This briefing looks at some of the challenges for existing corporate joint ventures as well as the key issues to be considered when entering into new joint venture arrangements whilst the continuing effects of the COVID-19 pandemic are felt and in the depressed market conditions which are likely to persist for the short to medium term. It supplements our recent briefing on COVID-19: Private M&A transactions: Issues and emerging trends.
Joint ventures (JVs) take many different forms and are entered into for many different strategic reasons, for example to combine financial resources or to pool knowledge. Some of those strategic drivers will continue to exist notwithstanding the current crisis, and indeed, the pandemic may accelerate the need for collaboration in some cases. In particular, we expect to see the objective of sharing and spreading risk to be reflected in more multi-party JVs, with the additional complexities which those create.
Preparing for an upcoming deal
Undertaking due diligence in preparation for a joint venture transaction has dimensions which differ from those typically encountered in private M&A transactions. Not only is focus required on the venture itself, its rationale and commercial drivers, but care is also required with regard to the JV partners since the importance of selecting the right partners is axiomatic in any joint venture deal and all the more so in current conditions.
Relevant questions about prospective partners are likely to include:
- Will they respect agreed governance arrangements and are they compatible partners in terms of the culture of the combining organisations and from a compliance perspective (having regard to anti-bribery, corruption, human rights and sanctions concerns and the legal liabilities which can arise for the joint venture parties)?
- Are they financially robust, particularly where it is anticipated that recourse to shareholders will be necessary and where exit or default arrangements may be affected by the insolvency of a shareholder?
Related to this topic is the question of the extent to which assumptions made and due diligence information supplied will be underpinned by formal warranty cover and, if so, who will give such warranties. For example, if warranties are to be given by the JV company itself to incoming investors, there is likely to be less prospect of formal recourse since the recipient of the warranties will become a part owner of the warrantor. Where, by contrast, the position is reversed because the transaction involves the transfer of an existing business into the JV by a shareholder, it may be appropriate for warranties to be given by that shareholder to the JV company. In that case, the documentation will need to address matters such as the control and conduct of warranty claims against the transferring shareholder. However, it is important to recognise that despite the inclusion of such cover, it is unlikely to be conducive to the JV’s aim of fostering a long-term relationship, to be engaged in warranty or indemnity claims.
For more detail on the topics of due diligence and warranties of particular relevance at this time see COVID-19: Private M&A transactions: Issues and emerging trends.
Execution and timing issues
There are many reasons why a delay may be needed between signing and completing a joint venture arrangement. Identifying these at an early stage will be key to the speed with which any deal can be implemented. Reasons for delay may range from taking the steps necessary to transfer an existing business to the JV to the need to secure regulatory approvals or mandatory merger control clearances. In the current environment, due to operational difficulties at some of the regulatory authorities and the difficulty of conducting market tests, merger control clearances and broader regulatory processes may take longer to complete and this will need to be factored into the transaction timetable.
Joint venture arrangements take many different forms but even minority investments may require merger control clearances. This may be because the minority shareholder will have veto rights over important aspects of the JV company’s strategy (e.g. over its budget, business plan, major investments or appointment of senior management) or because the regimes in some jurisdictions catch low levels of strategic influence or shareholding (for example, in the UK acquisitions of material influence over a business are covered; a concept which is interpreted broadly).
Parties also need to be careful not to miss mandatory filings in jurisdictions that may have little or nothing to do with the operational location of the JV but which catch transactions on the basis of the revenues or assets held by the parent companies (for example, the EU regime captures joint ventures operating entirely outside the EU if the corporate groups of the parent companies achieve sufficient revenues in the EU). Failure to make such filings could expose the parties to sanctions (including significant fines or liability for directors) regardless of whether competition issues are raised by the JV.
In this context it is also worth noting the current and growing global trend to scrutinise and restrict foreign direct investment (FDI) in the context of M&A and JV transactions. For further detail on the rules in the UK,1 see our separate briefing UK national security reforms move out of the shadows: National Security and Investment Bill proposed in Queen’s Speech. A comparative analysis of FDI restrictions by jurisdiction is also available in our summary of Global rules on foreign direct investment.
Where completion is contingent on receipt of merger control clearances, it will also be important to ensure that any steps taken to prepare for implementation of the deal do not infringe gun jumping rules which also carry heavy sanctions.
Where conditionality is required, the question which follows is whether the parties should be able to back out of the deal if the assumed market conditions for the JV deteriorate significantly before completion. There is much coverage in the financial press at present describing the attempts of parties to M&A deals to argue that material adverse change (MAC) or material adverse effect (MAE) termination rights have arisen because target businesses have suffered a sharp, and often catastrophic, deterioration in their performance and/or because sellers have failed to comply with pre-completion undertakings to carry on a business in its ordinary course.
In the context of a JV, the decision whether to proceed in the face of a drastically changed landscape may be more naturally balanced amongst the parties but will remain an important risk allocation point to address at an early stage. For more detail in relation to termination rights in the context of M&A transactions, see our separate briefing COVID-19: Private M&A transactions: Issues and emerging trends.
Decision making and maintaining good business practice
The current crisis highlights the importance of ensuring that flexible and agile decision making is possible whilst also respecting the interests of the shareholders.
In the context of proposed new ventures, the parties will need to address how the business will be run in practice – will the active involvement of representatives of the shareholders be required or will there be an existing or selected operational management team? For existing joint ventures, the parties should consider whether any changes to existing arrangements are required to facilitate agile decision making, whether on a temporary or permanent basis.
Key areas of focus for existing and proposed joint ventures include those discussed below.
Board members or board observers?
Whilst it would be typical for shareholders with a certain level of shareholding to have the right to appoint one or more directors to sit on the board of the JV company, there may be concerns in the current environment over the personal liability that this may entail for relevant individuals with a resulting heightened focus on D&O cover for those individuals on the board and, in some cases, a preference to hold non-voting positions as board observers (rather than as directors).2
Authority levels and consent matters
Defining the limits of delegated authority to executive management teams is likely to continue to be important whether shareholders are represented by nominee directors on the board or not. As a related point, further limits on the authority of the JV company’s management are also typically imposed by the use of reserved or veto matters. The scope of such matters, and the materiality levels which will apply to them, will continue to be important areas of focus They can create tension between shareholders seeking to maintain more visibility and control and management teams seeking greater autonomy to make quick decisions. Where reserved matters require the approval of the directors of the JV company, in the current environment those individuals may also be more focused on the inherent conflicts that such a role can present which may result in a preference for key decisions to be taken at shareholder rather than director level. This may be particularly so where the JV company finds itself in financial difficulties given the consequent shift in the emphasis of directors’ legal duties from the interests of shareholders to those of creditors.
Best business practice
In terms of the standards of business practice and compliance, required norms should continue to apply albeit the ability to monitor compliance may be more challenging in current conditions. Given the legal liabilities that may attach to joint venture participants under anti-bribery and corruption laws and the associated potential reputational risks and civil liabilities that may arise, retaining these standards notwithstanding difficult operating environments remains key.3
Flexibility of decision making
One challenge that commonly arises for JV companies with two or more corporate shareholders is achieving the flexibility required for agile decision making – especially in fast moving situations. In the current emergency, many businesses need to take major decisions with regard to their cost base or funding needs at great speed. Whilst governance protections may stipulate minimum notice periods for meetings (and the frequency and permitted location of/manner of holding such meetings), the parties may need additional flexibility. For existing joint ventures there may be a need to relax some of the current requirements, although caution is needed, especially where tax reasons dictate the location and required physical presence of directors at board meetings.4
Failure to achieve consensus
Where there is disagreement on matters identified as requiring unanimity or the approval of certain identified shareholders, a related question is what should happen if a deadlock is reached. Whilst the practical answer may be that matters will not be implemented without the required level of agreement, some shareholder agreements may also include structural solutions to these situations – for example, requiring or permitting a shareholder to buy out a dissenting shareholder. The workability of such structural solutions may be put under strain in current circumstances where the shareholders find themselves under financial pressure. An inequality in the financial strength of the shareholders there may pose a risk of a shareholder manipulating such provisions by creating an artificial deadlock situation.
Business and financial information
Detailing the nature and extent of information to be provided to shareholders and board appointees (both to support the decision making processes and to track progress against plans) will continue to be important especially where an emergency or contingency plan is in operation. In the context of existing joint ventures, this may present a particular challenge where ordinary business planning cycles have been disrupted and the shareholders face the prospect of having to agree revised or new business plans or budgets in short time scales.
Reliance on shareholders
Depending on the underlying rationale for the joint venture, its anticipated level of operating autonomy and the skill sets of the joint venture partners, goods/and or services may be provided to the JV company by one or more shareholders. This introduces a number of issues to be considered. In any economic environment, provisions to enable the validation and scrutiny of base line pricing and price escalation mechanisms are likely to be important. In the current circumstances, other issues may come to the fore such as understanding levels of resilience and considering alternative supply sources (with the flexibility to access these) should the relevant shareholder be unable to perform in a timely fashion as well as establishing the implications for the relevant shareholder of its failure to perform. For example, would such failure constitute such a fundamental issue for the JV that it should trigger a cross default under the joint venture or shareholders’ agreement?
Competing with the joint venture
The parties should address at the outset whether the shareholders will agree to non-compete and similar goodwill protections (such as non-solicitation of employees and customer base) in favor of the JV company. The significance of this topic will clearly differ according to the nature of the joint venture and its shareholders (and their activities outside the joint venture) but it can be an area of contention for shareholders with competing or overlapping activities. In the current environment, shareholders may seek greater flexibility to adapt their group-wide strategy in a way which might be competitive with the joint venture.
An associated issue will be the extent to which shareholders will be required to funnel new business development opportunities through the JV company – again, in a difficult environment, some shareholders may seek greater flexibility to divert resources away from those ventures which are struggling.
Funding the joint venture
Considering how the joint venture is to be funded is always an important area for detailed consideration. For existing joint ventures, the financial strains of the current environment highlight the importance of being able to identify and call on funding sources quickly. Accordingly, the extent of the parties’ commitment (and ability) to contribute further funding in an emergency situation will be a critical area of focus.
For joint ventures currently being planned, funding considerations will also be a key issue. In addition to considering how the venture will be funded, the rights and obligations of the shareholders in this context will also need to be documented. For example, shareholders may require pre-emption rights entitling (but not requiring) them to invest pro-rata in any further issue of equity so as to avoid dilution of their interest. However, particularly where there are financial or cornerstone investors, and in the context of the potential need for emergency funding to weather any difficult trading conditions, it may be appropriate for the documentation to permit an equity issue to be undertaken quickly and without respecting pre-emption provisions subject to other shareholders then having a window of time during which they are entitled to make a “catch up” acquisition. Whilst this may be pragmatic in theory, depending on the number of shareholders and their own internal process setting prescribed timescales (for both cornerstone and catch-up investment) may prove to be unrealistic or over ambitious.
Where the joint venture has a majority shareholder, that shareholder may require the right to advance debt funding to the JV company and to fund a failing minority shareholder’s share of such funding (ideally on pre-agreed terms) where this is required to preserve the financial position of the JV company.
Where the sources of funding include external finance providers, care will always be needed to ensure that the arrangements between the shareholders are consistent with the requirements and restrictions of such third-party arrangements. For example, ensuring that restrictions on incurring further debt or creating security are respected as well as compliance with financial and other covenants.
Making returns from the joint venture
Assuming the shares held by the shareholders do not carry preferential dividend rights, it would be usual to specify the joint venture’s policy with regard to the timing and quantum of dividend payments. This will need to be made subject to compliance with any external financing arrangements and, in current market conditions, there may be a need to recognize the likely inability of the venture to pay income returns for a considerable period of time.
As ever with joint ventures, tax issues will feature in their structure, funding and in the extraction of money from them. It will be important that there is no unnecessary tax leakage, for instance if debt payments to shareholders are not deductible for tax purposes. Equally, if the joint venture is loss-making, the shareholders may wish to monetise those losses by having them surrendered and offset against wider group profits. In many cases, this will be for payment, both so that other shareholders are not prejudiced and as a means of funding the venture.
Share transfers and exit provisions
There may be a range of approaches to the question of share transfers and exit generally.
At one end of the spectrum the parties may wish to keep things simple such that share transfers are prohibited without the consent of all shareholders leaving the documentation silent on the question of the timing and likely exit mechanism.
Where there is appetite and need for more detailed provisions, topics to be addressed are likely to include:
- Identifying prohibited transferees such as sanctioned persons or competitors as well as categories of permitted transferees such as group companies or related financial investors.
- Whether existing shareholders have the flexibility to sell their shares at any time or only after an initial “lock in” period. If such flexibility is intended, what associated rights should come with it – for example pre-emption or tag along rights conferred on the remaining shareholders or drag rights enabling outgoing shareholders to require a small number of remaining shareholders to sell their shares at the same time and for the same price.
- The rules of engagement around a trade sale or an IPO should these be the preferred exit method.
At the present time, shareholders are likely to be even more focused on very clear exit mechanisms with clearly defined timings for acceptance or determination of transfer values to ensure a quick and efficient sale process. Some strategic investors may even seek a right to “put” their shares at a heavily discounted price to the other shareholder rather than risk being locked into a failing venture. Rights of first offer may provide an easier exit mechanism, allowing a quick sale to an existing shareholder, rather than the time and expense involved in a right of first refusal process in an environment where third-party offers may be harder to come by.
Even where the situation may require share transfers or exit arrangements to be implemented quickly, there will still be a requirement to consider the need for third-party regulatory clearances and other mandatory consent matters as well as ensuring that, where there is external financing in place, lenders’ consent matters are respected.
Most joint venture agreements will identify a number of potential events of default. Structural remedies may be prescribed should any such event occur. These may include the right to buy out the defaulting shareholder or in some circumstances (most commonly in cases where there are two or a small number of shareholders) to require the defaulting party to buy its co-shareholders out.
An insolvency event affecting a shareholder (and sometimes its parent) is typically one such event of default. In the UK context, a liquidator or administrator of the defaulting shareholder may opt not to comply with such obligations if it would be in the interests of creditors generally to breach them. In practice, in the case of an obligation to sell, this is unlikely unless there is a more favourable buyer available, which is itself unlikely if the transfer of the JV company’s shares to a third party is prohibited or restricted by the JV company’s constitutional documents. Liquidators and administrators may also seek to set aside any contractual obligations which would have the effect of depriving the defaulting shareholder of an asset that would otherwise be available in its insolvency. Buy out rights could have that effect if the offer price is significantly below market value but the English courts may be unlikely to set aside such arrangements if satisfied that they were entered into in good faith for sensible commercial reasons.
Whilst the advantages of joint ventures in terms of enhanced financial and market bench strength may be clear, joint ventures also require a high degree of collaboration and cooperation against a backdrop of competing commercial requirements and priorities. Without good planning and expert advice, these competing features may be placed under particular strain in these tough and uncertain times.