Covid-19 presents unique challenges for joint ventures

Written by Ishan Zahoor, a commercial law expert at Pinsent Masons, the law firm behind Out-Law.

Innovative, strategic steps will be needed in order to maintain and honour the contractual arrangements agreed between the contracting parties to a JV, and allow them to re-focus on the long-term gains of these arrangements.

JVs are strategic partnerships through which two or more parties come together to provide the capital, goods and services for a jointly controlled commercial project. This unique structure makes JVs particularly vulnerable to Covid-19 disruption which, if not handled properly, could lead to severe issues - from loss and financial instability, to decision-making deadlocks and defaults and even voluntary liquidation or insolvency.

Liquidity challenges

As revenue sources dry up and operating expenses rise due to the worldwide economic shutdown, the first step will usually be to review the JV agreement to see what additional funding contribution events and methods have been stipulated for the contracting JV partners.

If the JV agreement contains commitments to provide additional funding, one or more of the JV partners may come forward, or may refuse to participate. The consequences of refusal to participate are usually set out in the JV agreement itself.

If a JV partner is unable to participate in a particular call for funding, it will have to consider the implications of the resulting dilution of its stake in the JV and the associated impact on future economic and governance rights. A non-contributing JV partner may face issues including loss in representation on the board; reduced decision-making power on reserved matters; a reduced role in the operation of the JV; or even, in some cases, trigger an event of default.

Where the JV agreement does not contain any call for funding arrangements, or where additional funding from JV partners is only permitted once external debt-raising options have been exhausted, we have seen JV partners seeking external debt through restructuring repayments, increasing a working capital loan, fully drawing down on revolving loan facilities and reassessing financial covenants in the existing financing agreements. Any of these options will require unanimous approval from all the JV partners.

Raising additional external debt is also likely to change the existing capital structure of the JV, which may push the JV outside the scope of agreed financing terms and conditions with its creditors. When coupled with changes in the leverage ratio, this may allow the lender to seek additional security by way of guarantees or collateral from the JV partners, creating additional liabilities and obligations on each of them.

If the JV is primarily relying on additional capital contributions from JV partners rather than external debt financing, the JV agreement will provide for either mandatory or optional additional capital contributions. Ideally, the agreement will provide the specific amount of any mandatory additional contributions, and the circumstances under which they must be made. They will usually be made on a pro rata basis as per the partner's interests in the JV, and therefore have no impact on ownership, economic or governance rights.

Again, capital contributions will require unanimous approval from the JV partners.

Good governance and deadlocks

JV agreements require the unanimous approval of the partners on major 'reserved matters' concerning the JV. These matters can include decisions relating to annual plans and budgets, material capital investments, disposal of assets, reduction of overall headcount and payroll costs and early termination rights under key commercial agreements.

Many JVs have been struggling to make the decisions needed during these difficult times quickly. At the same time the business plans and budgets of the JV, on which the JV's executive officers are required to act, do not reflect the impact of the pandemic and are out of date.

JV agreements usually contain a 'deadlock' resolution mechanism for where the partners are unable to come to an agreement. This is usually mediation, but can be arbitration. In normal circumstances, a fall-back provision of 'status quo' will usually operate during a deadlock. However, this provision may be counterproductive given the harsh economic realties of the pandemic.

In response to the crisis, we have seen some JVs creating revised operational structures using working groups and committees to streamline the decision process rather than following existing deadlock resolution mechanisms.

JV partners must also be alert to the possibility of a partner triggering a forced buy-out option during an ongoing stalemate. Instances have occurred where deadlocks have been engineered, enabling one of the partners to potentially acquire an additional stake in the JV at a time when the value of shares and assets has plummeted. Where buy-out becomes a genuine option, the partners will have to agree on the valuation of the JV or engage a third party appraiser to do so.

The exiting partner must establish its obligations in relation to guarantees, security, funding commitments, loan arrangements, licences and other intellectual property issues which continue to exist after the exit.

Dealing with default

Partners should also be aware of the risk of inadvertently triggering a default under the JV agreement on insolvency grounds, especially when partners are part of larger corporate groups. More often than not, the definition of insolvency of a JV partner includes where a group company is unable to service its debt or has entered into negotiations with its creditors.

JV partners should make a point of reviewing the definition of insolvency in their agreement, in order to give a currently solvent partner the time and option of pulling out from the JV in advance of any actual insolvency, or to establish control of the JV's interests and assets through by initiating a transfer. This may also help in reducing the risk of the JV's assets becoming part of any insolvency proceedings. Some governments have suspended the initiation of fresh insolvency proceedings for a certain period of time, in order to shield otherwise viable companies impacted by the pandemic.

Defaults can be triggered by all sorts of breaches of JV agreements including failure to make a capital contribution or any advance, assignment or sale for the benefit of creditors or otherwise, and any legal action undertaken by creditors. The JV partner is usually entitled to a 'cure' period in which to remedy the default, although this period is likely to be inadequate during the current pandemic.

Consequences of default vary from triggering cross-default, winding up the JV and industry-specific consequences. It may also lead to the trigger of a call-in option, allowing the non-defaulting JV partner to purchase the shares of the defaulting partner at a discount; or a put-option requiring the defaulting JV partner to buy the non-defaulting partner's share at fair market value or higher.