Plan for exit in case your construction joint venture unravels

JVs offer two or more businesses scope to pool their expertise, money and technology to deliver major projects, sharing in the associated risks and rewards. However, it is estimated that around two thirds of JVs encounter problems within the first two years of being set up.

Due diligence of potential JV partners before a JV contract is negotiated is important, though often problems stem from underlying problems with the project itself – distressed project increases likelihood of conflict. Cultural issues or personality clashes can also lead to escalation of issues – while strong project management with clear ideas of how to do things can be effective, with JV partners it can be a recipe for conflict at a personal execution level.

Problems can include when one party to the JV encounters financial difficulty. This is a particular risk in the construction sector where profit margins are traditionally tight. Financial difficulty can result in non-payment of materials and labour and delay the completion of works. This is ultimately a threat to the JV as a whole as it presents a risk of default on the project contract where the other parties are unable to step in to help.

Problems can also arise from disagreement between JV partners, such as over how a project is being managed, or where one party believes the activities another party expects them to undertake are unreasonable or not what was agreed under the contract.

At a recent roundtable event hosted by Pinsent Masons, the law firm behind Out-Law, construction sector clients shared their experiences of JVs in the Middle East. The discussion spurred consideration of the steps businesses can take to address the risk of JV arrangements unravelling. Planning for exit was heavily emphasised.

It is important that the JV contract makes provision for one party to take direct control of the performance of works under the project contract, to account for the possibility that one JV partner is unable to undertake their share of the JV contract. Consideration should also be given to clauses that allow for the replacement of a JV partner that is financially stricken or otherwise unable to perform the works under contract. In this respect, in the Middle East, global engineering and construction companies would need to account for any requirements to source a local partner to participate in a JV with.

The JV contract should provide a clear route to escalating issues and resolving disputes, while provision should also be made for either party to buy the other out at a pre-determined price.

With escalation, exit and termination clauses there is no one size fits all. The project, the implications of deadlocks and disagreements are relevant. They guide the type of exit provisions that might be appropriate.

Escalation provisions enable disputes to be resolved without the need for formal litigation or arbitration. There are a number of options that can be considered.

Disputes could be referred to JV management or to a special shareholders committee to resolve, or provision made for disputes to be dealt with through mediation or determined by dispute adjudication boards (DABs), or a combination of those processes. Parties will need to determine on a case-by-case basis what termination provisions are appropriate in the event disputes cannot be resolved through those mechanisms.

In short term JVs that are reliant on the parties, it may make sense to keep termination clauses tightly worded. However, it may be appropriate to allow a consensual termination where the exiting party sells their interest or shares and the JV is wound up. In other cases it might be appropriate to make provision allowing one party to exit, but thought would need to be given to any rights the majority shareholder has to first refusal of the shares being sold and their ability to force a minority partners' sale of shares to a third party under the shareholders' agreement.

If disputes cannot be resolved, parties to a JV may need to force the other side's compliance. This can be achieved through compulsory share transfer provisions in the JV contract, call off options that apply in certain circumstances, and through a material default clause which sets out consequences including selling shares to the other party.

Thought must also be given to the enforceability of a JV agreement. Looking at the complexity of those arrangements, businesses need to know what jurisdiction they are operating within, and if it is less mature, whether it is appropriate for JV arrangements.

Civil code jurisdictions like the UAE don't always facilitate the mechanisms you want to apply to the JV agreement. They don't necessarily give you certainty, unlike jurisdictions that have case law. Offshore holding companies might therefore be more appropriate. There might be tax or other reasons for doing that as well. It may be worth exploring incorporating holding companies in free zones like the DIFC or ADGM that would be involved in JVs, but businesses must be aware of tax implications stemming from economic substance rules that have come into force in low or no tax jurisdictions.

In a lot of cases, it might be appropriate for the JV agreement to be governed by laws other than the country businesses are operating within.