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24 October 2012
In Portugal, as in other jurisdictions, step-in rights are common contractual arrangements in finance deals, stemming from step-in clauses that grant lenders the right to intervene or 'step in' - generally on a temporary basis - in the special purpose vehicle (SPV) in order to ensure that key contracts entered into by the SPV are completed successfully.
Although step-in rights provisions are often associated with project finance transactions, such clauses may be included in other kinds of transaction in order to grant venture capitalists and other investors or lenders greater control over an SPV or an investee company.
Given that stockholders and lenders differ in their cash-flow rights and control rights, when a business raises venture capital, venture capitalists' rights must be negotiated and updated throughout, as their return on investment is closely related to the company's performance and to the way that they can expect to cash out.
In fact, one of the principal concerns of private equity participants will be the exit strategy - among other things, the type of exit expected to be available. Preparation for this key phase commences at the investment stage. Thus, specific provisions shall be set out in the articles of association and further regulated in shareholders agreements.
Venture capitalists may also secure contractual mechanisms entitling them to step in and seek additional board-level representation, in circumstances where the holding company underperforms.
Other investors will prefer to secure rights to take control of the company through a straightforward share deal. Invariably, all investors will seek to secure rights to take control of the holding company in the eventuality of underperformance, or when the investee company's equity value, financial stability or prospects are threatened. Conversely, management teams will want to ensure that the enforcement of such rights shall be restricted to insolvency scenarios, where results are lacking or where there have been major breaches of an investment agreement.
Finally, other control mechanisms are often preferred by venture capitalists. Sharing some minor similarities with step-in rights, exit or shoot-out provisions may be combined with the former in order to protect venture capitalists' rights.
Typical exit or shoot-out clauses make provision for the decision-making process and effective exit of one or more shareholders from the joint venture through the prior granting of buy/sell rights and put and call options. In the event that one joint venturer fails to meet its obligations, the remaining shareholders may enforce call options and acquire its shares.
Step-in and step-out clauses, and other ancillary clauses on their enforcement, are governed by a plethora of provisions interspersed among the Companies Code, Commercial Code, Civil Code, Securities Code and the Public Contracts Code. Due to the lack of a unified and cohesive regime, certain contract provisions attempt to fill the void.
One of the outcomes of the current financial crisis has been a reduction in the amount of credit available to Portuguese companies. Due to these increasing financial constraints, the negotiation of corporate finance deals is accompanied by intense scrutiny by all parties and investors are including more stringent conditions and covenants in the respective agreements, which may encompass step-in clauses. In addition, the security package negotiated by lenders often includes monitoring tools, such as reporting covenants or financial information covenants, in order to shield themselves against financial predicaments.
Generally, the exercise of step-in rights is contingent on the fulfilment of several conditions and requirements set up in the respective contract, such as:
Additionally, the parties are free to agree that step-in rights are enforceable on the occurrence of other events.
Step-in clauses are constructed as rights, not duties. Therefore, their beneficiaries are entitled to exercise the right but are not obliged to do so. They are always entitled to relinquish step-in and substitution rights. Furthermore, it is highly uncommon for step-in clauses to be triggered by third parties.
Also, the concept of 'default' should be carefully defined. It is advisable for the contract to set out a comprehensive but non-exclusive list of events and breaches deemed to threaten the interests of the investor or the lender, or where there is clearly a prospective lack of ability by the company to perform its obligations.
In financing agreements, in order for a default to constitute grounds for the termination of a contract, persistent failure to perform is often required. A simple or single breach does not constitute a material breach, whereas persistent default shall render the contractual relationship untenable and allow for its termination.
Portuguese contract law provides that the parties shall act in a reasonable and proportionate manner, in accordance with the general principle of good faith. Thus, the parties shall not engage in contradictory behaviour and should notify the other of its position regarding the breach or default as soon as possible.
Still, the investee company should be allowed to undertake all reasonable endeavours to rectify matters and mitigate the consequences of default or breach of contract within a reasonable timeframe. However, the step-in right is still enforceable if there is a likelihood that the company will again underperform.
Agreements are typically silent as to a step-out obligation. However, if the exercise of a step-in right is subject to the fulfilment of specific conditions, should such conditions cease to subsist, a step-out procedure should commence.
Transactional costs are a key factor in how step-in rights are ultimately structured.
Generally, the exercise of a step-in right translates into the enforcement of a financial pledge of shares or the exercise of a call option. Usually, the lender enters into a call option agreement with the company's shareholders pursuant to which, in the event of its default, the lender is given the right to exercise the call option and acquires all the shareholdings at a pre-set, often symbolic, strike price.
Under the Portuguese legal framework, these options are non-standardised calls and are governed by the general legal provisions of contract law.
Shareholders shall agree on the sale of their stakes under a condition precedent but will try to set a higher price and insert as many conditions as possible. As each participant's concerns are reflected in the documentation, the only way for the original shareholders to avoid the compulsory sale of their shares is to provide remedies for the default.
Nonetheless, both shareholders' financial pledges and option contracts serve the lenders' main purpose of acquiring shares and to indirectly step into the investee company. A share transfer agreement is the most simple and efficient method of stepping in and is usually cost effective.
In the event that a lender acquires shares in the company, it is not possible to hold the previous shareholders liable for any past liabilities. Only through a carefully drafted agreement entered into between past creditors and the previous shareholders would it be possible for the latter to take over the debts and liabilities.
The company will remain liable for any hidden defects or flaws arising from any contract entered into by it.
It is convenient, but not required, for the rights and obligations of lenders stepping in and out of a company to be regulated in an annex to the financing contract, which should include a schedule of all stages comprising the stepping-in process.
Pending the acquisition of the shares by the lender (ie, during the interim period between the notification of the lender's intention to exercise the right and actually taking control of the company), the latter's directors continue to be bound by special duties of due care, loyalty and independence.
Restrictions on board and shareholder action while the stepping-in process is pending may also be stipulated, such as:
The company should also be forbidden from practising any act that may materially affect the net asset situation of the company.
Finally, a complete agreement should include several covenants governing the disclosure of information by shareholders and the management team alike.
Given the time-sensitive nature of investment deals, arbitration is the best dispute resolution system due to its swiftness. Finance contracts should provide that the parties shall resort to arbitration proceedings for the resolution of any disputes pursuant to the Portuguese legal framework for arbitration.
If a step-in clause is excessively burdensome for one of the parties, it is challengeable in court on the basis of breach of good faith and public order.
In Portugal, step-in rights are often provided in project finance and public procurement agreements, but may also be applicable in other deals. Step-in clauses should be triggered only in the event (or likelihood) of a serious breach of obligations by an investee company. Step-in rights may also be combined with other defensive mechanisms, such as financial covenants. Although a financial pledge of shares is a viable step-in method, call options on the company's shares are the most common and effective way for investors and lenders to take control. Given the time-sensitive nature of finance deals, arbitration is the best dispute resolution system regarding step-in rights.
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João Gil Figueira