Deadlocks in cross border joint ventures

Kinshuk Jhunjhunwala & Vinita Choudhury

Why are we talking about joint ventures?

Businesses have combined their strengths for years with a common goal to increase synergies. Saturation of the world’s developed economies has led to a need for their corporates to expand operations beyond their territory. While these corporates have the benefit of technological innovation or financial muscle on their side, developing economies bring with them the promise of growth and expansion potential. The BRICS nations, with their massive population and expansive territorial limits provide an ideal playground for such collaboration.

Joint ventures in India typically entail a technical or financial collaboration, with a foreign joint venture (JV) partner providing technological or financial support to overcome the stiff competition and the Indian JV partner overseeing operation and execution of the project to get around regulatory rigmarole in India. This diversity of roles played by JV partners often leads to deadlocks due to differing visions on part of the JV partners.

What are deadlocks?

A deadlock is a disagreement between JV partners that remains unresolved for a pre-agreed time-period. An unresolved deadlock has the potential to stall the project and render the JV ineffective.

How does one “address” potential deadlock scenarios?

The JV partners should, at the very outset, identify key issues that are likely to result in a stalemate a few years down the JV’s business cycle. These points should be identified in the context of the objectives of each JV partner when they enter the JV.

The JV partners should designate potential points of deadlock into 2 buckets. The first bucket would contain key matters that may need the JV partners to provide a formal resolution process and ultimately part ways. For instance, the JV partners may have differing views on expansion and capacity. While the foreign JV partner may view the JV as a mode of simply reaching out to a singular new territory, the Indian JV partner may view the JV as a platform to expand operations to territory beyond its own waters. There could be various issues with such expansion. To name a few, (i) finances for such expansion would typically come from the foreign JV partner and the Indian partner would reap most of the benefit; and (ii) expansion of operations may lead to ‘cannibalisation’ of the foreign JV partner’s existing market.

The other bucket would contain less important matters, where pending deadlock resolution, business goes on as usual as if the deadlock matter had never happened. For these sort of deadlock matters, discussions on the deadlocked issue may be escalated to senior management but would never ultimately lead to an exit by a JV partner. For instance, a deadlock on shifting of a corporate office or change of corporate name may not warrant a situation where the deadlock needs to be resolved by winding up of the JV or exit by a JV partner.

How would JV partners part ways and how does one ensure that JV partners do not engineer an exit by causing a deadlock?

1. Exit based resolution mechanism:

JV partners have been grappling with situations where an unscrupulous partner may cause a deadlock on flimsy grounds to engineer an early exit. While this would partly be addressed by separating the deadlocks into buckets as previously mentioned, the JV partners may provide for certain deterrents in their exit clauses as follows:

1. Deterrence clause:

A deterrence clause provides for the determination of the fair market value (FMV) of each JV partner’s share in the business, usually by having it valued by an independent expert by way of a service of notice by a party. Once the valuation is made, the party who served the notice must either: (a) buy all the other party's share in the business at a premium on the FMV; or (b) sell its share to the other party at a discount on the FMV.

Key considerations:

• Since the party serving the deadlock notice needs to buy out the other party at a premium or exiting at a discount, this clause works very well to deter a party from engineering an exit.
• Pricing Guidelines: In most cases, a deterrence clause will work against a resident JV partner as the resident JV partner will be unable to purchase shares of the foreign JV partner at a premium or sell its shares to the non-resident joint venture partner at a discount.[1] Accordingly, the resident JV partner may find it difficult to honour its obligations under a deterrence clause.

 Russian roulette:

Under a Russian roulette clause, either party may serve a notice on the other offering either: (a) to buy the other party’s shares; or (b) to sell its own shares to the other party, at a specified price. The party in receipt of the offer may either accept the offer or reverse the offer at the same price.

Key considerations:

• The party serving the deadlock notice is exposed to the risk of being forced to buy out its JV partner’s shares or to exit the JV due to the reversal mechanism.
• Pricing Guidelines: Given that the foreign JV partner will have a cap on the sale price and a floor on the purchase price, in almost all circumstances, neither party will be able to reverse the offer and such clause may not work in the context of an Indian company.
• Texas shoot out:

A Texas shoot out clause involves each party sending a sealed bid to an independent third party with a binding offer stating the price at which such party is willing to buy out the other party entirely. The party making the highest bid (Highest Bidder) wins and the Highest Bidder is then required to buy out the other party and the other party is required to sell its shares to the Highest Bidder at the stated price.

Key considerations:

• The price in the sealed bid should be carefully evaluated by the parties as a high bid price would entail the party paying a higher premium to buy out the other party, whereas a low bid price may lead to the party being forced to exit the JV at a lower price.

Pricing Guidelines: In most cases, a Texas shoot out clause will work against a resident JV partner since the resident JV partner will have a cap on the purchase price and will not be able to offer a higher bid than the foreign JV partner. The foreign JV partner would simply be in a position to buy out the resident JV partner by marginally bidding above the estimated FMV.

While earlier, exits by JV partners were often frustrated on account of unenforceability of the exit clauses due to pricing guidelines, the Delhi High Court, in its recent judgments in Cruz City Holdings v Unitech Limited and in NTT Docomo Inc v Tata Sons Limited, has demonstrated a lot of initiative in assuring investors that corporate India would be made to stand behind their contractual obligations and honour their exit commitments. If the JV agreement does not provide alternate mechanisms to get around the pricing guidelines or if the resident JV partner is unable to honour its commitment to sell its shares or buy the other party’s shares, the party failing to honour its commitment may have to pay damages instead. Exchange control approvals are relatively easier to obtain for making payments for damages.

 Other resolution mechanism:

1. Winding up:

If the joint venture has irretrievably broken down and none of the aforesaid actions are commercially feasible, the parties may mutually decide to wind up the joint venture company and distribute the assets. However, winding up in the Indian scenario is a court driven and long drawn process. Further, the JV partners would be liable to pay tax on the proceeds received by them after winding up, making this an inefficient resolution mechanism.

2. Arbitration / Mediation:

Arbitration or mediation is also seen in joint venture agreements as a mechanism for resolution of deadlocks. The freedom given to the parties to choose the arbitrators, the procedure for adjudication, including opting for institutional arbitrations, makes arbitration an attractive option for JV partners. Arbitration, however, is viewed as sub-optimal in a lot of cases since the deadlock may be commercial in nature and the arbitrator may not have the commercial expertise to provide a helpful view. Another work around for this is to refer the deadlock to an independent expert, though the role of the independent expert is practically limited to providing data for resolution of the deadlock.

On a concluding note, it is ideal for JVs to avoid a buy out or an exit as a deadlock resolution mechanism and instead settle deadlocks by senior management intervention, with business continuing in the ordinary course (with perhaps even deemed approval for growth up to a certain pre-agreed percentage). There are various other measures that parties may adopt – for instance, addressing expansion related deadlocks by providing a right of first refusal (ROFR) to the JV for any upcoming opportunity. In case the JV declines the opportunity, either JV partner could have the right to pursue such declined opportunity on their own. The entire point of a JV is to come together and do business in accordance with long-term interests of a JV, rather than to part ways upon disagreement.

Author is Kinshuk Jhunjhunwala (Principal Associate) and Vinita Choudhury (Senior Associate) at Khaitan & Co

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