UKLA reduces burden of joint venture rules

United Kingdom

The UK Listing Authority has announced that significant changes are to be made to the Listing Rules that relate to joint ventures with effect from 6 August 2007.  These changes will make it much easier for listed companies and their subsidiaries to be involved in joint venture transactions.

WHAT ISSUES HAVE COME UP FOR LISTED COMPANIES WANTING TO ENTER INTO JOINT VENTURES?

Since the new Listing Rules were introduced in July 2005, two key issues have become wearyingly familiar when we have been dealing with joint ventures with listed companies.

Exit provisions and the Class 1 problem

When signing up for a joint venture, the parties often want to agree certain situations that will result in the joint venture being brought to an end.  These may include inability to agree on certain issues, breaches of the joint venture agreement or simply that a particular time has passed.

The mechanism for dealing with the end of the joint venture is typically that one party will often have the right to buy out the shares of the other.  This is often done at “market value”, as valued by an independent valuer.  Although not perfect, this is generally seen to be a fair way to bring the joint venture to a close.

Under the Listing Rules, if you give someone else (e.g. your JV partner) a right to buy your shares and you don’t have any discretion to say no, you are treated under chapter 10 as if you have actually sold those shares today.  It is therefore necessary to treat these types of provisions in a joint venture agreement as if they were a sale, and apply the Class Tests in chapter 10 to them.  These judge the size of the transaction in relation to the listed company’s size, looking at price (compared to its market capitalisation), gross assets and other factors.

Because the price under the exit provisions will only be set when the sale actually happens, the Class Test on price treats this as “uncapped” - and as a result this means the joint venture agreement is treated as a Class 1 transaction.  That then means shareholder approval is needed to enter into the joint venture. 

For many listed companies, it is just not practical - nor do they see it as justified - to seek shareholder approval when they enter into a small joint venture.  Although there are ways to avoid having to get shareholder approval, these may not be ideal - for example, a common approach has been to cap the maximum price payable under the exit provisions at a fixed amount just below the Class 1 threshold, but if the JV is to last for 10 years it becomes much more possible that the final value will be greater than that amount, and the listed company will have lost out.  Alternatively the JV partners may decide not to include any exit provisions at all, but that can simply store up problems for the future.

Related parties, related difficulties

It is fairly common for joint ventures to be established on a “deadlocked” basis - that is, each JV partner has equal control rights, and can appoint the same number of directors.  The general intention is that any decisions need the support of both JV partners - and this is often the most practical approach when two substantial organisations are coming together.

The second issue that has often come up is that chapter 11 of the Listing Rules states that, where the JV is deadlocked, a JV partner that is listed has to treat both the other JV partner and the JV company itself as its related parties.  This has several consequences, but the most serious is that any transaction with a related party that reaches 5% or more on any of the Class Tests must be approved by the listed company’s shareholders.  Even some smaller transactions - of 0.25% or above on any of the Class Tests - need the listed company’s sponsor to get involved and give a comfort letter.

As a result, any dealings with the JV can become very difficult: anything - from making small amendments to the JV agreement to transferring assets into or from the JV or terminating the JV and buying out the other party - can suddenly incur a lot of time and cost.

HOW ARE THE LISTING RULES BEING CHANGED NOW?

The main changes are:

Exit provisions

Where the JV agreement includes exit provisions where the price is uncapped (generally because it is to be market value at the time of exit), this will only be treated as a Class 1 transaction (and therefore needing shareholder approval) if any of the other Class Tests indicate that it should be Class 1 or 2.
 
If all of the other Class Tests indicate that it should be Class 3, the uncapped exit provisions will mean it is treated as a Class 2 transaction (therefore requiring only to be announced in sufficient detail in accordance with specific requirements in chapter 10 of the Listing Rules).

The change will ease the burden for a significant number of smaller joint ventures.  However, larger joint ventures will still need either to get shareholder approval or structure their transaction in a way that achieves the same commercial ends but doesn’t trigger the Listing Rules issue - again incurring time and cost.

The UKLA’s position is that only where there is a “remote prospect” that the actual price on an exit will reach the Class 1 level should it be treated as less than Class 1.  They think that the 5% maximum for Class 3 treatment is what is needed to show this level of remoteness. For now we have to accept this middle ground.  However, they say that they will keep the issue under review, so listed companies that find that this rule causes commercial problems should make sure that the UKLA is aware of these.

Incidentally, the relaxation of the uncapped consideration rule is not restricted to joint ventures but has general application to all transactions. It might, for example, enable a listed company or one of its subsidiaries to enter into uncapped earn-out arrangements without having to seek shareholder approval.

Ordinary course of business

The UKLA has confirmed that it is possible for the establishment of a JV, or for acquisition or disposal of interests in a JV, to be treated as a transaction in the “ordinary course of business”.  Generally this would be agreed between the listed company and the UKLA on a case-by-case basis.  The effect of this is that the JV would fall outside the Class Tests completely and the problems above would not apply.

The UKLA has also stated that they are neutral as to form, so that, if an activity would normally be treated as being part of the ordinary course of business for the listed company, this analysis would not change simply because the activity was being undertaken through a joint venture vehicle.

This may not be directly useful to most listed companies, where joint ventures are often used to take on something new.  However, in some sectors, such as property companies or those involved in PFI projects, a significant part of their ordinary business is arranged through JVs, and they are likely to find this valuable in minimising the overhead costs of those JVs.

Related parties

The creation of a deadlock joint venture will no longer automatically lead to the joint venture partner, and the joint venture itself, being treated as related parties of the listed company.  This should make dealings in relation to the joint venture much simpler and less costly, as they will only need to take chapter 10 into account.

Only where the JV partner exercises “significant influence” over the listed company (which might apply where the JV represented a very large part of the listed company’s assets or profits), or is a significant shareholder or director of the listed company, will the related party rules be likely to apply again.

WILL IT MAKE ANY DIFFERENCE?

The change on related parties will make a significant difference to deadlocked joint ventures, by reducing the burden that applies when dealing with the joint venture.  In most cases the related parties rules will no longer be relevant to joint ventures.

The change to the Class Tests is helpful but only really benefits smaller joint ventures.  Larger joint ventures - and this means anything that is over 5% on any Class Test - will still need shareholder approval before the parties enter into the type of exit provisions mentioned above.  But it is a welcome step forward. The UKLA have said that they will keep this issue under review, which leaves the door open for further changes.

The confirmation on ordinary course of business will probably not have much impact on most listed companies, but for some that use JVs on a daily basis it may offer a better way to deal with these.

Overall, this is a welcome package of changes, and shows that the UKLA has been listening to feedback from listed companies that have been struggling with joint ventures over the past two years.  It will be very helpful to listed companies, which from 6 August can focus on the commercial benefits of their joint ventures, rather than spending time and money on technical points.