A recent court decision highlights the risk that exit strategies in joint ventures can be held unenforceable penalties.

Does your joint venture arrangement need a rethink?

Although no one ever plans on a relationship (commercial or otherwise) failing, it is always advisable to hope for the best and plan for the worst.  For this reason most joint venture arrangements have exit strategies and deadlock mechanisms.

But in a recent matter, the NSW Supreme Court found that the exit strategy in question was unenforceable because it was a penalty.

It is a reminder that exit strategies need to be properly thought out and drafted to avoid the risk of being held unenforceable penalties.  Perhaps it’s also time for parties to move away from using only ‘sticks’ and consider whether ‘carrots’ may be a better device to keep joint ventures together.

Joint Venture Agreements and Exit Strategies

When a joint venture agreement doesn’t work out, an exit mechanism can be used to force out one joint venture partner by the other partner(s).

Exit mechanisms often give the other joint venture partner(s) the right to purchase the exiting partner’s interest in a pre-agreed manner.

These provisions can be activated on events like default, change of control, insolvency or serious breach.  Sometimes there are also pre-determined structures to arrive at a sale price, often with exotic names, such as Russian Roulette, Texas Shoot-out, Dutch Auction or simply Fair Market Value.

Some mechanisms are quite draconian.  For example, a Russian Roulette provision requires one of the two deadlocked parties to serve a notice on the other party, naming an all-cash price at which it values the other’s interest in the business.  The party receiving the notice then has the option to either buy the other party out, or sell out to the other party, at that price.

The Pioneer Case

The NSW Supreme Court case, RePioneer Energy Holdings Pty Ltd [2013] NSWSC 1134, shows that courts will not automatically enforce exit mechanisms in accordance with their stated terms and appropriate drafting is imperative. 

Pioneer involved a joint venture between Blue Oil and Morgan Stanley to develop and operate an automated diesel loading and storage facility in Mackay, Queensland.

Under the shareholders agreement, Blue Oil was to contribute funding to the project, and if it didn’t, Morgan Stanley was entitled to acquire all of its shares in the joint venture for $1.

Blue Oil failed to meet its funding requirements and Morgan Stanley issued a notice requiring Blue Oil to make further payments or risk being forced to transfer all of its shares to Morgan Stanley for $1.  At the time, Blue Oil’s shares were worth around $13 million.  Blue Oil claimed that Morgan Stanley could not exercise that right, because such a transfer would amount to a penalty and be unenforceable.

The law of penalties is a popular topic because of last year’s High Court decision in Andrews v Australia and New Zealand Banking Group Ltd (2012) 86 ALJR 1002.

That case significantly changed the accepted understanding of the penalty doctrine in Australia by ruling that a provision can be penal even if it is not triggered by a breach of contract.

The consequences of that decision are potentially broad (see Andrews v ANZ - One year on and still no certainty) with the penalty doctrine in Australia applying in ways it could not before, including to commonly used provisions in commercial agreements such as take-or-pay clauses and abatement regimes in performance based contracts.

The clause in Pioneer did not test the breadth of the decision in Andrews because the transfer of Blue Oil’s shares was triggered by a breach of the shareholders agreement (a failure by Blue Oil to meet its funding obligations).

The question for the Court in Pioneer was whether the transfer of the shares for $1 was extravagant and unconscionable or out of all proportion to the damage likely to be suffered as a result of the breach.

Morgan Stanley argued the transfer clause was not a penalty because its function was not to punish Blue Oil for breach, but rather was for a ‘good commercial reason’.  The good commercial reason asserted by Morgan Stanley was that unless it acquired all of Blue Oil’s shares it would be left with a partially completed and worthless project.

The ‘good commercial reason’ approach has had some success in overcoming penalty arguments both in Australia[1] and overseas[2].  However, in Pioneer, although the Judge accepted that that the parties’ intentions may have been to utilise the exit mechanism as an incentive for prompt payment, her Honour found that the forced transfer for $1 was out of all proportion to any loss that Morgan Stanley would suffer as a result of the breach by Blue Oil and therefore was unenforceable. 

As this was a separate question hearing, the consequences of finding the transfer mechanism unenforceable were not determined, but, absent finding another way to acquire Blue Oil’s share, presumably Morgan Stanley’s only recourse will be for damages arising from Blue Oil’s late or failed payment.

Looking to the future

No good relationship is built on fear and punishment.  The above case may be cause for a rethink of how joint venture relationships are structured and how incentive based approaches may be better for building successful partnerships rather than traditional ‘sticks’ and threats.