As companies expand into overseas markets, they are increasingly turning to joint ventures (“JVs”) with local companies instead of acquisitions or establishing their own local greenfield operations. This trend is not surprising and is likely to continue. A JV with a local company usually offers faster market entry and can help avoid foreign ownership restrictions. JVs can provide lower market entry cost than outright ownership, ready access to local knowledge, and an established local customer base. JVs do, however, pose their own pre-transactional due diligence and ongoing compliance challenges. Below we discuss these challenges, typical areas of diligence, and how you can mitigate the risks uncovered in that diligence. In essence, the purpose of due diligence in a JV is not only to identify risks to determine whether the transaction should go forward and under what financial terms, but also to enable the party contemplating the JV to know its partner. Such due diligence will empower the party to identify what contractual provisions regarding management, compliance and oversight may be necessary in the JV agreement. Because the agreement’s terms will govern the parties’ relationship throughout the life of the JV, including potential disputes or desired termination, the terms must be drafted carefully, in full recognition of who the partner is and how it may respond to evolving circumstances.
Challenges to JV Diligence and the Know-Your-Partner Approach
With an acquisition, due diligence can be conducted on a target entity. Risks can be probed and high-risk areas explored in detail. With a JV, there is no target entity and due diligence will focus on your potential partner. This can be awkward during discussions of the exciting new enterprise and can make extensive, risk-based diligence harder to conduct, especially in countries where such diligence is not the cultural norm. Additionally, in an acquisition, after closing you can immediately fold the acquired entity into your company’s compliance program. In a JV, the relationship between your company and your partner is just beginning, and you both must negotiate how to implement and monitor the compliance program. If you are the majority participant, U.S. regulators will treat the JV as if it is was your acquisition. Being the minority partner, however, does not absolve your company from compliance obligations or potential liability; the U.S. government expects even minority partners to use “best efforts” to ensure robust compliance.
Conducting Due Diligence in a JV
From a legal compliance perspective, due diligence in a JV is typically directed at the following areas: (1) anti-corruption; (2) export controls; (3) anti-money laundering (“AML”); (4) antitrust; (5) reputational risk; and (6) any particular risks specific to the partner or the anticipated JV. Diligence is a risk-based inquiry driven by the specifics of each transaction, such as the industry, geographical areas involved, and customer base of your partner and planned JV. The process often begins with a detailed questionnaire, follow-up questioning of key stakeholders, and a deeper investigative inquiry into specific areas if necessary. Basically, diligence can be boiled down to one concept: “know your partner.” Due diligence steps to consider include:
- Identify the structure and ownership of your partner’s entire organization, including parents, subsidiaries, and affiliates. Is there any government ownership or control?
- Identify all legal and beneficial owners, directors, officers, and key employees, including those critical to the JV. Identify any other business interests they may have. Are they or any close relations current or former government officials? Run their names and businesses against the various sanctions lists. Using a risk-based analysis, further investigate the background and reputation of key individuals.
- Obtain and verify relevant corporate registration documents, accounting and tax records.
- Conduct a litigation and legal proceedings search. Investigate your partner for prior criminal or unethical activity using software tools, the internet, and the press, and by exploring reputation in the local community.
- Identify your partner’s areas of operation and sales. Does it operate in areas known for corruption or that are transshipment points for embargoed nations? Does it have government contracts or sales to embargoed nations?
- Identify how your partner uses agents, middlemen, and consultants. For example, does it use agents to obtain major licenses and permits? Does it have a direct sales force or does it use independent sales representatives, distributors, or resellers? How does it handle customs clearances and tax payments? Obtain a list of your partner’s service providers, or at least the major providers and those relevant to the JV. Review sample contracts. Was due diligence conducted on these agents? If so, what was the diligence? Review sample diligence files.
- Significant antitrust issues can arise with a JV relationship. Is your partner a competitor? Are there any required antitrust filings? What impact will the JV have on price and competition? Are agreements not to compete or agreements with respect to price or market allocations contemplated with your partner or the JV? What membership in trade associations and other organizations does your partner have?
- Identify your partner’s financial institutions and location of accounts. Are any of these located in embargoed nations or tax havens? Run any lesser known institutions against the sanctions lists.
- Who are the partner’s key customers? Are there any unusual payment terms in place or payments to third parties to accounts in tax havens? Run key customers against the sanctions lists.
- Identify any large political or charitable contributions your partner has made. Do they tie into any transactions, permits or approvals?
- Identify key supply contracts and supply chains for your partner’s main business lines. Run key suppliers against the sanctions lists. Analyze the supply chain for anti-corruption and other regulatory risks.
- Identify products and technology that will be shared. Identify any regulatory hurdles, such as the Office of Foreign Asset Control (“OFAC”) or the International Traffic in Arms Regulations (“ITAR”), that might impact the transfer of products or technology.
- Review your partner’s compliance and ethics programs, including its policies, procedures, and training materials. Interview compliance personnel. Review your partner’s financial controls.
- Visit your partner’s corporate headquarters and physical operations.
- Identify which JV functions, if any, will be performed by your local partner, such as sales, customs clearances, licenses, and permits. Conduct a risk assessment of those functions. Deeper due diligence of your partner in those areas may be warranted, including reviewing transactional and financial records, contracts and agent agreements, and interviewing relevant personnel.
- Conduct interviews based on the responses to your questionnaire. Likely interviewees will include the general counsel, CFO, COO, head of marketing and sales, and head of internal audit.
Many of the above items also should be considered in designing and implementing the JV’s compliance program. Additionally, you should analyze any local legal issues that may impact your dealings with the JV. For example, will there be any local law restrictions on your ability to export financial records, electronic data, technology, or currency from the JV to your company? Unquestionably, the above is something of a wish list. How much of this information you can obtain may depend on local law and business custom, and will be the subject of negotiation. The amount of information you can obtain will, of course, play into your overall risk assessment of the transaction and inform your decision on whether to move forward. Your partner’s refusal to provide certain information can speak volumes. It is critical to verify the information you receive. The provision of inaccurate, incomplete, or misleading information factors significantly into the overall risk assessment. Third-party investigators are an excellent resource for verifying information, conducting background checks on key employees and agents, and delving into your partner’s reputation in the local business community. Consider whether to conduct diligence and retain an investigator through counsel in order to maintain the attorney-client privilege. You will need to go through outside counsel in jurisdictions that limit or do not recognize attorney-client privilege for in-house counsel. Maintaining privilege is important for various reasons, but it becomes most important when your company moves forward with a transaction even when concerns have arisen.
In a JV transaction, one of the purposes of due diligence is to identify risk areas so they can be addressed in the JV agreement. You will want strong representations, warranties, and covenants requiring all parties to comply with the law generally, and specific representations covering anti-corruption, export controls, AML, antitrust, and any other risks uncovered during your due diligence. These representations and warranties should be re-certified periodically. Because of the ongoing nature of the JV relationship, risk mitigation steps should be clearly stated in the JV agreement, and there are areas over which your company may want to maintain control. To help ensure ongoing anti-corruption compliance, in addition to strong covenants, include in the agreement an attached compliance policy for the JV. This will make it harder for your partner to backtrack on its commitment to anti-corruption compliance. Consider also seeking the contractual right to appoint the JV’s Chief Compliance Officer. Be as specific as possible in the JV agreement and avoid vague language such as “JV entity will adopt anti-corruption policies satisfactory to Company X.” Such language requires your company to negotiate anti-corruption compliance post-closing, after it has bought the risk. Of course, these caveats and suggestions apply beyond anti-corruption to other areas of risk uncovered during due diligence. Other measures to contemplate include who will appoint officers and directors, such as legal representatives and the general manager of the JV. Seek to retain veto rights over major corporate actions, operational decisions (mergers and acquisitions, large contracts, key hires, etc.), and oversight of the compliance program. Negotiate for annual Sarbanes-Oxley sub-certifications from the JV on internal controls. If your partner is to perform specific functions for the JV, seek to review the relevant financial records for those functions on an ongoing basis, especially if they are high-risk functions. If there is a significant breach of compliance obligations moving forward, you will want to have provisions in the JV agreement allowing a prompt exit in the best financial position possible. Consider what events would trigger the ability to exit the JV and how that exit would work. Examples of exit strategies include buy / sell rights with a pre-agreed formula price for each partner’s interest in the JV or a sale of the entire JV to third parties. As with due diligence itself, the level of protection you are able to build into the JV agreement will be negotiated and will inform your decision on whether to consummate the transaction. Remember, however, that terms in a JV agreement are typically a double-edged sword, applying equally to the partners. Accordingly, consider how any contract provisions, especially exit triggering events, could be used against your company.
From a compliance standpoint, JVs are riskier than an acquisition because they provide a lesser degree of control. Through robust pre-transactional due diligence that identifies the risks and strong contractual terms that address them, those risks can be effectively managed.