Tuesday 9 December 2008

How to Deal With a Distressed Venture

With the Chinese economy cooling, joint ventures are coming under increasing strain. However, a foreign investor does have options when its partnership founders and the joint venture becomes “distressed”.

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Guanyu said...

How to Deal With a Distressed Venture

Peter Thorp
8 December 2008

With the Chinese economy cooling, joint ventures are coming under increasing strain. However, a foreign investor does have options when its partnership founders and the joint venture becomes “distressed”.

Short of a negotiated exit strategy, a contractually prescribed “involuntary exit mechanism” offers the greatest potential for resolving joint-venture problems. Joint-venture contracts commonly contain a list of triggering events - insoluble deadlock, contractual defaults or partner insolvency, for example - enabling the foreign party to exit the venture either by exercising a put option (transfer of its equity interest to the Chinese party) or terminating the contract.

Exercising a put option requires unanimous board approval and the co-operation of the Chinese party. If the foreign party wants a quick exit concessions on price may be traded for indemnities. Any transfer will also be subject to approval and registration.

Alternatively, the foreign party could seek dissolution of the venture. This is possible where heavy losses or contractual breaches make the continued operation of the venture problematic, where its purpose has not been achieved and there is no potential for further development.

If these strategies fail, the foreign party may have to submit the matter to arbitration for termination. However, the time, costs and effective enforcement of arbitral awards in China often deter foreign investors. The foreign investor might also consider buying the Chinese party’s equity interest in the joint venture, generally turning the venture into a wholly foreign-owned enterprise.

The Chinese party might, however, be subject to multiple claims preventing it from freely transferring its equity interest. The interest may have been pledged to a creditor, or be subject to a court-issued freezing order. The transfer is conditional on the foreign party’s pre-emptive right of purchase. Purchase of a frozen equity interest may be done through talks between the partners and the court, or through a court-administered auction.

The Bankruptcy Law potentially offers a way to rehabilitate the joint venture’s business, though early reports on its effectiveness are mixed. This sees the distressed joint venture entering quasi-administration where a debtor or administrator will prepare a reorganisation plan.

Careful drafting of contracts and agreements will help avoid conflicts and also ensure the foreign partner can protect its interests as far as possible. For a minority foreign shareholder, this means including a list of reserved matters requiring consent from both parties, insisting on a high quorum requirement for board meetings, the right to appoint key management personnel and clear deadlock provisions.

Peter Thorp is a managing partner of Allen & Overy’s Beijing office