Shotguns and Deadlocks

Business divorce is an arduous affair. The process of resolving 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 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 selling shares, the party has an incentive to identify and name a fair price. Thus, accurate asset valuation is achieved without the use of outside appraisers 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 implementation of Shotgun provisions. Although Shotgun provisions have the potential for achieving equitable, expedient, and cost-efficient outcomes, 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 controlled laboratory experiments with human subjects to assess whether the Shotgun mechanism will have the predicted effects. Our experimental 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) Inequitable outcomes arose when the less-informed owner made the buysell 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 mechanisms 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.