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Deadlock: what to do when there is no key

22/04/2014 | Sally Mouhim

When two people decide to set up a company and are investing equally in terms of time, money and effort, they frequently do so by each holding 50% of the shares in that company and both being directors. There are many such quasi-partnership companies in existence. However, the equal shareholding structure does have the obvious drawback that in the event of a dispute between the two shareholders, the company will be unable to operate due to deadlock. 

The key to unlocking the deadlock is a properly drafted shareholders' agreement, which typically contains a so-called "texas shootout" clause which provides that the fastest on the draw, or in this case, the fastest to serve a notice, gets to buy the other out of their shares.

But how can the deadlock be overcome in companies whose shareholders do not have a shareholders' agreement? There are a number of potential actions a shareholder could bring, depending on the reasons for the deadlock and the actions of the other shareholder/director. 

A shareholder/director could bring a personal claim against another shareholder/director for breach of the company's articles of association, for example, if that shareholder/director was taking actions in the company's name without reference to the first shareholder/director and had failed to call meetings or comply with any other provisions of the articles of association. 

It may also be possible to file an unfair prejudice petition against the other director/shareholder under Part 30 of the Companies Act 2006. Usually considered to be the remedy of a minority shareholder, an unfair prejudice action can also be relevant in the case of an equal shareholder where there is deadlock if the actions of the other director/shareholder are unfairly prejudicial to the shareholder's interests. Types of action which has been held by the courts to be unfairly prejudicial include misapplication of company funds for the personal benefit of the director controlling the company, payment of excessive remuneration, misuse of company funds to pay for legal fees in relation to a dispute between shareholders, exclusion from management of the company, and acting in breach of fiduciary duties or in breach of director's statutory duties. The Court has wide powers to grant whatever relief it considers fit, but commonly the relief sought is a buy out order for the petitioning shareholder's shares to be purchased by the defendant director/shareholder at a price fixed by the court or determined by an independent valuer, on bases set by the court. 

If the other party has acted in breach of his statutory or fiduciary duties as a director or acted negligently and that has caused loss to the company thereby affecting the value of the shareholding in the company, a shareholder can bring a statutory derivative claim on behalf of the company. This applies even if the director has not benefitted personally from his actions or default. Since the claim is brought on behalf of the company, any damages awarded are for the benefit of the company and therefore the shareholder bringing the claim does not directly benefit, other than by virtue of the increased value in their shareholding. Such a claim could not resolve the deadlock, because the shareholder bringing the claim will still remain a shareholder even if successful, but it may be important to reinstate the value of the company as it was prior to the breach or negligence of the other director before taking another action to realise the value of the shareholding. 

The Court may authorise a derivative claim on behalf of the company in the course of proceedings for unfair prejudice if it believes that the petition alleging unfairly prejudicial conduct is well founded. There have been few cases in which the court has done so to date, but the remedy is available in meritorious cases. 

An example of a director acting in breach of fiduciary duties which may be relevant in the context of deadlock is if one director set up another company and diverted the company's contracts and opportunities to the new company in order that he could benefit to the exclusion of the other shareholder in the deadlocked company and basically run the deadlocked company into the ground until it has no value. This would be in breach of his duty to avoid a conflict of interests and in breach of the duty to promote the success of the company. The Court could order all profits made by the new company to be paid back into the deadlocked company. 

Finally, if the deadlock cannot be resolved by using one of the above methods, a petition may be issued for the winding up of the company on just and equitable grounds under section 122 of the Insolvency Act 1986. Deadlock is the most common reason for winding up on just and equitable grounds. However, the court will not order the winding up of the company lightly as it means the death of what may otherwise be a perfectly healthy company. It will only be wound up as a last resort and the parties will have to show that they have made every effort to resolve the deadlock through negotiation before filing a petition. Winding up is not usually in the interests of either party to the dispute, since it is likely to result in a lower return for the shares than by sale of the company or one party buying out the other's shares. However, if all other efforts have failed, just and equitable winding up does at least allow a shareholder to release their investment from the company and a complete parting of the ways with their co-shareholder/director. 

As the saying goes, prevention is always better than cure, and a lock is easier to open with a key, so if you are a shareholder in a company and you do not have a shareholder's agreement, now may be the time to put that right. If you are already in a dispute and do not have a shareholder's agreement, there are at least some statutory safety nets to protect your investment.

Sally Mouhim
Commercial Solicitor Dispute Resolution

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