I recently came across a fascinating article in which the authors, two prominent professors of law and economics, rely on experimental evidence to argue that courts should utilize the “shotgun” mechanism to resolve business divorce cases involving deadlock between two, 50/50 owners. The shotgun basically involves one owner setting a buyout price and the other owner opting to buy or sell at that same price, the theory being that the one setting the price, uncertain whether he or she will end up buyer or seller, effectively will be forced to offer a reasonable price for a business whose “true” market value otherwise may be very difficult to ascertain.

I’ll be posting more about this important and thought provoking article in the near future. (For those who can’t wait, here’s a link to the article by Professors Claudia Landeo and Kathryn Spier available on SSRN.) The topic for today is inspired by one particular court decision cited in the article, in which the judge not only ordered the sale of a deadlocked service business as a going concern using a shotgun mechanism, but also imposed a limited duration non-solicitation injunction upon whichever of the two shareholders ended up the seller.

The case, decided over 10 years ago by then-Vice Chancellor Jack B. Jacobs of the Delaware Court of Chancery (currently serving as a Justice of the Delaware Supreme Court), is Fulk v. Washington Service Associates, Inc., 2002 WL 1402273 (Del. Ch. June 21, 2002) (read here). It’s a case that deserves more attention than evidenced by the paucity of citations to it in subsequent case law. It’s a case that puts to the forefront questions about the appropriate reach of the judicial power in dissolution cases, to maximize shareholder value for both sides in winding up a 50/50 company with substantial good will that one of the two owners is threatening to walk off with.

Fulk was a dissolution proceeding under § 273 of the Delaware General Corporation Law which authorizes the Chancery Court to dissolve a deadlocked, two shareholder, 50/50 corporation and to appoint a custodian or receiver to wind up its affairs. The New York counterpart to § 273 is § 1104 of the Business Corporation Law.

The subject company in Fulk was a small but highly profitable service business that analyzed and reported various governmental policies for institutional investors. The business had two 50% shareholders, Fulk and Long. The decision notes that all of the company’s full-time employees, including two of Long’s sons, were “loyal exclusively” to Long, which became a critical factor when the relationship between the two owners deteriorated largely because of Long’s and his sons’ belief that they contributed a disproportionate share of the company’s value as compared with Fulk whom, the Longs also believed, was being overly compensated.

Fulk petitioned for judicial dissolution after the collapse of negotiations for a buyout by Long of Fulk’s shares, after Long rejected a third-party’s offer to buy the company for $16 million, and, in the court’s words, after Long “objected to, and obstructed, every effort and proposal Fulk has made to assure that [the company] would be sold at a fair market price.” Long’s obstructive tactics included telling an investment banker brought in by Fulk that if the company were to be sold, Long, his sons and the rest of the company’s employees, who collectively possessed all of the firm’s know-how and intellectual property, immediately would start their own, competing business. Long also gave the same warning directly to a potential third-party buyer.

During the course of the litigation, and after the court appointed a custodian to wind up the company’s affairs, Long continued to insist that he and his loyal employees intended to start a competing business if the company were sold. He also rejected without explanation Fulk’s offer to purchase his 50% interest for $2.3 million which was made as a counter to Long’s offer to purchase Fulk’s 50% interest for $1.5 million.

The custodian, in his report to the court, spoke of Long’s conflict of interest between his intent to compete and his duties as a director and officer of the company, noting that Long “is in a position to take actions that would lower the value of [the company] rather than maximize it in the event of a sale to anyone other than [Long].” Long’s competitive threat, his ability to control the employees, and his personal relationships with the firm’s largest clients, the custodian concluded, would “scare off most, if not all, potential third-party buyers” thereby “lower[ing] the value” of the company.

For these reasons, the custodian advised the court that a sale of the company to an outside buyer was not feasible and that value would be maximized in a non-public sale of the company to one or the other of the two shareholders. The recommended sale method was a shotgun offer to be made by Long, giving Fulk the option to buy Long’s 50% interest at the offered price or sell his 50% interest to Long at the same stated price, coupled with an injunction preventing the seller, for a six-month period, from soliciting business from any of the firm’s clients and from soliciting any employee of the company.

Fulk consented to the recommended sale process. Long consented to a shotgun mechanism, but only if it excluded the proposed six-month injunction. Long also contended that, absent Long’s consent to the sale process, the court lacked the authority to compel a sale by one shareholder to the other and, even if it had such authority, lacked the authority to impose a post-closing injunction of the type recommended by the custodian.

The court rejected each of Long’s objections. The court opined that the language of § 273 did not require the court to dissolve the corporation, stating that “[n]othing in the statute requires the process to be contorted into a procedural straightjacket that limits the Court to only one structure for discontinuing a joint venture in the absence of an agreed-upon plan.” Rather, the court continued, “the statute permits the Court flexibility in deciding how the joint venture should be discontinued.” The court also held that § 273 permits a sale of the entire business to a third party as a going concern, and that such authority necessarily encompasses the court’s power to “order a transaction that is its economic equivalent, differing only in form.”

The court also rejected Long’s objections to the proposed six-month injunction, holding that the court possesses broad powers of injunctive relief and pointing out that, under the recommended sale process, the company would continue in existence as a going concern, contrary to Long’s assumption that corporate fiduciaries are free to compete against a dissolved entity. Long’s position, the court wrote, was tantamount to “heads I win; tails I win” in which he assumed none of the risk normally associated with a former fiduciary’s right to compete. As the court further explained,

In truth, Long’s “right to compete” argument is a rhetorical smokescreen, designed to divert attention from the real issue. That issue is whether Long’s threat to compete while remaining an employee with fiduciary obligations to [the Company] and to Fulk, affords Long a legally valid basis to block off all potentially interested bidders except himself, to avoid paying Fulk the value that a genuine bidding contest, not constrained by Long’s threatened breaches of duty, would obligate him to pay. The answer to that question is clearly no.

The court accordingly found no merit to Long’s argument that his “right to compete” trumped the court’s inherent equity power, and its statutory power under § 273, “to order the sale of a business upon terms that would prevent a breach of fiduciary duty consisting of improperly diverting the economic interest of one of the firm’s 50% owners to the other.”

In reaching its decision, the court acknowledged that, because Long already had operational control of the company, as a practical matter the injunction would only benefit Fulk, and would only affect adversely Long were he the seller. However, the court did not see this disparate impact as unfair, or as outside Long’s ability to counteract. Here’s what the court said:

[I]t is clear that the injunctive provisions would adversely affect Long only if Long has been unwilling to pay a fair price for Fulk’s interest in the Company. The reason is not complex. Under the Custodian’s Plan of Sale, if Long offers a fair price for Fulk’s 50% interest, then Fulk will sell to Long; if, however, Long is unwilling to offer a fair price, then Fulk will not sell but would become the buyer. Thus, to avoid the adverse impact of the proposed injunctive terms, all Long need do is offer a fair price that Fulk is willing to accept.

In short, the entire thrust of the proposed injunctive provisions is to induce Long–who desires to be the sole owner of the Company–to pay a fair price for the 50% equity interest owned by Fulk. But, paying a price that is acceptable to Fulk is something that Long is unwilling to do and has mightily resisted doing all along. Long’s strategy has been to block Fulk from having any legal or practical alternatives, so that Fulk would have only one choice: accept whatever price for his ownership interest–however inadequate–that Long is willing to pay. Consistent with that strategy, Long has opposed the injunctive provisions by unleashing a torrent of hypertechnical arguments. Those arguments have not the slightest equity. Indeed, they are designed to persuade me that as a legal matter, the Court of Chancery has no alternative other than to reject the Plan’s injunctive provisions that would prevent Long from acquiring 100% ownership of [the Company] as a going concern without having to pay going concern value.

The fact pattern in Fulk, in which a 50% owner with lopsided control of employee and customer relations or critical know-how threatens to start a competing business after dissolution unless the other owner accepts an unfair buyout price, is one I’ve seen with some frequency. I’ve not seen a decision by a New York court that emulates Fulk‘s remedial  scheme. However, not unlike Fulk, there are a significant number of New York decisions addressing generally the scope of remedial powers involving buyouts in dissolution cases involving both corporations and limited liability companies, the upshot of which is to affirm the courts’ broad, equitable powers even in the absence of specific statutory authority. I would include in that group cases such as Matter of Wiedy’s Furniture in which the court compelled the buyout of a minority shareholder even absent an election to purchase by the majority shareholder; Lyons v. Salamone in which the court ordered the two members of an LLC to bid for each other’s membership interest; and Mizrahi v. Cohen in which the court allowed one 50% owner of a dissolved LLC to purchase the other’s membership interest. We’ll just have to wait and see if a New York deadlock case comes along in which some party will argue that, upon dissolution, the court should grant a shotgun-plus-injunction remedy as in Fulk.