A 50-percent shareholder in a computer technology company could show the existence of a “true deadlock” in corporate governance necessary to proceed with an action for involuntary dissolution under state law, the Massachusetts Supreme Judicial Court has decided.
The plaintiff and defendant are the sole shareholders and directors of Indus Systems, a company they formed in 1987. In June 2012, the plaintiff filed a petition in Middlesex Superior Court alleging that the parties had reached an impasse over the operation of the business, which necessitated the involuntary dissolution of the corporation pursuant to G.L.c. 156D, §14.30.
Judge Bruce R. Henry rejected the plaintiff’s petition after a bench trial.
Seeing an opportunity to construe the dissolution statute for the first time, the SJC transferred the case from the Appeals Court after the plaintiff sought review of the decision.
The SJC adopted a four-factor test for deciding when a deadlock exists in corporate governance for purposes of triggering relief under the statute.
Justice Barbara A. Lenk, writing for the unanimous court, said the plaintiff met the standard.
“We conclude that the utter impasse as to fundamental matters of corporate governance and operations shown to exist in these circumstances gave rise to a state of ‘true deadlock’ such that the remedy of dissolution provided by the statute is permissible,” Lenk wrote in reversing judgment.
The 28-page decision is Koshy v. Sachdev.
Boston attorney Charles M. Waters represented the plaintiff. Waters said the decision illustrates the risk that small private companies face when they fail to include dispute resolution provisions in their shareholder or operating agreements, forcing them to turn to the dissolution statute for relief in the event of a deadlock.
“It’s always better to agree to those [dispute resolution] provisions up front when the owners and directors are getting along,” he said.
Waters said it was also noteworthy that the SJC clarified that profitability should not be a significant factor weighing against the granting of relief under the dissolution statute, and recognized that the law inherently includes the ordering of remedies that may fall short of actual dissolution.
“What trial courts can do instead is appoint a custodian to sell the company to one of the two owners or a third party,” he said.
Boston attorney Thomas J. Carey Jr. filed an amicus brief on behalf of professor Brian J.M. Quinn, who teaches corporate law at Boston College Law School. Carey, who chairs the Massachusetts Bar Association’s Amicus Curiae Committee, said the SJC made it clear that lower courts are vested with considerable discretion in actions under the corporate dissolution statute.
“The Superior Court is going to have a lot of discretion in how to apply these factors in particular cases,” he said. “So it’s going to be tailored to the needs of the individual litigants.”
Quinn added that the fact pattern in Koshy presented a situation that is relatively rare in the sense that it involved the dissolution of a successful company as opposed to the dissolution of a corporation that was failing.
“The mere fact that a corporation continues to make money shouldn’t be sufficient to prevent the court from stepping in to act in everyone’s best interests,” Quinn said.
Michael F. Zullas, a Boston corporate attorney, said it was hard to overstate the importance of the SJC’s ruling.
“It’s the first time the court really provided some ‘flesh to the bone’ on how parties and partners can get a business divorce under Massachusetts law,” he said, noting the corporate dissolution statute has been in effect since 2004 with the Legislature’s enactment of the Massachusetts Business Corporations Act.
Defense counsel Maureen Mulligan did not respond to a request for comment.
“A deadlock that prevents corporate management from effectively addressing the vital functions of the corporation creates a threat of irreparable injury even if the company appears financially profitable.”
— Justice Barbara A. Lenk
Indus Systems provides computer-aided design services. The plaintiff and the defendant each own 50 percent of the company’s shares. Both parties are authorized to act on the company’s behalf.
The company’s annual revenue grew from approximately $700,000 to $2 million between 1997 and 2007, largely through business derived from contracts with federal agencies.
Despite financial success, the parties’ business relationship began to unravel in the late 2000s due in part to a sharp divergence in their respective strategic visions. Whereas the plaintiff wanted to focus on the company’s existing business servicing government clients, the defendant pushed for expansion into new markets.
The rift sharpened in a dispute concerning the issue of prepayments by Indus to eSystems Software, a subsidiary the parties founded to service the company’s contracts. The plaintiff allegedly suspected the prepayments were a way for the defendant to fund new projects under the table.
The parties’ relationship took another downward turn when, without the defendant’s consent, the plaintiff wrote himself a $690,000 check from Indus’s corporate account as a distribution from $1.4 million the company held as retained earnings.
The defendant responded by effectively locking the plaintiff out of Indus and initiating a lawsuit on behalf of the company to recover the $690,000 distribution.
While the parties resolved that dispute, the final straw occurred in December 2011 when the defendant hired a salesman, Michael Xifaras, without the plaintiff’s consent. The plaintiff clashed with Xifaras and twice attempted to terminate him. Each time the defendant blocked the salesman’s removal.
The plaintiff filed his own lawsuit in June 2012, alleging the defendant breached his fiduciary duty to his business partner as well as the implied covenant of good faith and fair dealing. Further, the plaintiff’s lawsuit sought corporate dissolution, alleging the parties were deadlocked in their management of Indus.
In August 2015, following an eight-day bench trial, Judge Henry rejected the plaintiff’s claims and certain counterclaims raised by the defendant.
Under G.L.c. 156D, §14.30, any shareholder or group of shareholders that have the right to vote on dissolution and hold 40 percent of the combined voting power of a company’s outstanding stock can petition the Superior Court for dissolution of the corporation.
A judge can order dissolution only in cases of “true deadlock,” meaning the petitioner must prove: (1) the directors are deadlocked in the management of the corporate affairs; (2) the shareholders are unable to break the deadlock; and (3) “irreparable injury to the corporation is threatened or being suffered.”
The SJC’s first task was to define the term “deadlock.”
Citing authority from other states, Lenk adopted a four-factor test for determining whether a deadlock exists.
The first factor involves an analysis of “whether irreconcilable differences between the directors of a corporation have resulted in ‘corporate paralysis.’”
The second factor addresses the size of the corporation at issue, meaning a deadlock is more likely in a small or closely held corporation, particularly when ownership is divided evenly between two shareholder-directors.
The third factor, one that weighs against a finding of deadlock, looks to whether one of the parties has “manufactured” a dispute in order to “engineer” a deadlock.
Finally, Lenk wrote, courts must look to the “degree and extent of distrust and antipathy” between the directors.
Applying the test to the case at hand, Lenk wrote that it was “inescapable” that the conflict between the parties constituted a deadlock. In particular, she said, there was clear evidence of corporate paralysis.
“Over the past few years, the parties appear to have agreed only on the matter of employee raises and the need to hire a new salesperson,” Lenk wrote. “As the Xifaras incident demonstrates, their agreement on the latter issue was superficial at best. The parties are diametrically opposed on nearly every issue of importance concerning Indus’s current operations and its future.”
Likewise, she said, there was ample evidence in the record to support the trial judge’s finding that the parties’ relationship operated under a cloud of mutual distrust and antipathy, thereby satisfying the fourth and final factor for determining deadlock.
Finding the existence of a deadlock, the SJC turned to the second prong of the three-part test for a true deadlock: whether the shareholders were unable to break the deadlock.
Lenk wrote that the primary inquiry in that regard was whether a shareholder or other agreement provided a mechanism by which a deadlock could be broken. For closely held corporations, two of the more common mechanisms to break a deadlock are buy-sell agreements and agreements providing for alternative dispute resolution, she said.
Lenk pointed out that none of those mechanisms governed the relationship between the plaintiff and the defendant.
Finally, the SJC concluded there was a threat of irreparable injury to the corporation, satisfying the third prong of the true-deadlock test. On that issue, the court underscored the point that the current financial viability of a corporation does not preclude a finding that such a threat exists.
“A deadlock that prevents corporate management from effectively addressing the vital functions of the corporation creates a threat of irreparable injury even if the company appears financially profitable,” Lenk wrote.
With respect to the dispute between the two Indus shareholders, the SJC found it compelling that the parties had resorted to “costly litigation” for the purpose of outmaneuvering each other and gaining the upper hand in steering the corporation.
“Resort to management by litigation is neither a viable means of corporate governance nor an adequate substitute for functional management and planning,” Lenk wrote. “On the record before us, the trajectory of Indus plainly points south and a threat of irreparable injury has been shown.”
Accordingly, the SJC remanded the matter to the Superior Court for entry of a judgment that the parties had reached a true deadlock within the meaning of G.L.c. 156D, §14.30.
In providing guidance to the lower court on a remedy, the SJC recognized that while the statute explicitly authorized a court to order an involuntary dissolution, the law also implicitly authorized lesser remedies, such as a buyout or the sale of the company as an ongoing entity.