As the prevalence of COVID-19 continues to grow worldwide, together with the resulting social and business restrictions, the inevitable fallout will be a failure to achieve business plans and an increase in business insolvencies.
The UK Chancellor, Rishi Sunak, stated whilst unveiling recent plans for a £330bn economic boost in light of the pandemic, “this is an economic emergency. Never in peacetime have we faced an economic fight like this one".
In light of the economic environment, businesses should give serious consideration as to how to deal with a situation where joint ventures and joint venture partners are struggling financially or are susceptible to insolvency.
What are the risks?
Joint venture parties should be considering a number of issues such as:
- how to protect joint venture assets where a joint venture partner is in (or is susceptible to) default;
- how to mitigate exposure where the joint venture vehicle or its operations may lead to default;
- what if the purposes of the joint venture are going to fail due to coronavirus through no-one's fault?; and
- how to discontinue a relationship with a defaulting joint venture partner effectively.
For a five minute health-check of issues to consider in the context of joint ventures generally, see COVID-19 UK: Protecting your JV operations – Five minute health check.
PROTECTION AGAINST JOINT VENTURE PARTNER DEFAULTS
1. Review joint venture documents to establish the trigger for an insolvency-related default
Most joint venture agreements/shareholder agreements will contain default provisions which are triggered upon breach of one of the parties to the agreement. However, whilst a party's failure to pay following a demand is often the focus of default provisions, default may also be triggered when a joint venture partner is in financial difficulty and/or is insolvent.
Insolvency-related default clauses can vary widely in their drafting, including the time at which they may be triggered. The recent Government announcement as to the suspension of wrongful trading rules and the position being adopted by the courts to slow down or halt winding up petitions and administration orders mean that formal insolvency procedures may well be relaxed or delayed – for further details see COVID-19 UK: Prospective changes to insolvency law (England and Wales). However many default clauses will apply in situations which are short of formal insolvency.
Joint venture partners should review insolvency default clauses as soon as possible. The ability to utilise these clauses may well give the solvent parties the option to withdraw from joint venture in advance of any actual insolvency, or to take full control of joint venture interests and/or assets through compulsory transfer provisions. This reduces the risk of joint venture assets forming the subject of an insolvency practitioner's enquiries, and also reduces the risk of being caught in a joint venture with an undesired third party.
A key factor when reviewing and/or drafting insolvency-related event of default clauses, is the point at which the clause is engaged. Options include deeming a joint venture partner insolvent when:
- "the value of its assets is less than its liabilities (taking into account contingent and prospective liabilities) for the purposes of section 123 of the Insolvency Act 1986"
The relevant provision in section 123 of the IA86 is subsection (2), which states that "a company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities."
However, the application of this test can be relatively complicated, requiring a detailed consideration of the particular circumstances of the company whose solvency is being assessed and the prospective or contingent liabilities in question; if the counterparty were to resist the enforcement of this sort of provision it may not provide a straightforward ground to terminate.
In the context of a default clause, it is better instead to define insolvency through a strict balance sheet assessment which expressly excludes the section 123(2) test.
In any event, given that it may not be possible to assess a joint venture partner's balance sheet solvency contemporaneously, a broader provision should be considered.
- "it [the defaulting party] suspends making payments on any of its debts or, by reason of actual or anticipated financial difficulties, commences negotiations with one or more of its creditors with a view to rescheduling any of its indebtedness"
This provision allows a joint venture party greater scope to challenge a joint venture partner's solvency, by including reference to cash flow insolvency both on a formal basis (usually following the expiration of a statutory demand), as well as a factual assessment after a shareholder suspends payments of any of its debts.
Further still, the clause affords a joint venture party a better chance to claim that its counterparty is in default should it commence negotiations with its creditors by reason of its actual or anticipated financial difficulty.
In comparison to clause (i), clause (ii) therefore accelerates an insolvency-related event of default given its wider drafting.
2. Consider notice periods which run from an insolvency-related event of default, and their effect on the timeline
Even if an insolvency-related default can be established, some joint venture agreements will grant the shareholders time to remedy short-lived insolvency following a notice of default. The party claiming default should therefore consider the potential timeline as early as possible.
If the event of default is not cured in time, the claiming party can usually serve a default notice on the defaulting joint venture partner, which may require the defaulting shareholder to sell all of its shares to non-defaulting shareholders in proportion to their holding of shares in the joint venture through compulsory transfer mechanisms.
Finally, whilst a default notice can give rise to the forced sale of the defaulting shareholder’s shares, the actual transfer of those shares can be delayed as a result of administrative or regulatory requirements. Accordingly, parties should ensure that provisions are drafted to give a compulsory transfer right in relation to an insolvency default as early as possible.
3. Consider the ramifications of serving a default notice
Apart from the compulsory transfer of the defaulting shareholder's shares in the joint venture company, consequences of a default notice also often include:
the suspension of voting rights attached to the defaulting shareholder's shares;
limitations on the day to day management participation of directors appointed by a defaulting shareholder; and
the cancellation of a defaulting shareholder’s entitlement to information from or about the joint venture.
As a result, from the moment a default notice is served, non-defaulting shareholders often have the ability to advance their chosen agenda(s), and to position the joint venture as attractively as possible should third parties be approached as potential incoming shareholders following expulsion of the shareholders in default.
As for the sale of the defaulting shareholder's shares, it is common to see compulsory transfer mechanisms which provide that the shares subject to a compulsory transfer be offered to the non-defaulting shareholders at a discount on fair value on account of the defaulting shareholder's default. However it is possible that a liquidator of the defaulting party might challenge such a provision so parties should proceed with caution and take legal advice before attempting to enforce a compulsory transfer for less than fair value.
PROTECTION AGAINST INSOLVENCY OF THE JOINT VENTURE COMPANY: SECURITY AND SEPARATION OF LIABILITIES
Often one of the main reasons for establishing a joint venture in the first place is to ring-fence any assets of the joint venture and to protect the parties from further exposure. However if the parties have to provide guarantees or security to third parties for the joint venture liabilities, removing a joint venture party on grounds of insolvency can increase the remaining party's guarantee liability
In the context of finance guarantees, it is often the case that the original parties guarantee the joint venture company's obligations on a joint and several basis, meaning that each guarantor could potentially be liable for the full amount in respect of which the guarantee is given. Whilst the parties may enter into a contribution agreement giving each guarantor the right to seek contribution from other guarantors, insolvency-related defaults by their nature undermine the comfort derived from such an agreement. Instead, should the beneficiary of the guarantee call upon the parties under its guarantee this may well crystallise an already financially dubious joint venture partner's insolvency and place the entire liability with the remaining party. Having had to pay out under the guarantee, the solvent party may then be left with an unsecured debt against the joint venture company which may well have prior ranking creditors to pay first.
The ramifications of granting security in respect of the joint venture company's obligations present similar risks. For example, if a joint venture party has granted charges over its shares in the joint venture company, any default on the underlying liability could lead to enforcement of the charge, in turn resulting in an undesired third party (likely with a keen interest in liquidating any remaining value in the joint venture) suddenly becoming a co-party to the joint venture. A similar control-centric risk assessment is key in the context of debentures, where holders may have the right to remove and/or appoint directors.
It is therefore imperative for joint venture parties to consider the actual separation of liabilities between the joint venture company and the shareholders themselves, and to investigate restructuring options at an early stage to curb increased exposure in the event of
a joint venture partner's insolvency-related default.
FAILURE OF THE JOINT VENTURE ITSELF
The foregoing has looked at the position in the event that one of the joint venture partners is, or is near, insolvency. But what if neither party is in default but the business cannot operate due to the commercial effects of the coronavirus pandemic? Perhaps the business plan adopted by the parties, and which they will have undertaken to use all reasonable endeavours to achieve, is incapable of being fulfilled?
Very few joint venture agreements will contain force majeure clauses, and in any event such clauses would be of little assistance, given that it isn't the performance of one of the parties which is under scrutiny. If the parties disagree on the viability of the business, the only solution will be any deadlock resolution procedures contained in the joint venture agreement. Such provisions will usually prescribe what amounts to a fundamental disagreement and a procedure for attempting to resolve the disagreement. Ultimately though, if the disagreement cannot be resolved, the solution under these types of provisions will usually be either a winding up of the joint venture or one or more of the parties buying out the shares of the others.
If there is a disagreement over the viability of the joint venture business, before invoking and deadlock procedure, the party concerned should check whether it has any open obligations to fund the business which could survive any deadlock procedure (this would unusual but possible).
FORMALISE/UPDATE JOINT VENTURE ARRANGEMENTS
Some joint ventures will operate on more of a “trust” or “usual course” basis. This is particularly so where joint ventures have been operating over a long period of time. At this time of uncertainty, it is important to formalise and update joint venture relationships by:
- ensuring that there is a joint venture agreement/shareholders’ agreement in place;
- ensuring that any joint venture agreement/shareholders’ agreement is up to date and relevant to current business practice;
- ensuring that any financing arrangements (such as shareholder loans) have been formally documented on an arms length basis; and
- ensuring that records and accounts are agreed and accurately reflect the understood position.
Whilst almost all joint ventures will operate under a formal agreement, many such agreements will not have been properly reviewed or updated to reflect legislative changes and current best practice.
Clarity of obligations is also of paramount importance when it comes to the funding requirements and history of each joint venture party. Many joint ventures will have received shareholder funding over a period of time which has not properly documented (i.e. through shareholder loan agreements) or where the position has become unclear. In current circumstances, it is all the more important to ensure that joint venture partners are clear between themselves as to the liabilities owed to and by each joint venture partner; this should be formally documented.
Formalising shareholding funding arrangements will be valuable in the event that it becomes necessary to pursue a defaulting shareholder for any shortfall, since any claim could be based on a liquidated debt as ascertained through reference to the funding arrangements, rather than needing to pursue formal dispute resolution to come to the amount owed. In the context of a financially strained joint venture partner, a liquidated debt forms a powerful basis upon which formal insolvency proceedings could be threatened. In turn, such a liquidated debt could allow for more prompt repayments to be procured to the joint venture company or other shareholders than if the debt was disputed and there was no formal documentation speaking to its nature or amount.
Additionally, should further funds be required in order to fulfil the objectives of the joint venture company, it may be desirable to place stringent funding obligations on the parties to contribute finance when required. Penalties for non-compliance with an additional contribution demand commonly include interest-bearing loans from non-defaulting shareholders who are left to cover a resulting deficit.