Unlocking the Deadlock Mechanism

“Do we really need detailed deadlock mechanisms? It’s very difficult to anticipate what will happen in ten or twenty years’ time, can’t we sort it out then?” This is not an uncommon question from parties intending to form a joint venture. The future may be hazy, but the risk of deadlock is clear.

Deadlock is an inherent risk of joint ventures because all joint ventures will involve some kind of shared control (except in extreme scenarios where one or more of the investors are minority shareholder(s) with such small shareholding that does not warrant them to have any form of control). A joint venture is formed when two or more commercial parties pool their resources to operate a business together. In return for their contributions, each party acquires some kind of control over the joint venture. Where the joint venture takes the form of a company, control may be positive (in the form of voting rights and board seats) or negative (in the form of veto rights). Regardless of the form of control, what is likely to happen is that no one party would have full control over all the strategic and important management issues of the joint venture. When control is shared, deadlocks are inevitable.

Therefore, it would be wise for the parties to adopt, at the outset, an appropriate contractual framework for addressing deadlocks. Before drafting a deadlock mechanism, it is important to understand the fundamental dilemma within the mechanism and how it affects each part of the structure – these are the issues considered in this article. For the sake of discussion, this article will examine a joint venture set up as a private company by two parties, each holding roughly the same number of shares in the company.

The Fundamental Dilemma

All deadlock mechanisms should aim at addressing a fundamental dilemma. On the one hand, since the success of a joint venture usually depends on the input of both parties, each party would naturally want to lock the other party in the partnership and prevent it from triggering a deadlock too lightly or engineering a deadlock to get out of the deal. If this is the more important concern, the parties could increase the threshold for triggering the deadlock mechanism or even add a punitive element. On the other hand, if there is a fundamental disagreement regarding business operations, no party would want to be dragooned into a business it no longer has faith in or be stuck with a reluctant and disgruntled partner. Parties who place more emphasis on this aspect would favour a more balanced and neutral approach.

The tension between these two competing interests underlies every aspect of the deadlock mechanisms and explains the positions adopted by the parties. The fundamental dilemma first manifests itself in the definition of “deadlock”.

Defining “Deadlock”

The deadlock mechanisms are triggered when a dispute falls within the contractual definition of “deadlock”. Parties who wish to make it harder to kick off the process prefer to define “deadlock” narrowly. Frequently this means setting out an exhaustive list of matters and defining “deadlock” as a disagreement over one of the listed matters.

Obviously, the narrowing-down effect of the list depends largely on its length and how specific each listed matter is described. A broad description such as “disagreement over the business of the joint venture company” simply defeats the purpose. Accordingly, this approach requires the parties to spend considerable time in negotiating the list, which may distract them from the more important component of the deadlock mechanisms – the consequences of deadlock.

It is therefore not surprising that parties are becoming increasingly relaxed about the definition of “deadlock”. They may simply define “deadlock” as having occurred when one party boycotts a general meeting or board meeting, or blocks a resolution on two consecutive occasions. Some parties have sought to qualify this broad definition by adding conditions such as the parties must act in good faith, or the disagreement is, in the reasonable opinion of one party, materially adverse to the operations of the joint venture company. Other parties prefer to focus the discussion on the consequences of deadlock, which is the most powerful deterrent of abuse.

Consequences of Deadlock

Escalation

Nowadays the escalation provision is a staple in the deadlock toolbox. It seeks to salvage the relationship and continue the joint venture by encouraging parties to reach a compromise. A good escalation provision should, therefore, establish a formal structure to facilitate amicable and constructive communication between the parties.

For instance, the escalation provision could require each party to prepare and circulate to the other party a memorandum setting out its position on the disputed matter and its reasons for adopting that position. In preparing such a memorandum, the parties are forced to rationalise their stance. This discourages a party from engineering a deadlock, which may be exposed by this process. It also provides each party with an opportunity to lay out supporting facts and details which the parties might have lost sight of during heated debates. If the memorandum is properly prepared, it would serve as a useful basis for further discussions.

An escalation provision would typically require each party to escalate the dispute to a senior management officer in its organisations, and stipulate a timeframe for both sides’ senior management officers to discuss and resolve the deadlock, if possible. The existence of an escalation provision curbs arbitrary behaviour at the joint venture level, because the managers of the joint venture company would not wish to escalate matters to their seniors without good cause.

More importantly, the unique position of the senior management officers as both outsiders and insiders increases the likelihood of a satisfactory resolution. They are outsiders in the sense that they were not directly involved in the dispute. Therefore, they could start discussions with a clean slate, unburdened by any bad feelings that might have accumulated from previous exchanges, and free to depart from any entrenched positions. They would also be able to offer a more detached and objective perspective on the disputed matter.

The senior management officers are insiders of each party’s organisation. They are familiar with the commercial objectives and concerns of the relevant party, as well as the operations of the joint venture. As such, they are better equipped than completely independent outsiders to deal with deadlocks involving business decisions and commercial judgment (which are the more likely causes of deadlock).

Needless to say, there are deadlocks that reflect a fundamental difference in interest and vision, which cannot be resolved even with the best escalation provision. In these circumstances, a breakup is inevitable and in the interest of all parties.

Breakup

There are many varieties of breakup provisions. They could be designed as a facilitator of amicable separation, a backdoor exit, a clamp to squeeze out the minority, to name just a few. As such, they should be the focus in resolving the fundamental dilemma between preventing an abuse of the deadlock mechanisms and allowing parties to exit in the event of a genuine deadlock.

The basic form of the breakup provision resolves the dilemma in favour of fairness between the parties. Take for instance the buy-sell mechanism, which is the most commonly used means of separation. These provisions allow one party to buy out the other party or sell all of its shares to the other party; the joint venture is put to an end by consolidating control in one party. If the provisions are not well thought out, they may increase the chance of the deadlock mechanisms being abused by the parties. A party (Party A) may abuse the mechanisms by engineering a deadlock to force the other party (Party B) to buy it out at an inflated price, or squeeze out Party B at an undervalue. Such behaviour can be discouraged by putting in place mechanisms that motivate Party A to offer a fair price.

The Russian Roulette is a good example of buy-sell procedures that encourage fair pricing. Simply put, Party A starts the process by offering to buy all of Party B’s shares in the joint venture company at a fixed price per share. Party B must then elect either to accept the bid at the proposed price or buy all of Party A’s shares at the same price per share. Since Party A’s offer could be reversed at Party B’s sole discretion, if Party A makes an offer that is below the market price, Party B is very likely to jump at the opportunity to buy out Party A at a bargain price. Hence Party A is, in theory, motivated to put forward a fair price for the shares.

However, the fairness of the Russian Roulette may be compromised if Party B has only a small shareholding in the joint venture company or is financially weaker than Party A. In these circumstances, Party A is incentivised to offer a low price because it knows that it is very costly for Party B to reverse the offer and Party B may not have the financial means to do so, and hence it is very likely that Party B will have no choice but to sell its shares to Party A at a low price.

To some extent, measures can be put in place to mitigate the effect of unequal shareholding or financial abilities. For example, an independent third party could be brought in to determine the fair market value of the shares. The fair market value thus determined could either be taken as the price of the shares per se or the price floor of any offer under the buy-sell procedures.

The buy-sell procedures discussed above seek to address the fundamental dilemma in a balanced manner. The parties could of course decide that it is more important to prevent abuse or generally deter parties from initiating the buy-sell procedures too lightly. One way to do this would be to apply a pre-agreed discount to the value of the initiating party’s shares (if the non-initiating party elects to buy these shares) and apply a pre-agreed premium to the value of the non-initiating party’s shares (if the non-initiating party elects to sell its shares). This mechanism increases the cost of the initiator and hence provides strong incentive for it to reach an amicable resolution with the other party.

A more drastic approach in favour of deterrence is to stipulate liquidation as the means of separation. In most cases, the value of a joint venture company on a breakup basis would be lower than that on a going-concern basis, so both parties have much to lose on a liquidation. In order to avoid this lose-lose consequence, both parties are strongly incentivised to reach a sensible compromise or find a mutually beneficial means to exit the joint venture, such as a joint sale to a third party. For the weaker party in a joint venture, the right to resort to liquidation may help it to bring the stronger party to the negotiation table and give it more bargaining power.

Conclusion

Do parties really need detailed deadlock mechanisms? The answer is surely a definite “yes”. All joint venture agreements are forward-looking documents, so agreeing on how to deal with a future deadlock is no different from agreeing on other matters. Naturally, discussing a breakup is less appealing than discussing future business plans, but it is a discussion worth having. Deadlock is a fact of life in many joint ventures and a prolonged deadlock hurts everyone involved. Deadlock mechanisms accept this reality. A well drafted deadlock provision can address both the need to deter an easy exit as well as the need to provide a definite exit route when it is better for the parties to go their separate ways. 

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Mayer Brown JSM, Senior Associate

Xin Fang holds a First-Class Honours Master’s Degree in Corporate Law from the University of Cambridge. She has worked at Mayer Brown JSM since 2010, focusing on international mergers and acquisitions, joint ventures and private equity transactions.