MASSACHUSETTS

Volume 46Issue No. 40

October 2, 2017

‘True deadlock’ foundin corporate governance

By Pat Murphy pmurphy@lawyersweekly.com

A 50-percent sharehold-er in a computer technology company could show the ex-istence of a “true deadlock” in corporate governance necessary to proceed with an action for involuntary dissolution under state law, the Supreme Judicial Court has decided.

� e plainti� and defen-dant are the sole sharehold-

ers and directors of Indus Systems, a Concord company they formed in 1987. In June 2012, the plainti� � led a petition in Middlesex Supe-rior 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 plainti� ’s petition a� er a bench trial.

Seeing an opportunity to construe the disso-lution statute for the � rst time, the SJC trans-ferred the case from the Appeals Court a� er the plainti� sought review of the decision.

� e SJC adopted a four-factor test for decid-ing when a deadlock exists in corporate gov-ernance for purposes of triggering relief under the statute.

Justice Barbara A. Lenk, writing for the unan-imous court, said the plainti� met the standard.

“We conclude that the utter impasse as to fundamental matters of corporate governance and operations shown to exist in these circum-stances gave rise to a state of ‘true deadlock’ such that the remedy of dissolution provided by the statute is permissible,” Lenk wrote in revers-ing judgment.

� e 28-page decision is Koshy v. Sachdev, Lawyers Weekly No. 10-147-17. � e full text of the ruling can be found at masslawyersweekly.com.

Cautionary taleBoston attorney Charles M. Waters repre-

sented the plainti� . Waters said the decision il-lustrates 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 dissolu-tion 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 clari� ed that pro� tability should not be a signi� cant factor weighing against the granting of relief under the dissolution statute, and rec-ognized that the law inherently includes the or-dering of remedies that may fall short of actu-al 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 � omas J. Carey Jr. � led an amicus brief on behalf of professor Brian J.M. Quinn, who teaches corporate law at Boston College Law School. Carey, who chairs the Mas-sachusetts 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.

“� e Superior Court is going to have a lot of discretion in how to apply these factors in par-ticular 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 suc-cessful company as opposed to the dissolution of a corporation that was failing.

“� e mere fact that a corporation continues to make money shouldn’t be su� cient to pre-vent the court from stepping in to act in every-one’s best interests,” Quinn said.

Michael F. Zullas, a Boston corporate attor-ney, said it was hard to overstate the importance of the SJC’s ruling.

“It’s the � rst time the court really provid-ed some ‘� esh to the bone’ on how parties and partners can get a business divorce under Mas-sachusetts law,” he said, noting the corporate dissolution statute has been in e� ect since 2004 with the Legislature’s enactment of the Massa-chusetts Business Corporations Act.

Defense counsel Maureen Mulligan did not respond to a request for comment.

Corporate feudIndus Systems provides computer-aided de-

sign services. � e plainti� and the defendant each own 50 percent of the company’s shares. Both parties are authorized to act on the com-pany’s behalf.

� e 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 � nancial success, the parties’ busi-ness relationship began to unravel in the late 2000s due in part to a sharp divergence in their respective strategic visions. Whereas the plain-ti� wanted to focus on the company’s existing business servicing government clients, the de-fendant pushed for expansion into new markets.

� e ri� sharpened in a dispute concerning the issue of prepayments by Indus to eSystems So� ware, a subsidiary the parties founded to service the company’s contracts. � e plainti� al-legedly suspected the prepayments were a way for the defendant to fund new projects under the table.

� e parties’ relationship took another down-ward turn when, without the defendant’s con-sent, the plainti� wrote himself a $690,000 check from Indus’s corporate account as a dis-tribution from $1.4 million the company held as retained earnings.

� e defendant responded by e� ectively lock-ing the plainti� 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 � -nal straw occurred in December 2011 when the defendant hired a salesman, Michael Xifaras, without the plainti� ’s consent. � e plainti� clashed with Xifaras and twice attempted to ter-minate him. Each time the defendant blocked the salesman’s removal.

� e plainti� � led his own lawsuit in June 2012, alleging the defendant breached his � du-ciary duty to his business partner as well as the implied covenant of good faith and fair dealing. Further, the plainti� ’s lawsuit sought corpo-rate dissolution, alleging the parties were dead-locked in their management of Indus.

In August 2015, following an eight-day bench trial, Judge Henry rejected the plain-ti� ’s claims and certain counterclaims raised by the defendant.

‘True deadlock’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 out-standing 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 a� airs; (2) the shareholders are unable to break the deadlock; and (3) “irreparable injury to the corporation is threatened or being su� ered.”

� e SJC’s � rst task was to de� ne the term “deadlock.”

Citing authority from other states, Lenk ad-opted a four-factor test for determining whether a deadlock exists.

� e � rst factor involves an analysis of “wheth-er irreconcilable di� erences between the direc-tors of a corporation have resulted in ‘corpo-rate paralysis.’”

� e second factor addresses the size of the corporation at issue, meaning a deadlock is more likely in a small or closely held corpora-tion, particularly when ownership is divided evenly between two shareholder-directors.

� e third factor, one that weighs against a � nding 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” be-tween the directors.

Applying the test to the case at hand, Lenk wrote that it was “inescapable” that the con� ict 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 demon-strates, their agreement on the latter issue was super� cial at best. � e parties are diametri-cally opposed on nearly every issue of impor-tance concerning Indus’s current operations and its future.”

Likewise, she said, there was ample evidence in the record to support the trial judge’s � nd-ing that the parties’ relationship operated under a cloud of mutual distrust and antipathy, there-by satisfying the fourth and � nal factor for de-termining 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 sharehold-ers were unable to break the deadlock.

Lenk wrote that the primary inquiry in that regard was whether a shareholder or oth-er agreement provided a mechanism by which a deadlock could be broken. For closely held corporations, two of the more common mech-anisms to break a deadlock are buy-sell agree-ments and agreements providing for alternative dispute resolution, she said.

Lenk pointed out that none of those mech-anisms governed the relationship between the plainti� and the defendant.

Finally, the SJC concluded there was a threat of irreparable injury to the corporation, satis-fying the third prong of the true-deadlock test. On that issue, the court underscored the point that the current � nancial viability of a corpo-ration does not preclude a � nding that such a threat exists.

“A deadlock that prevents corporate manage-

ment from e� ectively addressing the vital func-tions of the corporation creates a threat of irrep-arable injury even if the company appears � nan-cially pro� table,” Lenk wrote.

With respect to the dispute between the two Indus shareholders, the SJC found it compel-ling that the parties had resorted to “costly liti-gation” for the purpose of outmaneuvering each other and gaining the upper hand in steering the corporation.

“Resort to management by litigation is nei-ther a viable means of corporate governance nor an adequate substitute for functional man-agement and planning,” Lenk wrote. “On the re-cord 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 stat-ute explicitly authorized a court to order an in-voluntary dissolution, the law also implicitly au-thorized lesser remedies, such as a buyout or the sale of the company as an ongoing entity.

Shareholder’s bid to dissolve co. can proceed

Reprinted with permission from Lawyers Weekly, 10 Milk Street, Boston, MA 02108 • (800) 444-5297 © 2017 #02348

WATERSPlainti� ’s lawyer

prevails at SJC

“It’s the � rst time the court really provided some ‘� esh to the bone’ on how parties and partners can get a business divorce under Massachusetts law.”

— Michael F. Zullas, Boston