PROTECTIVE COVENANTS

Aside from the standard 12 headings, Heads of AgreementHeads of Agreement: a non-binding summary of the main issues on which the parties intend to base an agreement. often include clauses that report additional matters to which the parties have agreed. Most of these clauses take the form of “protective convenants.”

Protective convenants modify or restrict the behaviour of the parties in order to channel benefits to one or the other of them. It is often appropriate for the covenant to indicate the consequences or penalties, should a party fail to live up to the covenant. As parts of the Heads of Agreement, protective covenants are included in the Shareholder AgreementShareholder Agreement: a legally-binding document which describes the mutual obligations of the parties to a Joint VentureJoint Venture: commonly, a business to which two or more parties contribute the essential land, capital, and services, in return for a share in its ownership and control. (Note: the Joint Venture is very strictly defined under Canadian law.).. There, backed by the power of the law, they become powerful means for constraining the actions of a JV.

Protective covenants can be written at any stage of the negotiation of the Heads of Agreement. Anything of particular importance to a party can be specified. If training is a significant part of the deal, for instance, a covenant about work force preparation could be written. The same would apply if downstreamDownstream: downstream business refer to suppliers of products and services such as exploration, production, processing, product development, technical services, marketing and sales that supply the mine but are not owned by the mine. benefits or environmental safeguards became an important part of the discussions.

Let’s say a First Nation development syndicate organized itself as a corporationCorporation: the most common form of business organization. It pursues set objectives and is empowered with legal rights usually only reserved for individuals, such as to sue and be sued, own property, hire employees, or loan and borrow money. in order to negotiate a deal with a mining company. The syndicate put together enough capitalCapital: cash, property, equipment, services, and contracts or leases. to take a 6% share of the mine’s ownership. Its advisor observed that under normal circumstances, any partner with 4.9% or more or the shares is subject to cash calls. (In mining you may not even protected from cash calls with less than 5% of the common shares.)

What to do? The syndicate could reduce its equityEquity: the dollar value of what a person or organization owns (as opposed to debt, which indicates what a person or organization owes). A person or organization can have an equity interest in something if they have part or full ownership. to less than 5%. It might also be possible to negotiate for preferred shares. (While non voting, preferred shares do not subject their owners to cash calls. If it had special benefits to offer, the syndicate might still secure a seat on the board even as a preferred shareholder.)

Alternatively, the syndicate could negotiate a protective covenant against cash calls.

Protective covenants can also be an effective way to protect the interests of smaller and more inexperienced partners. Picture a JV partner who holds 49% of the shares but is not fully confident about the financial management practices of the majority (or “managing”) partner. A protective covenant could instruct that financial reports be provided monthly. Failure to do so would result in the minority partner automatically getting 51% ownership. When the parties sign the Shareholder Agreement, the minority partner's remedy to the potential problem gets the force of law.

Kitsaki innocently accepted common shares in the trucking deal. In the first nine months a big growth in contracts meant the Joint VentureJoint Venture: commonly, a business to which two or more parties contribute the essential land, capital, and services, in return for a share in its ownership and control. (Note: the Joint Venture is very strictly defined under Canadian law.) all of a sudden needed to spend $1.5 million on trailers. We discovered that we were vulnerable to cash calls to finance those transactions. Fortunately, business was good and our cash flow was strong. We took the money right out of profits.

As you can see, common shares can be a 2 edged sword. They look good. They look fair. But you could have your interests just as well served (and maybe better protected) as a preferred shareholder.

Say you owned between 40% and 51% of the business. Its cash flow showed you that you were likely to be pretty liquid. Your combination of assets and profits would suffice to finance any unanticipated growth. Then you can go for the common shares. When you only are looking at 1% or 6% of the shares in a large project (like a mine), it's a tougher call. In that case, define all the benefits that you want from the deal and insert protective covenants to guard against arbitrary action by the majority shareholders.

Remember: the real source of benefits is your Shareholder Agreement.