India: Deadlock Resolution Mechanism In Joint Venture Agreements

Decision making in Joint Ventures (JVs) can often be challenging, especially where there is fundamental disagreement between joint venture partners on matters that require unanimous consent. Where such situations remain unresolved, deadlock occurs, which is disruptive to business and diminishes shareholder value.

Deadlock is not limited to just 50:50 JVs but may also extend to JVs where partners have disproportionate shareholding and/ or Board seats and some identified matters require consensus of the minority shareholder and/ or its nominee(s) on the Board (Reserved Matters).

A deadlock can bring decision-making to a complete standstill. Therefore, it is in the interest of the JV partners that the JV agreement and the articles of association of the JV company contain clearly defined deadlock provisions (including on what constitutes a deadlock and the resolution mechanism). Such deadlock resolution mechanisms would of course depend upon the objectives of each of the partners for entering into the joint venture, shareholding percentage, financial strength of the shareholders, and applicable caps on foreign direct investment (FDI) under extant FDI Policy of the Government of India.

A question may arise that, if a JV agreement has a dispute resolution mechanism then what is the need for a separate provision on 'deadlock' resolution? To answer this, one needs to understand that a deadlock is not a dispute per se between the parties to a JV agreement, as there is no breach of any representation or warranty or covenants as stipulated in the JV agreement which may be resolved through the dispute resolution mechanism provided for under the agreement (i.e. arbitration or court proceedings, as may have been agreed upon). Even an arbitrator/ arbitral tribunal empowered to resolve a 'dispute' may not have absolute power to resolve a 'deadlock' in the absence of a clearly defined deadlock resolution provision in the JV agreement providing for consequences of deadlock or which clearly provides that deadlocks are to be resolved through arbitration which is not advisable.

Deadlock can occur both at the Board as well as at the shareholder level. Usually the JV agreements provide that a deadlock is deemed to have occurred if the board/ shareholders, as the case may be, are unable to pass a resolution on any Reserved Matter. At the Board level this would mean that either: (i) the nominee director of one of the JV partners has not voted in favour of such Reserved Matter or, the nominee director of one of the JV partners has abstained from voting at consecutive board meetings (two or three); or (ii) there is lack of quorum at consecutive board meetings. Similarly at the shareholder level, a deadlock may occur in the event of (i) one of the JV partners not voting in favour of a resolution on a Reserved Matter; or (ii) such JV partner having abstained from voting at consecutive General Meetings (two or three); or (iii) lack of quorum at consecutive shareholder meetings.

A deadlock resolution provision usually has two parts:

The most common exit measures followed in JV agreements include the following or any combination or variation of these.

(a)Russian Roulette: Under this procedure which is common to 50:50 JVs, the initiating shareholder (who had proposed that the Reserved Matter be voted upon at a Board or shareholder meeting, and which resulted in deadlock) serves a notice to the other shareholder requiring the receiving shareholder to purchase the initiating shareholder's shares at a specified price or to sell its shares to the initiating shareholder, at a specified price (the notice sets out only one of the aforesaid two options). The shareholder receiving the notice then has the option of either accepting the initiating shareholder's offer or to make a counter offer. In the latter case, if the original notice required the receiving shareholder to purchase the shares of the initiating shareholder, then the receiving shareholder by way of a counter proposal may require the initiating shareholder to purchase the shares of the receiving shareholder at the specified price. Alternatively, if the original notice required the receiving shareholder to sell the shares to the initiating shareholder then the receiving shareholder by way of a counter proposal may require the initiating shareholder to sell its shares to the receiving shareholder at the specified price. The aforesaid is similar to the game of Russian Roulette which is based on probability and has a high element of risk.

Under this procedure, the offering shareholder is exposed to the risk of being forced to buy out its JV partner's shareholding or to sell its shareholding and exit due to the reversal/ counter offer mechanism. However it ensures a fair price for the shares as the offering shareholder does not know whether it will be the seller or the buyer of the shares. This clause works best in favour of the financially stronger shareholder as the financially weaker shareholder may not be able to make a counter offer. In a cross border joint venture which involves one Indian and one foreign partner, the Russian Roulette may not work given that the foreign partner will have a cap on the sale price and a floor on the purchase price under Indian Foreign Exchange laws and therefore, the receiving party may not be able to make a counter offer.

(b)Texas Shoot-out: In a Texas Shoot-out clause, each shareholder submits a sealed bid to an independent third party (e.g. auditors of the JV company) with a binding offer stating the price at which such shareholder is willing to buy the entire shareholding of the other shareholder in the JV company. Both bids are then opened simultaneously, and whichever shareholder bids the higher price is obliged to buy the other at the said price.

The most interesting thing about this clause is that each shareholder would have to carefully evaluate the price to be stated in the bid as a high bid price would entail the shareholder paying a higher premium to buy out the other shareholder, whereas a low bid price may lead to the involuntary expulsion/ exit of the shareholder at a lower price. In case of cross border joint ventures, the foreign partner would have to bid above the estimated fair market value determined as per the foreign exchange laws of India and the Indian partner will have a cap on the purchase price and will most likely be unable to offer a higher bid than the foreign partner and therefore, Texas Shoot-out usually works against the Indian shareholder.

(c)Vanilla Put and/ or Call Options: Under a 'Put Option', one shareholder is obliged to sell its shares to the other shareholder, whereas under a 'Call Option', one shareholder is obliged to buy the other shareholder's shares. Usually any or both of such options are provided to the initiating party at a pre-determined price/ fair market value without any option to the receiving party to make a counter offer. In an unequal JV, 'Put Option' may be beneficial to a minority shareholder whereas 'Call Option' may be beneficial to a majority shareholder.

(d)Liquidation: Where none of the parties are in a position to buy out the other, voluntary liquidation of the company may be resorted to as the last remedy. This is a very drastic measure and should not be undertaken without full and absolute deliberation and care shall be taken that if a shareholder has provided/ licensed/ leased certain assets (such as moulds, tools) and intellectual property to the joint venture company the same shall revert back to that shareholder. Further, this may not be ideal in cases where there are running contracts especially with government or where the joint venture company is otherwise financially sound.

There is a tendency to provide a laundry list of Reserved Matters even in the case of a 50:50 JV. Therefore, even the slightest disagreement on a minor/ less relevant matter may lead to a deadlock situation entitling a joint venture partner(s) to exit from the joint venture. This may neither be in the interest of the joint venture company nor its partners/ shareholders. Therefore, it is advisable that for the purposes of deadlock, the list of Reserved Matters be curtailed so that disagreements on non-fundamental issues do not result in deadlocks The curtailed list of Reserved Matters should include matters which are of fundamental nature and utmost importance (such as merger, joint ventures, expansion of business, approval of business plan, capital expenditure beyond a threshold) which may have a bearing on the business, growth prospects of the JV company and/ or the objectives of the JV partners

Having said that, in the case of strategic alliances, it may be in the interest of the JV company that an exit option to JV partners as a deadlock resolution be avoided and instead the same be settled at the senior management level of the JV partners. In this regard, it has been well said that "An ounce of mediation is worth a pound of arbitration and a ton of litigation!"

Abhinav Rastogi, Partner (abhinav@duaassociates.com)

*The views expressed are personal and may not necessarily reflect the views of the Firm.

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