Joint venture arrangements can take many forms, and the final structure is usually selected after careful consideration of the commercial and other tax requirements of the joint venture parties.
For income tax and other related reasons, a unit trust structure is often utilised instead of a corporate joint venture structure or a partnership agreement. One of the key documents in such a structure is the unitholders agreement, which sets out the terms of the relationship between the unitholders.
The overarching purpose of a unitholders agreement is to encourage structured and smooth decision-making processes, with clearly defined rights and obligations of each party, and to minimise disputes (or at least set out the mechanism by which disputes may be satisfactorily resolved).
Some of the more common challenges encountered in unitholders agreements, along with some suggested possible approaches to deal with those challenges, are set out in this article.
Joint purpose vs different individual objectives
It almost goes without saying that the unitholders need to ensure that the unitholders agreement contains a clear statement of the purpose of the joint venture, and the alignment of the parties with that purpose. It is not unusual, and in fact is almost expected, that the individual unitholders will have different goals, investment horizons, and risk tolerance levels to each other, even though they are all seeking the same joint objective.
It is important that the unitholders agreement appropriately addresses these differences. The different timeline on which each unitholder may be operating will influence the way in which the following items are addressed.
Financial inputs and outputs
Expectations around funding or capital injections need to be clearly articulated between the parties and captured in the drafting of the unitholders agreement. For example, a unit trust structure that is established with a long-term view of holding real estate investments should set out clear expectations of funding requirements (eg. for initial development works, and then subsequent repair or upgrade works).
From a distributions perspective, unitholders may have different tax environments depending on their jurisdictions or tax characterisations, and this may affect how distributions, profits, and losses are shared (including in terms of timing). It will also probably affect the tax treatment of disposal of units, or the issue of new units.
Decision-making
Determining how decisions are made (eg. majority vote vs. unanimity) can be a source of tension. Clearly, if one unitholder has a disproportionate amount of control or influence over decisions, this control can quite quickly lead to a mis-alignment of the unitholders with respect to the originally-determined joint objectives, and can then undermine the entire venture.
Regardless of the number of unitholders, the unitholders agreement should contemplate differing types of decisions and allocate different “weightings” for resolutions for those decisions. It will not always be the case, but many unitholders agreements will need to include drafting that is “future-proofed”, so that it can apply with 1, 2 or 3 additional unitholders.
During non-contentious times, the clauses regarding meetings, quorums, notice periods, agendas etc. can appear staid, formal and of minimal value. However, it is important for unitholders to recognise that these structures are critical, because they are intended to set out an objective, sensible and clear mechanism for potential decisions to be raised with unitholders, and then resolved.
Dispute resolution, including deadlock
These items can be considered to extend to conflicts of interest that may arise in connection with the unit trust. For example, if the trustee of the unit trust enters into separate contracts with entities that are wholly controlled by one of the unitholders, the unitholders agreement must contain a mechanism under which decisions in relation to that contract can be made with a different voting structure than would otherwise apply. The absence of such controls can lead to entrenchment of the related party, or other situations which, objectively considered, could be detrimental to the unit trust.
The unitholders agreement should specify how disputes will be resolved—whether through mediation, arbitration, or litigation. If there are no clear mechanisms, disagreements between the unitholders can lead to prolonged legal battles or strained relationships and, ultimately, a devaluing of the joint venture as a whole.
In some circumstances, it may be appropriate to consider exit mechanisms that are triggered by a unitholder if there is no ability to reach an agreed solution to an issue. Careful consideration should be given to this issue at the start (when the parties are prepared to discuss these issues with each other!), and not left for formulation when a dispute exists.
Ultimately, the unitholders can always agree on an informal dispute resolution process if the parties are willing to do so, and not apply the formal structures that should be contained in the unitholders agreement. However, the consequences of a complete absence of a dispute resolution or deadlock mechanism can be commercially disastrous.
Changes in ownership and exit strategies
It is important that a unitholders agreement includes provisions to set out what happens if a unitholder wants to transfer its units to another party. Usually, the initial unitholders will have entered into the joint venture arrangement with a clear understanding of the purpose and direction of the joint venture, and the introduction of a new unitholder can lead to changes in control dynamics, which in turn may affect the direction of the business or investment.
It is common for a unitholders agreement to contain a pre-emptive rights structure, which requires the unitholder which is intending to sell its units to first offer those units to the remaining unitholder(s). These pre-emptive rights structures are also sometimes triggered by and apply to a unitholder who is in breach of its obligations under the unitholders agreement. While the concept is relatively simple, complexities arise when considering the valuation mechanism that applies to the units offered for sale, with issues such as determining a fair market value for something that may have limited equivalents, or whether to apply a percentage discount if the proposed sale units belong to a defaulting unitholder.
Not all possible disposal structures need to be included in every unitholders agreement. Some of the factors that the parties should consider include the underlying nature of the unit trust (eg. an investment property unit trust may need quite a different strategy to an operating restaurant or a retail venture), and the relative marketability of the investment. Concepts such as “Russian roulette” provisions, “tag-along” and “drag-along” rights will not apply to every unit trust.
Concluding comments
It is almost incumbent on a lawyer to consider the worst possible scenarios in a proposed joint venture arrangement, including a unit trust, and to include provisions in the relevant contractual documents to deal with those scenarios. However, it is almost always the case that the parties will see things more objectively and more clearly at the outset of the transaction, than at the time that they need to rely on the clauses that deal with the thorny issues. It is better to draft appropriately for these issues at the start, rather than seek to agree a resolution during a time of dispute between the parties.