Shotguns and Deadlocks - University of Michigan Law Shotguns and Deadlocks ... Business deadlocks...

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Transcript of Shotguns and Deadlocks - University of Michigan Law Shotguns and Deadlocks ... Business deadlocks...

  • [Yale Journal on Regulation, forthcoming.]

    Shotguns and Deadlocks

    Claudia M. Landeo and Kathryn E. Spier∗

    c©2013 Claudia M. Landeo and Kathryn E. Spier. All rights reserved.

    Abstract

    Business divorce is an arduous affair. The process of resolving dead- locks 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 out- comes 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 busi- nesses. 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 dead- locks and value business assets. Specifically, we argue that Shotgun

    ∗Claudia M. Landeo is an Associate Professor of Economics at the University of Alberta Economics Department. Kathryn E. Spier is the Domenico de Sole Professor of Law at Harvard Law School and NBER Research Associate. We thank Albert Choi, Louis Kaplow, Mark Ramseyer, Adrian Vermeule, and Michael Waks for helpful discussions and comments. We also thank Tim Yuan for programming the software used in this study, and Susan Norton, Lisa Junghahn, and June Casey for their editorial assistance. Support from the National Science Foundation (Award No. SES- 1155761) is gratefully acknowledged. Part of this research was conducted at Yale Law School and Harvard Law School, where Professor Landeo served as a Visiting Senior Research Scholar in Law.

  • mechanisms, where one owner names a single buy-sell price and the other owner is compelled 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 sell- ing shares, the party has an incentive to identify and name a fair price. Thus, accurate asset valuation is achieved without the use of outside ap- praisers or inefficient public auctions. We also show that 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.

    Important lessons and insights for the judicial resolution of business deadlock are derived from our analysis of the private design and im- plementation of Shotgun provisions. Although Shotgun provisions have the potential for achieving equitable, expedient, and cost-efficient out- comes, these mechanisms pose challenges in private contractual settings, including the risk of opportunistic behaviors by owners who are at an informational or financial advantage. We argue that these risks 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 in a better position to identify the presence and nature of the asymmetries and to tailor the mechanism accordingly.

    Although our arguments regarding the benefits of ex-post judicial design of Shotgun mechanisms are logically consistent and supported by current legal cases, actual field data on the use of these mechanisms is not available. To begin to fill this void, we conducted a series of con- trolled laboratory experiments with human subjects to assess whether the Shotgun mechanism will have the predicted effects. Our experi- mental design simulated 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 were considered. In the first treatment, the better-informed owner was compelled to make buy-sell offer; in the second treatment, the less-informed owner was compelled to make the buy-sell offer. Our experimental findings support our arguments: (1) In- equitable outcomes arose when the less-informed owner made the buy- sell offer, and (2) equitable outcomes were obtained when the better- informed owner made the buy-sell offer. Specifically, 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 application of Shotgun mech- anisms by judges when they are called upon to resolve deadlocks and manage business divorce will serve the interests of the business parties themselves and, more generally, the interest of society as a whole.

    2

  • Article Contents

    I. Introduction 5

    II. Business Deadlock 13

    A. Management Rights . . . . . . . . . . . . . . . . . . . . . 14

    B. Preventing Business Deadlock . . . . . . . . . . . . . . . 16

    III. Lessons from Private Contracting 17

    A. Private Resolution: Dissociation and Dissolution . . . . . 18

    1. General Aspects . . . . . . . . . . . . . . . . . . . 18

    2. Asset Valuation . . . . . . . . . . . . . . . . . . . 22

    B. Shotgun Provisions . . . . . . . . . . . . . . . . . . . . . 22

    1. Benchmark Environment: Symmetric Information 23

    2. Asymmetric Information . . . . . . . . . . . . . . 26

    3. Other Asymmetries . . . . . . . . . . . . . . . . . 29

    a. Asymmetric Financial Resources. . . . . 30

    b. Asymmetric Capabilities. . . . . . . . . . 31

    c. Non-Monetary Preferences. . . . . . . . 33

    C. Alternative Provisions . . . . . . . . . . . . . . . . . . . 34

    1. Auctions . . . . . . . . . . . . . . . . . . . . . . . 34

    a. Symmetric Information. . . . . . . . . . 35

    b. Asymmetric Information. . . . . . . . . 36

    c. Other Asymmetries. . . . . . . . . . . . 37

    2. External Appraisal . . . . . . . . . . . . . . . . . 37

    D. Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . 38

    IV. Judicial Resolution with Shotgun Mechanisms 39

    A. General Aspects . . . . . . . . . . . . . . . . . . . . . . . 40

    B. Asset Valuation . . . . . . . . . . . . . . . . . . . . . . . 42

    C. Court Intervention with Shotgun Mechanisms . . . . . . 43

    1. Ex-Ante Private Design . . . . . . . . . . . . . . 43

    2. Ex-Post Judicial Design . . . . . . . . . . . . . . 44

    V. Ex-Post Judicial Design of Shotgun Mechanisms: Ex-

    perimental Evidence 47

    A. Numerical Example . . . . . . . . . . . . . . . . . . . . . 48

    3

  • B. Games and Sessions . . . . . . . . . . . . . . . . . . . . 49

    C. Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

    D. Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . 54

    VI. Conclusion 54

    Appendix 56

    A. Shotgun Mechanisms with Informed Offeror . . . . . . . . 56

    B. Shotgun Mechanisms with Uninformed Offeror . . . . . . 57

    C. Point Predictions . . . . . . . . . . . . . . . . . . . . . . 58

    4

  • I. Introduction

    “The answer is easy if you take it logically. I’d like to help you in your struggle to be free.

    There must be [thrifty] ways to leave your lover” (Paul Simon).1

    Like soon-to-be-married couples, future business partners often fail

    to plan for the possibility that their working relationship will deteriorate

    due to irreconcilable differences or how the business assets will be divided

    in the event of “divorce.” As a consequence, judges are often called upon

    to intervene and resolve business deadlocks. Prolonged resolution pro-

    cesses, 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.

    Haley v. Talcott,2 a case decided by the Delaware Court of Chancery

    in October 2004, provides an illustrative example. In 2001, Matt Haley

    and Greg Talcott started the Redfin Grill, a restaurant in Bethany Beach,

    Delaware. Talcott provided the start-up capital and Haley managed the

    restaurant without drawing a salary for the first year. In 2003, the par-

    ties “tied the knot” and formed Matt & Greg Real Estate, LLC, a 50/50

    limited liability company. In May 2003, the LLC borrowed $720,000 from

    a local bank, personally guaranteed by both Haley and Talcott, and pur-

    chased the real estate beneath the Redfin Grill. The LLC leased the

    real estate to the restaurant at below-market rates. By late 2003, the

    business relationship between Haley and Talcott began to deteriorate:

    Talcott fired Haley from the restaurant. Haley reciprocated by send-

    ing Talcott a notice purporting to revoke the lease between the Matt &

    Greg LLC and the restaurant. Because the