Judicial Resolution of Business Deadlock

The following post comes to us from Claudia M. Landeo, Associate Professor of Economics at the University of Alberta, and Kathryn E. Spier, Domenico de Sole Professor of Law at the Harvard Law School and Research Associate at the National Bureau of Economic Research.

Irreconcilable differences among joint owners are all too common in business entities, including closely-held companies such as general partnerships and LLCs. While many joint owners foresee possible deadlocks and include resolution mechanisms in their business agreements, others fail to do so. Judicial involvement may become necessary when a deadlock clause was included in the business agreement but the grounds for dissociation or dissolution are unclear, or when a deadlock clause was not included at all. In both situations, the court may be called upon to determine the appropriate remedy and to design an asset-valuation procedure.

Placing an accurate value on the business assets of a closely-held company can be a daunting task. While publicly-traded companies often have active markets for ownership, closely-held companies may be very difficult for outside investors and/or appraisers to evaluate. By virtue of their experience with the business venture and their expertise, the joint owners may themselves be in the best position to accurately pinpoint the value of the assets. Thus, the court faces the challenge of designing a deadlock resolution mechanism that induces the owners to accurately reveal the value of the business assets.

In recent previous work, Shotguns and Deadlocks (Yale Journal on Regulation, forthcoming, discussed on the Forum here), we have argued that courts both can and should make greater use of so-called “Shotgun mechanisms” in business divorce cases. In these mechanisms, the court would require one owner to name a buy-sell price, and the other owner would be required to either buy or sell shares at the named price. Under ideal conditions, Shotgun mechanisms have the desirable feature that the owner who makes the buy-sell offer has an incentive to name an accurate and fair price, since he or she may end up on either side of the transaction. We have also demonstrated that Shotgun mechanisms may lead to inequitable outcomes when owners have asymmetric information, asymmetric capabilities, and asymmetric financial resources. Importantly, these risks are likely to be mitigated in judicial settings. Since courts have the ability to design valuation mechanisms ex post rather than ex ante, they may well have enough information to identify the presence of asymmetries and tailor the Shotgun mechanism appropriately. For example, the court may assign the role of offeror to the better-informed party, and may give the parties adequate time to arrange for external financing.

Our article, Irreconcilable Differences: Judicial Resolution of Business Deadlocks, forthcoming in the University of Chicago Law Review, extends our work on the judicial resolution of business deadlocks by theoretically and experimentally studying the ex post judicial design and properties of the Shotgun and Private Auction mechanisms. We first construct a theoretical framework in which a business venture with two joint owners is deadlocked; the value of the business assets will be higher if ownership is consolidated in the hands of just one owner. The owners are equally capable at managing the firm, and both owners have adequate liquidity to purchase the stake of the other. The two owners differ, however, in how much information they possess about the future cash flows from the business assets. One owner is assumed to be well-informed about the future value of the cash flows, while the other owner is uninformed and also realizes that he is at an informational disadvantage. In this framework, we show that an equitable outcome is obtained by the judicially-mandated Shotgun mechanism when the better-informed party is forced to make the buy-sell offer. Since the better-informed party may be on either the buying end or the selling end of the deal, he/she has an incentive to fully reveal the value of the assets and split the surplus evenly the less informed party. Conversely, if the uninformed party were compelled to make the buy-sell offer, the uninformed party would be at a significant disadvantage and would receive the proverbial “short end of the stick.” The auction mechanism also fails to achieve an equitable division.

We then conduct a series of controlled laboratory experiments with human subjects paid according to their performance to assess whether the judicially-mandated Shotgun and Auction mechanisms will have the predicted effects. Our experimental environment simulates a deadlocked business venture where two owners need to divide the business assets, and only one of the two owners knows the true value of the business assets. Two Shotgun treatments are included in our experimental design. In the first Shotgun treatment, the better-informed owner is compelled to make buy-sell offer; in the second treatment, the less-informed owner is compelled to make the offer. Our design also encompasses a Private Auction treatment where both owners propose bids to purchase the stake of the other. Our experimental findings support the theory: The Shotgun mechanism with an informed offeror leads to a more equitable division of the assets than the other Shotgun mechanism and the Private Auction. The Shotgun mechanism induces the informed offeror to truthfully reveal his private information and, as a result, an equitable outcome is more likely to be achieved.

The results in this article, taken together with the legal and formal analysis presented in our earlier work, suggest that Shotgun mechanisms can and should play a larger role in the judicial resolution of business deadlocks. Importantly, our proposal, which involves the active participation of judges in the evaluation of the environments surrounding the legal cases and the choice and design of the most appropriate resolution mechanism, is aligned with current judicial practices regarding the management of business divorce in the United States.

The full article is available for download here.

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