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Interview With Professors Claudia Landeo and Kathryn Spier on Shotguns and Deadlocks: Part Two

Posted in Buyout, Deadlock, Interviews

This is the second installment of a two-part interview of Claudia Landeo (photo right; read bio here), Associate Professor of Economics at the University of Alberta, and Kathryn Spier (photo left; read bio here), the Domenico de Sole Professor of Law at the Harvard Law School, on their forthcoming article in the Yale Journal on Regulation called “Shotguns and Deadlocks” [available on SSRN here].

Click here to read Part One of the interview, here to view Professor Landeo’s SSRN home page linking to her numerous published articles and discussion papers, and here to view Professor Spier’s lengthy list of academic publications.

Part One covered some of the basics of the shotgun buy-sell mechanism, its utility in resolving deadlock disputes, and the challenges posed by asymmetries of information and financial capabilities as between the owners. The discussion continues in Part Two, focusing on judicial implementation of the shotgun and the experimental data supporting selection of the better-informed owner as the offeror.

Mahler: You told us that, unlike in the context of ex ante private agreements, judges might have the ability to address problems with asymmetries that can better ensure equitable outcomes for shotgun mechanisms. What are some of the things judges can do?

Spier: The judge might use her discretion when one party is under financial duress. Specifically, the judge might mitigate the negative effects of financial asymmetries by giving parties adequate time to arrange for financing of the buy-sell operations. If the financial asymmetries cannot be mitigated by judicial order, then the judge can certainly consider alternative mechanisms or approaches.

Mahler: Assigning the role of offeror to the better-informed owner is an important part of your analysis. What criteria are used to determine if one owner is better informed about company value than the other, particularly when both are active managers of the business?

Landeo: The better-informed owner refers to the party who is a better position to more accurately assess the value of the business assets. If for instance, one owner has been intimately involved in the management and operations of the company, it might be inferred that this owner is the better-informed party. The judge should then mandate this party to name the buy-sell price.

Spier: If both of the owners are sophisticated and active in management and operations, the shotgun will lead to equal division regardless of which owner names the buy-sell price. In the judicial resolution setting, the judge could require either party to make the buy-sell offer.

Landeo: It is worth noting that the judicial resolution of deadlocks with the shotgun mechanism requires an active participation of the judge in determining whether the specific characteristics of the legal case are conducive to an appropriate implementation of the mechanism, and tailoring the mechanism accordingly.

Mahler: I found fascinating your article’s description of the experiment with human subjects you conducted to test your thesis regarding the optimal ex post judicial use of shotgun mechanisms in the presence of asymmetric information. How was the experiment conducted?

Landeo: Given that field data on the judicial use of shotgun mechanisms were not available, we conducted a series of controlled laboratory experiments to assess whether the court-mandated assignment of the role of the offeror to the better-informed owner will generate equitable outcomes. Our experimental design followed experimental economics methods. Core elements of these methods involve the replication of the theoretical framework in the laboratory, the use of a minimum necessary context, and the payment to human subjects according to their performance.

Specifically, our experimental design simulated a deadlocked business venture with two owners where only one of the two owners knew the true value of the business assets. Two different experimental treatments were considered. In the first treatment, the better-informed owner was compelled to make the buy-sell offer; in the second treatment, the less-informed owner was forced to make the buy-sell offer.

We ran four 90-minute experimental sessions, two sessions per treatment. Subjects were randomly assigned to the sessions. Within each experimental session, the roles (offeror and offeree) were randomly allocated, and the pairs of owners (businesses) were randomly determined. Each pair of owners played a two-stage business-dissolution game. In the first stage, the offeror proposed a price; after observing the offer, in the second stage, the offeree decided whether to buy the other owner’s assets or to sell his business assets to the other owner at the proposed price. Econometric techniques were used to evaluate the qualitative differences between experimental treatments.

Mahler: What results did the experiments yield, and did they support your thesis?

Landeo: Our experimental findings support our thesis. First, our results suggest that the shotgun mechanism induces the better-informed offeror to truthfully reveal her private information to the less-informed owners. Second, our findings indicate that equitable outcomes might be achieved under asymmetric information when the ex post design of the shotgun mechanism involves the assignment of the role of the offeror to the better-informed owner. In fact, our results suggest that the likelihood of equitable outcomes is positively influenced by the assignment of the role of the offeror to the better-informed owner.

Mahler: Your article also compares the efficacy of the shotgun versus private auction and appraisal. When is one technique better than another?

Spier: When the owners are equally knowledgeable about the value of the business, then the private auction and the shotgun mechanism will be equally effective in achieving an equitable split. Having an independent appraisal would be a waste of money in this case, however, since presumably the best knowledge about the company lies with the owners themselves. When one owner has better information than the other we show that the shotgun mechanism does better than the auction, assuming that better-informed party is the one who makes the buysell offer.

Landeo: In a recent article (Landeo, C.M. and Spier, K.E., “Irreconcilable Differences: Judicial Resolution of Business Deadlock,” The University of Chicago Law Review, forthcoming [manuscript available here]), we extend our work on the judicial resolution of business deadlocks and provide experimental evidence of the equity-superiority of the shotgun mechanism with an informed offeror with respect to the private auction mechanism. Cost inefficiencies and unnecessary delays might also arise with the private auction method.

Mahler: Your article recommends greater judicial utilization of the shotgun mechanism to resolve deadlock disputes. Do you think judges have adequate authority to do so under the governing state law schemes?

Landeo: The judicial resolution of business deadlock works within the framework of current statutory rules and case law. Importantly, recent case law empowers judges to an active participation in the design of resolution mechanisms for business divorce. For instance, in Mizrahi v. Cohen (2013 NY Slip Op 50092[U] (Sup. Ct. Jan. 15, 2013) [2013 BL 16658]), Justice Demarest argues “[H]aving determined that the LLC should be dissolved, it is the duty of the Court to provide a mechanism for the liquidation and distribution of its assets … [I]n fashioning an appropriate procedure for the winding up of a dissolved LLC, the Court is possessed of discretion to exercise principals of equity.” We extend the discussion of these issues in our forthcoming University of Chicago Law Review article mentioned above. Your blog also provides an interesting discussion of the Mizrahi v. Cohen case.

Mahler: Finally, your article focuses on deadlock between 50-50 owners. Can a shotgun also be used successfully, either ex ante or ex post, when shareholders have unequal equity stakes?

Spier: Although business deadlocks often do involve 50-50 owners, the shotgun method can be just as effective when parties have unequal stakes. Rather than make a bid for half of the equity, the proposer would instead name either a price per share, or name a value for one hundred percent of the equity. So, the shotgun method can be easily adapted so the amount that is actually paid by the buyer will depend on the proportion of equity originally held by the seller. In previous work (Brooks, R., Landeo, C.M., and Spier, K.E., “Trigger Happy or Gun Shy: Dissolving Common-Value Partnerships with Texas Shootouts,” The Rand Journal of Economics, pp. 649-673 [2010] (available on SSRN here)) we provide a theoretical analysis of this topic.

Mahler: Professors Landeo and Spier, thanks so much for doing this interview. Shotguns and Deadlocks is an important piece of scholarship with practical application in the business divorce arena. I hope all my readers will take the time to study it.