Texas Business Dispute Blog

Tuesday, May 19, 2015

Untying The Gordian Knot: Getting Past Shareholder Deadlock Part 1

By Charles Rubio (Houston)

“From a relational standpoint, people enter closely-held businesses in the same manner as they enter marriage: optimistically and ill-prepared.”

Charles W. Murdock, The Evolution of Effective Remedies for Minority Shareholders and Its Impact Upon Valuation of Minority Shares, 65 NOTRE DAME L.REV. 425, 425 (1990).

A beautiful wedding ceremony offers no guaranty the couple will not ultimately end up in divorce.  Similarly, a great start to a new company does not mean the business owners won’t become deadlocked in the future over how the business should be run.  Many relationships become strained when family and friends go into business together and face the inevitable stress that confronts new and growing companies.  These conflicts can lead to an impasse when the business is owned on a 50-50 basis or when groups of family members or friends hold an equal ownership interest that precludes either side from exercising majority control.  This impasse is likely to have a serious, negative impact on the company’s operations. 

This is Part 1 of two Blog Posts focusing on private company business owners who hold a 50% ownership stake in a Texas company and therefore lack control over decision-making in the business.  In Part 1, we review the legal options available when the 50% owner becomes deadlocked with the other owner, i.e., this is the “pound of cure” for resolving business deadlocks when they arise.  Part 2 covers the “ounce of prevention” approach and details how business owners who hold an equal stake in the company can resolve deadlocks by entering into contract terms that will address inevitable future conflicts without the need for litigation.    

The Legal Options to Business Deadlock 

When deadlock situation arises in a private business, if the owners have not adopted any deadlock breaking mechanism, they may still have legal avenues available to them under Texas law.  The potential legal avenues the deadlocked business owner may consider include the following: (i) seeking appointment of a provisional director to break the deadlock, (ii) seeking the appointment of a custodian, or (iii) requesting appointment of a rehabilitative receiver to operate the business.  The appointment of the rehabilitative receiver may lead ultimately to the liquidation of the business.  If the rehabilitative receiver does not present a plan to the court within one year, which remedies the condition that required the receiver to be appointed, the court may then appoint a liquidating receiver.  Each of these legal options is reviewed below. 

The Provisional Director

If the company at issue is a Texas corporation and if company owners have elected the status of a “close corporation” under the Texas Business Organizations Code (TBOC), the owners may seek court appointment of a provisional director.[1] There are a number of procedural requirements that apply to close corporations, but in general, a close corporation under Texas law is a private company that chooses to operate without strict formalities and more like a partnership without notice of meetings and resolutions, but without the ability to freely transfer shares.  

Seeking the appointment of provisional director is one of the least drastic legal steps available to a business owner to resolve a deadlock.   Under the TBOC, the court is authorized to appoint a provisional director upon a showing that the directors or the persons empowered to manage the business under a shareholders’ agreement are so divided in the management of the business and affairs of the close corporation that the required votes or consent to take action for the corporation cannot be obtained, resulting in the business being conducted in a manner that does not benefit the shareholders.

The person appointed to serve as a provisional director must be impartial and not a shareholder, a party to a shareholders’ agreement, a person empowered to manage the close corporation under a shareholders’ agreement, or a creditor of the corporation or of a subsidiary or affiliate.   The provisional director is given all the rights and powers of a director and/or a shareholder under the shareholders’ agreement and to vote at meetings of directors and shareholders.  The provisional director is paid by agreement with the close corporation or the court may set the compensation.  The provisional director serves until the company until removed by court order or by a vote of the directors or shareholders authorized to do so by the shareholder agreement.  

This provisional director appointment is therefore narrowly tailored to address the specific problem at issue.  The appointment of the director is for a limited purpose, for a limited time and subject to the court’s control.

Appointment of a Custodian

Another option available to owners of close corporations to break a deadlock is to seek the appointment of a custodian.   A court may appoint a custodian of a close corporation if the shareholders are so divided that they cannot elect directors or the shareholders or if the people who are empowered to manage the business are so divided that the required consent to take action for the corporation cannot be obtained.  

A custodian has all the powers and duties of a receiver, as discussed below, provided that the custodian shall continue the business and not liquidate the business unless the court or the shareholders’ agreement authorizes the liquidation.[2] 

Appointment of a Rehabilitative Receiver to Run the Deadlocked Business

A more broad-reaching legal remedy for resolving shareholder deadlocks is to seek the appointment of a receiver. This remedy is available to all Texas “domestic entities” which includes corporations and LLC’s, not solely companies that elected close corporation status.  The legal standard to secure the appointment of a receiver, however, is more stringent and requires a showing that all other available legal and equitable remedies, including the appointment of a receiver for specific property of the entity are inadequate.  If this test is met, a court is authorized to appoint a receiver only when “the governing persons of the entity are deadlocked in the management of the entity’s affairs, the owners or members of the entity are unable to break the deadlock, and irreparable injury to the entity is being suffered or is threatened because of the deadlock.”   BOC 11.404(a)(1)(B).  

It is much more difficult to secure the appointment of a receiver than a provisional director, because a receivership is a much more expansive remedy.  While a provisional director joins the business as a tiebreaker, by appointing a receiver, the court is effectively taking control of the business.  As a result, receivership is viewed as “an extraordinarily harsh remedy and one that courts are particularly loathe to utilize.” Hillwood Inv. Props. III, Ltd. v. Radical Mavericks Mgt., LLC, No. 05-11-01470-CV, 2014 WL 4294968, at * 3 (Tex. App.—Dallas Aug. 21, 2014, no pet.) (mem. op.). The burden to show the existence of circumstances justifying the appointment of a receiver rests on the party seeking the appointment.” Id.

The legal hurdle of proving irreparable harm is a steep one and likely to be too great in many, if not most, instances to make the appointment of a receiver a remedy that is readily available or viable for resolving most shareholder deadlocks.  It will apply only in the most dire and severe of circumstances.  

Appointment of a Receiver to Dissolve the Business – Liquidating Receivership

The most drastic remedy - a court-appointed receiver to dissolve the company - is a final, and severe type of action.   The circumstances must be such that in the absence of a liquidation, there would be damages to people with a stake in the business, e.g., creditors.  Although the statute does not specify how significant the damages must be or which specific persons need to be at risk to justify liquidation, it is clear from the case law that this statute and the appointment of a liquidating receiver is intended only for extreme situations.

As a starting point, a member or director of the company does not have the right to seek appointment of a liquidating receiver unless the company has already started a liquidation process.  The statute provides for the attorney general or creditors to institute these proceedings, or members or directors of non-profit companies.  Thus, it appears that the director or member must first seek a rehabilitative receiver and, only if that rehabilitation fails, then seek to transform the rehabilitative receivership into a court-ordered liquidation.

Further, the court is authorized to appoint a liquidating receiver only when all available legal and equitable remedies other than liquidation are deemed to be inadequate, including the appointment of a rehabilitative receiver.

As a practical matter, even if serious conflicts exist between the business orders, a court is unlikely to order the dissolution of a successful company, which is paying its bills and employing a number of people.   The court will instead look to maintain a successful business as a going concern and appoint a provisional director (if allowed by statute) or a rehabilitative receiver to resolve the conflict and/or to sell the business in a manner that potentially preserves both the company’s value and the jobs held by the employees.

Thus, a court is likely to issue a dissolution order only when liquidation of the business is the only way to preserve assets to pay creditors and when one of the owners or an owners group is pillaging the company’s assets to the detriment of the other owner(s) and creditors.  A dissolution order is therefore tantamount to an involuntary bankruptcy proceeding, although the receiver who is appointed by the court to preside over the dissolution of the company is not a trustee who is subject to and governed by the restrictions of the bankruptcy code.  

Deadlocks No More

In our next Post, we will review a number of different contract terms that provide a means for business owners to resolve deadlocks without resort to legal action.

[1]  Tex. Bus. Orgs. Code Ann. § 21.752.
[2] Tex. Bus. Org. Code Ann. § 21.762.


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