Beware the Deadlock: Delaware Courts Step in on Corporate Dysfunction

| Jason M. Knott

The board of directors controls a corporation, but individual directors don’t always agree on the future direction of the company. Sometimes, boards can split into factions. A company’s CEO may align himself with one side and oppose the other.

In rarer circumstances, these disagreements can develop into corporate gridlock. This happens when the warring factions on a board are equally divided.

What can a court do to fix this situation?

In Delaware, at least, courts have powerful remedies to break these kinds of deadlocks, as illustrated by two recent cases—Kleinberg v. Aharon and Shawe v. Elting.

In each case, the court invoked its power under Delaware law to appoint a custodian to dislodge the deadlock. Under 8 Del. C. § 226, a court may appoint a custodian “upon application of any stockholder” if (1) the stockholders are so divided that they can’t elect a board; (2) the business of corporation is “suffering or threatened with irreparable injury” because the directors are so divided that they can’t take action; or (3) the corporation has abandoned its business but isn’t dissolving, liquidating, or distributing its assets. The court can even order the custodian to shut down the corporation.

That’s what the Delaware Court of Chancery did in Shawe. According to the Delaware Supreme Court, which recently affirmed the decision, the Court of Chancery held a “six-day trial filled with unprecedented evidence of a lengthy and seriously dysfunctional relationship between the owners.” Following the trial, the court found that the company’s co-owners—Shawe and Elting—were “hopelessly deadlocked as stockholders and directors.” As a result, the court appointed a custodian to sell the company and distribute the proceeds to the stockholders.

How did things go so wrong between Shawe and Elting? A bad breakup, according to the Delaware Supreme Court, that left Shawe “crawling under Elting’s bed and refusing to leave.”

Over the following years, Shawe and Elting “continued to harass each other, interfere with the business, and demoralize the employees,” and also filed “four lawsuits against each other.” Meanwhile, the company suffered from employee departures, damage to reputation, and an inability to grow through acquisitions. The Delaware Supreme Court found that in the face of this dysfunction, the Court of Chancery did not abuse its discretion in taking the extreme action of ordering a sale.

In Kleinberg, the plaintiff stockholders brought suit against the CEO and his allied directors to break a 3-3 deadlock on the board. The CEO accused the plaintiffs of manufacturing the deadlock in bad faith and attempting to steal his company’s technology. However, the Court of Chancery found that the deadlock was legitimate, and decided to “appoint a custodian with the power to vote as a seventh director and the authority to take additional steps to resolve the deadlock.”

Unlike the Shawe court, however, the Kleinberg court declined to order a sale, because the company’s affairs were in such “disarray” that selling its valuable technology would likely only generate a fraction of its value.

Both the Shawe and Kleinberg decisions show that if a board can’t work together to move a company forward, then it may find matters taken out of its hands by an appointed custodian, who can have the power to break a deadlock or even sell the company. This is an incentive for rational directors to avoid complete dysfunction.

But corporate deadlocks aren’t always rational.

Information provided on InsightZS should not be considered legal advice and expressed views are those of the authors alone. Readers should seek specific legal guidance before acting in any particular circumstance.

As the regulatory and business environments in which our clients operate grow increasingly complex, we identify and offer perspectives on significant legal developments affecting businesses, organizations, and individuals. Each post aims to address timely issues and trends by evaluating impactful decisions, sharing observations of key enforcement changes, or distilling best practices drawn from experience. InsightZS also features personal interest pieces about the impact of our legal work in our communities and about associate life at Zuckerman Spaeder.

Information provided on InsightZS should not be considered legal advice and expressed views are those of the authors alone. Readers should seek specific legal guidance before acting in any particular circumstance.