As the COVID-19 outbreak has evolved into a worldwide economic shutdown, businesses are reevaluating their operating plans in order to remain viable. This is particularly true for joint venture (JV) businesses, which are owned and jointly controlled by two or more partners or equity holders.
Through dozens of alerts, articles, and blog posts, we have addressed a multitude of legal and commercial impacts caused by this pandemic, including supply chain challenges, employment considerations, and legislative actions. Our aggregated COVID-19 topic center and resources can be found here.
JVs are uniquely customizable business structures. As we’ve learned by listening to, and working with, our clients over the past few weeks, the COVID-19 issues JVs are facing can be equally unique. The available solutions to these issues are often collaborative and creative. JV partners are navigating daunting liquidity challenges and making mission critical operating decisions as a result of the impact of COVID-19. Each of these decisions presents meaningful risk for disagreement or “deadlock” among the JV partners that can place the existence and direction of the JV in jeopardy.
Below we discuss some of the more impactful themes for JVs and their operations during this global crisis. While the commentary below is necessarily general in nature, ideal solutions to individual JV problems are often bespoke; so please reach out to us any time to discuss your specific issues. We are very happy to leverage our global experience, and there’s a good chance that the issues you are currently facing are ones that we have already had to consider for other JV clients.
New strategic directions
JV arrangements commonly require unanimous partner approval before key decisions are made regarding the JV and its operations. The scope of these decisions – often referred to as “major decisions” or “reserved matters” – is negotiated in advance among the JV partners. Almost universally, these major decisions include strategic operating plans, annual and capital expenditure budgets, debt and equity financing topics, executive officer appointments and compensation, acquisition or disposition of key assets, material commercial arrangements, related party transactions, and dissolution and liquidation of the JV.
JVs typically run based on strategic operating plans and annual budgets that are approved as major decisions by the JV partners. Executive officers are directed and empowered by the JV partners to conduct the day-to-day business of the JV in accordance with these approved plans and budgets. COVID-19 has fundamentally changed the economic and operating landscape for many JVs, rendering it impractical or even impossible for the JV to continue to operate pursuant to these previously approved plans and budgets for the remainder of 2020.
Our JV partner clients are proactively evaluating the strategic direction and budgets for their JVs. We are seeing JV partners desiring to cause their JVs to eliminate or defer material capital investments or expenditures, reduce overall headcount and payroll costs, exercise force majeure or early termination rights related to key commercial agreements, and dispose of select assets. JV partners are, in some cases, also seeking to amend or terminate existing supply, distribution, support, and other related party commercial agreements with their JVs, including to bring certain functions historically performed by the JV “in-house,” which itself may be a source of dispute. In more extreme cases, one or more of the JV partners may wish to discontinue the joint venture and liquidate the entity. Any of these actions is likely to be a major decision or reserved matter under the JV agreement, requiring unanimous consent of the JV partners.
While the environment is ripe for partner disagreements, we are mostly seeing alignment among JV partners in making major strategic decisions arising out of the COVID-19 pandemic. Where they are not aligned, meaningful disputes are arising and deadlock may prove inevitable.
Liquidity challenges and capital funding obligations
With the present economic shutdown, many JVs face imminent liquidity challenges, as revenue sources dry up and operating expenses pile up. JVs with debt leverage are assessing impacts to their financial covenants and material adverse change (or MAC) provisions and are also taking proactive steps with their relationship lenders. We are helping clients to increase their overall working capital borrowing capacity and draw down on their revolving loans in order to help alleviate these short-term liquidity concerns.
Many JVs do not, however, have third-party credit facilities. Instead, JV partners are relied upon to provide funding or additional capital contributions to the business when needed. Capital contribution provisions within JV agreements generally come in two flavors – mandatory and voluntary. JV agreements that impose mandatory capital contribution requirements may provide an avenue for one or more of the JV partners to unilaterally cause the JV to quickly call capital to fund business operations. That said, mandatory contribution requirements are not all that common for operating capital needed by JVs. Instead, most JV agreements do not require (or even permit) additional capital contributions by one or more of the JV partners without unanimous partner consent. This is because equity financing is usually a major decision or reserved matter.
Our JV partner clients are carefully evaluating the nature and magnitude of their various capital contribution requirements to JVs. At the same time, they are assessing the current financial wherewithal of their JV partners to determine if they will be able to satisfy their portion of the capital needed by the JV. Where there are mandatory capital contribution requirements and a JV partner is not able to fulfill its obligations, we are advising our clients about punitive dilution and other remedies that may be available under the JV agreement.
As our clients address head on the liquidity challenges faced by their JVs, they are exploring various partner financing alternatives including:
— Proportionate debt or equity financing: The JV partners provide additional equity capital or debt financing to the JV on a pro rata basis, with no adjustment to ownership shares or governance rights;
— Disproportionate equity financing: One JV partner provides equity financing to the JV, resulting in dilution to the non-funding JV partner and, in some cases, adjustment to the parties’ relative governance rights; and
— Disproportionate debt financing: One JV partner provides short-term or long-term debt financing to the JV, which does not result in ownership dilution to the non-funding JV partner, but provides the funding partner with various economic priorities, including a market interest rate, and collateral and governance rights as a lender to the JV.
Where one JV partner refuses or is unable to contribute capital to the business (and the other partner desires to continue operating the business and has sufficient available capital to do so), the funding JV partner may require revisions to the governance structure such as diminished decision-making/operating roles for the non-funding partner or officers affiliated with the non-funding partner; partial or total loss of board representation for the non-funding partner; or loss of some or all major decision protective provisions for the non-funding partner. Non-funding partners will likely be reticent to agree to complete overhauls of heavily negotiated governance structures, so it is important to take a calculated approach to the scope of these revisions and to consider preserving the non-funding partner’s participation in certain truly fundamental major decisions or reserved matters.
Deadlock risks, ownership buyouts, and other potential solutions
As noted above, it is possible that JV partners may not be able to agree on critical major decisions for their JVs, and equally controlled JVs are especially vulnerable to deadlocks in decision making. Deadlock in any JV is a tough spot – it can trigger a slippery slope of increasingly more drastic and sometimes unforeseen outcomes for the JV partners.
JV agreements often include a “status quo” provision that requires the JV partners to maintain the operational status quo and continue to run the business consistent with past practice if deadlock arises. Having this clear fallback position is valuable under normal circumstances, as it predetermines a path forward for the business. Maintaining the status quo may not, however, be in any JV partner’s best interest and doing so may, in fact, be financially or operationally devastating in the current economic environment.
JV agreements sometimes also include other forms of deadlock resolution, such as non-binding mediation or binding arbitration by third parties. Less often JV agreements will mandate a buy-sell process if deadlock can’t be timely resolved by the partners. In that case, valuation mechanics may or may not be prescribed within the JV agreement. Where valuation mechanics are prescribed and those mechanics rely on multiples to historical financial results, such valuation may not be representative of the new economic reality facing the JV as a result of COVID-19 or may be unduly punitive at this particular moment in time.
If stalemate among JV partners persists and contractual resolutions are not available or palatable, then cash-rich JV partners may see this as an opportunity to buy out their other JV partners. The economic impact of COVID-19 may permit them to do so at bargain prices. In contrast to typical M&A transactions, JV partner buyout transactions can be accomplished quickly and with little diligence, as all parties have been heavily involved in the business. The principal task of the JV partners will be to agree upon (or engage a third party to calculate) a valuation of the business. Once that is completed, the transaction documents are often straight forward, focusing on only the fundamental matters needed to transfer ownership.
Unresolvable deadlock can lead to judicial dissolution
Even though JV partners will have a number of options available to attempt to resolve deadlock, in some cases, negotiations may break down and JV partners may simply be unable to agree on any path forward. One or more of the JV partners may desire to liquidate and dissolve the JV. Voluntary dissolution and liquidation is nearly always a major decision or reserved matter requiring unanimous partner approval. Where only one of the JV partners desires to liquidate and dissolve the JV, the slippery slope of deadlock can in the United States, for example, give rise to the often unforeseen result of that JV partner unilaterally petitioning for judicial dissolution of the entire business.
Where judicial dissolution is an available remedy, the process and outcomes vary across jurisdictions, but in many instances they result in judicially mandated sale mechanisms. As such, they allow one or more partners to seek and obtain judicial relief where deadlock between the partners makes it not reasonably practicable to continue to carry on the business in conformity with the JV agreement. As an example, Delaware courts will generally grant judicial dissolution where there is a deadlock between equal owners, the JV agreement does not include a mechanism for breaking the deadlock, and the JV agreement does not include an exit mechanism that would provide the aggrieved party with complete and equitable relief. Once judicial dissolution is granted, courts typically will appoint a receiver to liquidate the JV’s assets.
Judicial dissolution is often viewed as a remedy of last resort in the context of JV partner deadlock. That said, JV partners need to be conscious that, unless judicial dissolution or other similar remedies have been expressly waived in the JV agreement, they may be invoked and used as a means to supersede what is otherwise provided for in the JV agreement.
The COVID-19 pandemic is requiring JVs to navigate new operational structures, revised budgets and potential deadlocks in decision making. As we have described above, JV partners have a number of tools available to work through these issues and resolve disagreements in order to avoid unintended outcomes, such as judicial dissolution. Accordingly, and because of the relative importance of long-term relationships to the continued success of any JV, we fully expect to see most JV partners working collaboratively during these difficult times to best position their JVs going forward.