As the love-struck engaged couple idyllically plans a new life together without ever imagining divorce, many soon-to-be joint venture partners draft their joint venture agreements without ever contemplating dissolution. Like too many marriages, joint ventures often end in dissolution because the parties disagree on key issues. However, a properly drafted deadlock provision in a joint venture agreement can prove to be as helpful as a well crafted prenuptial agreement.
In the event of a deadlock in a joint venture, it is helpful to have a clear mechanism in the agreement for resolving the conflict as that will streamline the process, avoid confusion and uncertainty, and save time and money. Deadlock provisions (a) provide a mechanism that will treat the partners fairly while at the same time allowing the business to continue, or (b) if a separation is inevitable, provide a mechanism that allows the company to survive in one of the partner’s hands rather than dissolve or be sold to a third party. Without a deadlock provision, dissolution of the enterprise is often the only choice. Below are some commonly used deadlock provisions:
Escalation. In the event of a deadlock, the joint venture agreement can provide that the issue is escalated to certain key executives of each partner in an attempt to solve the problem; unfortunately, this often results in the same deadlock.
Chairman Tie-Breaking Vote. The joint venture agreement can provide that the Chairman of the Board has the right to cast a tie-breaking vote in the event a Board vote results in a tie (this tie-breaker can apply with or without the escalation clause). The problem with this approach, however, is that it is not appropriate in every deadlock scenario (e.g., what is the penalty to be applied if a partner defaults on its capital contributions). Also, this gives one party control, which is contrary to the entire purpose of the 50/50 joint venture in the first place.
Independent Tie-Breaking Vote. To eliminate the problem of one party having too much control, rather than providing the Chairman with the tie-breaking vote, the joint venture can provide that an independent, non-executive director has the right to cast the tie-breaking vote. However, finding an independent director that the partners agree on may prove difficult for various reasons (and no person may be willing to take on this burden without any upside). Also, as with the Chairman tie-breaker vote, this is not appropriate in every scenario.
Mediation. Rather than merely casting a vote, the partners can hire an independent expert or arbitrator to find a solution to a deadlock. There are many different forms of mediation, ranging from a more formal arbitration and having the mediator make its own binding decision to “baseball mediation”, where each side writes down its final position and the mediator picks one side or the other (this should lead to the partners presenting their most reasonable position in order to be picked), to “golf mediation,” where the mediator writes down the most equitable solution and whichever partner presents a solution closest to the mediator’s wins. Mediation works well for factual matters but not so well for solving multi-faceted business issues, such as determining the best capital raising terms or whether to admit a new strategic partner.
Buy-Sell. When the parties do not want to let a third party settle the deadlock, one solution is the buy-sell provision pursuant to which one of the partners buys the other partner out. This can be handled in many different ways but the following are commonly seen favorites:
“Russian Roulette.” One partner serves notice to the other partner stating the notifying partner’s perceived value per share of the joint venture. The partner receiving the notice must then either sell all of its shares to the other partner at that price per share or purchase all of the other partner’s shares at that price.
“Texas Shoot-Out.” Each partner submits a sealed bid containing its perceived value per share of the joint venture. The partner with the higher bid buys the other partner out at the higher bid amount.
Dutch Auction. Each partner submits a sealed bid containing the lowest price per share at which it would sell all of its shares. The partner with the higher price buys the other partner’s shares at the lower price submitted.
Adjusted Fair Market Value. An expert or auditor determines the “fair market value” of the price per share. Once determined, the partner triggering the buy-sell provision will either buy the other partner’s shares at a set premium (e.g., 20%) or sell its shares to the other partner at an equivalent discount.
Buy-sell provisions are the last resort because, once implemented, the joint venture arrangement terminates and one partner acquires 100% of the joint venture vehicle. Careful consideration should be given to a partner’s current and future liquidity position because a less liquid partner could find it being forced out of the joint venture at a less than fair price. Also, a less liquid partner will need to ensure that the buy-sell provision cannot be manipulated to avoid the more liquid partner being able to trigger the provision on the pretext of a deadlock in order to buy the company (perhaps even at a discount).
In the absence of a deadlock provision, applicable law will govern. Below is a summary of how deadlocks are handled under Delaware and New York law based on whether the joint venture is formed as a corporation or limited liability company (“LLC”), which are the most commonly used forms of joint venture entities. Note that parties often prefer using LLCs as the entity choice given the favorable tax treatment and governance flexibility.
Custodian. If the joint venture is a Delaware corporation, Section 226(a) of Delaware General Corporation Law (“DGCL”) provides that, upon application of any stockholder, the Court of Chancery “may appoint 1 or more persons to be custodians, and, if the corporation is insolvent, to be receivers, of and for any corporation when: (1) at any meeting held for the election of directors the stockholders are so divided that they have failed to elect successors to directors whose terms have expired or would have expired upon qualification of their successors; or (2) the business of the corporation is suffering or is threatened with irreparable injury because the directors are so divided respecting the management of the affairs of the corporation that the required vote for action by the board of directors cannot be obtained and the stockholders are unable to terminate this division; or (3) the corporation has abandoned its business and has failed within a reasonable time to take steps to dissolve, liquidate or distribute its assets.” Such an appointed custodian has all the powers and title of a receiver appointed under Section 291 of DGCL, but the authority of the custodian is “to continue the business of the corporation and not to liquidate its affairs and distribute its assets,” except in limited cases.
Dissolution. In the event a partner does not want a court appointed custodian to continue the business and would rather terminate the business, the partner can seek dissolution under DGCL. If the Delaware joint venture corporation only has 2 stockholders that each own 50% of the stock therein, Section 273 of DGCL provides that, unless prohibited by the certificate of incorporation or agreement among the stockholders, either stockholder may petition the Court of Chancery “to discontinue such joint venture and to dispose of the assets used in such venture in accordance with a plan to be agreed upon by both stockholders or that, if no such plan shall be agreed upon by both stockholders, the corporation be dissolved.” Otherwise, if the Delaware corporation has more than 2 stockholders, Section 275 of DGCL generally requires the following for dissolution: (i) a board resolution approved by a majority of the directors and approval at a stockholders’ meeting of the stockholders owning a majority of the outstanding stock of the corporation entitled to vote thereon, or (ii) unanimous written consent of all of the stockholders entitled to vote thereon.
New York Corporation. If the joint venture is a New York corporation, Section 1104(a) of New York Business Corporation Law (“NYBCL”) provides that, except as otherwise provided in the certificate of incorporation, the holders of shares representing 50% of the votes of all outstanding shares entitled to vote in an election of directors may present a petition for dissolution on one or more of the following grounds: “(1) that the directors are so divided respecting the management of the corporation’s affairs that the votes required for action by the board cannot be obtained; (2) that the shareholders are so divided that the votes required for the election of directors cannot be obtained; or (3) that there is internal dissension and two or more factions of shareholders are so divided that dissolution would be beneficial to the shareholders.” Section 1104(b) of NYBCL provides that if the certificate of incorporation requires a supermajority vote of directors for board action or a supermajority vote of shareholders for board election, then a petition for dissolution “may be presented by the holders of shares representing more than one-third of the votes of all outstanding shares entitled to vote on non-judicial dissolution” under Section 1001 of NYBCL, which generally requires, except as otherwise provided under Section 1002 of NYBCL, a majority or two-thirds vote of the shareholders, depending on when the corporation is formed. Section 1104(c) of NYBCL provides that, “notwithstanding any provision in the certificate of incorporation, any holder of shares entitled to vote at an election of directors…, may present a petition for its dissolution on the ground that the shareholders are so divided that they have failed, for a period which includes at least two consecutive annual meeting dates, to elect successors to directors whose terms have expired or would have expired upon the election and qualification of their successors.” Section 1104-a of NYBCL provides for judicial dissolution under special circumstances, but the typical petitioner in such case is usually a minority shareholder wanting to be bought out by the majority shareholder(s).
Delaware or New York LLC. If the joint venture is a Delaware or New York LLC, Section 18-801 of Delaware Limited Liability Company Act (“DLLCA”) and Section 701 of New York Limited Liability Company Law (“NYLLCL”) provide, as applicable, for dissolution upon certain events, including at the time specified in the LLC agreement, upon the happening of events specified in the LLC agreement, upon consent of the members (except as otherwise provided in the LLC agreement), at any time there are no members with certain exceptions (except as otherwise provided in the LLC agreement) and upon decree of judicial dissolution. Section 18-802 of DLLCA and Section 702 of NYLLCL provide, as applicable, that upon application by or for a member, the applicable court, “may decree dissolution…whenever it is not reasonably practicable to carry on the business” in conformity with the LLC agreement.
A joint venture partner may argue that deadlock provisions are rarely used and that statutory law can be relied on instead so it is not worth the time to negotiate such provisions, but just having a deadlock provision may be helpful to prevent deadlocks (i.e., a party may not want to trigger the deadlock provision so it will attempt to find a resolution rather than trigger the provision). Also, the negotiated deadlock provision can be utilized for more than just deadlocks. The mediation “deadlock” provision referenced above can be used to address partner defaults or breaches to avoid having to go to court to address the issue or take other drastic means. The buy-sell “deadlock” provisions summarized above can be used in the event a partner breaches the joint venture agreement or, in the event a partner is an entity, undergoes a change of control. For example, the agreement can provide that if a partner materially breaches the agreement, or if a partner that is an entity undergoes a change of control, that the non-breaching or non-changing partner can trigger the buy-sell provision. In such case, it must be clear in the agreement that only the non-defaulting or non-changing partner can trigger the buy-sell provision and only in certain specific scenarios (e.g., the buy-sell provision may only be triggered in the event of certain breaches or only if the change of control involves a competitor). Note that if the adjusted fair market value buy-sell provision is triggered because of a breach, the premium (or discount) may be considered liquidated damages and therefore not enforceable so using another buy-sell provision in the event of breach is preferential.
Although deadlocks are an unfortunate occurrence, they do happen and carefully drafted and negotiated deadlock provisions in the joint venture documents can ease much of the agony that deadlocks cause and prevent “corporate divorce.” Each joint venture has its own unique set of circumstances surrounding its endeavors, so what may work for one joint venture may not be the best solution for the next. Before executing joint venture documents, partners should explore which deadlock provisions best meet their needs as the proper deadlock provision may allow them to live “happily ever after.”