753. Claudia M. Landeo & Kathryn E. Spier, Shotguns and Deadlocks, 08/2013; forthcoming in Yale Journal on Regulation.
Abstract: The process of resolving business deadlocks is time consuming and expensive, typically requiring the services of lawyers, financial experts and judges. Prolonged resolution processes, cost-inefficient administration of those processes, and inequitable outcomes impose high monetary and non-monetary costs on the parties themselves and on society as a whole.
Asset valuation, which is required to complete the transfer of assets in a business divorce, can pose particular problems for closely-held businesses. In contrast to publicly-traded companies with active markets for equity ownership, closely-held companies may be very difficult for outsider investors and appraisers to evaluate. The economic value of closely-held businesses is often intertwined with the human capital of the founders, their relationships with business associates (including key suppliers and customers), and their tacit business knowledge. The true economic value of closely-held businesses may not be fully reflected in the official business documents and financial statements; instead, the best wisdom concerning the value of the business may lie in the minds of the business owners themselves.
This article studies business deadlocks and their resolution. We advance a proposal to reform the way that courts resolve business deadlocks and value business assets. Specifically, we argue that Shotgun mechanisms, where the courts mandates one owner to name a single buy-sell price and compels the other owner to either buy or sell shares at the named price, should play a larger role in the judicial management of business divorce. Since the party proposing the offer may end up either buying or selling shares, the party has an incentive to identify and name a fair price. In addition, inefficient delays and administration cost associated with external appraisers and public auctions will be avoided. Our proposal is aligned with current statutory rules and case law. General partnerships and limited liability companies (LLCs), the most commonly chosen legal entities, are the focus of this study.
We first explore the private design and implementation of Shotgun provisions. Important lessons and insights for the judicial resolution of business deadlock can be derived by studying deadlock clauses in private contracts. Although Shotgun provisions have the potential for achieving equitable, expedient, and cost-efficient outcomes, we show that these mechanisms can pose serious challenges in private contractual settings. Owners who find themselves at an informational or financial advantage have an incentive to behave opportunistically in private environments.
Second, we evaluate the properties of Shotgun mechanisms in judicial settings. We argue that the risks of opportunistic behavior are less severe in the judicial context than they are in the private context. Since courts have the ability to design the Shotgun procedure ex-post rather than ex-ante, they are often in a better position to identify the presence and nature of the asymmetries and to tailor the mechanism accordingly. Despite their obvious potential benefits, courts in the United States seldom use Shotgun mechanisms to resolve business deadlocks.
Finally, we provide experimental evidence regarding the ex-post judicial design of Shotgun mechanisms. Although our arguments are logically consistent and supported by current legal cases, field data on the use of these mechanisms is not available. We conduct a series of controlled laboratory experiments with human subjects to assess whether the court-mandated assignment of the role of the offeror to the better-informed owner will have the predicted effects. Our experimental design simulates a deadlocked business venture with two owners where only one of the two owners knew the true value of the business assets. Two different treatments are considered. In the first treatment, the better-informed owner is compelled to make buy-sell offer; in the second treatment, the less-informed owner is forced to make the buy-sell offer. Our experimental findings support our arguments: The likelihood of equitable outcomes is positively influenced by the assignment of the role of offeror to the better-informed owner. When obligated to make a buy-sell offer, the better-informed owner truthfully revealed his private information to the less-informed owner. To the best of our knowledge, ours is the first experimental study of mandatory Shotgun mechanisms where one party knows the value of the assets while the other does not.
Our analysis demonstrates that the appropriate judicial use of Shotgun mechanisms as an asset valuation procedure will serve the interests of the business parties and, more generally, the interest of society as a whole.