Issues in Governance of Joint Ventures

By Dennis J. Block and Jonathan M. Hoff

The New York Law Journal

THE JOINT venture has in recent years become an increasingly important business form because it allows firms to take mutual advantage of complementary expertise, technology and business resources. The importance of joint ventures can be crudely gauged by the number of articles concerning such ventures in The Wall Street Journal; on one recent day, seven articles appeared, describing domestic and international joint ventures in areas as varied as entertainment, medical technology and telecommunications.1

While joint ventures can present tremendous opportunities, they can also present significant pitfalls. Partners may attempt to subvert the joint venture to their own, unfair advantage, or over time, the parties' business objectives may change such as to become inconsistent with the initial purposes of the joint venture or to dampen the parties' enthusiasm for it. Issues of concern involve general considerations in the structure and governance of joint ventures, as well as (i) the fiduciary duty of a controlling member to act fairly towards the other participants; (ii) the duty of members not to enter into competition with the joint venture and (iii) the duty of partners not to usurp opportunities belonging to the joint venture.

Structural Considerations

The variety of forms runs the gamut from implied contracts between two companies to more formal partnerships, limited partnerships, limited liability companies and corporations. The choice of form is dependent on a number of factors, most importantly liability and tax considerations. ;2 Separate and apart from the organizational form are the mechanisms for control over the organization and the allocation of responsibility for day-to-day management (for example, whether the joint venture will be managed by the partners as equals or whether one partner will operate as a "managing partner") as well as the ability of the venturers to control or veto important decisions (such as offering of equity securities, incurrence of debt, acquisitions and divestitures and the appointment of executive officers). These issues can be addressed in the governing documents. ;3

It is also important to establish the purpose and scope of the venture, including the partners' respective contributions and their ability to undertake related business outside of the venture.4 The more these issues are addressed in ambiguous terms, or not at all, the more difficult it will be to avoid conflict between the partners, particularly as the partners' business objectives change over time.

IN THAT regard, exit provisions that allow a partner to leave gracefully can provide a solution to the problem of diverging strategic interests among the partners as the venture progresses. As one court has observed, "because the participants in such joint venture projects often have important investments in related businesses held outside the joint venture structure, the venturers will not have identical incentives in all future situations." ;5 A wide variety of exit mechanisms can be used, including rights of first refusal or first offer among the partners, put or call provisions, or public offerings.6 Flexibility and creativity can assist in designing provisions that are fair to both parties and do not provide incentives for one party to manipulate the exit process or use the threat of its exercise to harm the other partner.

Finally, the joint venture should also be designed with antitrust considerations in mind, as they may raise a variety of issues, such as market monopolization, loss of potential competition, market exclusion, collateral or ancillary restraint and collusion between partners.7 Prospective joint venturers are well advised to be aware of the antitrust implications and the uncertainties of antitrust law as applied to these ventures.8

Duty Not to Oppress

Unlike minority shareholders in a close corporation, partners in a joint venture may have sufficient bargaining power at the outset to ensure that the venture is set up in a way that minimizes the potential for one partner to take actions to its advantage and to the disadvantage of the other participants. Techniques for avoiding such oppression include giving a minority partner the right to name more directors than its proportional ownership might otherwise provide, supermajority voting provisions, or granting veto power to minority partners over certain strategic corporate decisions.9

A recent Delaware case, SICPA Holding S.A. v. Optical Coating Laboratory Inc.,10 considered the responsibilities of a majority participant in a joint venture toward the minority holder. In that case, plaintiff SICPA Holding was the minority shareholder in Flex Products Inc., a joint venture with Optical Coating Laboratory Inc. (OCLI), the majority shareholder.

Under certain shareholder agreements between SICPA and OCLI, SICPA had call rights on OCLI's stock interest in Flex. The call rights would become exercisable in 1998 but would terminate, in certain circumstances,

upon an "initial public offering" of Flex stock.

SICPA claimed that shortly after it informed OCLI that it intended to exercise its call rights, OCLI caused the Flex board of directors to consider issuing 16,000 Flex shares for the sole purpose of extinguishing SICPA's call rights, which SICPA presently valued at $30 million.

SICPA sued Flex, OCLI and the members of the Flex board designated by OCLI to enjoin the contemplated offering. SICPA claimed, among other things, that the offering would violate the shareholder agreements and would be a breach of the fiduciary duty of OCLI and the board members.

SICPA also sought declaratory relief that the offering would not constitute an "initial public offering" for purposes of extinguishing the call rights under the shareholder agreements. Flex, in return, counterclaimed seeking a declaration that it possessed the power to undertake an initial public offering.

The Delaware Court of Chancery held that the Flex board had the legal power to issue shares, as nothing in the shareholder agreements constituted a relinquishment of the board's power to do so. Because Flex had determined not to go forward with the challenged private placement, however, the court did not decide whether the defendants had breached their fiduciary duties to SICPA by virtue of a proposed stock offering, nor did the court interpret the contours of the term "initial public offering" for purposes of the shareholder agreements. The court nevertheless observed that OCLI and its designees to the Flex board owed a fiduciary duty of loyalty to SICPA, stating:

[OCLI] has an intense financial interest in continuing such control through (1) terminating the call right on its stock held by SICPA (which can be done under the contracts by the completion of an initial public offering of stock) and (2) diluting SICPA's stock thus affecting its veto power under the corporation charter's supermajority provisions. While the parties have in the 1994 contracts contracted various protections against each other, as is prudent, nevertheless in their bargain OCLI has been left with residual control of the joint investment (i.e., Flex) ... . This residual power ... gives rise to a fiduciary duty ... . of loyalty ... .

Thus, the court noted, where a fiduciary engages in a transaction that confers a benefit on himself, the fiduciary must show that the transaction is supported by sound business reasons independent of the benefit and that the terms of the transaction were entirely fair under the circumstances.

Here, the court admonished the Flex board that even though the board had the legal power to issue shares, it would nonetheless "bear a burden to establish that the decision to do so is fully justified by a corporate purpose and that in fact it was not motivated in any substantial part by a desire to employ corporate power to assist the interest of [OCLI] at the cost to the minority shareholder."

Non-Compete Clause

Partners in joint ventures are under a fiduciary obligation to act with loyalty toward the joint venture. However, partners are often actual or potential competitors and may be tempted to devote their resources to business lines that compete with the joint venture to its possible detriment.11 Restrictions on the partners, by contract or by operation of law, are intended to ensure that one partner does not neglect or undermine the joint venture in favor of its own, competing business as the partner's strategic plans change, either in the natural flow of time or by change in control of the parent.

A recent Delaware case, Universal Studios Inc. v. Viacom Inc.,12 discussed the obligations of a partner to a joint venture to comply with contractual limitations on competition. In 1981, Time Incorporated and Gulf &; Western Industries (later Paramount Communications Inc.) formed a partnership and executed a joint venture agreement, the scope and purpose of which was to "engage generally in the business of providing to cable television systems a national, video, advertiser-supported basic cable network."

The agreement further provided that the venturers would not provide a similar network to cable television systems other than through the joint venture, and it contained a series of exit provisions, including a complicated buy-sell arrangement.

As a result, the parties created the USA Network. Shortly after its formation, a third partner, MCA Incorporated (now Universal Studios Inc.), joined the venture. Although Time ultimately sold its interest to Paramount and Universal, the joint venture ran smoothly until Paramount was acquired in a merger by Viacom Inc. in 1994.

At the time of the Paramount acquisition, Viacom owned a number of cable networks, including MTV, Nickelodeon and Nick-At-Nite. Universal sued Paramount and various Viacom entities for, among other things, breach of contract and breach of fiduciary duty, claiming that Viacom's continued operation of its pre-existing cable networks and its proposal to launch a new cable network, TV Land, constituted a violation of the non-compete obligations undertaken by Paramount in the joint venture.

In concluding that defendants were in breach of the joint venture agreement, the Delaware Court of Chancery held that the non-compete provisions were plain and unambiguous and applied to Viacom as successor in interest to Paramount by virtue of various guarantee agreements executed in connection with the joint venture agreement.

The court rejected Viacom's argument that the non-compete provision was not intended to apply to Viacom's pre-existing business which, from the perspective of the cable industry, was in no greater competition with USA Network after the merger than it was before the merger.

According to the court, however, the purpose of the non-compete was to protect the venture from the hazards of divided loyalties of its owners and not from competition generally.

The court found that defendants had breached their fiduciary duty of loyalty to the venture and to Universal, but it did not analyze the fiduciary duty claim independent of the duty as defined in the joint venture agreement itself. The court stated:

The parties and their predecessors in interest intended to define the participants' duty of loyalty to each other and to the Venture partnership within the non-compete or covenant not to compete clause. As such, I need not discuss the issue of any independent breach of common law fiduciary duty. All of the parties' respective contentions concerning the scope of the duty, the existence of a breach of duty, the effect of the breach, the nature of the harm suffered by the USA Networks, and who bears responsibility as a result, can and should be discussed within the framework crafted by the parties themselves -- the non-compete clause and associated provisions of the contractual relationship.

Given the court's conclusion that the breach of fiduciary duty analysis was coterminous with the breach of contract analysis, it is not clear why it was compelled to reach the fiduciary duty issue. The finding of fiduciary breach, however, may have arisen out of the court's determination to reject Viacom's contention that Universal's failure to show actual injury negated the claim of breach of fiduciary duty.

In that regard, the court stated, "what is important in determining whether there has been a breach of fiduciary duty by the defendants is whether action inconsistent with their obligations has been taken, not the effects of the action." ;13

The court also rejected Viacom's defense that the agreement constituted an illegal restraint on competition in violation of antitrust laws. In so doing, the court made an observation which would appear to underlie its overall perspective of the dispute.

It noted that from the inception of the joint venture, the parties abided by the non-compete provision and either exited from the venture (as in the case of Time) or agreed to a narrow modification when the provision created difficulty.

In the court's view, Viacom's succession to Paramount's interest in the joint venture had distorted the positions of the parties: one party, Paramount, received the benefit of the joint venture and by virtue of its merger with Viacom, the benefit of a more extensive group of cable networks; the other party, Universal, remained in its original position of abiding by the contract and channelling its entire cable business through the joint venture. The court concluded that "[t]o allow Viacom International (as Paramount incarnate) to reap the benefits of this structure at [Universal's] expense would be inequitable."

The court declined to immediately grant Universal's requests for injunctive relief, specific performance and an accounting. Instead, it fashioned a remedy analogous to those for a dissolution of a joint venture corporation under Delaware law, and required the parties to submit plans for discontinuance of the USA Networks venture in its present form.14 The court expected that with the legal issues resolved, the business people at the companies would proceed to fashion a sensible plan.

Finally, the court sounded a warning to prospective joint venturers who do not take care to address the circumstances where their future business objectives may become constrained by the objectives and terms of the joint venture:

As a matter of policy, leaders in industry must be encouraged to pool their resources without fear that they run the risk of having the conditions changed when they no longer serve the purposes of their coventurers. It may well be true that one or the other or all of the coventurers will eventually determine the rules of the game ought to be changed. At such time, the parties must operate within their previously agreed guidelines or otherwise by mutual agreement. A court of equity will not step in to alter the playing field to the distinct disadvantage of one over the other.

Opportunities

Closely related to competition restrictions is the issue of allocation of business opportunities among the partners and the joint venture itself. Under the corporate opportunity doctrine, a fiduciary is not permitted to obtain the benefit of a business opportunity which rightfully belongs to the enterprise as to which he is a fiduciary.

Thus, in the absence of an agreement to the contrary, an opportunity belongs to the enterprise when (1) the opportunity is in the line of business of the enterprise, (2) the opportunity would be advantageous to the enterprise, (3) the enterprise has the means to take advantage of the opportunity, and (4) taking the opportunity would bring the fiduciary into conflict with the enterprise.15

Chancellor Allen of the Delaware Court of Chancery recently discussed the application of the corporate opportunity doctrine to joint ventures in US West Inc. v. Time Warner Inc. ;16 In that case, US West and Time Warner had entered into a limited partnership joint venture called Time Warner Entertainment (TWE), which was to be "the primary vehicle through which the partners would exploit cable, filmed entertainment and programming opportunities."

Under the joint venture, Time Warner was the general partner and US West a limited partner. At the time US West and Time Warner entered into the agreement in 1993, Time Warner owned, as permitted under the agreement, a minority interest in Turner Broadcasting System (TBS) and, Time Warner contended, had certain rights to buy the remainder of TBS.

In 1996, US West brought an action to enjoin a proposed merger between Time Warner and TBS, alleging that the transaction would constitute a breach of the non-competition provisions of the joint venture agreement and a breach of fiduciary duty. After concluding that Time Warner's acquisition of TBS was permitted by the joint venture agreement, the court concluded that the acquisition did not in and of itself constitute a breach of fiduciary duty.

The court first observed that the doctrine of corporate opportunity applied to partnerships such as TWE, albeit uncomfortably, given that the duty of loyalty in a partnership is more readily limited and defined by the partnership's constitutional documents.

Nevertheless, the court acknowledged that the distinction between the corporate and partnership form in this regard may be less "than meets the eye." ;17 In the case of TWE, the court concluded that even though, as the court held, the parties to the joint venture had by agreement permitted Time Warner to acquire TBS, that understanding was not based on the assumption that TBS would subsequently dramatically change its business in a way that was not foreseeable by US West at the time the agreement was executed.

Accordingly, the court stated, the contours of Time Warner's fiduciary obligations could not be limited by reference to its contractual right to acquire TBS.

The court then determined that the corporate opportunity doctrine did not apply to the facts of the case because Time Warner had represented that it would sell TBS's entertainment assets to TWE if the parties could arrive at a fair price.

Failing to arrive at an agreement on price, however, would mean only that the joint venture had passed up the opportunity, and no duty would be breached. Significantly, however, the court concluded that the acquisition of TBS in and of itself did not implicate other aspects of Time Warner's fiduciary obligations to avoid conflicts of interest in connection with its management of TWE and TBS, despite the fact that the two engaged in related businesses.

In that regard, the court recognized that Time Warner's ownership of TBS presented a temptation for it to favor TBS over TWE. However, given that the parties were renegotiating their relationship (in the court's view, leading to "the most sensible and likely outcome" of the unwinding of TWE) and that US West was not a small investor in need of protection, the court was unwilling "to foreclose the fiduciary [Time Warner] from attempting to meet its obligation of loyalty to TWE in a difficult, case-by-case manner."

Accordingly, the court determined that the issuance of the injunction was premature.

Partners in joint ventures, however constituted, owe one another a fiduciary duty of loyalty. That duty includes a duty not to favor one's own interests over those of the joint venture, or to unfairly manipulate corporate control processes to retain control, or to appropriate for oneself an opportunity that belongs to the joint venture.

Joint ventures, however, are creations of contract, and the nature and extent of the partners' fiduciary duties may be delimited within the agreements. Because courts will look to the joint venture agreements to determine the scope of the duty of loyalty, such documents should be drafted with fiduciary concerns in mind, and issues relating to corporate opportunity, competition and exit scenarios should be carefully addressed.