Summary and implications

In these difficult economic times, the risk for joint venture partners is that the very person with whom an alliance has been formed is unable to fulfil its agreed obligations. When might this happen and what should your response be?  

Partners in joint ventures should be aware:

  • of the precise events that constitute a default;
  • of the consequences of a partner going into default; and
  • whether practically it is worthwhile terminating the joint venture or taking other enforcement action if the worst happens.  

Events of default provisions are meant to protect investors

There will be certain circumstances which if they occur would materially prejudice the non-defaulting party's position, either through a non-performance of an obligation or its exposure to an increased risk. These events might not automatically lead to a joint venture being terminated, but it may result in the innocent party having the option to so act. Also, there may be a grace period allowed for remedy of the breach.

What can be events of default?

Insolvency

Events of default which are related to insolvency proceedings are typically of an anticipatory nature. A non-defaulting party will wish to be permitted to terminate the joint venture when insolvency of a partner looks imminent, rather than wait until such partner is actually declared insolvent or administrators are appointed. Events that can act as warning signs that a party is in financial trouble include the inability to pay debts when due, enforcement of security and steps being taken for a company's winding up.

Failure to fund or late payment

These events would, in most cases, be a material breach of the fund documentation. Failure to make payments in a timely fashion may be a red flag for financial troubles. Failure by investors to meet funding obligations is becoming increasingly common in the current economic environment. A common feature is for the funding partner to receive a disproportionate share of profits whilst a partner is in default for failure to fund. This is of little use if no profits are made.

Change of Control

Change of control can trigger concerns for parties to a joint venture. There could be a reduction in support provided by a parent company or there might be some personal relationship between one party and the individuals behind the parent company of the other party which formed the basis of the decision to joint venture in the first instance. Change of control is usually linked to a specific percentage of shares in an entity or the ability to control the board of directors.

Breach of Covenants

A non-defaulting party may be entitled to call a default if a representation or covenant proves to be incorrect when it was made. There are normally qualifications applied to such provisions namely a greater period within which a breach may be remedied; or requalification and a restriction on the right to terminate only in relation to specified representations.

A non-defaulting investor will usually have many options if its partner defaults

Buy out of defaulting investor

The ability of the investors to buy out a defaulting investor will vary depending on the type and number of participants to a joint venture. When considering their options, any investor faced with a buy out situation will look to the past, present and projected venture performance in light of their commitment to the venture. At present a number of real estate funds are looking to extend their terms and this, coupled with an increased stake in a fund, could be very attractive to certain investors.

Readjustment of commitments This strategy is becoming increasingly popular in the real estate funds market and may be viewed by investors as a way of avoiding further loss to the fund whilst retaining distribution rights and operating status. However, investors who reduce their commitments will also be required to accept a reduced return. Termination

Termination rights will vary on a fund by fund basis and the right to terminate will depend on a number of factors. In the event of investor default it would be likely that the consent of the non-defaulting investors would be required to terminate the joint venture. Issues to consider include:

  1.  the length of the remainder of the life of the venture;
  2. external investment opportunities;
  3. tax issues associated with termination;
  4. whether the venture should be sold or wound up; and 5.the reputational risks of a winding down/sale.  
  5. the reputated risks of a winding down/sale.