China Joint Ventures. Who's Your Partner?

By Steve Dickinson

The Chinese Supreme Court recently issued a set of regulations to be used in court cases involving disputes within foreign invested enterprises (最高人民法院关于审理外商投资企业纠纷案件若干问题的规定). These regulations came into effect on August 16, 2010. The official Chinese version can be found on the Supreme Court website here. Though the Regulations are technically concerned with all foreign invested enterprises, the disputes that actually arise are limited almost entirely to joint ventures. This is natural, since joint ventures are the area where internal disputes among shareholders are most likely to arise.

The areas covered by the regulations fall into the following general categories:

• Validity of shareholder agreements that have not been approved by the regulatory authorities (Articles 1—3)

• Disputes concerning delay or failure to contribute capital contributions (Article 4)

• Validity of agreements transferring ownership interests (Articles 5—12).

• Validity of agreements with creditors secured by ownership interest in the foreign invested enterprise (Article 13).

• Validity of nominee shareholder arrangements (Articles 14—21).

This breakdown provides an interesting overview of the types of disputes that tend to arise within joint ventures, but the Regulations themselves focus mostly on highly technical issues that actually do not arise with great frequency. The most common area of dispute in joint ventures concerns management, control, and distribution of profits. The Regulations studiously avoid these common areas of dispute.

There is one provision of the Regulations, however, that should be carefully considered by anyone who enters into a joint venture in China. Most foreign enterprises look at a joint venture as the equivalent of a partnership. They see the identity of the joint venture partner as absolutely key to the joint venture arrangement. A joint venture with manufacturer A is simply a different enterprise than a joint venture entity with manufacturer B. As a result, most foreign enterprises simply assume that their Chinese joint venture partner is not permitted to sell its ownership in the joint venture to a third party.

However, in the Regulations, the Supreme Court provides for exactly the opposite rule. The Regulations provide that as a general principal, a joint venture owner has the right to sell its ownership interest to a third party. The remaining joint venture owners can prevent this sale only by purchasing the ownership interest. If the remaining owners do not purchase do not choose to purchase their co-owner’s ownership interest, the co-owner who wishes to sell has the right to sell. In this way, a foreign participant in a joint venture can find itself forced into the following difficult position: it must either (a) purchase the interest of the other joint venture owner on very short notice or (b) find itself with a new joint venture “partner.” This new partner may even be the foreign participant’s direct competitor.

This provision is provided in Article 11, a masterful piece of very bad legal drafting which can be appreciated by the translation below. For those with little patience, the key wording is in the very last sentence, which artfully contradicts the apparent intent of the first sentence:

Article 11: In the event that one party in a foreign invested enterprise transfers all or part of its ownership interest in the foreign invested enterprise to a third party, it shall first obtain the consent of all of the other shareholders. If the other shareholders bring suit seeking to nullify the sale to the third party on the grounds that their consent has not been obtained, then the court shall support that claim, except in the case of the following three circumstances:

(1) There is proof that the other shareholders have in fact already consented.

(2) The transferring party has already given written notice of its intent to transfer to the other shareholders, and the other shareholders have not responded within a 30 day period of receipt of such notice.

(3) The other shareholders do not consent to the transfer, but do not purchase the transferred shareholding interest.

As best as I can make this out, this Regulation sets out the following procedure:

1. The selling shareholder provides written notice to the other shareholders.

2. The other shareholders must respond within thirty days. If there is not response, the transfer is permitted.

3. If the other shareholders object, they must agree to purchase the shares. If they do not agree to purchase the shares, then the sale can go through. Presumably, their purchase must be on the same terms as offered to the third party, though the Regulations are silent on this point.

4. This is then the general rule for sale of shares in a Chinese joint venture. Any party is free to sell its shares to a third party, provided that it has provided written notice of the sale to the other shareholders in the joint venture. The only way the other shareholders can prevent this sale is to agree to purchase the shares on the same terms. This is usually impossible. As a result, a determined seller will almost always succeed in selling its shares.

I believe that most foreign participants in Chinese joint ventures would be quite shocked at this result. In my experience, most foreign participants in Chinese joint ventures expect exactly the opposite rule: that shares can only be sold with the consent of all of the other participants in the joint venture. In my experience, the Chinese side of most Chinese joint ventures has the same expectation. Assuming this is the result desired by both sides of the joint venture, what can be done?

The only solution is to confront this issue directly in the joint venture documentation. The rules for sale of joint venture interests should be set out in both the Articles of Association and in the Joint Venture Agreement. If unanimous consent for sale is desired, then this must be clearly stated in both of these documents. These documents must be approved by the foreign investment regulators. If the documents are approved, then it should be assumed that this is the advance consent required by requirement 2 of the Article 11 discussed above.

There are two potential problems with this. First, many local approval authorities will take the Regulations as controlling law and will not approve formation documents that deviate from the rules. Second, the status of the Regulations is not settled. Accordingly, it is not certain that a court would agree to be bound by the Articles and Joint Venture Agreement, even in a case where these documents have been approved.

Regardless of this residual uncertainty, the issue of the sale of stock in a joint venture must now be confronted directly by dealing explicitly with the issue in the Articles and in the Joint Venture Agreement. For most, this will create an additional step in the already difficult joint venture negotiation process.