Double Duty: JV Director Duty of Loyalty

November 2019 — MANY JOINT VENTURE Board Directors find themselves in a perceived state of conflicted interest: deference to their nominating shareholder versus loyalty to the joint venture company. The dilemma is a difficult one, as promoting one shareholder’s interests at the expense of the JV can undercut venture performance, while prioritizing the venture can limit the shareholder’s strategic interests and financial returns outside the venture.

Directors on joint venture Boards, like those on corporate Boards, likely owe certain fiduciary duties to the JV company, most notably a duty of care and duty of loyalty.^[1]When suits have been brought citing a breach of a joint venture Director’s duty of loyalty, as was the case of TNK-BP, Danone-Wahaha, Pacific National, and other instances, such challenges have … Continue reading The duty of loyalty is especially tricky in joint ventures, as Board Directors who are employees of one shareholder are simultaneously a fiduciary to their employer and to all other shareholders. This issue of mutual agency introduces three types of conflicts: business opportunity conflicts (i.e., situations where a Director needs to decide whether a new opportunity is best pursued through the venture or by their shareholder outside the venture); self-dealing conflicts (i.e., situations where the Director needs to vote on whether the venture will buy, sell, or otherwise transact with their shareholder for products, services, technology, or other assistance, and the terms associated with such arrangements); and information disclosure conflicts (i.e., situations where a Director must decide what potentially-valuable information can and cannot be shared between the venture and their shareholder).

Balancing such conflicts is a regular occurrence on joint venture Boards. For instance, the Board Directors of an Asian media joint venture were asked to grant permission to negotiate a minority investment in a technology company which, unbeknownst to management and other Board members, was being separately evaluated by one shareholder. Or consider the Directors in a Canadian oil sands joint venture were asked to vote on an economically-attractive major capital investment which, if approved, would create labor and cost pressures on a capital expansion that one shareholder had planned at a wholly-owned asset just up the road from the venture.

In our experience, joint venture counterparties rarely undertake – and courts are generally not sympathetic to – direct legal action against one partner or its Directors for a breach of the fiduciary duty of loyalty. While the law does not treat joint ventures differently from other corporate structures, the notion that a Director’s loyalty is “undivided and supreme”^[2]See Meinhard v Salmon 164 N.E. 548 (NY, 1928). as the courts have held in other partnership structures, does not reflect the reality on the ground with joint ventures. After all, joint ventures are unlike public companies in that individual shareholders likely have direct Board representation and the opportunity to negotiate specific contractual rights to protect their interests. This creates at least an implied understanding that Directors will advance their own shareholder’s interests over those of other shareholders, whose Directors also serve on the Board. Indeed, when freed to do so, such as in Delaware LLCs, JV partners will often contractually agree to release each other from the duty of loyalty, sidestepping issues.

Nonetheless, Directors serving on joint venture Boards may be exposed to legal liabilities and, at a minimum, are understandably confused. Directors often receive conflicting guidance as to whether they should bring independence to their role, casting votes based on their own professional judgment and what in their view is best for the venture, versus simply voting what is, or what they have been told is, in their shareholder’s interests. Similarly, in our analysis and experience, the most prevalent contractual method for handling Director duties of loyalty – that is, remaining silent – runs the risk of exacerbating misalignments and undermining a culture of trust within the Board and between partners.

The purpose of this article is to help those structuring joint venture legal agreements understand their options for drafting duty of loyalty provisions, to offer guidance on how to reduce the “zone of conflict” for joint venture partners, Boards, and Directors, and describe how to select the optimal contractual approach, including whether to waive, partially waive, be silent on, or explicitly affirm a Director’s duty of loyalty.

Four Contractual Approaches and Benchmarks

Four Contractual Approaches: Ankura recently analyzed a cross-section of 50 joint venture legal agreements in our database to understand how JV Directors’ duty of loyalty is handled contractually.^[3]Ankura reviewed the primary legal document governing the relationship among shareholders of the applicable JV. Where available, Ankura also reviewed related organizational or governance documents. … Continue reading These agreements cover multiple industries, geographies, corporate forms, and formation years, but exclude unincorporated and other contractual joint ventures in which no separate corporate entity was established, as such ventures do not have the same type of fiduciary duties, namely those imposed by statute or common law.^[4]Unincorporated joint ventures operated by one partner, which are widespread in the upstream oil and gas sector, introduce interesting related questions pertaining to the Operator’s obligations and … Continue reading

This analysis identified four approaches to handling Directors’ duty of loyalty: Explicit Affirmation, Implicit Affirmation, Qualified Waiver, and Complete Waiver (Exhibit 1).

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1. Explicit Affirmation: Venture agreements can be drafted to explicitly establish a Director’s duty of loyalty to the joint venture and, directly or indirectly, not to the shareholder. The shareholders agreement of a large oil and gas joint venture corporation makes this singular duty of loyalty clear: “The duty of a Director is that of a fiduciary and accordingly the Directors on the Board must act and vote in the interests of Corporation and not in the interest of the Shareholders.” Other agreements affirm Director loyalty to the venture somewhat less directly, as observed in a U.S. power industry joint venture structured as an LLC: “Each Director shall perform his duties in good faith; in a manner the person reasonably believes to be in the best interests of the Company, and with such care as an ordinarily prudent person in a like position would use under similar circumstances.”^[5]Ankura reviewed the primary legal document governing the relationship among shareholders of the applicable JV. Where available, Ankura also reviewed related organizational or governance documents. … Continue reading
2. Implicit Affirmation: Legal agreements can be structured to make no mention of Director fiduciary duties. The lack of specific language does not mean that fiduciary duties, including the duties of care and loyalty, do not apply, as the existence of fiduciary duties serves as the default in most jurisdictions, including Delaware. Thus, silence implicitly means that Directors remain subject to fiduciary duties imposed by applicable law.
3. Qualified Waiver: Qualified waivers are present when the agreements provide for blended loyalties or subject a Director’s duty of loyalty to specified limitations. Our analysis identified three types of qualified waivers: loyalty carve-outs, dual loyalties, and legal waiver with policy caveat. In loyalty carve-outs, the agreements stipulate that it is permissible in certain matters for a Director to solely reflect the interests of his or her nominating shareholder, while in other matters the Director is expected to vote based on the venture’s interests, even at the expense of the Director’s nominating shareholder. Under the dual loyalties structure, the agreements affirm a Director’s loyalty to both the venture and the nominating shareholder. This language is present in a bilateral alternative energy venture incorporated in Delaware: “In carrying out his duties, each Director of the Company shall owe to the Company and its Members fiduciary duties of loyalty and care”. Under the legal waiver with policy caveat, the legal agreements waive the duty of loyalty, thus eliminating Director legal liability for breach of this duty, while the venture’s governance policies (e.g., governance framework, Director role descriptions) state that the Directors should balance the interests of the venture and a shareholder.
   
   This is the case in a healthcare joint venture, where the LLC agreement provides a complete waiver of Directors’ duties of loyalty to the venture, while the venture’s Board-approved governance guidelines contain multiple statements suggesting Directors should endeavor to focus on the interests of the joint venture. Such statements include reference to a desire for the Board “to speak with one voice to management” and to “focus on the broader interests of the company and its business overall, rather than owner-specific issues.” The intent of this qualified waiver is to promote the interest of the venture and prevent the Board from denigrating into a negotiating forum for individual owner interests, while exculpating legal liability for any failure of a Director to satisfy the duty of loyalty.
4. Complete Waiver: Complete waiver refers to agreements that completely waive all JV Director fiduciary duties of loyalty. For example, in one healthcare Delaware LLC, the joint venture agreement waives the existence of fiduciary duties with unequivocal language: “Each Member irrevocably and unconditionally waives and acknowledges that the other Members irrevocably and unconditionally waive, to the fullest extent permitted under Delaware law, any fiduciary duty that could be deemed to be owed to any Member or to the Company by it, any Member or any Director.” However, this approach ultimately depends on whether it permits parties to waive such duties in the applicable jurisdiction.

Benchmarking and Analysis

Our analysis of 50 JV agreements reveals that implicit affirmation is the most common (52% of agreements analyzed) and complete waiver is second most common (34% of agreements) approach to defining Director duties of loyalty (Exhibit 2). Notably, some two-thirds of JVs structured as LLCs include a complete waiver. This suggests that limited liability companies may provide greater flexibility and potential protections for parties concerned about potential liabilities arising from Director conflicts of interest. Outside of LLCs, 81% of ventures structured as corporations and 86% of those with other corporate forms remain silent (i.e., implicit affirmation) on this matter.

Beyond corporate form, jurisdiction appears to play a role in what approach parties take to fiduciary duties. Some 57% of all U.S. JVs surveyed included a complete waiver, while no JVs outside the U.S. included such a waiver. Thus it appears that U.S. companies are much more likely to waive fiduciary duties.

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There are a few potential explanations for the disproportionality of complete waivers in the U.S. One reason may be that U.S. corporate law is both quite developed and highly litigious. As a result, American contractual drafters may insert extensive clauses, like detailed fiduciary duty language, to limit legal liability. Another possible contributing factor is the recent trend in Delaware to waive fiduciary duties. Numerous U.S. companies organize under Delaware law due to its developed law and streamlined system for entity formation and other states tend to follow Delaware’s lead in statutory and case law. Thus the change in Delaware law may have proliferated throughout the U.S. Furthermore, a large number of the U.S. JVs surveyed were LLCs so perhaps the limited liability company corporate form, which is popular in the U.S., is driving parties to include a complete waiver in their JV agreements. Whatever the reason, be it U.S. litigiousness, trends in U.S. law, or the LLC corporate form, U.S. companies and, in particular, U.S. LLCs tend to disproportionately have a complete waiver of fiduciary duties.

It is notable that none of the legal agreements and supporting governance policy documents of the 50 JVs we reviewed provided additional guidance as to what “in the interests of the joint venture company” means at a practical level.^[6]This lack of clarity was on display in a five-partner financial services technology solution JV, which included four partners who were customers of the venture, and one private equity firm which was … Continue reading

Practical Guidance

We believe that joint venture partners should actively consider structural methods to reduce a Director’s “zone of conflicts” and, because the potential for conflicts of interest can never be eliminated entirely, joint venture partners should not stay contractually silent on Director fiduciary duties of loyalty. We believe that establishing explicit expectations for Directors – whether explicit affirmation, qualified waiver, or complete waiver of their duty of loyalty – drives partner alignment and trust, reduces Director uncertainty, and promotes a common boardroom culture. Meanwhile, the decision as to whether to explicitly affirm, waive with qualifications, or completely waive these duties should be based on both jurisdictional and business-specific factors, including view of risks and the likelihood and relative conflicts of interest between the partners. Once an approach has been codified in the joint venture agreements, the shareholders should seek to ensure the approach is understood by all Directors and consistently applied. Our recommended approach can be summarized in a three-step process (Exhibit 3).

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Step 1: Structurally Reduce Director Conflicts of Interest

Before determining how to contractually handle Directors’ duty of loyalty and the challenges of mutual agency, those negotiating and structuring joint venture agreements should consider various methods to reduce potential conflicts of interest between the partners and within the JV Board, including:

1. Non-Compete Provisions: Clear and well-defined covenants to not compete delineate the authorized scope of the venture from that of the shareholder companies, thereby reducing the potential zone of conflict and relieving pressure on Directors to balance dual loyalties. This is especially the case when the JV agreements are drafted in a manner where the JV is the exclusive vehicle for a shareholder to compete in the venture’s particular product, customer, or geographic scope, and when the venture is contractually restricted from operating in areas where the shareholder currently operates or has the potential to operate.^[7]For an excellent academic discussion on covenants to not compete in JVs, please see Sarath Sanga, “A Theory of Corporate Joint Ventures,” California Law Review, October 2018.
2. Reserved Shareholder Matters: The voting and control sections of most joint venture agreements differentiate between shareholder and Board matters. Typically, shareholder reserved matters are foundational decisions between the parties or about the company, such as amending the shareholders agreement, initiating bankruptcy proceedings, disposing of all or most of the company’s assets, approving capital calls, bringing in new owners, or filing for an initial public offering. But this list of reserved shareholder matters can be expanded to include approvals of more business matters (e.g., dividend policies, five-year business plan, affiliated party transactions, annual operating plan and budget)^[8]An extreme example of this approach is the creation of a purely owner-managed entity, where all voting is done by the owners directly, with no formal decision authority delegated to a Board, … Continue reading – thereby taking potentially contentious and conflict-ridden decisions outside the Board, reducing any potential duties of loyalty to the venture.^[9]Such steps should be taken with caution, as doing so carries negative consequences, including creating a two-tiered governance structure and disempowering the Board. At the extreme, and permissible under certain jurisdictions and corporate forms, the agreements can establish the Board and Directors with no decision-making capacity, pushing all decisions to the shareholders and leaving the Board as a forum for oversight, information exchange and coordination.
3. Independent Directors: Roughly 22 percent of joint ventures in our database have at least one independent Director – i.e., individuals who are not employees of any shareholder. The presence of independents can implicitly or explicitly reduce conflicts by allowing these non-partisan Directors to drive the discussion (and, in some cases, the voting) on decisions where a shareholder has a conflicted position. For example, in a financial services joint venture, the nine-person Board included two outside Directors, three Directors from management, and four Directors from the two shareholders. The agreements established a “one-person, one vote” structure and set the approval level for most decisions at simple majority. The practical effect was that no shareholder-nominated Director, no matter how conflicted, could block a Board decision. In a large aerospace and defense joint venture, the agreements deployed a different – and more creative – structure to reduce Director conflicts. The agreements established an independent advisor to the Board, who would serve as the casting vote in determining whether a new business opportunity sufficiently competed with either shareholder’s business, and therefore could not be pursued.
4. Non-Board Decision Forums: The governance system of joint ventures can be structured to include non-Board governance forums to handle certain shareholder or high-conflict decisions. Various JVs establish a Shareholders Committee, often composed of the senior business sponsors from the owners (who may or may not be Board Directors), to decide major decisions pertaining to strategy and investments.^[10]An Annual General Meeting is conceptually similar to a Shareholders Committee although, as a practical matter, tends to be more procedural and less substantive in nature. Alternatively, the governance system might include a Commercial Committee composed of non-Board Directors to handle pricing, delivery, and other terms related to supply and purchase agreements with the shareholders. Similarly, if the shareholders are also customers of the JV, as is often the case in financial service, healthcare, and telecom ventures, the venture might establish a Customer Forum to solicit and manage customer input. In so doing, these often self-interested and sometimes contentious issues related to the future product roadmap, product or service functionality, or service reliability are channeled into and resolved outside the Board.
5. Existence of Shareholder Representatives at Board Meetings: Shareholder representatives can reduce Board conflicts by solely representing shareholder interests. Specifically, shareholder representatives serve as outside observers specifically designated to voice shareholder interests, therefore alleviating pressure on Board Directors to represent both shareholder and the JV interests.
6. Delegations to Management: Shareholders and the Board can reduce Board conflicts by putting more decision power in the hands of the JV CEO and management team. Practically, this is likely to mean increasing overall fiscal sign-off authority, providing management with a 5-10% overall allowance on approved budgets, and/or allowing management to enter into affiliated party contracts up to a certain financial threshold.^[11]Another means by which decisions are made by JV management as opposed to the JV Board is if earnings are retained in the JV as op-posed to distributed because JV management then has the discretion to … Continue reading
   
   Even if dealmakers use one or more of these methods when drafting the JV Agreement for a venture, in almost all cases, there will still be some potential conflicts with which a Director will be confronted. Furthermore, parties may determine that some or all of these methods are not appropriate given the venture’s specific purposes or circumstances. Therefore, dealmakers must then determine how fiduciary duties should apply to Directors who may be conflicted – albeit with a reduced number of conflicts.

Step 2: Determine which Contractual Approach to Apply to Director Duties

When drafting legal agreements, Ankura recommends working through four key questions to help determine an appropriate contractual approach to address Director fiduciary duties (Exhibit 4). The questions are as follows:

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1. Does the jurisdiction impose a fiduciary duty of loyalty on the Directors of the JV in its likely corporate form?
2. Can the parties contract out of these default fiduciary duties?
3. Is one company more or less likely to be conflicted than its partner(s) in the JV?
4. Do other factors, including growth, funding and risk, favor a particular approach?

Note that this approach is merely one simplified test for determining whether or not to waive fiduciary duties. It leads parties to a clear-cut answer of yes, waive, or no, don’t waive.

However, given the number of factors at play and the specific context of a particular joint venture, a more nuanced approach may be appropriate. For example, there may be circumstances that warrant a qualified waiver, in which certain provisions of fiduciary duties are waived while others are affirmed. In all cases, Ankura recommends contract drafters advocate for the preferred contractual approach to be codified in legal agreements.

Question 1: Does the jurisdiction impose a fiduciary duty of loyalty on the Directors of the JV in its likely corporate form?

Whether or not fiduciary duties apply to a specific joint venture will depend upon the JV’s jurisdiction of organization and what type of entity the JV is (e.g. corporation, LLC etc.). Most jurisdictions impose fiduciary duties on Directors. For example, all U.S. states impose such duties on the Directors of corporations. Whether a jurisdiction imposes such duties may depend on what type of entity is involved. For example, states may give less freedom to Directors of corporate Boards than to the Board of managers of an LLC as LLCs are generally a more flexible, contractual type of entity than a corporation. Parties should consult legal counsel to determine if fiduciary duties apply to the joint venture given the JV’s jurisdiction of formation and corporate form.

Question 2: Can the parties contract out of these default fiduciary duties?

Although most jurisdictions impose fiduciary duties, jurisdictions vary in the extent to which parties can contract out of these duties. Some jurisdictions, such as Arkansas, historically have not allowed parties to opt out of fiduciary duties. On the other hand, since 2000, Delaware has allowed parties to waive the duty of loyalty with respect to corporate opportunities. Whether or not parties can waive fiduciary duties may vary by the JV’s jurisdiction of organization and the JV’s corporate form. Parties should consult legal counsel to determine if fiduciary duties applicable to the joint venture, if any, can be waived in the relevant jurisdiction given the JV’s corporate form.

Question 3: Is one company more or less likely to be conflicted than its partners in the JV?

The shareholders of a joint venture often have asymmetric potential for their Directors to have conflicts of interest, which differences depend upon the shareholder’s degree of interaction with the venture. The asymmetry is important in determining whether or not to waive the duty of loyalty because a shareholder whose Director is likely to be more conflicted would typically want that Director to be able to vote however is best for the shareholder, not the JV since by doing so the shareholder’s interest collectively is most protected. Thus, such a shareholder would want the parties to waive the duty of loyalty.

By contrast, a shareholder whose partner’s Director is likely to be more conflicted than that shareholder’s Director would typically want all Directors to be obligated to vote in the best interests of the JV, in which case they would not desire a waiver of the duty of loyalty.

Generally, the more a shareholder interacts with the JV, the more likely there is to be a conflict of interest. A shareholders’ level of interaction with the JV stems from a multitude of factors, such as the extent to which the parent company provides services to the JV, the JV’s role in the supply chain, the amount of shared assets and infrastructure, the prevalence of secondees and synergies in the JV, and the shareholder’s level of ownership and control (Exhibit 5).

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When assessing the relative potential for conflict, Ankura recommends first reviewing each shareholder’s relative interdependence with the JV and potential for conflict. Then, determine which of three situations applies to the JV:

1. If a shareholder has a higher degree of interdependence with the venture than the counter party, and therefore a higher likelihood of conflict, Ankura recommends waiving fiduciary duties
2. If a shareholder is less interdependent with the venture when compared to the other parent company, Ankura favors explicitly affirming the duty of loyalty to emphasize the counter party’s obligation to venture
3. If there is an equal level of interdependence, we recommend examining alternative factors to evaluate whether to waive or affirm the duty of loyalty.

Question 4: Do other factors, including growth, funding, and risk considerations favor a particular approach?

If the shareholders are equally interdependent, a shareholder should look to other factors to determine whether to waive or affirm duties fiduciary duties. A number of factors should be weighed in this assessment. Some of these factors include the natural likelihood of conflicts at the Board level, the materiality of such conflicts, the potential legal risk to Directors, and the waivers’ potential implications for Board culture (Exhibit 6).

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The weight of each factor should differ based on the specific circumstances of the joint venture. For instance, if the joint venture is highly material to a shareholder’s strategy, that shareholder would likely want to ensure that JV Board decisions are in line with the shareholder’s long-term strategy, even if that strategy does not necessarily maximize JV profit. In such a case, the shareholder might want to waive the duty of loyalty to allow its Board Directors to vote in favor of the company’s strategy. In a different venture, such considerations may be much less relevant, and that other factors, such as the risk to boardroom culture from waiving Board duty of loyalty, could be more material. Thus, while parties should review all factors, the relative weight of each should be determined based on the judgment of the applicable shareholder.

Of course, not all factors are solely situation-specific. In our experience, seasoned JV Board Directors understand how to use their fiduciary duties, including the duty of loyalty, and exposure to personal liabilities to drive action. For example, in a large mining JV in South America, one JV Director recently used his status on the Board to demand management to elevate its risk management and assurance processes, and to request that a committee develop a range of technical alternatives to develop an adjacent ore body. As that Director said: “I believed that those positions were absolutely right for the JV – but because they were also consistent with my shareholder’s position and somewhat counter to the inclinations of some of the other shareholders, if the legal agreements had waived the Director duty of loyalty to the JV, I could have been accused of promoting my own company’s interests.”

Step 3: Establish Practices to Support Understanding and Implementation

Even narrowing the scope of Director conflicts and including an explicit approach to fiduciary duties in the JV agreement falls short of guiding Directors on how to address conflicts when they inevitably arise. Therefore, shareholders should establish practices to support Director understanding of their rights and obligations in order to facilitate implementation of the selected approach – be it explicit affirmation, qualified waiver, or complete waiver.^[12]Partners in existing joint ventures where it is not possible to include an explicit provision in the JV agreement addressing fiduciary duties should still seek to drive understanding among Directors … Continue reading Doing so will ensure Directors appointed by different shareholders or at different times have the same understanding of how to behave, making application of the selected approach more consistent. Some practices to develop this understanding are Director training and development, conflict of interest protocols, and Director indemnification.

1. Director Training and Development: Director training and development educates Directors about whether or not they have fiduciary duties and any limitations on these duties. It should bring these duties to life with real world examples and provide guidance on what Directors can do that clearly complies with their obligations, that clearly does not, and on what they can do if in the “grey” area in between.^[13]See: James D. Bamford, “Soothing JV Directors’ Tortured Souls: A Scenario-Based Tool to Manage Conflicts of Interest and Other Risks in JVs,” Joint Venture Exchange, March 2013. Directors should receive such training when onboarding onto a JV Board and periodically thereafter.^[14]At a recent roundtable hosted by Ankura, one JV Director illustrated this sense of conflict when she noted: “My duty of care and the feelings of angst are most intense when restructuring a JV. As … Continue reading Engaging in this training with the Board as a group as opposed to individually can help to drive a common understanding and develop Board culture, particularly in instances where the JV agreement includes an Explicit Affirmation of the duty of loyalty.
2. Conflict of Interest Protocols: A second practice to drive understanding is the development of Conflict of Interest Protocols. Conflict of Interest Protocols establish procedures to follow in the event of a conflict of interest in order to facilitate compliance with legal and contractual duties, if any, and good corporate governance. While such Protocols will not allow Directors to avoid conflicts altogether, they are intended to enable individuals to recognize situations that may involve a conflict of interest and to provide guidance on how to resolve the situation. Conflict of Interest Protocols should include common conflict scenarios and what actions, if any, a Director in that situation should take, which may include disclosing the conflict to the rest of the Board.
3. Director Indemnification: Shareholders may also wish to include indemnification for JV Director breach of fiduciary duties in the JV agreement. Such indemnification entitles the Director to be reimbursed by the JV for attorneys’ fees and costs and even judgments incurred as a result of the Director’s service to the JV, subject to limitations such as if the Director acted in bad faith. Many JVs purchase Director and officer insurance to insure against this potential loss. Such indemnification lessens the personal risks to Directors as only egregious breaches of their duties will result in personal financial liability.

These practices are not exclusive and can, and often are, combined to ensure Directors have a common understanding of their duties, tools to assist with conflicts when they arise, and latitude to make good faith mistakes about how to behave as a Director on a JV Board.

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Although Joint Venture Directors will always be in a game of tug-of-war with the shareholder and Joint Venture’s interests, the tension on the rope can be eased. Structurally reducing the number of conflicts, incorporating appropriate fiduciary duty contractual language and introducing proactive company practices all serve as viable means to reduce the zone of conflict and give Directors tools to appropriately address conflicts that arise. In short, these tactics can turn a weighty tug-of-war battle into a manageable game.