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May 30, 2013

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Key Aspects of a Legal Due Diligence


- Harshita Srivastava, [ Nishith Desai Associates ]
- Simone Reis, [ Nishith Desai Associates ]

Harshita Srivastava & Simone Reis

Joint Ventures (JV) are a form of collaboration between two or more parties.

They are most commonly used in the following situations:

    • By businesses looking to expand internationally;
    • New business start-ups;
    • To ensure compliance with regulatory restrictions on independent operating in certain countries, such as india;
    • Some jurisdictions require, for example, that a certain percentage of the shares in any company are owned by local entities;
    • To make use of an existing local presence in a business sector, or availability of appropriate existing networks;
    • In order to take advantage of local know-how, skills and expertise; and
    • To combine skills and resources in order to achieve cost benefits;
    • By businesses enter into teaming or joint bid arrangements; and
    • Where usually large entities outsource non-core areas of their operations such as information technology, facilities management, security, human resources, health care, catering etc.

The form a JV takes varies significantly and they will come in all shapes and sizes. Commonly used JV vehicles include the limited liability company or a hybrid vehicle like a limited liability partnership. However, it is not uncommon to find a partnership structure being utilised in certain jurisdictions. Ultimately, the final vehicle is usually determined by a careful consideration of the following factors:

    • Tax;
    • Limitation Of Liability;
    • Setting Up Formalities;
    • Exit Strategy;
    • Nature/Culture Of Parties;
    • The Pros And Cons Of Each Jurisdiction;
    • Local Regulation; And
    • Duration.

This article will focus on limited liability companies, as this is the most common structure for long-term JVs. Most English and European businesses entering into JV arrangements in India have tended to use a limited liability company as the JV vehicle.

Early Stage Planning Careful planning, budgeting, research and due diligence exercises are required to establish the basic foundations of the JV. The parties' respective contributions and rights, governance protocols, budgets, deadlock and dispute resolution mechanisms, exit routes, termination and other fundamental elements will need to be understood at the outset of the venture.

Listed companies have a number of additional formalities and requirements to consider prior to entering into a JV including class tests and other legal requirements which impact on some of the more common provisions used in JVs, such as options and exit provisions.

In particular, the following key documents should ideally be put in place before moving too far in the JV formation process:

    • Confidentiality Agreement: Confidential information disclosed by each party to the other is bound to be extensive, and needs to be closely governed under the terms of a confidentiality agreement.
    • Term Sheet/Memorandum of Understanding/Heads of Agreement (binding/non-binding): Following the early planning and due diligence exercises, the parties should document the principal terms of their proposed JV. This document will usually provide a basis on which further negotiations can take place. As such, the parties will need to ensure the term sheet (or its equivalent) is non-binding, except for certain terms such as the choice of law and the dispute resolution clauses.
    • Exclusivity Agreement: The parties are bound to incur cost and divert resources to negotiating the terms of the agreement. They will need know that each party is committed to the process for a certain period. An exclusivity (or lock-out agreement) ensures that the parties have a period of time in which to negotiate solely with each other. The duration of the agreement varies, but one to three months is common.
    • Material Agreements: Beyond the early stage documentation, which sets the ball rolling for the due diligence exercises and commercial negotiations,

      the following documents will need to be put in place in order to set out the overarching framework of the JV:
    1. Joint Venture Or Shareholders' Agreement: This sets out the basic rights and obligations of the JV parties, defines how the parties intend to govern the JV on an ongoing basis and addresses key issues such as exit, disputes and change management.
    2. Articles of Association: The articles govern the basic constitution of the JV company, and will cover areas such as transfers of shares and meetings of directors and shareholders. Whilst the JV agreement is a confidential document, the articles are not, meaning that any confidential material will need to be set out in the JV or Shareholders' Agreement. However, in countries such as India, provisions of the JV agreement will mandatorily need to be inserted in the articles of association to ensure that the JV vehicle is bound by them.
    3. Guarantees: These may be general, or relate to a specific issue. These are often given by parent companies to support the obligations of a subsidiary which is a party to a JV. Guarantees may need to be given by the parties to a bank to support banking facilities.
    4. Management Agreements: The JV may require management expertise from one or more of the shareholders.
    5. Service Agreements: These will document the terms of service for senior directors and other key executives.
    6. Secondment Agreements: Short or long term secondments of employees of the shareholders may be required.
    7. Purchase Of Business And Assets Agreement: Sets out terms on which the parties will transfer certain businesses and assets into the JV.
    8. IP/IT Agreements: IT systems supply and support arrangements may be required by, and intellectual property may be licensed to, the JV company by the JV parties or other third parties.
    9. Supply Agreements: The parties, or third parties, may supply the JV with certain goods and services to enable it to operate and these will need to be documented in a supply agreement.
    10. Option Agreement: A "put" or "call" option may be granted over the shares of the JV company.

These provide parties with the right (and possibly also the obligation) to purchase the shares or another shareholder, or to require another party to purchase its own shares when certain conditions are met or, for example, in the case of disputes. Option arrangements should be used with care in jurisdictions such as India, particularly in relation to public companies, as Indian courts have tended to disregard such option agreements as a fetter on free transferability of shares.

Key Issues to Address in JV Agreement


The JV parties will need to consider each of the below issues carefully in the light of their commercial objectives:

    1. Parties: There particular concerns relating to contracting with overseas companies in terms of identity, capacity, authority, execution requirements, enforcement, jurisdiction (local laws may override the governing law and provisions in the agreement), solvency etc. A thorough due diligence exercise should be conducted to establish each of these areas to the satisfaction of the JV parties.
    2. Conditions Precedent: These are conditions that need to be satisfied before the transaction can complete. They commonly include third party consents for key contracts, properties, regulatory and competition approvals. As of 1 June 2011, all JVs and acquisitions satisfying the asset and turnover thresholds in India will need to be approved by the newly empowered Competition Commission of India and as such this will need to be factored into all transaction timelines.
    3. Finance: The parties will need to consider how the JV will be financed at the outset, as well as on an ongoing basis. This may include debt or equity provided by the parties, potential future investors, or banks and financial institutions.
    4. Acquisition of Assets: The JV company will need the resources to operate its business. These may be purchased from one of the JV parties, or from a third party.
    5. JV Business: The nature of the business and objectives of the party will need to be clearly understood and documented. The basis on which each JV party receives benefit from the JV should also be clear, and should address management fees, dividends, royalties, fees for supply of goods or services etc.
    6. Reserved Matters: A list of reserved matters which may only be undertaken by the JV company with the affirmative vote of the shareholders should be agreed upon. They are normally included to protect a minority shareholder. In a deadlock (50:50) company reserved matters are used to prevent managers acting on matters without obtaining express shareholder approval.
    7. Management/Governance: A common area of difficulty in a joint venture lies in the lack of proper governance, management, reporting lines, communication and lack of clear authority levels. A strong statement of the management and governance protocols should be agreed upfront, with an identified structure to elevate certain issues to senior management or the shareholders themselves to prevent operational hitches.
    8. New Share Issues/Transfers:The rules on share issues and transfers (i.e. pre-emption rights, lock-in periods, sales to third parties), and circumstances where voluntary transfers are permitted (i.e. to group companies) must be considered. If in the future a 3rd party purchaser makes an offer for the majority of the shares in the JV, it is common to have "tag-along" rights, so that the remaining shareholders can also sell their shares to that purchaser. "Drag-along" rights are also common and allow a shareholder who has received a favourable offer for his shares to require the remaining shareholders also to sell to the chosen buyer.
    9. Compulsory Share Transfers: The agreement will set out the circumstances in which a party will be forced to sell his shares, usually to the remaining shareholders, e.g. upon insolvency, material breach of the agreement (or material ancillary agreement) or change of control of a shareholder. The terms governing the value of a share on transfer will usually depend on the circumstances; thus a lower price may be realised if the transfer was triggered by a material breach.
    10. Protective Covenants: The agreement will set out non-compete and non-solicitation provisions in order to protect the business of the JV.
    11. Deadlock: Where management becomes deadlocked, it is usual for the agreement to provide for the dispute to be escalated through the parties’ senior management. If this fails to resolve the issue, provisions are required to determine how the JV will terminate. Options include liquidation, sale of dissenting party’s shares to a third party, Russian Roulette (one party offers to sell its shares to the other at a specified price, the other party must either buy those shares, or sell its shares at the same price), or Mexican/Texan Shootout (both parties submit sealed bids to middle party and the party who makes the higher bid buys the company at that price).
    12. Employees / Immigration Issues: Where key employees need to be seconded to or placed in the JV vehicle, a careful analysis of their employment contract and possibly also any relevant immigration regime will need to be conducted to ensure that key personnel are able to work in the jurisdiction of choice.

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