Transfers and Exit

Exit Mechanism

A joint venture agreement will commonly provide for an exit mechanism which is designed primarily to deal with the disposal and realisation of assets at the conclusion of the joint venture.

Joint venture agreements are usually based on mutual trust and the personal or entity-specific capacity and characteristics of the other parties. For this reason, the premature transfer of an interest may be wholly prohibited.

The agreement may of necessity deal with cases where termination is mandatory such as on insolvent winding up. It cannot affect the rules on the priority of external creditors in the event of winding up.

The joint venture agreement may also provide for the termination of the agreement where there has been a fundamental breakdown in the relationship of the parties or a serious breach of the agreement by one party during the course of the intended joint venture.

The deadlock provisions may be triggered in a number of defined circumstances. They may arise where there is deadlock and an inability to resolve a particular matter. It may be due to an inability to agree on a particular course.

Certain events may trigger a transfer or compulsory winding up. This may occur on the fundamental default or insolvency by one party, a change of control, loss of a material licence for a project etc. Such a termination event may give rise to an automatic termination or give the “innocent” party the right to terminate.


Tag Along and Drag-Along

In some cases where an external sale is permitted, there may be drag along and tag along rights.  These rights make the possibility of a sale more realistic as they allow for the sale of the entire interest in the company. Generally, a buyer will not wish to buy a minority interest or even a majority interest, with a significant minority.

The majority may be able to require the minority to sell its shares on the same terms as it sells to an outsider. Equally the minority may be entitled to insist that its shares are sold on the same terms as the majority sells.

Tag-along rights are commonly provided. The minority may be entitled to oblige the majority to include it in any sale at the same price and on the same terms if the majority sells its r shareholding.

There may be drag-along rights whereby the majority can require the minority to sell its interest on the same terms when they are selling their interest to an external third party outside.

A more extreme version allows one or any party to seek an outsider and have the option of requiring the other party(ies) whether a minority or majority to sell to that outsider on its terms (together with the minority) or alternatively to buy out that party on the same terms and conditions as the outside offer.


One Party Wishes to Exit

In an unincorporated joint venture, the right to transfer will depend on the terms of the agreement. The default partnership law position is that no person may be admitted to a partnership without the consent of the other partners. This is usually altered by agreement. In theory, the partnership interest may be sold and held on trust for the buyer, without his participation as a partner.

In the case of a corporate joint venture, there are usually restrictions on the disposal of shares. The very essence of the arrangement may be that the parties agree to undertake a certain project, works or a certain business for a defined period. Any termination within this period may be incompatible with this fundamental objective.

There may be provisions in some cases, which allow for an external sale by one shareholder, provided that he has given the option to buy to the remaining shareholders. In many if not most cases, such a right will not apply, as it may trigger termination at any time on short notice and lead to ongoing instability. The transfer may take place in these cases, only with the consent of the other shareholder parties.

The issue may arise as to whether the outgoing shareholder is entitled to have his loans redeemed or whether they may be required to remain in place to the company. The seller may regard it as part of his overall investment. It may be required that the seller remains liable on guarantees given to third-party lenders at least insofar as default is based on anything which occurred while he was a shareholder.


Pre-Emption Rights

It may be provided that there is to be no transfer of shares or an interest in them for an initial period. It may be provided that there is no transfer without the consent of the board. It may be provided that from the beginning or after a period, transfers are permissible, but that the shares must be offered to the other joint venture partners on the equivalent terms

The pre-emption rights and mechanism are usually set out in the shareholders’ agreement and/or constitution.  The right of pre-emption may be set out and entrenched in the company constitution. This is not necessarily binding legal notice to third parties of the existence of the pre-emption rights. However, at a minimum, it makes it more likely that the pre-emption terms come to their attention.


Pre-Emption Procedure

The procedure usually commences with notice of the proposed transfer and price being given by the party wishing to sell. He may be required to give details of any external purchaser and the proposed applicable terms.

The other joint venturers are given the opportunity to take up the offer or not. Where there are several parties, each may be entitled to buy a proportionate part of the shares. If they do not do so, those shares are offered around to the other shareholders. The other shareholders may have a period during which to elect whether to buy these shares or not. Usually, they must buy all or none of the shares.

If the other shareholders do not agree to buy, then the transferring party may be entitled to offer the shares for sale externally at arm’s length. Usually, this must be at a price not less than that offered to the other shareholders. If this is not done, the transferring may not be able to sell or mist first re-offer the shares on the proposed terms of sale to the other shareholders.


Sale of Interest in Shares

The provisions in the standard company constitution which enable the directors to veto a transfer of shares do not usually apply to the transfer of a beneficial interest. If shares are transferred in breach, and the purchase monies are paid, then the selling shareholders must hold the shares on trust and act as to voting, dividend and other economic rights for the benefit of the purchasing shareholder.

Shareholders’ agreements usually provide that the pre-emption rights apply to the shares, or any beneficial interest in the shares and any contractual or like interest or right in respect thereof.

It may be provided that if a party attempts to dispose of shares in breach of the pre-emption requirements that this is deemed to initiate the offer around procedure and give the other parties the right to purchase.

In some cases, it is required that the share certificates have a specific endorsement to the effect that the pre-emption right exists. This is more common in some other jurisdictions.


Fixing the Price

A key issue in pre-emption provisions is that of valuation and price. The shares in a private company will not usually have a readily ascertainable value. The parties may legitimately dispute the correct value. There are a number of mechanisms for fixing the price in the context of a transfer and the pre-emption rights. The price may be determined by an independent expert such as the company’s auditors or accountants. A wholly external third party may be nominated for this purpose.

The price may be set in accordance with a pre-determined formula, or it may be “at large” for the expert auditor / accountant to determine in accordance with such criteria as he may select. Generally, it is provided that there should be no discount due to the shareholding being a minority shareholding. All things being equal a minority shareholding has less value and is commonly discounted when valued on an arm’s length basis by itself to reflect the lack of control.


Valuer

A third party valuer may be appointed to act as an expert or arbitrator. An arbitrator acts on the basis of the evidence and facts presented. An expert may take into account the evidence offered, but ultimately makes the determination of the evaluation on the basis of his own knowledge and experience,

There may be provision for challenging the valuation, particularly in the case of an arbitrator. If the valuer sets out the basis of his valuation, it may be possible to show that it is based on a fundamental error or in breach of the terms of the valuation. However, the courts may be reluctant to interfere in such cases. It is more difficult to challenge the decision of an expert which is commonly deemed to be final.

Where a valuer incorrectly values through his negligence, there may be a right of action for a party who thereby suffers loss notwithstanding the traditional immunity in quasi-judicial proceedings.

An alternative to providing for a valuation mechanism is that the seller proposes a price. If this is not accepted by the buyer, the seller may sell to an outside party during a certain period for no less than that price.


Pre-Emption Clause Issues

The share capital may be divided into different classes of shares. In this case, it may be appropriate commercially that shares are first offered around to the other holders of that class of shares.

It is usually provided that the seller must sell his entire shareholding if he sells at all. Otherwise, there may be a greater risk of dispersed shareholding, which may complicate the management, operation and ultimate disposal of the joint venture.

There are usually exceptions from the requirement to offer the shares around on disposal or transfer. There is commonly a provision that a transfer of shares may be made by each joint venturer between its group companies.

There may be a provision for the transfer of shares on death to the party’s successors. There may be a right of veto to the acceptance of a successor where the specific characteristics of the parties are important. This will often be the case with a joint venture.

It might be provided that the liquidation, death or bankruptcy of a party automatically triggers the issue of a transfer notice. A transfer notice once given may be revoked unless it is provided that it is irrevocable. It is usually so provided in order to limit the possibility of abuse of the right.


Approving the Buyer

There may be a provision for the sale of shares, but the remaining parties may have a veto on any an incoming third party. There may be a risk that the remaining parties frustrate the sale process or depress the price where their consent is not forthcoming.  It may be provided in some cases where consent is required there is an option for the outgoing party to liquidate the company in the event that consent is not forthcoming.

In some cases, the seller may be required to identify the proposed third-party purchaser at the pre-emption stage. It may be provided that if the pre-emption rights are not exercised that the seller may only sell to that proposed third party.

If the third party is not identified when it is required, the question arises as to whether the continuing shareholders should have a further pre-emption when the third party is identified. These scenarios raise practical issues with securing a third party bona fide purchaser who may be reluctant to undertake comprehensive due diligence in order to fully understand the company in circumstances where he may not ultimately be entitled to purchase.

In some cases, a regulatory consent may be required for an incoming shareholder. In some sectors including in particular most financial services businesses, the regulatory authorities look inside at the shareholding and management of an entity, as a condition of licensing or regulatory approval.


Put and Call Options

A call option entitles the holder of the option (which may be in favour of each party or one party) to acquire the interest of the other. The price may be expressed as the fair value or may be ascertained by reference to a formula.

Exceptionally one party may have a put option whereby it can require the majority to buy out its shares/investment in certain defined circumstances.

There may be a formula to determine the price in the case of a put or call option. There may be a reference to an independent valuer. The criteria for valuation may be set out. This mechanism may provide an effective means for the minority to prevent itself being locked in.


Deadlock Resolution

Deadlock can arise in a joint venture company where the directors and / or shareholders take different views on a matter.  It may arise in a 50/50 joint venture company or where one party has a right to veto or to have to assent to the disputed matter. There are a number of well-known mechanisms to deal with a deadlock scenario.

If a joint venture has irretrievably broken down, the parties may decide that it be wound up and its assets distributed. As a termination mechanism, this may have the advantage of concentrating the minds of the parties on resolving the dispute without a complete termination of the relationship. It may be better to agree on a deal than to see the business or venture die.

One party may wish to buy the other out, so as to continue the business alone. Each party may wish to buy out the other.  There are a number of mechanisms that can be used to determine who buys out whom and what price is paid.


Buy Out Mechanisms

The so-called “Russian Roulette” option is a variation of a mutual put and call option. The party making the offer on deadlock may serve a notice on the other requiring the receiving party to purchase his share or alternatively to sell the receiver’s shares to the person making the offer at the price set out. The purpose is to ensure a fair price is offered at which the offering party is equally willing to buy and to sell at. This would only be appropriate for companies with two shareholders parties of equal financial strength so that either party could afford to buy out the other at the relevant time.

A further option is a “Mexican” or “Texas” shoot out.  Under this mechanism, the initiating party may serve a notice stating that he is willing to buy the other out and specifying the price at which he is prepared to buy. The receiving party then has a period in which to serve a counter-notice, either stating he is prepared to sell at the specified price or that he is willing to buy the shares of the initiating party at a higher price.

Both parties may make simultaneous sealed bids with the person whose bid is highest being entitled to buy out the other. Alternatively, the bidding process can be run as an auction with the parties raising their bidding in competition. This is a mechanism which is open to misuse when one or other party does not have resources or desire to buy.