue operating its business.

If the court does invoke the buy-out remedy for a deadlock situation, the court will closely examine the facts to determine which party is causing the deadlock and is more likely to order that party to sell their stock to the other. For instance, many small businesses have a line of credit that requires an annual renewal. The line of credit will impose various requirements, such as submission of tax returns annually.

Frequently, in an effort to gain an advantage or force another shareholder out, one shareholder may refuse to renew the line of credit by refusing to submit the required documentation. Any such action, however, may ultimately backfire as the court may view that shareholder as unreasonably causing the deadlock and may order them to sell their stock to the other shareholder.

Yes, corporate deadlock can be a useful and valid claim in a shareholder oppression case, it cannot be reliably used as a weapon to create a deadlock and then seek to have the court order your partner to sell their stock to you.

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