Corporate Governance: Options for Breaking/Avoiding a Shareholder Deadlock
When running your San Diego business through a corporation, one of the practical issues that must be addressed is possible corporate deadlock. In general, corporations run on the ideas of voting and majority rules. The shareholders own the company and they vote to elect the members of the board of directors. The shareholder(s) with the most votes elect a majority of the board of directors. In turn, the major decisions of the corporation are made by the board of directors. In making those decisions, the directors cast votes and, again, majority rules.
Because voting is the mechanism for making decisions, if there is disagreement, there is the potential for voting deadlocks. Thus, principles of good corporate governance caution against a pure 50%-50% split in ownership and against a board of directors with an even number (such as four or six). When the votes can result in a tie, there is a danger of deadlock causing the corporation to be unable to make major decisions and carry on with business. An example of shareholder deadlock can be found in the unpublished California Court of Appeals case Ielmini v. Patterson Frozen Foods, Inc., Case Nos. F073377, F074088 (Cal. App. 5th Dist. 2018). In that case, the original corporation was formed by two cousins and it was structured such that each cousin had 50% of the shares. One cousin died, and his shares passed to his four children. As time passed, disputes about the direction of the company arose between the 50% shareholder and the others creating the potential for deadlock. The case ended up being litigated.
The best solution to potential shareholder deadlock is to avoid the possibility from the start. That is, an experienced San Diego corporate attorney can offer advice and counsel on how to structure the ownership shares and draft the corporate bylaws to avoid possible deadlock. Another option is to negotiate a solid and well-conceived Owner’s Agreement that creates a mechanism for breaking a deadlock. An example might be empowering some mutually trusted person — a member of the family — with a tie-breaking vote. An experienced San Diego corporate attorney can help draft such an agreement.
Where the shareholder deadlock relates to election of directors, another option is to bring a lawsuit under California law to have the courts appoint a provisional director. See Cal. Corp. Code, §308(b). Generally, section 308 governs deadlock. Subdivision (a) covers deadlocks on the board and subdivision (b) covers shareholder deadlocks.
Under subdivision (b), a shareholder or a combination of shareholders with at least 50% of the voting power can file a petition in California State Court to ask the court to appoint one or more provisional directors. Any provisional director appointed must be what the statute calls an “impartial person.” This is defined as a person who is not:
- A shareholder
- A creditor of the corporation or
- Related to any of the current directors or to a judge in the county where the case has been filed
As explained by the court in Ielmini, the reason that more than one provisional director can be appointed is to avoid creating a potential deadlock on the board. For example, if the current board has three members, appointing one provisional director creates a potential deadlock where the four directors can split 2-2. Under such circumstances, the court might appoint two provisional directors to avoid that problem.
Contact San Diego Corporate Law
If you would like more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard provides a full panoply of legal services for San Diego and California businesses. Mr. Leonard can provide advice and counsel on starting up a new business, with respect to forming a new corporate entity, assist with corporate formalities, and can help review and draft business contracts. Mr. Leonard can be reached at (858) 483-9200 or via email.