Joint Ventures Flow Into Unchartered Waters Amidst Covid-19

Although economies across the world are endeavouring to resurrect, businesses especially those operating as joint ventures (JVs) across the spectrum stand at a crucial juncture. With an unprecedented disruption of supply chains, liquidity challenges, employment and commercial contract issues, JVs are now required to swiftly adapt, comprehend and manage unanticipated risks in order to maintain and honour the contractual arrangements agreed between the contracting parties to a JV.

JVs are in itself a unique strategic partnership with two or more stakeholders coming together to provide the capital, the goods and services, or both, to form a jointly controlled commercial project. This unique structure makes JVs most vulnerable in these unprecedented times arising due to the COVID-19 pandemic, which if not handled properly are likely to lead to severe issues from loss and financial instability, to decision-making deadlocks and defaults and even voluntary liquidation or insolvency.

During my recent interactions with various stakeholders, including those with JVs in the Indo-German front, I have come to realize that the pandemic has yet again brought to light issues that are to a certain degree innate to a JV. Therefore, based on my recent experiences, I have listed out in this article the broad issues faced by JVs during this pandemic and the collaborative and perhaps innovative approach to be adopted to resolve such issues.

Liquidity Challenge

The imminent result of the worldwide economic shutdown has been the drying up of revenue sources with rising operating expenses. Ideally, in such a scenario the first step includes appraising the existing JV agreement for any additional funding contribution events and methods that have been stipulated for the contracting JV partners. If the JV partner has a prescribed commitment in the JV agreement to provide a contribution for additional funding, then one or more JV partners may come forward or at times even refuse to participate in the 'call for funding'. The consequences of refusal to participate are usually laid down in the JV agreement itself. Where a JV partner is not able to participate in the call for funding, it has to consider implications resulting from the dilution of its stake as the JV partner and the associated impact on future economic and governance rights. A non-contributing JV partner may face issues ranging from loss in the representation of the board, reduced decision-making power for a reserved matter, or reduced roles in the operation of the JV or even at times trigger an event of default.

Where JV agreements do not provide any arrangement for such call for funding in exigent times or trigger the requirement of funding from the JV partner only once the external debt raising option has been exhausted, then time and again we have witnessed JV partners coming together and seeking external debt arrangements ranging from the restructuring of repayments, increase in the working capital loan, full draw-down on revolving loan facilities and the reassessment of financial covenants in the existing financing agreements. And expectedly so, raising external debt is stipulated under reserved matter in the JV agreement which requires unanimous approval of the JV partners.

Furthermore, raising additional external debt is more likely to cause a change in the existing capital structure of the JV, which may push the JV outside the scope of agreed financing terms and conditions with its creditors. Moreover, coupled with the changes in the leverage ratio, this may allow the lender to seek additional security by way of guarantees or collateral from the JV partner, thereby creating additional liabilities and obligations on each such JV partner.

Where JVs are primarily relying on the capital contribution from JV partners with little or no reliance on external debt financing as part of their structure, JV agreements provide for either mandatory or optional additional capital contributions. Ideally, a mandatory additional capital contribution clause in the JV agreement provides the specific amount and the circumstances under which mandatory capital contributions must be made. Though it seems a reasonable way out for a struggling JV, such mandatory capital contributions from a JV partner (more often than not) do not form part of the working capital requirements of the JV i.e. the cash required for running the day-to-day operations.

JV partners funding contributions could either come in the form of debt or equity financing, which is usually made on a pro-rata basis as per the JV partner's interests in the JV, which if contributed proportionately have no impact either on the ownership, economic or any governance rights.

Yet again, capital contributions are also subject to reserved matter approvals, which require unanimous approval of the JV partners.

Good Governance and Deadlocks

As put forth in the preceding paragraphs, JV agreements require a unanimous approval of JV partners on matters that are fundamentally major decisions concerning the JV. These reserved matters may range from decisions relating to annual plans and budgets, material capital investments, disposal of assets, reduction of overall headcount and payroll costs, or early termination rights related to key commercial agreements.

Many JVs are struggling in making quick decisions relating to operations of the JV, which is especially required during these difficult times since these decisions are mostly related to the reserved matters that require a unanimous decision from the JV partners. And, in some cases, this may as well trigger the veto rights of the JV partner, hence contributing to the slow and cumbersome decision-making process. Moreover, the executive officers appointed by the JV are required to conduct the business of the JV in accordance with the business plan and a budget, which are approved, based on a certain projection from the previous financial year; however, these unprecedented times have rendered annual plans and budgets unpredictable and impractical.

Since a major chunk of decision-making during these times is concerned with reserved matters, including business plan and budget-related decisions, it is often the case that the JV partners may not be able to agree on one of the matter and therefore trigger a deadlock. In such an event, JV agreements do provide for a deadlock mechanism through some sort of resolution process by initiating meditation and at times even arbitration. It is mostly the 50/50 controlled JVs with each JV partner having equal split of control and ownership which are more prone to these decision-making deadlocks

Though during a deadlock under normal circumstances, a fall-back provision of 'status-quo' in the JV agreement proves to be beneficial, that requires the JV to be run in the normal course of business-as-usual, but with harsh economic realities during this pandemic, the status-quo provision may prove to be counter-productive.

JV partners also need to keep a look-out for triggering of a forced buy-out option by a JV partner during an ongoing decision-making stalemate. Instances have occurred where decision-making deadlocks have been engineered, enabling a JV partner to potentially acquire an additional stake in the JV at a time when the valuation of shares and assets have plummeted. As a result, such a JV partner can have more control/stake and in-turn the governance rights in the JV at much less expense. As a JV partner is already deeply engaged in the working of the JV, the process of buy-out can be initiated with little or no due diligence and value discovery process. It could also be the case that the JV agreement lays down the valuation procedure based on historical financial figures that may not be a true representation of the current economic downturn or perhaps may even be unjustifiably punitive. In cases where buy-out does become a genuine option, the JV partners will have to agree upon a valuation of the JV or even engage a third-party appraiser for the same. It is important to note that in an exit scenario, a JV partner must evaluate its obligations relating to any guarantees or security/collateral provided, funding commitments, existing loan arrangements, licenses and other intellectual property related issues which may continue to exist after the exit and its viability in continuing to maintain them.

Defaults

Among the issues cropping-up during this pandemic for a JV, there is also a high risk of inadvertently triggering a default under the JV agreement, especially when a JV partner is part of a group. More often than not, the insolvency definition relating to the JV partner includes a default by a group company of the JV partner, which is unable to service its debt or has entered into negotiations with its creditors. The reviewing of the insolvency definition across the board is of primary importance during this time for a JV partner, which may allow a solvent JV partner at least the time and the option to pull out from JV in advance of any actual insolvency, or to establish control of the JVs interests and assets through initiating a transfer. This may also help in reducing the risk of JVs' assets' becoming part of any enquiry of an insolvency administrator, if any. Still, to the great relief of stakeholders across the board, both the German and the Indian government have suspended the initiation of fresh insolvency proceedings to shield companies impacted by the outbreak of Covid-19 for a certain period of time.

Though defaults can be triggered by breaches of JV agreements, ranging from failure to make a capital contribution or any advance, an assignment and/or sale for benefit of the creditors or otherwise or any legal action undertaken by the creditor, JV partner is generally entitled to a cure period to remedy the default. During this pandemic; however, such cure period is often inadequate.

JV partners have to keep in mind the consequence of a default may vary from triggering cross-defaults, winding-up of the JV to any industry-specific consequence. And, it may also lead to the trigger of a call-option by the holder of such option which allows the non-defaulting JV partner to purchase the shares of the defaulting JV partner at a discount, or in some circumstances a put-option by virtue of which the defaulting JV partner must buy the non-defaulting JV partner's share at fair market value or higher.

Conclusion

These are unprecedented times, which require innovative and strategic steps to resolve a myriad of issues and help re-lay the focus of the JV partners on the long-term gains which truly contribute to the success of a JV.

We are seeing a number of our JV partners creating a revised operational structure by establishing working groups and committees to streamline and fast pace the decision-making process, rather than following deadlock resolution mechanisms.

Views are personal only

(Ishan Zahoor is a commercial lawyer at Pinsent Masons. Email: ishan.zahoor@pinsentmasons.com)