Set Up To Fail: Joint Venture Board Conflicts Of Interest

Saturday, September 1, 2007 - 01:00

Almost by definition, equity joint ventures are schizophrenic entities. They must balance the conflicting interests of their members, which are in line enough at the outset to form the venture, but which frequently diverge. Joint ventures between competitors, whose interests are almost always in conflict, are especially volatile. These inherent conflicts are fraught with peril for the board members of the venture, who are usually allied with one side or the other. This article will discuss those conflicts, and a few techniques to deal with them. As with many legal problems, we will see that advance planning and some thought at the outset of the relationship can avoid significant liability.

Two or more parties form an equity joint venture by forming or incorporating a new, separate entity to act as the venture, and to carry on the business of the venture. This new entity can be a corporation, a limited liability company (LLC) or less frequently, a partnership. The venture partners together own 100% of the new entity's shares or interests. An equity joint venture is different from a contractual joint venture, which is created by contract, and does not involve creating a new entity. Sometimes, two parties will form an equity joint venture to jointly manufacture or develop a new product, one party contributing technology or know-how and the other manufacturing capability. Joint ventures are also common in the health care, pharmaceutical, technology and telecommunications industries, as well as in the energy, financial services and entertainment and media fields.

Regardless of the reasons for their formation, the parties typically form a governing board to manage the business and affairs of an equity joint venture: a board of directors in the case of a corporate entity, and in the case of an LLC or partnership, a board of managers or a similar body. Usually each venture partner has the sole right to appoint or remove its designees to the board. In the case of 50-50 joint ventures, each member will appoint two or three directors. Rarely do they appoint independent directors, except in the case where the venture partners perceive that it is good to have an odd number. The venture partners usually designate members of their own management to serve as directors of the venture.

The directors of these entities consider themselves the spokespersons for their constituency, and each of the parties believes that their designees should represent their own particular interests. Indeed, the parties would be surprised if you told them otherwise.

Unfortunately, corporate law, including Delaware law, is in fact, otherwise.

If the joint venture is a Delaware corporation, an extensive body of case law defines the board's responsibilities. Delaware law provides, among other things, that the directors owe a fiduciary duty to the venture, including a duty of care and a duty of loyalty and good faith. The duty of loyalty is most implicated here. It is a breach of the duty of loyalty to act in a manner which prefers the adverse self interest of the director or a related person over the venture.1 A director appointed by a venture partner, therefore, will violate his or her duty of loyalty to the venture if he or she acts in a way that favors the adverse interests of his or her employer over the interests of the venture. Most other states' corporate law would come out the same way, and if the entity is a partnership or an LLC, and the board members have a fiduciary duty to the venture, then the result is the same.

Often this tension occurs around opportunities that might be right for the venture but are also right for one or more of the partners. For example, let's suppose two lamp manufacturers, Partner A and Partner B, form a venture to develop a new florescent lamp that will generate even more light than those currently on the market. Both partners have made research and development efforts in this regard, but both efforts stalled. They decide to combine their efforts and share the expense by forming an equity joint venture, expecting that they will both license the technology from the venture once the venture perfects it. They form the venture as a corporation with a board of directors. Partner A and Partner B each appoint three directors to the board. Each board member is an employee of either Partner A or Partner B.

The development efforts go along fine, but let's also suppose that the venture's development efforts pay an unexpected dividend: the venture develops a longer lasting incandescent bulb that would compete head to head with one of Partner B's bulbs, but would last longer. Partner B views this technology as a big competitive threat.

It is very clear that it is in the venture's best interests to exploit the new technology as best it can. It might try to license it to another lamp manufacturer or even work on developing and selling the new bulb itself. It would also be very clear that the directors of the venture, including those who are employed by Partner B, have a fiduciary duty to not favor Partner B in the decisions as to what to do about this new technology. On the other hand, in their capacity as employees of Partner B, they want to do everything they can to obtain the technology for Partner B or kill it. The Partner B venture directors are in a terrible conflict position, torn between their duty to their employer and their fiduciary duty to the venture.

Conflicts such as these are some of the reasons why joint ventures have such a low success rate, especially among competitors.2 The directors of these entities are in the middle of inherent conflicts that are difficult to solve because of the very structure of the venture and the composition of its shareholders. The implicit understanding that each party's directors would protect their parochial interests may get forgotten when the venture breaks down, and a party who believes they have been wronged seeks a remedy by claiming a breach of fiduciary duty.

There are a few ways to avoid these problems, and to give effect to the party's intentions from the outset:

1) Eliminate the Board. The traditional corporate structure is incompatible with the very nature of equity joint ventures, and inevitably leads to conflicts. If the venture is a Delaware corporation, it should elect under Section 343 of the General Corporation Law, to be treated as a "close corporation." Almost all joint ventures are eligible to be treated as a close corporation, since they generally have fewer than 30 shareholders and provide for restrictions on the transfer of shares.3 By electing close corporation treatment, the venture can eliminate the board and provide for shareholder management.

If the parties feel some sort of board is advisable, then they can always create an advisory board or some other type of informal body that does not have the same responsibilities as a board of directors.

2) Care in Drafting the LLC or Partnership Documents. If the venture is an LLC or partnership, the organizational documents should not provide for a board with fiduciary duties that are the same as the duties of a traditional corporate board. Because there is more flexibility in defining these duties, it is possible to establish a board with some but not all of the fiduciary duties of a traditional corporate board, eliminating or providing exceptions to the duty of loyalty, for example. This will require a fair degree of care and skill in drafting however, so that these duties are not indirectly implicated in the duty of care or good faith.

3) Advance Waivers. The joint venture or other documents establishing the joint venture can have the venture partners waive in advance any breach of the duty of loyalty in the event a director favors his employer's interests over those of the venture. Advance waivers are always suspect, and depending on the jurisdiction may not work, but are still better than nothing if the board cannot be eliminated.

4) Indemnification. Each venture partner should indemnify the board members they designate to be the directors of the venture. The venture's indemnification provisions or insurance probably won't be of much value, since they often hinge on whether the director acted in good faith and in a manner the director reasonably believes to be in or not opposed to the best interests of the venture4 - a standard that generally eliminates protection against the conflict problem we are trying to address. Similarly, the director limitation of liability provisions, like the one authorized by Secion 102(b)(7) of the Delaware General Corporation Law, do not provide relief with respect to a breach of the duty of loyalty. Obviously, indemnification only shifts the liability and doesn't eliminate it, but allows the venture directors to sleep a little better at night.

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By their very structure, equity joint ventures are embedded with conflicts of interest that create significant problems for their directors. In general, it is better to be aware of these potential problems from the outset, and to attempt to address them in the structure of the venture. 1 See e.g. In re Walt Disney Company Derivative Litigation, No. 411, 2005 (Del. June 8, 2006), at page 72. 2 Some studies have suggested that as many as 70% of all joint ventures fail. Gonzales, M. (2001), "Strategic alliances: The right way to compete in the 21st Century," Ivey Business Journal.

3 Section 342 of the Delaware General Corporation Law defines a Close Corporation as follows:

(a) A close corporation is a corporation organized under this chapter whose certificate of incorporation contains the provisions required by 102 of this title and, in addition, provides that:

(1) All of the corporation's issued stock of all classes, exclusive of treasury shares, shall be represented by certificates and shall be held of record by not more than a specified number of persons, not exceeding 30; and

(2) All of the issued stock of all classes shall be subject to 1 or more of the restrictions on transfer permitted by 202 of this title; and

(3) The corporation shall make no offering of any of its stock of any class which would constitute a "public offering" within the meaning of the United States Securities Act of 1933 [15 U.S.C. 77a et seq.] as it may be amended from time to time.

4 See e.g. Section 145 of the Delaware General Corporation Law.

Stephen A. Tsoris is a Partner in the Corporate & Securities Practice Group of Drinker Biddle & Reath LLP. His practice concentrates on corporate, securities and commercial matters, including mergers and acquisitions, joint ventures, venture capital, federal and state securities law and licensing and distribution for both public and private companies.

Please email the author at stsoris@dbr.com with questions about this article.