Dissolution cases involving deadlocked 50/50 owners of closely-held business entities present some of the most intractable problems likely to be encountered by business divorce practitioners and judges. In states such as New York, the problems are greatly exacerbated by the absence of a statutory buy-out remedy in deadlock dissolution cases — unlike dissolution cases brought by oppressed minority shareholders where the statute gives the corporation or the other shareholders the ability to avoid dissolution by acquiring the complaining shareholder’s stock for fair value. The LLC laws in New York and many other states likewise have no statutory buy-out mechanism in dissolution proceedings.
The difficulties with deadlock cases also frequently stem from the absence of a “natural” buyer and seller, that is, each of the 50% owners may be vying to buy out the other; from the owners’ divergent valuations of the business assets and operations, which may be tied to the owners’ personal know-how and/or their transient relationships with customers and vendors; and from the challenges, expense and time involved in getting appraisals for closely-held firms in an adversarial environment.
When both deadlocked owners are potential buyers, and under the right circumstances, the “shotgun” buy-out mechanism can be one of the most efficient means of getting to a business separation. For those not familiar with the shotgun, it’s when owner #1 sets the buy-out price and owner #2 has the option either to buy or sell at that price. Lawyers who prepare shareholder agreements sometimes feature the shotgun in the agreement’s buy-sell provisions, its exercise being made contingent on specified trigger events. Some weeks ago, I wrote about the Fulk case, involving a deadlock dissolution lawsuit before the Delaware Court of Chancery, in which the court compelled one of the company’s two owners to make a shotgun buy-out proposal.
I discovered the Fulk case in a fascinating and highly informative article called Shotguns and Deadlocks (available on SSRN here), authored by Professors Claudia M. Landeo and Kathryn E. Spier and slated for publication in the Yale Journal on Regulation. Professor Landeo (pictured above right; read bio here) is an Associate Professor of Economics at the University of Alberta in Edmonton, Canada. Professor Spier (pictured above left; read bio here) is the Domenico de Sole Professor of Law at Harvard Law School. Their collaborative article advocates greater judicial utilization of shotgun buy-outs in business deadlock cases and, using economic theory and data from laboratory experiments, argues that courts should assign the role of offeror to the better-informed owner. It’s a must-read article for members of the bar and bench who litigate and preside over deadlock dissolution cases.
I couldn’t resist contacting the professors to ask if they’d be willing to answer some questions about their article for an online interview. I’m glad to report that they graciously agreed, so without further ado, I give you Part One of a two-part interview of Professors Landeo and Spier:
Mahler: What are some of the basic features and advantages of the shotgun?
Spier: In the context of business divorce, the shotgun is a method to consolidate ownership in the hands of one of the business owners. The mechanism is pretty simple: One owner names a single buy-sell price, and then the other owner must either buy or sell shares at that price. So, in the end, one party owns one hundred percent of the business and the other party is paid off. A great thing about this mechanism is that the owner making the offer has a strong incentive to be accurate and equitable in setting the buy-sell price, since he can end up on either end of the transaction. In his opinion in Valinote v. Ballis, 295 F3d 666 (7th Cir 2002), Judge Frank Easterbrook explained it in the following way: “The possibility that the person naming the price can be forced either to buy or to sell keeps the first mover honest.”
Landeo: The shotgun mechanism is especially appropriate in deadlock situations involving closely-held business entities. While publicly-held companies often have active markets for ownership, closely-held organizations may be very difficult to evaluate for outside investors. The owners themselves might be in the best position to accurately assess the value of the business assets. Then, a valuation mechanism that triggers the owners to truthfully reveal their private information might be pretty useful in these circumstances.
Mahler: Why your interest in business deadlock in general and shotguns in particular?
Landeo: Business deadlocks are all too common in organizations with an even number of owners, and especially in business entities with just two owners. Inefficient resolution processes impose high costs on the parties and on society. As mentioned before, the shotgun mechanism might alleviate valuation problems in case of business divorce associated with closely-held organizations, and has the potential to generate equitable outcomes. Hence, it is valuable to study the properties of the shotgun mechanism, and the conditions under which the positive features of this mechanism are enhanced. The topic of business deadlock resolution is aligned with my previous research on the efficiency properties of bargaining institutions in legal and financial environments, and the design of pretrial bargaining mechanisms. The opportunities for institutional design and the strong policy implications of this project are particularly appealing to me.
Spier: This project fits with my long-standing interest in dispute resolution, and in how private parties can craft settlement agreements and the role of legal institutions and procedures in the settlement process. The strategic issues surrounding business deadlocks are particularly interesting, especially when the value of the business is closely tied to the human capital of the owners themselves.
Mahler: How did you end up collaborating on this project?
Spier: Claudia and I have collaborated on several different projects over the last years. We are law and economics scholars. I am primarily an economic theorist, and I tend to favor the use of abstract, rational actor models to study legal institutions.
Landeo: My methodological approach involves the application of economic modeling and experimental economics methods to the assessment and design of legal institutions. Our joint work combines our interests and research tools. We are very fortunate to have the financial support from the National Science Foundation (Law Program and Economics Program).
Mahler: In your article, you write that, assuming symmetrically-informed owners, in addition to providing equitable outcomes, the shotgun buy-sell provision narrows the bargaining range versus what you call “decentralized” bargaining against a backdrop of continued deadlock or judicial resolution of deadlock. How does that work?
Spier: Shotgun clauses in private business agreements might help owners to “frame” their negotiations. The fact that each party has the option to trigger the shotgun clause can provide some discipline for the parties when negotiating a business divorce. Basically, the shotgun clause encourages the parties to be more realistic, since out-of-the-ballpark demands would be much less likely to succeed when an alternative method for fair division exists.
Mahler: Your article also warns that shotgun mechanisms can backfire due to “asymmetries” between the two owners. What are these asymmetries, and how can they backfire?
Landeo: Although the shotgun mechanism certainly has the potential to create accurate and equitable outcomes, it might not live up to that potential in the presence of asymmetries. Different types of asymmetries can arise in practice. For instance, asymmetries of information regarding the value of the business assets might occur: One owner may be the hands-off financial investor, leaving all of the day-to-day managing decisions to the other owner. Asymmetries regarding the owners’ financial capabilities might be also present: One party may be wealthy, while the other may be struggling to make ends meet.
Spier: For the mechanism to work properly, the party who is in the position of naming the buy-sell price should be well-informed about the value of the company’s assets. Suppose that the party naming the offer is less knowledgeable and sophisticated than the party who is receiving the offer. The receiver could be opportunistic, buying when the value of the assets is high and selling when the value is low. The shotgun method will backfire in situations like this. The shotgun method can also backfire if one of the parties is financially constrained, and cannot raise the funds to complete the transaction. In this case, the party proposing the price has an incentive to make a low-ball offer, since the recipient cannot afford to purchase and will essentially be forced to sell at a deflated price.
Landeo: In the presence of asymmetries, it is important to consider, first, the ability of the party to name an accurate buy-sell offer and, second, the ability of the parties to follow through with the buyout and transfer of ownership.
Mahler: You also argue in your article that, in those instances where there is a shotgun provision in the shareholders’ agreement, the trigger rarely gets pulled. What explains that phenomenon?
Landeo: There are two possible features of privately-contracted shotgun clauses that might explain these outcomes. First, the way that shotgun clauses are typically written in the business agreements gives the parties discretion over whether to use the clause, i.e., these clauses are generally non-mandatory. Each party has the option to trigger the mechanism by proposing a buy-sell offer, but is not required to do so. Parties might instead choose simple offers to buy or to sell, which might allow them to get more profitable outcomes. In fact, 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  (available on SSRN here)) we study asymmetric-information environments, and theoretically and experimentally demonstrate that parties prefer to make simple offers to buy or to sell. Second, privately-contracted shotgun clauses do not generally assign the role of the offeror. Standoffs might arise in asymmetric-information settings since each party prefers the other to be the one to make the buy-sell offer. So, in practice, we might see owners dancing around the shotgun clauses and rarely triggering them. In a recent study (Landeo, C.M. and Spier, K.E., “Shotgun Mechanisms for Common-Value Partnerships: The Unassigned- Offeror Problem,” Economics Letters, pp. 390-394  (available on SSRN here)) we address these issues.
Mahler: You suggest in your article that the problems with asymmetries are likely to be less severe in the ex post judicial context than in a private agreement, ex ante context. What are the advantages available to judges?
Landeo: When parties are drafting their business agreements, it is not always possible for them to foresee how their relationship will change over time or how their roles in the business might evolve. Parties who begin their relationship with symmetric stakes and symmetric responsibilities may find themselves in very asymmetric positions down the road. One party may be more involved in the day-to-day operations of the venture, for example, while the other party may be more active on the financial side. When considerable uncertainty exists, it may be difficult for the parties to draft appropriate shotgun clauses ex ante. At the ex post stage, on the other hand, at least some of the uncertainty from the ex ante stage will have been resolved. Then, it would be feasible for the judge to identify the presence of asymmetries and appropriately design the shotgun mechanism.
Be sure to check back next week for Part Two of my interview with Professors Landeo and Spier.