Joint ventures – a time to reflect

Joint ventures are a preferred route for international businesses wanting to expand into new territories, sectors and developing markets. Sharing risk and having a local partner to open doors are key drivers behind this. The commercial advantages, however, must not be allowed to disguise the highly technical legal issues that are often brought into play – sometimes with disconcerting results. It is vital to understand what – as far as the law is concerned – can and cannot be done.

The joint venture

Picture this. A successful business is looking to expand ahead of the competition by breaking into a new overseas territory – let’s assume the target market is the Middle East. It agrees to buy a 60% stake in a target business (the Target) from the present owner, a well-known businessman in the region (the Seller), who will retain a 40% interest in the Target. The buyer secures his continued involvement with the Target by making him a non-executive director.

The purchase price is payable in three instalments – the first on completion, and the remainder staggered over a number of years.

The Seller enjoys personal relationships with the clients of the Target, and also has interests in other businesses in the region that compete with the Target. The Seller gives the standard non-compete restrictive covenants and agrees that, if he breaches the covenants, he will forfeit any unpaid instalments of the purchase price and will sell his 40% shareholding to the buyer at a discount to market value. All this is negotiated by international law firms and included in the purchase and joint venture agreement which documents the whole transaction (the JVA).

The transaction completes and the buyer pays the Seller the first portion of the purchase price. Not long after completion, though, it emerges that the Seller has been diverting customers and employees away from the Target to his competing businesses. This is exactly what the buyer had feared. It could wipe millions off the value of the Target, and therefore the value of the buyer’s 60% shareholding.

The buyer turns to the JVA. Thank goodness it has not paid the full purchase price yet and that it made the Seller agree to sell out at a discount: some value can still be salvaged from this mess! The Seller, however, demands that the full purchase price be paid, despite his deliberate breaches of contract and despite what the JVA says. The Seller also refuses to sell his shares. The parties end up in court.

Who won?

You might regard the Seller’s position as weak: he has deliberately acted in bad faith, breached the JVA and caused significant loss to the Target and the buyer. It will surprise you, then, that in a case very like this the English Court of Appeal found in favour of the seller, ordering the buyer to pay the remaining instalments of the purchase price in full, and ruling that the right to buy the seller out at a discount was unenforceable.

The case was Makdessi v Cavendish Square Holdings. In broad terms, Makdessi was the seller, Cavendish the buyer, and the Target was a business based in the Middle East. The decision turned on two particular points of English law not always fully appreciated by parties to joint ventures. The points in question were reflective loss and the unenforceability of penalty clauses.

Reflective Loss

Reflective loss refers to the diminution in value of a shareholder’s shares in a company that reflects losses suffered by the company.

Take the example of a shareholder who owns 100% of a company. If that company suffers a $10 million loss due to actions of a third party, the shareholder’s loss is the $10 million reduction in the value of his shares. Similarly, if the shareholder only owned 60% of the company, his loss would be $6 million.

Under the doctrine of reflective loss, if the company has a right to bring a claim against the wrongdoer, the company’s claim displaces the shareholder’s. The loss suffered by the shareholder is the reduction in value of his shares and is said merely to reflect the company’s loss, because his position would be restored if the company recovered in respect of its own loss. The logic here is to avoid the shareholder and company competing against each other to recover essentially the same loss from the same wrongdoer. The fundamental point to bear in mind here is that, if the company does not (or cannot) make its claim, the shareholder is still left without any remedy for his own claim.

Although the restrictive covenants that Makdessi breached were given only to Cavendish in the JVA, Makdessi’s behaviour was also a breach of his fiduciary duties as a director of the Target. The same wrongful acts breached both the JVA and Makdessi’s fiduciary duties at the same time. This meant that the Target had a right of action in respect of the wrongdoing, and Cavendish was barred from bringing its claim for breach of the JVA. Consequently, the recoverable losses suffered by Cavendish were nil, as it had no right of action.

Penalty clauses

This left Cavendish relying on its contractual rights to avoid paying the outstanding purchase price instalments and to buy Makdessi out at a discounted price. Makdessi claimed that refusing to pay the remaining instalments of the purchase price upon breach of the restrictive covenants amounted to a penalty. So, too, was forcing him to sell his shareholding at a significant discount to market price.

Very broadly, if an agreement provides that, if the relevant party is in breach, it must pay the other party a fixed sum of money (or do something with a similar economic effect, such as forfeit a valuable right or sell an asset for less than it is worth), that provision will not be enforceable if the party in breach can show that the provision is a penalty clause. Clauses are particularly at risk if the same sanction applies to a range of breaches of greatly varying significance. The failure of a penalty clause does not prevent the aggrieved party from seeking damages for loss; in this particular case, though, the reflective loss principle stopped Cavendish from claiming a loss.

What constitutes a penalty clause has been debated in the courts for many years, and in this case the Court of Appeal reviewed the history of this area in some detail. Although it introduced no new concepts in the case, the court adopted a new two-stage approach to determine whether provisions amounted to penalty clauses:

• the court should first ask whether the remedy was based on a genuine pre-estimate of the losses that would be suffered as a result of breach: in other words, was the primary purpose of the provisions to compensate the victim for its recoverable losses? A provision based on a genuine pre-estimate of loss could not be a penalty; and
• if the court finds that a provision was not based on a genuine pre-estimate of loss, it then asks whether there is some other commercial justification for upholding the provision.

Genuine pre-estimate of loss

The Court of Appeal considered whether the consequences for Makdessi as a result his breach of contract were “extravagant or unreasonable” when compared with the losses Cavendish would be likely to suffer. Crucially, in this context, the court noted that Cavendish’s recoverable losses were nil, as a result of reflective loss (it was beside the point that Cavendish misunderstood the position and in fact envisaged recovering substantially for breach of covenant). In contrast, Makdessi stood to lose approximately $44 million in unpaid instalments of the purchase price, and many more millions of dollars through having to sell his 40% shareholding at the agreed price. The court therefore decided that the consequences of breach for Makdessi were extravagant and unreasonable compared with Cavendish’s recoverable losses.

The court also noted that the provisions were not proportionate. Any breach of the restrictive covenants, even it was trifling (such as an unsuccessful attempt to recruit one of the Target’s employees), would have the same drastic financial consequences for Makdessi.

Therefore, the primary purpose of the consequences of breach was not to compensate Cavendish for its losses.

Was there nevertheless some other commercial justification for the provisions?

Commercial justification

If the court finds that there is a good commercial justification for the provisions it can be persuaded that the primary purpose was not a deterrent to breach, so that the clauses might not be penalty clauses after all.

The court again noted that there was no proportionality between Makdessi’s breach and the financial consequences he would bear. In that context, the court found that the provisions were firmly of a deterrent character. The court found there was no commercial justification for them, and concluded that both provisions were penalties.

Conclusions

English law has arguably become the “go to” law for international businesses in relation to key corporate contracts, and there is good reason for this. But the parties need to take advice, as technical points like reflective loss and penalties can have a real, tangible impact. It is also important to remember that these issues are not confined to joint ventures, but are equally relevant in many other contexts, such as shareholder agreements, private equity and M&A transactions.

• Always think carefully whether the joint venture company should be a party to the JVA: giving contractual rights to the company could have the unexpected consequence of blocking shareholder claims due to the reflective loss principle. There are certainly pros and cons to the joint venture company being party to a JVA – for example, the shareholders may want direct contractual undertakings from the joint venture company which sit best in the JVA – and each joint venture will have its own features. Careful drafting of the JVA can reduce the chances of the reflective loss principle applying even if the joint venture company is a party to the JVA, but it is not possible for the company simply to contract out of reflective loss.
• Remember that the rights that are fatal to the shareholder’s claim can also arise in other ways. Makdessi did not grant the same restrictive covenants to the company, but he owed duties to the company as a director that were breached by the same behaviour that breached the covenants. Look at the situation in the round. Are there other links between the potential wrongdoer and the company that might provide a remedy to the company - such as a duty of care in tort – and block the shareholder’s claim?
• If the agreement provides a bespoke remedy for breach of contract, ask yourself whether it is based on a genuine pre-estimate of the innocent party’s likely loss (judged at the time of the agreement) or if it is really there to deter the other party from breaching the agreement.
• It is possible to craft provisions so that they avoid being penalties. The court in Makdessi noted that, if the provisions had been drafted as conditions – so that, for example, payment of the instalments was conditional on Makdessi complying with his restrictive covenants at the time of payment – they would not have been penalty clauses. Generally, an obligation to pay money or to transfer property that arises from a choice by the relevant party rather than a breach of contract by him will not be a penalty.