Less than a month ago, we wrote a post, entitled, How To Form A China Company (WFOE or JV). Hong Kong Entities. They’re Baaaaack. The gist of that post was that my law firm was now favoring the forming of Special Purpose Entities in Hong Kong to hold the soon to be formed Mainland China Wholly Foreign Owned Enterprise (WFOE) or Joint Venture (JV).  We wrote on how our position on this had changed due to China’s having recently become increasingly tough on company formations involving non-Hong Kong companies:

It is relatively easy to prove the existence and organizational structure of a Hong Kong company. The process is straightforward and the Chinese investment authorities understand the documents and readily accept them. This is not true for corporate documents from other countries. The Chinese authorities want documents that are similar to their own. They do not understand foreign company systems, and will often challenge perfectly standard documents from foreign jurisdictions that do not accord with the way they think the world should work. For example, the Chinese authorities will often demand notarized documents. When the notary is from a common law jurisdiction like the United States or England, they will object to the form of the notarization because it does not look like a Chinese or civil law country notarization.

In other cases, we have had Chinese authorities object to United States limited liability company documents because the officers’ titles do not match the equivalent terms in Chinese. For example, in most U.S. jurisdictions, a limited liability company (LLC) does not have directors and officers. Instead, the LLC is either member managed or manager managed. We have had Chinese authorities object to both forms of management because they do not understand the U.S. system. Of course, the issues can be even worse when the investor company is based in a system even more different from China, such as the Middle East, Central Europe or Africa.

All of these sorts of problems are solved if the foreign investor sets up a Hong Kong company and specifies the Hong Kong company as the shareholder of the Chinese WFOE or Joint Venture. For this reason, many of our clients will almost automatically plan to form a Hong Kong company as the first step in the China company formation process.

We received a not surprising amount of blowback to that post, both in the form of comments and in the form of a fairly large number of angry emails.  As I have written many times previously, virtually whenever we say anything that might lead anyone to believe that doing business in China involves little more than just walking in, we get push back, mostly from those whose incomes depend entirely on a smooth flow of China business. Anyway, we received plenty of communications saying or hinting that absolutely nothing had changed in China and that it was either all in our heads or due to our inability to negotiate China’s bureaucracy.

This is the “I told you so” follow-up post.

I just read a Financial Times article, entitled,  “China, India and Russia less business friendly,” on how “executives around the world” think China has become “less friendly towards business over the past three months,” as based on an FT/Economist Global Business Barometers Survey.  This survey is conducted every three months of 1,500 global senior executives.  According to the survey, of the four largest emerging market economies, only Brazil has eased up on business; China, Russia and India have gotten tougher. “The survey comes amid concerns that growth in Brazil, Russia, India and China – together known as the Brics – is slowing.” Brazil was the only one of the four Brics that more consider friendly than unfriendly towards foreign business.

I yearn for the day when China views getting “friendlier” towards foreign business as its best reaction to a slowing economy, rather than getting more “unfriendly.”

What are you seeing out there?

 

This is the final of our three part series on how to handle Chinese negotiating tactics.  Part One can be found here.  Part Two can be found here.

Following on my previous two posts on Chinese negotiating techniques, in this post I will discuss two additional and common techniques used by Chinese companies to drive foreigners mad during the contract negotiation process.

4. Never never land.

The Chinese often will justify its outrageous demands with the vacuous statement that “China is different.” It is shocking how many foreign negotiators fall for this statement and accept such terms. The problem, of course, is that China IS different from many countries. This is a trivial statement, since every country is different from every other country.

The fact is, however, that in terms of laws and regulations, China is not all that different from other countries. Chinese laws are not original. They are based for the most part on foreign models. In addition, as far as foreign investors are concerned, the content of Chinese laws is further constrained by China’s participation in the World Trade Organization (WTO), the World Intellectual Property Organization (WIPO), the Convention on the International Sale of Goods (CISG) and other international standards setting bodies and conventions.

China has worked very hard and successfully over the past decade to bring its foreign investment and business laws in line with international standards. In most cases, China’s laws hew closer to international standards than the often eccentric laws of the United States and England. Chinese laws are based on the civil law standard. What often seems to a U.S. investor as an unusual legal provision is often nothing more than the difference between the common law approach and the civil law approach to certain issues.

Whenever the Chinese side of a negotiation argues that “China is different,” I request that it provide me with a copy of the Chinese statute or regulation that imposes this difference. In over 25 years of negotiation in China, I have never once received a substantive response to this request. On occasion the Chinese side will send over a host of Chinese language documents. To date, it has always turned out that these rules and regulations have nothing to do with the issue at hand and do not impose the rule that the Chinese claim requires that their unreasonable request be accepted. We just wrapped up a negotiation where when the Chinese side did provide us with the law, it said exactly what we had been saying it said all along, just as we knew that it would.

What is “different” about China is that Chinese negotiators do not feel constrained by the rules of good faith negotiation. Thus, when a Chinese company argues that “China is different,” what they really mean is that the fair and impartial laws of China do not reflect the reality of China. The reality is that the Chinese side must take advantage of the foreign side. This means that the foreign side must accede to the unreasonable request of the Chinese side. If the foreign side does not concede to patently unreasonable terms, then no deal can be made.

It is very true in this sense that China is different. However, this is a difference that should not be tolerated by the foreign party to any contract. The response from the foreign side should be first to demand to see the law that requires the unreasonable condition. After the Chinese side fails to provide that law it will usually say something like: “well, the law does not provide for this but our government will not approve the deal unless we include this provision. The response to that statement should be that “if your government will not approve the deal, then we will not do the deal.” This should be made very clear. If the Chinese side does not back down, you should terminate the negotiation.

Let me give an example. It is common in negotiating China Joint Ventures for the Chinese side to insist that the intellectual property contributed to the JV by the foreign partner must ultimately be transferred to the Chinese JV partner. The same is true in many technology license agreements where the Chinese side will say: “sorry, but you cannot protect your IP. You must transfer everything to us at the end of the license.” This situation is obviously the opposite of what the foreign side wants from the transaction. When the foreign side resists, the Chinese side will then play the “never never land” card and state that Chinese law requires such a transfer. In fact, however, Chinese law does not make any such requirement. This is simply what the Chinese side wants out of the deal. Of course, the Chinese government supports the Chinese side, since the free transfer of technology arguably benefits China, so everyone in China is on the same side. Thus government authorities involved will usually do nothing to clarify the situation.

The foreign side will all too often accept the “China is different” justification and go forward with the deal. Later, the Chinese side will drive out the foreign JV partner or terminate the license and appropriate the technology. When that happens, the foreign side will complain about the Chinese law that mandates such a result. However, there was never such a law. It is virtually always a case where the foreign side agreed to a contractual provision that guaranteed its own eventual doom. Chinese law is not at fault. Gullibility in falling for the China is different argument is where the fault lies.

5. Revenge is a dish best served cold.

In the discussion above, I advise that the foreign side strongly resist agreeing to unreasonable Chinese demands and negotiation techniques. I advise that if the Chinese will not back down, then the foreign side should terminate the transaction and return home. My point is the obvious one that the foreign side should not enter into a bad deal or a deal that it does not understand simply because it has been manipulated by standard Chinese bad faith negotiation techniques.

In these tough negotiations, it is usually required that the foreign side just has to say “take it or leave it.” In a surprisingly large number of cases, the Chinese side will “leave it,” even in cases where this decision seems to make little economic sense. Thus, when the foreign side gives the final ultimatum, the foreign side has to be prepared for the Chinese side simply walking away from the deal.

In some cases, however, the Chinese side will back down and will accept restrictive provisions against which it has been vehemently fighting during negotiations. It will accept the challenge and it will “take it,” rather than walk away from the deal. In that case, the foreign side will congratulate itself on their negotiation skills and the fact that it “won” the negotiation.

The problem with this though is that the Chinese side oftentimes does not fully accept its concession and it will treat it as a personal challenge. It will then work to unwind the concession in some way during the life of the transaction. It will focus on taking revenge for its defeat on the contract issue. It will focus on this revenge with little regard for whether it obtains economic benefit from its actions. Even when it will actually suffer economic damage from its conduct, it may still focus on obtaining revenge for its defeat. The passage of time makes little difference. Their only concern is on obtaining revenge.

Why is this? Social researcher Ian McKay has this to say in general about people who seek revenge:

People who are more vengeful tend to be those who are motivated by power, by authority and by the desire for status. They don’t want to lose face.

This description nicely describes the average Chinese business negotiator. They treat contract concessions as a loss of face, and they will focus on getting back their “face” to the exclusion of everything else. The economics of the deal does not matter. What really matters is the balance of power and their face. This attitude is quite foreign to most foreign business people who treat contract negotiations as a purely economic issue and not as a personal matter. It is therefore very hard for foreign business negotiators to understand how this issue can impact their future business relations with a Chinese party.

The issue goes beyond face. If you discuss these matters with Chinese business people you will learn that the Chinese side views the Western approach to contract negotiation as fundamentally unfair. They see the Western insistence on certainty and clarity as fundamentally a bad faith phenomenon. For the Chinese, certainty in contract terms is justified only for a one off, single transaction, “horse trade” style sales contract. The sale of an office building or a single shipment of a commodity is an example of this type of contract.

For any contract that requires a continuing performance over time, the Chinese believe that any attempt to pin them down and impose certainty on their behavior is fundamentally unfair and contrary to reality. For the Chinese, the future is essentially uncertain and the attempt to impose certainty on this uncertain future makes no sense. Any party who insists on this must have a bad intent. Where the Chinese side agrees to such certainty, they do it under protest and they strongly feel that unequal bargaining power on the side of the foreign party has forced them into an inherently unfair transaction. Thus, they do not have moral qualms in taking their revenge by undoing the terms of this inherently unfair agreement at a later date. Their belief that they have the moral high ground fuels their need for revenge and explains why they will seek revenge even in cases where there is no economic benefit.

This feeling runs very deep in China and is difficult to deal with rationally pursuant to the typical Western company business calculation. For foreign parties, it leads to very complex assessments of negotiation strategy. Total victory is seldom useful in China. This then leaves open the question of what sort of compromise short of total victory will result in a contract that is still acceptable to the foreign party.

In my own experience, there are two viable options in dealing with the final battle over key terms. The first is to walk away from the deal. No deal is better than a bad deal, and what looks like bad deal in China will certainly turn out to be just that. Where abandoning the deal is not acceptable, then the foreign side should plan to concede on some issues that are important to the Chinese side so as to provide the Chinese side with some feeling of victory in the conclusion of the negotiation. This concession should always be balanced against an overall assessment of the benefits of the deal to the foreign side. No deal should be concluded in China that does not provide for substantial benefit to the foreign side. Close deals never work out in China. The foreign side needs a lot of room on the benefit side to overcome the constant Chinese pressure to chip away at the foreign benefits at every stage in the process of performance.

What do you think?

 

 

By: Steve Dickinson

When making a WFOE (Wholly Foreign Owned Enterprise) or JV (Joint Venture) investment in China, the investor must consider: who will be the shareholder in the PRC entity? Will the investor invest directly, or will the investor create a special purpose subsidiary company  (an SPV or Special Purpose Vehicle/a/k/a SPE or Special Purpose Entity) to act as shareholder. If an SPV is used, where will it be formed?  In the U.S.? In a generally recognized tax haven such as the British Virgin Islands or the Cayman Islands? Or in Hong Kong in accordance with the favorable PRC/Hong Kong tax treaty?

From a tax standpoint, the decision is complex and requires careful analysis by the primary investor. Ignoring the tax issue, however, from the standpoint of company formation, the use of a Hong Kong entity offers the advantage that it solves many of the technical problems in forming a WFOE or JV in China.

It is relatively easy to prove the existence and organizational structure of a Hong Kong company. The process is straightforward and the Chinese investment authorities understand the documents and readily accept them. This is not true for corporate documents from other countries. The Chinese authorities want documents that are similar to their own. They do not understand foreign company systems, and will often challenge perfectly standard documents from foreign jurisdictions that do not accord with the way they think the world should work. For example, the Chinese authorities will often demand notarized documents. When the notary is from a common law jurisdiction like the United States or England, they will object to the form of the notarization because it does not look like a Chinese or civil law country notarization.

In other cases, we have had Chinese authorities object to United States limited liability company documents because the officers’ titles do not match the equivalent terms in Chinese. For example, in most U.S. jurisdictions, a limited liability company (LLC) does not have directors and officers. Instead, the LLC is either member managed or manager managed. We have had Chinese authorities object to both forms of management because they do not understand the U.S. system. Of course, the issues can be even worse when the investor company is based in a system even more different from China, such as the Middle East, Central Europe or Africa.

All of these sorts of problems are solved if the foreign investor sets up a Hong Kong company and specifies the Hong Kong company as the shareholder of the Chinese WFOE or Joint Venture. For this reason, many of our clients will almost automatically plan to form a Hong Kong company as the first step in the China company formation process.

However, there are several important issues that must be considered before making the final decision regarding formation of a Hong Kong company.

1. The use of an SPV is in many cases prohibited by Chinese law. For many investments in the service sector, the investor must prove that the foreign shareholder has been in operation for a certain number of years. In other cases, the foreign investor must prove that it has had a certain business income for a specific period or that its capitalization meets a certain standard. Where this type of requirement exists, the standard is applied to the direct shareholder in the Chinese company. That is, it is not acceptable to say that the ultimate parent company meets the requirement. For this reason, many investors in China are required to make the investment directly and not through a SPV or other subsidiary.

2. Though establishing a Hong Kong company is relatively fast, cheap, and easy, creating a bank account in Hong Kong is not. For formation of a Chinese company, the Chinese authorities require that a Hong Kong bank account exist and they also require a letter from the Hong Kong bank stating the details of the account formation. Under Hong Kong banking and anti-money laundering rules, a bank account in Hong Kong can only be opened by a person who is personally present at the bank in Hong Kong. Moreover, the rules on who this person is are very strict.  This person must be the party the Hong Kong banking authorities determine is the person who exercises actual control over the Hong Kong company. Usually this will be the chairman of the board of directors of the Hong Kong company. Where there are multiple shareholders, this will also include a representative of each shareholder who holds more than 10% of the stock in the Hong Kong company.

For many Hong Kong companies, the shareholder will set up the Hong Kong company so that the chairman of the board is a high ranking officer in the corporate parent. For company formation purposes, this is is easily done since for company formation, only the signature of that officer is required. This then backfires when it is time to open the company bank account in Hong Kong. For this, the chairman must be physically present in Hong Kong. In addition, the chairman must also prove his or her identity using documentation that cannot be determined precisely without consultation with the bank. It is not acceptable for the chairman to designate another person such as a lower level staff person or a lawyer to act on his or her behalf. Only the chairman or similar officer of the Hong Kong company can act.

In our experience, it is the rare chairman of the investor company that has the interest in or the time to travel to Hong Kong simply to open a bank account. However, no one else will be permitted to open the account and without a funded Hong Kong bank account, it is not possible to form a company in China. Once this problem arises, it can be difficult and time consuming to fix. For this reason, consideration of how a company bank account will be opened in Hong Kong should be considered in advance, before forming the Hong Kong company. We have seen many unnecessary delays in forming a Chinese WFOE or JV that arise as a result of having to deal with bank account issues.

Having said all this, forming a WFOE that is owned through a Hong Kong company is — more often than not –generally easier these days than just forming a WFOE that is owned direct from a country like the United States.

What do you think?

One of the favorite topics among China lawyers is the big mistakes they have seen their clients, rejected clients, and others make when trying to navigate China. The discussion usually transpires with one attorney telling the facts, with the others then giving a knowing laugh and nod and then trying to top it. Had this discussion the other day and here are my favorites from it (some are mine, some come from others:

1.  Sophisticated U.S. company calls lawyer about setting up their publishing business in China as a WFOE. Brags about the market for their publication in China, basing that on a USD$500,000 study they just completed. U.S. lawyers asks whether they did any research on whether such a business can be conducted legally in China as a Wholly Foreign Owned Entity. Super long pause.

2.  Sophisticated U.S. company builds factory in China and right before they are ready to take it online, they learn that they cannot import the key chemical they need for it without Chinese government approval regarding its safety. Six months later they get the approval and the factory opens.

3.  U.S. company insists against attorney advice that it can go into a China Joint Venture without contributing anything other than just its technology. In other words, it fails to abide by the requirement that it contribute a certain amount of monetary capital. Just as its lawyer predicted, it ends up leaving China within a year while its technology stays.

4.  U.S. company insists against attorney advice there will be no problems in forming its WFOE in China illegally because the local government supports them 100%. Within a couple of years Beijing comes in and shuts them down.

5.  Foreign companies (we talk about this sort of thing as a common occurrence) hires inadequate company formation firm to form its China WFOE and buys into the notion that the lower the minimum capital requirement, the better. After the China WFOE is formed and has run low on money, the home office in the United States or wherever sends an infusion of money to the China WFOE. China then taxes that money as income to the WFOE.

6.  U.S. company pays bribes and then gets investigated for Foreign Corrupt Practices Act violations.

7.  U.S. company fails to register its trademark in China because it was “just” manufacturing there. Ends up getting its product blocked from leaving China by a Chinese company that registered the trademark the U.S. company was using but had not registered in China.

8.  U.S. company buys expensive property in big-time China city and then spends millions refurbishing it for high-end offices. Then hires lawyer to handle the legalities of raising additional funds in the United States to complete the refurbishment. Lawyer spends a few hours doing his own due diligence on the project and quickly discovers the building is zoned for hospital only.

What are your stories from the front lines?

This is part II of our relatively new series setting forth how we “really feel” about the issues that have generated controversy on our blog over the years. Part I dealt with guanxi and the comments to that post alone have made it a great read.

We started this series because “we have taken many strong positions over the years, but in some cases those positions have been at least somewhat misunderstood and this new (and irregular) series will aim to clean up misconceptions.”

We have developed quite a reputation for not liking joint ventures and that is not really true. Wary would be a better word for how we feel about them. I am always bothered when a client or potential client calls about their proposed joint venture and starts out by saying “I know you don’t like joint ventures.” Are we losing business because of this reputation, or maybe we are getting more because people believe that if we give the go-ahead on theirs, it really is as good as they think it is. Of course, we will never know, but we can at least try to clear the air. We like the appropriate and necessary joint ventures; we just think it is a big mistake to consider a joint venture as the default method for entering China.

Of all the China legal work done by my law firm, our work setting up and dismantling joint ventures is probably my favorite and certainly one of the most lucrative. We charge a flat fee for probably 90% of our China work, but for forming joint ventures, we always charge hourly. We charge hourly because setting up a China joint venture can range from fast and easy to difficult and contentious. It is the rare one that is fast and easy.

A joint venture consists of two independent businesses, one foreign and one Chinese, going into business together. That alone ought to tell you how difficult they can be. The most difficult questions usually center around control. Which of the two companies will control what and what really needs to be done to ensure control and to ensure that no
one company gets out of control?

It is this complexity and its attendant fees that we love.

For more on what is involved in the forming of a joint venture in China and when China joint ventures make sense, check out the following:

Just to be clear, we love forming joint ventures, but only when they truly do make sense.

We also love taking apart China joint ventures that have gone wrong. And again, we love doing this not for because it is in any way a good thing for our clients, who usually are in dire straits when they come to us with their joint venture problems, but because resolving joint venture disputes is like a chess game, but at our hourly rate.

The problem with China joint ventures is not China-specific; it is joint venture specific. Joint ventures simply tend too often to be a bad way to conduct business. My firm has seen this with Russian joint ventures, Vietnamese joint ventures, Mexican joint ventures, Korean joint ventures, Japanese joint ventures, even a Gambian joint venture. I was going to try to explain why this is the case, but I came across a Seth Godin post that does so better than I ever could. Godin posits the following in his post, “Why joint ventures fail so often“:

There are two reasons joint ventures fail. The joint part and the venture part.

All ventures are risky, because they involve change and the unknown. We set off on a venture in search of something, or to make something happen–inherent in the idea of a venture is failure. It’s natural, then, for fearful people on both sides of a joint venture to back off when it gets scary. When given a choice between a risk and sure thing, many people pick the sure thing. So any venture begins with some question marks.

The joint part, though, is where the real problem arises. Pushing through the dip is the only way for a venture of any kind to succeed. The dip separates projects that begin from projects that finish. It’s easy and hopeful and exciting to start something, but challenging and often painful to finish it. When the project is a joint one, the pressure to push through the dip often dissipates. “Well, we only have a bit at stake here, so work on something else, something where we have to take all the blame.”

Because there isn’t one boss, one deliverable, one person pushing the project relentlessly, it stalls.
Every joint venture involves meetings, and meetings are the pressure relief valve. Meetings give us the ability to stall and to point fingers, to obfuscate and confuse. If a problem arises, if a difficulty needs to be overcome, it’s much easier to bury it at a meeting than it is to deal with it.

In my experience, you’re far better off with a licensing deal than a joint venture. One side buys the right to use an asset that belongs to the other. The initial transaction is more difficult (and apparently risky) at the start, but then the door is open to success. It’s a venture that belongs to one party, someone with a lot at stake and an incentive to make it work.

Only one person in charge at a time.

He is, of course, absolutely right.

For more on the downside of entering into a joint venture in China, check out the following:

What do you think? China joint ventures, good, bad or indifferent?

A truism about lawyers is that we benefit when the economy is either rising or falling, so long as there is change. I was talking with a China lawyer friend the other day regarding his firm’s very small China office and we both talked of how we were getting all sorts of work related to the downturn. Both of our firms have seen a marked increase in the following work, all of which we attribute to the bad economy last year or this year:

1. Lawsuits against Chinese companies. There are a lot of reasons why these are increasing, but the economic downturn is definitely one of them. When Western companies are making a lot of money, they do not have time to pursue lawsuits. Suing in an upswing is oftentimes a waste of precious human recourses. In downturns, when every dollar counts and when employees have extra time, litigation makes better sense. Many more Chinese companies now have assets outside of China is making collection against them far easier and making suing them a much better proposition. For more on the benefits of suing Chinese companies, check out my recent Wall Street Journal article, Chinese Companies Court Disaster.

2. Setting up China Joint Ventures. AmCham interviewed me on this back in October, 2009, and what I said then still holds true now. Many Western companies are coming to the view that they must be in China and yet, they do not want to spend the money to go in with both feet, so they are sticking just one foot in, via a joint venture with a Chinese company.

3. Winding Down China Joint Ventures Gone Bad. Both of our firms have seen a precipitous increase in these matters and after discussing these matters, we both concluded this increase too is due to the bad economy. In most instances, the joint ventures had been bad for years, but the downturn caused our clients to decide to do something about them, for pretty much the same reasons Western companies are getting quicker to sue Chinese companies.

3. Licensing deals. This is a strange one, but both of us attribute this to the bad economy as well, or at least to the fact that China’s economy is doing so much better than the West. We both talked about how over the last year or so we have been seeing a marked increase in Western companies licensing their technology and/or name out to Chinese companies. Struggling companies are more likely to jump at this chance for extra revenue. For more on this increase in licensing to China, check out, “That’s Hot: Made In China For China. By Foreigners.

4. Shutting down WFOEs. Many Western companies went into China with the expectation of making money there fast. Other Western companies went into China not expecting to be profitable there for five to ten years, if ever, but out of a belief that if they did not go in, they would be losing out to competitors even outside of China. Increased financial tightening has now caused some of these companies to pull out of China, which means having to close down their Wholly Foreign Owned Entities there. China has very strict rules on how to close down a WFOE (a/k/a Wholly Owned Foreign Entity, or WOFE) and if those rules are not followed to the letter, the Western company (and even some of its key personnel) run a serious risk of never being allowed into China again. The smart company closes their China WFOE by the book. For the worst that can happen for failing to close down properly and pay off all debts, check out “How Not To Get Kidnapped In China.”

5. Labor Disputes. The economic downturn, coupled with China’s relatively new Labor Contract Law have also led to a marked increase in matters stemming from job layoffs in China. The New York Times just did a story on this, entitled, “Global Crisis Adds to Surge of Labor Disputes in Chinese Courts.

What are you seeing out there? What parts of your China business are increasing due to the current tough times?

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 [link no longer exists]. 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.

 

The China Economic Review just published a piece on China business relationships by Andrew Hupert, a professor of negotiation at NYU in Shanghai. The article is entitled, “Trouble in commercial paradise,” and its thesis is that Chinese companies usually view their relationships with Western companies as short-term.

Hupert starts out by talking of how even the “big boys” have recently been complaining about being tossed aside by China:

Long term relationships are never easy, especially when one of the partners is a Chinese SOE. Until recently, many European and a few of the more patient & deep-pocketed US firms took upon themselves the role of a corporate Dr. Phil, offering easy, smug advice on how to woo and win the affection of a Chinese partner. But now even the happiest of Western partners – like GE, Siemens and BASF – are publically complaining that they are not feeling very significant in China in any more. If there’s trouble in commercial paradise for the most eligible suitors, where does that leave the newcomers?

Hupert goes on to seek to reconcile the apparent “paradox” between the insistence that “Chinese dealmakers have a long-range, relationship-oriented view of business” and their consistently engaging in actions that bely this. According to Hupert, Chinese companies do think long term, but that does not mean that “they are looking to settle down with any long-term partner in general – and a Western one in particular.” Be prepared for your Chinese partner to bolt when a more attractive partner comes along:

Many Euro and American management teams that have been involved with a Chinese supplier for more than 10 months tend to congratulate themselves on achieving a win-win, guanxi relationship but the reality is that they are actually engaged in a series of one-off deals with the same people. Once a better opportunity presents itself, the Chinese side considers itself a free agent.

*    *    *    *

Western firms that are getting a little more “mature” — with a bulging pension liability and a thinning customer base – like the idea of settling down with the sexy young Asian firm that still has its best demographics ahead of it. Sure, the match may make sense on paper right now, but do the local Chinese targets share the same long-term hopes and dreams? The ugly truth is that established Mainland firms – the kinds with government support and resources of their own – tend to see a Western brand as a short-term partner, a medium-term customer and a long-term competitor.

Sure, the Westerners can be fun for a while. They have interesting technology, a new way of doing things and, oh – that intellectual property can be hot stuff. But once the assets have been transferred and the IP has been digested – well, that Western firm seems more appropriate as a customer, client or even a distributor. And in the longer term – say five or 10 years – the math changes completely. Now that partner is looking like less and less of a source of assets and growth and more of a liability – or even a competitor on the global stage. The Chinese firm knows that it is quickly outgrowing the maturing Western counter-party.

Sorry to say, but what Hupert describes is exactly what I have seen happen time and time again. Call me cynical, but every joint venture agreement my firm writes is written based on the assumption that we will be dealing with it again in a few years when the Chinese company is seeking to push our client out. It is a shame that my firm has garnered a reputation for not liking joint ventures because we actually love joint ventures for very selfish reasons.  We love them because they make us a lot of money in the drafting of the contract and then they make us even more money when they go bad, and they nearly always do.

This short term tendency also frequently manifests itself in China licensing deals, of which I wrote previously:

My firm has been involved in countless IP licensing agreements over the years where foreign companies have licensed their IP (be it a patent, trademark or copyright) to Chinese companies.

One of the things we cannot help but noticing with these agreements is the tendency of the Chinese company to stop paying the licensing fee as the licensing contract starts nearing its end date. By then, the Chinese company has made good use of the IP and the Western company has made a good chunk of money from the agreement.

I have always seen this as simply a cost-benefit analysis by the Chinese company. It has paid the Western company, let’s say, USD $3 million for the IP and it simply does not believe the Western company will sue it in China over the remaining $200,000 due. So it just stops paying. At that point, we typically send a demand letter to the Chinese company, reminding it of its obligations, reminding it of exactly how the contract favors us if we sue, and telling it that it had better pay the $200,000 immediately or we will sue.

At that point the negotiations begin and a settlement usually follows.

Because of the above, our advice to our clients who license their IP to China is three-fold:

1. Base your pricing on the assumption that you will not get full payment on your final     payments;

2. Do whatever you can to make sure the Chinese company still needs you at the end of     the deal so that the Chinese company has no choice but to keep paying you;

3. Put in some killer provisions in your contract that deal with a situation where the Chinese     company stops paying at the end.

And for more on how to do a joint venture with China (or how not to), check out the following:

You might also want to listen to an AmCham podcast I did at the end of last year on the “return of the China joint venture.

My co-blogger and fellow China Lawyer Dan Harris recently did an interview with AmCham on China joint ventures and a couple of follow up posts, entitled, Love The One You’re With. When China Joint Ventures Make Sense, and The China Joint Venture. It’s BACK!!!

We are writing about joint ventures so often these days because we are seeing a pronounced resurgence both in companies wanting to go into Chinese joint ventures and in companies coming to us needing legal assistance with their failed and failing joint ventures here in China. We have often expressed cautions about joint ventures in the past, and nothing we have seen recently causes us to change our mind.

In many cases we are not able to effectively assist the foreign party in a troubled JV because their original joint venture agreement has been so poorly drafted as to preclude any real assistance. We usually attribute this to the foreign company’s originally misinformed view that “China has no law” or that the “JV contract is not worth the paper it is written on.”

Based on these misguided views of Chinese law, the foreign joint venture participant failed to secure good legal representation when it went into the joint venture deal, leaving us with little or nothing to work with in terms of fixing the joint venture problems. The foreign joint venture participant has made basic mistakes that make it impossible to use the very effective Chinese laws and legal system to resolve the problems that have arisen in the JV. Though China’s courts do generally enforce foreign arbitral awards, the issues between joint venture partners more often hinge on issues relating to control and operations, which typically require a Chinese court ruling.

Some examples of the basic mistakes are:

1.  In order to resolve a joint venture dispute, the issue oftentimes must be resolved in China, either through litigation in the Chinese courts or through arbitration with CIETAC, BAC (Beijing Arbitration Commission), or some other legitimate Chinese arbitration body. Foreign partners often provide in the JV agreement, however, that litigation or arbitration must take place outside of China, either in the home country of the foreign partner or in some expensive and well known arbitration forum like Stockholm or London. This type of provision does little to nothing to protect the foreign partner and makes it impossible to resolve any disputes in China, where the problem exists.

By way of an example, many companies come to us complaining that the JV’s representative director has highjacked the operations of the China joint venture company and is operating without supervision and against the wishes of the board of directors. To effectively address this issue, it is imperative that we proceed in court in China directly against the rogue director. However, if the JV Agreement provides for jurisdiction outside of China, we are effectively precluded from taking such direct action.

2.  Our China lawyers are often called on to try to help foreign companies that are in deep trouble with their China JV for reasons stemming from their failure to hire their own independent legal and accounting advisor during the joint venture formation process. Instead of using their own independent counsel, these companies instead relied on the Chinese JV partner for all of the formation legal work. This is a guaranteed disaster. We have seen US companies that have put tens of millions of dollars into a Chinese joint venture, using no legal counsel at all, using the legal counsel of their joint venture partner, or using a local Chinese lawyer who has no experience with foreign joint ventures and no real incentive to protect their foreign client. We had one client who when he first came to us boasted of the great job his Chinese lawyer had done for only $600. When we pointed out how his joint venture so heavily favored the other side that his multi-million investment would likely never yield him a penny, we began to suspect he no longer thought of his counsel as such a bargain.

3.  Relying on a majority share interest to control the venture, rather than exercising effective control through the right to appoint the representative director and the general manager.

4.  Relying on a personal guarantee from the Chinese JV partner as a substitute for failing to properly document the project.

5.  Failing to provide clearly for protections for the foreign partner, assuming share ownership is sufficient to provide adequate protection.

6.  Failing to carefully monitor capital contributions and the use of contributions to capital, assuming that accounting reports will be adequate to reveal the fate of money contributed.

Though the above looks like a long list, I often see joint ventures where the foreign participant has made every single one of these mistakes and more that I have not mentioned. When this happens, we as China attorneys are severely constrained in terms of what we can do to help. But this is not because China has no law or because Chinese contracts are worth nothing. It is because the failure to properly form and manage the JV has made it impossible to proceed. The blame for this generally falls on the shoulders of the foreign JV partner, not on the Chinese side or the Chinese system.

Joint venture agreements are really no different from any other contract. The better the agreement, the less likely there will be problems and the more likely there will be a quick and inexpensive resolution to whatever problems arise.

AmCham China just posted an interview here [mp3] of me regarding the return of joint ventures to China. Josh Gartner conducted the interview and he did a great job.
Though joint ventures obviously never left China, there has definitely been a post-recession resurgence. Whereas in the past, most American companies that did joint ventures in China did so for very specific and China-particular reasons, the “new” joint venture is being done as a cost savings devise. The old joint venture was done when the Chinese company had something the foreign company could not supply. That something was usually along the lines of a distribution network or necessary government contacts.
We are now seeing way more of what I call cost-saving joint ventures. By way of example, an American manufacturer might choose to joint venture with an existing Chinese factory, rather than spend the money to build a factory from scratch. The reasons for this upsurge are pretty obvious. American companies have less money now and, perhaps even more importantly, less access to credit.
If you are thinking of going into China as a joint venture, I recommend you give it a listen.
And If you want to read more on joint ventures, check out the following:
— “China Joint Ventures. Find Me A Good One….
— “Avoiding Mistakes in Chinese Joint Ventures.
— “China’s Joint Venture Jeopardy
What do you think?