Joint Ventures: War Gaming Legal Options And Solutions Where Your Counterparty Is In Financial Difficulty

09 April 2020

COVID-19 has had an unimaginable impact on the corporate world. The assumptions on which parties approached corporate transactions like Joint Ventures (JV) have often been blown off course. Businesses that are party to JVs must monitor not just themselves but the condition of their JV partner and the impact that they may have on the JV. There is no 'off the shelf' Joint Venture Agreement (JVA). Analysing the legal and practical rights and constraints in each JV is therefore essential. This can equip businesses with a strategy to deal with their JV partner and perhaps even take advantage of the situation.



Insolvency or material breach of the JVA by counterparty

Most JVAs contain a default mechanism if one party enters into an insolvency process (typically very broadly defined to capture any formal procedure plus arrangements with creditors). The drafting may capture an insolvency event higher up that party's corporate group. Typically a material breach of the JVA will also be an event of default. JVAs rarely define what is meant by 'material', so legal advice should be taken before any such provision is relied upon.

The consequences of an event of default:

Disenfranchisement

A well drafted JVA usually provides that a shareholder that has suffered an event of default (a "Defaulter") will, upon notice, lose voting rights and the ability to appoint directors plus the benefit of veto rights. This effectively gives the 'innocent' party control of the JV. Depending on the nature of the default, it may be possible for the Defaulter to cure the default before it loses its rights or so that the loss of the rights is only temporary. Accountants should be consulted in advance where the effect of disenfranchisement could give a party control which may trigger consolidation of the JV onto a group balance sheet.

Buy out right

Many JVAs require a Defaulter, upon notice, to offer to transfer its shares to the innocent party (generally drafted as a buy out right or a call option). The Defaulter may be forced to transfer at a discount (perhaps 15% - 25%) to market value. However, for the buy-out right to be worthwhile, the innocent party still needs to be able to write a large cheque. This may not be practical; indeed, general cash constraints may make these difficult circumstances in which to exercise a buy out right.

Sell out right

Sometimes a JVA may entitle an innocent party to force a Defaulter to buy it out (sometimes drafted as a put option), particularly where one party likely has deeper pockets. The sell out right is usually at full market value; there is a reasonable argument that the Defaulter should have to pay a premium (so the Defaulter is penalised), but this is rarely successfully negotiated.

This mechanism might suit JVs whose purposes have been largely exhausted or which are considered less attractive. So "getting out" at full market value and generating substantial cash quickly, without having to deal with third parties, might be a good result. However, it can also be seen as sub-optimal because: (a) value is being calculated when market values are depressed or speculative; and (b) unwanted loss of the right to continue to be involved in the JV's business (potentially of wider importance to a party's group than just an investment e.g. the JV may be a customer of the innocent party) and the chance to make a return once things have stabilised. Finally, if the Defaulter is insolvent, it won't be able to carry out a buy out, regardless of the JVA. Consequently, if only buy out and sell out rights are available, an innocent party may opt to take its chances and remain in the JV, hoping for better things or gambling perhaps on new ownership of the Defaulter emerging (noting that such a change of control may also be restricted under the JVA).

More nuclear options

Alternatively/in addition, the JVA may allow the innocent party to instigate a process where the JV is sold or wound up. There are obvious disadvantages, not least where achieving a good valuation is challenging or where the value to some extent depends on one of the JV partners remaining involved. This risk could be mitigated by a right of first refusal where, a third party having made an offer for the business, the existing shareholders have the right to match.

A winding up of the company on a solvent basis will see the JV's assets sold and a return of capital to shareholders. If the JV has largely been exhausted this may be appropriate. In other circumstances it is a blunt instrument, often used as a threat to persuade the parties to seek a better result.

Funding for the JV company

In addition to default and exit, COVID-19 is also set to impact on the ability of parties to fund JVs. Many JVAs require that the JV partners each contribute committed funds (either as shareholder loans or equity). If one JV partner fails, the innocent party may fund the defaulting party's entitlement (note that failure to fund will not necessarily of itself constitute an event of default which triggers a buy out or sell out right - this will be determined by the court in all the circumstances). Providing funding is clearly a risk. If the JV partner is not likely to recover, or if the JV is in terminal decline, an exit could in any event be close, with a high risk that such further funds are ultimately wasted.

Where the JV is still viable and regarded positively and the JV partner a sound long term bet, a party can contribute funds the other party cannot and at the same time improve its own position. Where the further funding is by equity, dilution can materially rebalance voting rights, board seats, veto matters etc. Where the further funding is through shareholder loan, if one shareholder can't participate the JVA will likely allow the participating shareholder to lend at a special 'default' rate (typically around 15% as a deterrent) and provide that such shortfall loan ranks ahead of any other payments to shareholders.

Finally, whilst the financial difficulty of a shareholder will most obviously trigger an exit or impact on funding, a full strategy needs to consider all of a party's JV rights, including voluntary transfer and deadlock provisions, which are beyond the scope of this article.

A negotiated solution?

Where a party has the contractual right to terminate a JV or dilute a JV partner, this can give it considerable leverage to renegotiate the JVA and improve its position. In return for granting a temporary waiver, a party may seek improvements in its position for instance a better return or additional directors or veto rights which a counterparty in difficulty may be forced to concede to keep the JV alive.

Conclusion

For those businesses that have entered into JVAs where the JV or their JV partner might be materially affected by COVID-19, there is no 'magic bullet' solution that works every time - each option has disadvantages and some will not always be feasible. However, there is no substitute for a business gaining a thorough understanding of its legal position under the JV documentation, so it can make the best of its joint ventures in these uncertain times.


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