Irreconcilable Differences: Judicial Resolution of Business Deadlock
In 1999, Ronald Mizrahi and Ezra Cohen, a dentist and an optometrist who were related by marriage, formed a limited liability company (LLC) to purchase and develop property in Brooklyn, New York. The mixed-use structure housed four residential units and seven commercial units. Mizrahi established his practice in a spacious unit on the second floor of the building while Cohen occupied a first-floor storefront unit. Because the LLC operating agreement required unanimous approval for business decisions, seemingly minor obstacles escalated into major problems. Conflicts arose over the monthly rents that Mizrahi and Cohen were paying to the LLC for use of their office space. When Cohen fell behind in his financial contributions, Mizrahi advanced sums of money to the LLC to avoid defaulting on its loans.
In 2006, Cohen withdrew $230,000 from the company coffers. Mizrahi brought suit seeking judicial dissolution of the LLC, alleging that Cohen had breached his fiduciary duty and embezzled funds. In addition to determining that the LLC should be dissolved, the court held that it was its duty “to provide a mechanism for the liquidation and distribution of [the] assets.” Commentators argue that the court’s decision reflects the current trend of more active participation by judges in the design of resolution mechanisms for business divorce.
Irreconcilable differences among joint owners are all too common in business entities, including closely held companies such as general partnerships and LLCs. In practice, the resolution of business deadlock might involve the dissolution of the business entity or the dissociation of joint owners. While many joint owners foresee possible deadlocks and include resolution mechanisms in their business agreements, others fail to do so. Judicial involvement arises in the absence of privately contracted divorce clauses. It may also occur when a deadlock clause was included in the business agreement but the grounds for dissociation or dissolution are not clear. In both situations, the court may be called upon to determine the appropriate remedy and to design an asset-valuation procedure.
Placing an accurate value on the business assets of a closely held company can be a difficult task. While publicly traded companies often have active markets for ownership, closely held companies may be very difficult for outside investors and/or appraisers to evaluate. By virtue of their experience with the business venture and their expertise, the joint owners may themselves be in the best position to accurately pinpoint the value of the assets. Thus, the court faces the challenge of designing a deadlock-resolution mechanism that induces the owners to accurately reveal the value of the business assets. To resolve the deadlock in Mizrahi v Cohen, for example, the court appointed a trustee to oversee a private auction between the two co-owners for sole ownership of the LLC.
In recent, previous work, we have argued that courts both can and should make greater use of so-called Shotgun mechanisms in business-divorce cases. In these mechanisms, the court would require one owner to name a buy-sell price, and the other owner would be required to either buy or sell shares at the named price. This proposal represents an application of the classic cake-cutting mechanism, in which one party cuts the cake (sets the buy-sell price) and the other party chooses a piece (by either buying or selling shares). Under ideal conditions, Shotgun mechanisms have the desirable feature that the owner who makes the buy-sell offer has an incentive to name an accurate and fair price, since he or she may end up on either side of the transaction.
Our previous research has also demonstrated that Shotgun mechanisms may lead to inequitable outcomes when owners have asymmetric information, asymmetric capabilities, and asymmetric financial resources. Importantly, these risks are likely to be mitigated in judicial settings. Since courts have the ability to design valuation mechanisms ex post rather than ex ante, they may well have enough information to identify the presence of asymmetries and tailor the Shotgun mechanism appropriately. For example, the court may assign the role of offeror to the better-informed party and may give the parties adequate time to arrange for external financing.
This Article extends our work on the judicial resolution of business deadlocks by theoretically and experimentally studying the ex post judicial design and properties of the Shotgun and Private Auction mechanisms. We first construct a simple theoretical framework. In this framework, a business venture with two joint owners is deadlocked, and the value of the business assets will be higher if ownership is consolidated in the hands of just one owner. The owners are equally capable at managing the firm, and both owners have adequate liquidity to purchase the stake of the other. The two owners differ, however, in how much information they possess about the future cash flows from the business assets. Owner 1 is assumed to be well informed about the future value of the cash flows, while Owner 2 is uninformed and also realizes that he is at an informational disadvantage. This theoretical setting involves common values, since the information that is in the hands of Owner 1 is directly relevant for the future payoff of Owner 2 if Owner 2 were to maintain an ownership stake in the company. We assume that the value of the business assets is randomly drawn from a range of equally likely values (so the density of asset values is uniform).
We derive several important theoretical predictions. First, an equitable outcome is obtained by the judicially mandated Shotgun mechanism when the better-informed party, Owner 1, is forced to make the buy-sell offer. Since Owner 1 may be on either the buying end or the selling end of the deal, Owner 1 has an incentive to fully reveal the value of the assets and split the surplus evenly with Owner 2. Second, an equitable division of surplus is clearly not obtained when Owner 2 is put in the position of making the buy-sell offer. Since Owner 2 lacks accurate information, the best he can do is make an offer that reflects the average value of the assets. Owner 1, being rational and selfinterested, will sell his stake to Owner 2 when the asset value is low and buy Owner 2’s stake when the asset value is high. So, when forced to make the buy-sell offer, Owner 2 is guaranteed to receive the proverbial “short end of the stick.” Third, we show that the Private Auction does not lead to an equitable outcome either, as Owner 1 shades his bid below the equitable value, thereby profiting from his informational advantage.
We then conduct a series of controlled laboratory experiments with human subjects to assess whether the judicially mandated Shotgun and Auction mechanisms will have the predicted effects. Our experimental environment simulates a deadlocked business venture in which two owners need to divide the business assets, and only one of the two owners knows the true value of the business assets. Two Shotgun treatments are included in our experimental design. In the first Shotgun treatment, the better-informed owner is compelled to make the buysell offer; in the second treatment, the less informed owner is compelled to make the offer. Our design also encompasses a Private Auction treatment in which both owners propose bids to purchase the stake of the other. Our subject pool, undergraduate and graduate students from the University of Alberta, was paid according to performance.
Our experimental findings support the theory: The Shotgun mechanism with an informed offeror leads to a more equitable division of the assets than the other Shotgun mechanism and the Private Auction. The Shotgun mechanism induces the informed offeror to truthfully reveal his private information and, as a result, an equitable outcome is more likely to be achieved. Moreover, the uninformed owner is better off on average and the informed owner is worse off on average in this treatment.
The results in this Article, taken together with the legal and formal analysis presented in our earlier work, suggest that Shotgun mechanisms can and should play a larger role in the judicial resolution of business deadlocks. Importantly, our proposal, which involves the active participation of judges in the evaluation of the environments surrounding the legal cases and the choice and design of the most appropriate resolution mechanism, is aligned with current judicial practices regarding the management of business divorce in the United States.