This browser is not actively supported anymore. For the best passle experience, we strongly recommend you upgrade your browser.

Freshfields Transactions

| 6 minutes read

To consolidate or not, and the impact on negotiations in a joint venture context

When forming a joint venture or a consortium (JV), each party is likely to have a specific view about whether or not they wish to consolidate the JV group’s financial results with their own. 

In some circumstances, a shareholder that might otherwise need or be expected to consolidate a subsidiary will specifically look to avoid consolidation – whether indefinitely or just for a period of time. This might be because the short to medium term financial position of the JV is expected to be poor. Think of a large-scale infrastructure development asset, for instance, where there will be no revenue for a number of years, or an existing infrastructure asset with a capital intensive expansion plan where revenue will not immediately track the investment. New debt introduced to fund the development could adversely impact a party’s existing debt covenants if the asset were consolidated and new capital introduced will not show any immediate return.

Often though, a party (particularly a majority shareholder) will want, or may even be obliged, to consolidate their financial statements with those of the JV.  In some circumstances, a party may instead want the option to consolidate only at a later stage - for example, when the development has been completed and is generating revenue – in the meantime adopting equity accounting.

In this blog, we examine the way in which a party’s desires or obligations to consolidate can impact negotiations or, indeed, can be used as a tool for negotiation. 

In determining whether a shareholder can or must consolidate, the shareholder’s accounting standards are your first port of call. Those accounting standards include guidance on consolidation, generally linked to that shareholder’s level of control of the JV group. 

IFRS 10 (a common accounting standard) sets out the following three-part test for determining whether a shareholder has control over a company:

  • does the shareholder have power over the JV group to direct the activities that significantly affect the returns of the JV group? 
  • does the shareholder have a right to a variable return (as opposed to fixed dividends / interest)?
  • does the shareholder have the ability to exercise its power over the JV group to affect the amount of its returns?

While clearly one aspect of the consolidation analysis, ownership of a majority of the voting rights is not always necessary (or sufficient) for a shareholder to be deemed to have control over a company for IFRS purposes. To establish control, you therefore need to look at other factors that might give a shareholder the ability unilaterally to impact the activities of the JV group - particularly those activities that may affect the JV group’s returns. The activities that may or may not impact a JV group’s returns will need to be established as part of the consolidation analysis – these are often referred to as “relevant activities” and will of course vary depending on the nature of the JV group.

Each shareholder’s governance rights in respect of the JV group will ordinarily be set out in the constitutional documents and / or a joint venture agreement. The governance rights are a key indicator of control as they often determine whether a shareholder can impact “relevant activities”. For a majority shareholder, consolidation itself can therefore be used as a tool if they are seeking enhanced governance in respect of a JV group. That concept of enhanced governance can also be used by such a majority shareholder to restrict the level of control the other shareholder/s may have over the JV group – on the basis, they’ll say, that negative control by a minority shareholder prevents them demonstrating control over the “relevant activity” for the consolidation analysis.

Negotiations and issues surrounding governance become particularly acute in scenarios where a shareholder holds just enough shares to be the majority shareholder and wishes to consolidate but where the JV group is co-controlled by shareholders. In such a scenario, the majority shareholder could use consolidation arguments to justify limiting the minority shareholder’s governance rights, even though the minority shareholder would expect to receive almost equal governance rights to reflect the minimal difference in shareholding. 

We’ve set out below some of the key measures of control in governance arrangements relevant to the consolidation analysis, though this list is not exhaustive:

Reserved matters: reserved matters are likely to be important in determining a shareholder’s control. It is widely accepted that a “protective” reserved matter right (such as a power to block amendments to constitutional documents and share capital) in favour of one shareholder will not prevent another from consolidating. On the other hand, if a minority shareholder has a “substantive” veto over, for example, operational business decisions (e.g. over the business plan and budget of a company), this could be considered to give that shareholder an ability to influence the “relevant activities” of the JV group. As mentioned above, shareholders wishing to consolidate may try to use this in negotiations to prevent a minority shareholder having a veto over the business plan and budget, which may be uncomfortable for minority shareholders.

Board appointments and casting votes: a shareholder who wishes to consolidate may argue that it needs to control the majority of the board (or have a casting vote at board meetings) in order to demonstrate its control over the company. 

Right to appoint and remove key executives: given management are responsible for the day to day operation of a company (and therefore arguably have the biggest influence on returns to shareholders), if a shareholder has the right to appoint or remove key executives they may be considered to have control over a company. 

Where a shareholder does not wish to consolidate in the short to medium term, but does want the option to consolidate in the future, they may look to build future or contingent rights into the joint venture agreement that could impact the level of control they have over the JV group. For example, a shareholder may request the right to acquire additional voting rights under a call option. The terms of any such call option would need to be analysed in detail as, in circumstances where a majority shareholder has the power effectively to gain control of the JV group at any time by exercising their call option, then even if they have not yet exercised the call option they may still be deemed to have control for the purpose of the consolidation analysis (and therefore may still be obliged to consolidate). It may be possible to structure the call option so that it is only exercisable when certain milestones have been reached - be they financial milestones or linked to specific time periods. This is, of course, always subject to the wider control analysis as a shareholder may still be prevented from consolidating even if it holds a majority of voting rights if a minority shareholder has a substantive veto as set out above. In this situation, it may be necessary to agree up front changes that would be made to the reserved matters in the future so that veto rights would be amended to allow consolidation in such circumstances.

Although not examined as part of this blog, it should be noted that where the agreed governance position of the JV group sits is at the margins of what would be considered acceptable for the desired consolidation outcome, shareholders of the JV group may explore principles-based protection mechanisms that require the governance arrangements to be revisited if there is a change in the consolidation position, for example, as a result of a change in law or to the IFRS standards.  Remember, also, that many of the factors that inform the accounting treatment will also be relevant to other analysis – including antitrust.  

If a shareholder is determined to have “control” of the JV group, it is likely that they will be required to consolidate.  Don’t forget though that there is an exception under IFRS 10 for investment entities, who can instead apply “fair value” to the investment on their balance sheet. 

There is no one size fits all approach to analysing whether or not a shareholder can or must consolidate their financial statements with those of a JV group, but the above factors are often informative. The analysis is, though, by its nature subjective and involves detailed review on a case-by-case basis from both a legal and an accounting perspective. Often the positions taken fall into a grey area and different accounting firms may have different views on the impact they have on the control analysis. On that basis, a minority shareholder faced with being asked to accept certain positions so that a majority shareholder can consolidate (or could do so in the future) may wish to seek independent advice from their own advisers to help them with negotiations, although it should be noted that the final decision on whether the JV group is in fact consolidated by a majority shareholder will ultimately be made by the majority shareholder’s auditors.