The Death and Resurrection of the Joint Venture
01.08.2018 | ZAG-S&W
The Ten Commandments for Foreign Companies who enter into Joint Ventures in China
In recent years, more and more Chinese investors are presenting international companies with the option to form Joint Ventures (JVs) in China. Therefore, our firm has recently assisted many Israeli and international companies in advising and supporting the establishment of JVs in China. There is a feeling that there just may be a renaissance of the JV mechanism.
Until 2017, the Chinese government’s policy was to encourage outbound investments in certain industries in order to acquire innovative technologies into China. During this period, we assisted Chinese companies in their outbound investments.
However, the current situation is that many Chinese outbound investments are restricted while the Chinese government is still encouraging and supporting the acquisition of innovative technologies using other methods. China’s current method for bringing innovative technologies to China without transferring money outside of China (e.g. via the use of outbound investments) is through the JV model. Where the Chinese party contributes funds, but within Chinese territory and into the JV and the foreign party contributes technology or knowledge and intellectual property. This model actually serves a dual purpose for China: 1) It is able to acquire innovative technologies without transferring funds outside of China, and 2) the JV itself can receive significant grant payments and subsidies from the local government (mainly in remote provinces that have a need for innovative technologies).
In the past, when China was first opened up to the world, most foreign companies were incorporated in China in the form of a JV. This was because the Chinese government did not permit any other form of incorporation in most industries. Over the years, the restricted and prohibited industries in the Foreign Investment Catalogue (the “negative list”) have been reduced, and additional industries became available as Wholly Foreign-Owned Enterprise (“WFOE”) companies. In accordance with the development of the legislation, the JV mechanism became gradually less common until it almost disappeared and most of the foreign companies that entered the Chinese market chose to establish a WFOE. The main reason was that most JVs in China failed. Generally, the statistical chances of JVs succeeding are low, especially when it comes to intercultural JVs. While a well-known Chinese saying regards JVs in China as a win-win situation, others claim that the Chinese party is the main benefactor of such mechanism. I think that JVs in China truly are “one bed two dreams . . . ”
We have listed below, in accordance with our experience, the “Ten Commandments” of establishing and operating a JV in China. These are the main issues that are important to fully understand and pay attention to during negotiations and establishing and operating a JV in China:
- Preliminary DD on the potential partner: The first step is to keep in mind that JV is actually a partnership for all intents and purposes, and it is always advisable to make preliminary checks and due-diligence on the potential partner, and the legal entities associated with it. To assess the Chinese party’s ability to fulfill its obligations in the JV, it is advisable to review the company’s previous investments and overall financial strength, including registered and paid-in capital. Do not be blinded by the large amount guaranteed in the negotiation; in practice, the actual amount of capital is almost always much smaller.
- Negotiations: JV negotiations in China are usually long and arduous and many times the way to reach quick agreements is to meet in person with decision-makers. Sometimes, Chinese companies prefer to conduct negotiations without lawyers, but it is important that you have representation so that you can get full and transparent information in order to protect your interests. It is important to properly prepare for the negotiation and set clear goals prior to the negotiation. One should also be prepared to be patient about all the changes that are typical during negotiations, and usually there will be many changes even after the signing of any such agreements. In one of the negotiations attended by representatives of our firm, the CEO of an Israeli company informed the Chinese party that he had arrived with a one-way ticket and that he planned to stay until they reached agreement on all the open issues in the negotiations. After a whole week of negotiations at a hotel in one of the most beautiful cities in China, they signed the agreement.
- The JV Law: It is important to know that JVs in China are subject to the very comprehensive regulation “Law of the People’s Republic of China on Chinese-Foreign (Equity) Joint Ventures” (“JV Law”). Most of it determines the essential conditions for the establishment and operation of a JV in China. In accordance with the JV Law, the Board of Directors is the highest authority in the JV and all the following significant decisions in the JV must be made unanimously by all directors: the increase and reduction of registered capital (parallel to the issuance of new shares in the company), changes in the JV’s articles of association, mergers and acquisitions, and the liquidation of the JV. Any transfer of shares to a third party is subject to the first right refusal. Any related agreements you make to circumvent such provisions of the JV Law are not be enforceable in China, as the JV shall be subject to Chinese legislation and jurisdiction.
- Legal Representative and JV Chop: The Legal Representative (who is usually the Chairman of the Board) has the greatest authority and power but also bears great responsibilities and liabilities. In fact, pursuant to Chinese law, the JV’s chop with the signature of the Legal Representative can bind the JV in every respect. Therefore, it is important to ensure the division of powers in the JV and if the Chinese party appoints the Legal Representative, the foreign party shall demand full control over the JV’s chop.
- License/Service Agreement: It is worth mentioning that in addition to the percentages due for your holding in the JV, it is better that the foreign party also have a License/Service agreement with JV that will allow them to receive fixed amounts that are independent of the JV’s revenues/profits.
- Appointment of officials: In most cases, the Chinese party will demand the ability to appoint the Legal Representative, the GM and the CFO, and will offer the foreign party the ability to appoint the vice Chairman of the Board and supervisor, which essentially has no meaning or significance. From the perspective of the foreign party, it is very important to try to appoint the GM position, who governs the day-to-day operations and management of the JV, as well as the role of the CFO, who is in charge of the JV’s financial matters.
- Finance: It is important that the parties mutually agree on the accounting firm and the auditing firm appointed to accompany the JV. In addition, it is important to choose the bank where your bank account will be opened (ideally it will not be a small bank) with joint signatory rights and online access to the bank account.
- Veto Rights: In most cases, the foreign party will be a minority in the JV since the Chinese party most of the time demands control over the JV. Therefore, it is important to allow the foreign party to have veto rights with respect to many corporate resolutions. Apart from the day-to-day corporate resolutions in China, it is also important to pay attention to all related party transactions that are common in China and less in the West, and allow the foreign party to veto any such transactions.
- Registered Capital: How will the parties contribute to registered capital in terms of time and volume? It is important that the articles in the JV agreement regarding registered capital are clear, and it is always preferable that the investment be carried out according to detailed stages and milestones. Note that if the foreign party contributes the registered capital in know-how, intellectual property or technology, the foreign party must check that there is no commitment to any local authority (or any other applicable governmental body), educational institutions or any outstanding tax exposure, and if applicable, to examine such exposure. In addition, if the registered capital transferred in the form of licensed intellectual property, it is important to understand the significance of the matter since this is different from ordinary license agreements and is more similar to an IP assignment agreement to the JV.
- Miscellaneous: As the JVA is submitted to the authorities in the Chinese language, it is important to remember the language barrier and always make sure that a suitable translator is present; otherwise, many things may be lost in translation. It is important to define the territory and cooperation and of course limit issues of confidentiality, non-competition, non-circumvention and non-solicitation. It is important to clarify the conditions under which the JV Agreement may be terminated before the end of its term, including reference to dead lock and appropriate mechanisms. In addition, it is important to choose a jurisdiction that will enable suitable enforcement.
In conclusion, the foreign party must ensure that it understands all the implications of the agreement and that the JV Agreement fully addresses all the important issues. From our experience, we have found that when foreign companies know and understand the significance of the JV in China, conduct preliminary examinations on the Chinese party and have ensured that the JV agreement is balanced and allows the foreign party to assume real control over JV, the JV’s chances of succeeding are significantly higher.
There are many other important elements in JV negotiations and operations in China. It should be remembered that the JV would face many challenges, including business, cultural and language differences, in addition to the usual commercial challenges. It is important to have the right adviser who can walk you through it and understand the “10 Commandments” as it will put you ahead of the game.