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Fundamentals of Joint Venture Success

May 13, 2015
A joint venture may make sense for lots of reasons, but how it is established is critical to its success. Partnership is a big step. Look before you leap! Defining governance, control Defining partners’ obligations Documenting the exit strategies

There are many good reasons for a forger (or any manufacturing company) to enter into a “joint venture”: Joining with another industry player or competitor can expedite a producer’s entry into a new geographic region or product market, provide a way to share the cost and risk of a new venture, or allow companies with different capabilities to combine their specialties in a manner that benefits each of them. In a foreign country, it can provide a partner knowledgeable about local business and markets, or a mechanism for investment that otherwise would be prohibited by local regulations.

However, statistics show that many JVs fail, and often it is because they aren’t fully and carefully considered at the outset. While lawyers should actively participate in the planning and documenting stage — and three critical, legal aspects of a JV’s formation are examined below — it is a big mistake to turn the process over to lawyers exclusively.  Before you sign any JV agreement your organization’s operations people must spend a lot of time, alone and together with the potential JV partner, talking through “what if” scenarios and making sure that the JV partners’ expectations, culture, and goals are aligned.

Properly planning and documenting a joint venture is critical to ensuring that all relevant issues are addressed and that the parties’ agreements are accurately expressed. 

Defining Governance and Control — Once a JV is proposed, the first legal consideration must be to define how it is to be governed.  There is no legally required structure for a JV; the form depends upon the scope and duration of the joint venture, and tax, accounting, intellectual property, and antitrust considerations. Often, a new limited liability company (LLC) or corporation is formed through which the JV operates. Sometimes, no legal entity is formed and a JV is established the form of a complicated contract.

No matter the form of the JV, it must be managed and controlled by a board or other governing body. How will the members of the governing body be appointed? Will it reflect the partners’ ownership shares or some other allocation? In a 50/50 joint venture, it’s typical for half the board members to be appointed by each partner. If one party contributes greater resources, it will want control of the governing body.

Sometimes the law of the jurisdiction where the JV is located will prohibit foreign majority ownership. For example, Chinese regulations prohibit foreign control of investments that are deemed to be in the national interest or that compete with state sanctioned monopolies or favored domestic industries.

Will the JV be managed by a president or other officer? The JV agreements must spell out clearly which decisions will be made by the officers and which decisions must be made by the governing body. If the governing body is controlled equally (50/50) by the parties, then all decisions of the governing body must be agreed upon by the parties. But, if a majority of the governing body is appointed by one party, the other (minority) party should request the protection of “super majority” provisions applicable to specified decisions.

For example, how significant must a contract be before it must be approved by the governing body? And then, how significant must a contract be before it must be approved by both majority and minority JV partners? What about taking on debt? Issuing stock? Buying property? Buying out a member? Buying significant equipment? Approving a business plan? Adding a new JV partner? The JV documents should clearly address the mechanism for making these and a myriad of other decisions.

Fiduciary Responsibilities

Next come the definitions of each JV partners’ obligations to each other and to the venture. The governing body, particularly of a JV organized as a corporation, LLC, or partnership, has a fiduciary duty not existing in an arm’s length commercial relationship. This duty means that a member of the JV governing body must do more than watch out for the interests of the party who appointed him or her. Instead, that person (and the partner that he or she represents) has a duty to look after and demonstrate loyalty to the JV itself, and must act with good faith and integrity in dealing with their partner. Although fiduciary duties can be waived or modified under certain state laws (and this should be considered in drafting the JV agreement), in general joint venturers must assume that they owe a fiduciary duty to the JV and to each other, and act accordingly.

One example of breach of JV fiduciary duty claims in the news recently involved a 2007 JV between Tiffany and Swatch to jointly develop and sell watches. Swatch initiated legal proceedings against Tiffany in 2011, claiming among other things that Tiffany breached its fiduciary obligations, in that Tiffany did not in good faith try to sell the watches. Swatch won an arbitration award of approximately $419 million against Tiffany.  In March 2015, Tiffany announced that a Dutch court overturned the arbitration award.

Undoubtedly, the battle will continue. The lesson from this example is that JV partners must recognize that if their individual goals deviate from the goals of the JV or the other partner, discussion, negotiation and compromise must follow. A JV partner that follows its own goals to the detriment of the JV or its partner risks a serious legal challenge that it breached its fiduciary duty.

Getting Out Safely

Perhaps the most difficult issue in documenting a JV is the exit strategy. The average joint venture lasts only about five years. A good JV agreement includes mechanisms by which the partnership can be terminated, sold, and/or by which one party can “buy out” the other.

Commonly, default in fulfilling obligations under the agreement by one party can result in termination of that party’s interests at a stated price or formula. In a non-default situation, the parties may wish to provide “put” or “call” rights.

Frequently, JV agreements will have a “right of first offer” or “right of first refusal,” by which the selling party must give the other party the opportunity to buy its interest before selling to a third party. The problem is agreeing upon a fair way to determine the buyout price. Some JV agreements rely on appraisal, and some on a formula price. Either of these may prove to be inaccurate over time.

Due to this uncertainty, a “Russian roulette” or “Texas shoot out” provision might be used, giving either party the right to offer to sell its interests to the other party for a price determined by the offering party. Then, the party receiving the offer has the right to accept it or turn the tables and buy the offering party’s shares at the offered price. This is intended to cause the offering price to be reasonable -- but if the non-offering party is in financial distress, unfairness can result.

A JV agreement also may contain “drag-along” or “tag-along” rights, the former giving the majority owner the right to require the other party to sell its interests to a third party upon request, and the latter giving the minority owner the right to “tag along” in when the majority shareholder sells out its interest. The parties also might include as part of any exit strategy the continuation of confidentiality and non-compete obligations of the selling partner.

In sum, the most critical aspect of a successful JV is choosing a trustworthy partner whose interests are aligned, and talking through all the what-if’s before signing the agreement. The parties must recognize their fiduciary obligations to each other, and negotiate a JV agreement that comprehensively and clearly provides for how the JV is to be governed and terminated. 

Susan Apel is a partner at K&L Gates LLP in Pittsburgh, and the former general counsel of Ellwood Group Inc. Contact her at [email protected].