November 29, 2021

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Five areas of litigation risk in a joint venture

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This article has been written by Aarushi Yadav, pursuing a Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.

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A joint venture is a kind of a group project, where people come together to complete the task or in this case, achieve a certain objective.“Joint Venture” under the Companies Act 2013, means a joint agreement entered into, in writing, whereby the parties that have joint control of the arrangement, have rights to the net asset of the arrangement. 

In other words, a joint venture means, an association of two or more people/persons who come to an arrangement via oral or written agreement, with a specific purpose. To achieve such a purpose, they collaborate their assets, resources, skill sets, knowledge, experience, time and money, anything and everything they can for mutual benefit.

But as they say, “There can be no great accomplishment without risk.” And every venture that was incorporated was bound to have some risks. When a joint venture is initiated, the parties involved undergo a legal agreement, which can either be termed as a contractor or as a joint venture agreement. The joint venture agreement must contain the basic clauses such as provisions related to the distribution of profits and losses, management and control of the joint venture, business structure, tax considerations, and exit strategy, etc. Typically, individuals or firms enter into a venture with the intention to achieve their goals. But this also attracts risks when the goals are not clearly defined and it affects the whole arrangement.

 Litigation risks come into the picture when there is a breach in any of the arrangements or when the venture does not comply with the regulations of the statute. The most common grounds on which a joint venture can get a lawsuit are:

  1. Breach of contractual agreement,
  2. Breach of NDA (Memorandum of Understanding),
  3. Violation of any law, 
  4. Taxes,
  5. Exit strategy. 

Joint ventures can be an incorporated business (separate legal entity from its owner or partners) or an unincorporated business (not a separate legal entity from its owner). Therefore, an Incorporated joint venture gets registered under the Companies Act as a limited liability company or under Limited Liability Partnership Act. 

Joint ventures are formed with a specific purpose for a limited period. Under which if the members involved are on good terms with each other then also the contractual relationship should be bound by some legal formalities.

In this type of arrangement, the people involved have their respective roles to perform, the contract drawn specifies such roles. When such obligations are not fulfilled, then there is a chance of dispute that will arise. Which not only creates a bad impression but also leads to an opportunity for legal proceedings. 

For example, Orange Ltd is a foreign entity, who is willing to enter into the local market with its product. They have sufficient monetary strength and quality product (Product X), but are unable to establish their stand in the local market of a particular region. Due to cultural differences, dynamic market conditions, etc.

Therefore, it entered into a contractual agreement exclusively with Peach Ltd, which is known for its marketing skills and a strong circular chain (logistics) in that particular local market. While entering into the agreement, the two entities accepted that this collaboration shall go on until Orange Ltd gets market stability and for Peach Ltd, it was to increase its business-coverage, outside the local jurisdiction. 

Here, when Orange Ltd, collaborates with Company Red, the manufacturer of raw material used in Product X, has its own logistic team and it allows Orange to use the same, for quick results and more coverage. This leads to a breach in its contracts with Peach Ltd. as they agreed that Peach gets exclusive rights for the distribution of products. Here Peach Ltd can file a suit against Orange Ltd as Orange went against what was agreed between them. 

While entering into a joint venture agreement a confidentiality agreement (NDA) and Memorandum of Understanding (MoU) are two of the main agreements that are signed by the parties at an initial stage of incorporation.

MoU is not legally binding on the parties but carries weight in court. For instance, Orange Limited is obligated to assist Peach Limited in developing its market coverage area by providing financial support and other resources.

All these negotiations and discussions that took place among partners of both sides, resulted in the Memo of Understanding, which can be used in the court of law when there is a dispute or misunderstanding during the course of business. Therefore, when parties breach these agreements, it leads to litigation risks.

In another scenario, Orange Ltd has a product that is Product X. To capture market coverage, Peach Ltd needs to know about the product and its specifics for various reasons such as the handling and transportation of such product, whether the product’s quality changes due to change in temperature or is fragile in nature, etc. Therefore, to disclose such information parties tend to enter into an NDA to protect their product’s ‘secret ingredient.’ And when such secrets are disclosed due to any reason then the party is liable for damages. Similarly, exclusive rights given to Peach Ltd can be under the MoU but not in the actual agreement which gives Orange Limited translucent breach, which can be resolved with some compensation.

When the parties involved in a joint venture violate any law then both the culpable members of the venture are held liable. For instance, if a joint venture is established as a private limited company, then it is mandatory to have at least two shareholders. Whereas in the case of a joint venture established as a public company it should have at least seven shareholders. And it’s mandatory that at least one director should be a resident of India. (If incorporated under Companies Act 2013).

In case the joint venture is incorporated under the Limited Liability Partnership Act,2008. Then the established firm needs to have at least two designated partners and out which one should be a resident of India. Similarly, there are many Acts and statutes that are applicable to joint ventures.  Which constricts them to act accordingly. These acts are there not to hinder the functioning of joint ventures but to protect people’s interests and also allow them not to monopolise in any sector.

There are times when companies are compelled to use underhand methods to achieve their objectives. Which leads to violation of many rules and regulations.  There are situations when ventures have to limit their operations due to country-specific regulations and that creates a hindrance for them. Some of the regulatory bodies that are there for governing joint ventures are the Reserve Bank of India, the Foreign Exchange Management Act, 1999, Competition Law 2002, Labour Laws such as Code on Wages Act, 2019, Industrial Dispute Act 1947, etc. There are some state-specific laws that are also applicable and various industry-specific laws as well.

When the parties enter into a joint venture agreement, they need to sort out their tax consideration at the initial stage. In India, every entity is required to pay tax on its own taxable income. According to the provisions of the Indian Income Tax Act, a joint venture company comes under a slab rate of 30% (plus applicable surcharge and cess). But there are certain exemptions like ‘minimum alternate tax’ etc. where the rate is 18.5 %. There are many charges levied by the Government of India on joint ventures, direct and indirect. Like the normal basic tax, that is tax on income generated and/or profit gained by the company.

Tax on dividend distributed to their shareholders, Tax of Goods and Services, etc. and then there’s Double Tax Avoidance Agreement (DTAA). Here the overseas investors are generally advised to invest through intermediate jurisdiction to save on tax. Hence, one needs to go thoroughly through Indian tax schemes as the breach of such schemes leads to hefty penalties and fines. In some cases, even the licenses or permissions granted for any activity can also be revoked.

Every joint venture has pros and cons. When a Joint Venture is formed it leKnow ads to better market access, boosts expertise, resources, etc. But it falls when the goal becomes blurred when different work cultures clash. When the people at the top are unable to balance and support each other. This reduces the chance of a successful venture and hence the ‘exit strategy’ comes into the picture, or when the goal is achieved and it is time to leave.

The clause of exit strategy is one of the main clauses in the joint venture agreement. With the help of these clauses, the venture will liquidate itself through IPO (Initial Public Offer) or put and call options or third-party sale or any other way through which the Joint venture will conclude. All these methods are different sets of legal obligations that the company has to go through. 

And when the clauses are not framed properly then it leads to the arousal of many disagreements among the partners, members, shareholders, employees, etc. which creates issues internally and externally. And then the dispute resolution procedure such as litigation or arbitration etc. comes into play.

In India, there are various challenges that torment the operation of joint ventures, which has led to the rejection of many foreign investors. Any breach in any law attracts a lawsuit. But in the past years, there has been an improvement in the legislative and judicial system that has uplifted the operation of joint ventures in the country.

Steps are taken by the government to reduce stress on companies and their investors which helps smoothen the functioning of the operations. Even the Alternate Dispute Resolutions such as litigation, mediation, conciliation, laws have been amended which reflects that the Indian system is trying to ease the path of business in India. Hopefully, in the coming years, the legal and administrative structure will become more compliant and flexible towards the investors and market, which can improve the business environment of the country.


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