The era of large scale “take over” type Chinese investment in U.S. companies appears to be over. However, our China lawyers still seeing a lot of interest in smaller investments from China in U.S. companies involved in emerging technologies. Though it is possible this investment interest from the Chinese side is completely legitimate, just over half the time, that is not what we are seeing. What we usually see is what our China attorneys have taken to calling the “free look investment scheme.”
The free look investment scheme usually applies to when the Chinese company or individual that purports to want to invest in a U.S. company but actually has no interest in a long term investment. Instead, what the Chinese side is seeking is a “free look” The goal of the Chinese side is to investigate the American company’s innovative technology and then appropriate that technology for its own use. The Chinese side uses the promise of investment and financing to convince the U.S. side to drop its guard. The Chinese side then takes what it wants and disappears when it is time to make the full investment.
Our firm is seeing these free look investment schemes virtually every week and we are seeing these schemes become more refined. The result is always the same: no investment from the Chinese side and lost time, money and confidential information from the U.S. side. Though losing confidential information is always a disaster, the lost time and money is oftentimes even more damaging for smaller U.S. target companies, particularly for start-ups that cannot afford to wait around for magic.
The free look investment scheme is usually organized in one of the following three ways:
Free Look Investment Scheme Number One: This scheme is normally limited to smaller but established U.S. companies. The Chinese side proposes to make a substantial investment in the U.S. target company. The amount to be purchased is either a controlling interest in the stock of the target company or substantially all of the stock in the target.
The Chinese side enters into a stock subscription agreement to purchase the stock, but insists on performing extensive due diligence before making the purchase. During the due diligence period, the Chinese investor works to obtain as much confidential information about the operations of the U.S. target company as possible. Often, the proposed closing date is extended several times as the Chinese side seeks more and more sensitive information. The U.S. side provides the information, believing that since the Chinese side will eventually own the company, it cannot hurt to provide them with what would otherwise be considered information that should not be disclosed. But in the end, when the closing date arrives, the Chinese side announces the deal cannot close because the Chinese government will not allow for payment to be made from China. The Chinese side then argues that it cannot be held liable for breaching the subscription agreement because the actions of the Chinese government constitute force majeure and therefore frees them from having to close on the deal. In some cases, the Chinese side will have paid a modest initial deposit or down payment. In those situations, the Chinese side will then argue that the American company must refund its deposit due to its force majeure defense. If the deposit is not refunded, many Chinese investors will file suit demanding the refund. Litigation is always expensive, and that is even more true of this sort of complicated cross-border type of litigation.
Free Look Investment Scheme Number Two: The Chinese side proposes to invest in a U.S. company. The focus of the investment is not the U.S. company itself, but rather the technology either currently owned by the U.S. target company or (more often) the technology the U.S. target company is developing. The Chinese side offers to make a substantial investment in the U.S. company, but conditions its investment in one of two ways: First, the U.S. target must prove to the the Chinese side that its technology is commercially viable. Second, the U.S. target company must enter into a China Joint Venture with the Chinese investor to develop and market the technology in China.
Normally this scheme is structured as follows:
a. Minimal initial investment amount.
b. Payment of the remaining investment amount will be in a series of small installments, often five or more.
c. The China Joint Venture business structure is presented in a way that appears very attractive to the U.S. target company, but this attractive structure is not permitted under Chinese law. The usual “bait” is either i) no financial investment from the U.S. side in exchange for the U.S. company getting a large percentage ownership interest in the China Joint Venture and b) the false promise of an early IPO on one of China’s public markets.
What then actually happens is the following:
a. The Chinese side delays making the initial payment and then delays making each installment. The Chinese side then presses for more and more confidential information, even though it has not made the required payments.
b. At some point in the process, the Chinese side decides it has obtained enough information and it then defaults on its remaining payments. In the old days, that would be the end of it. More recently, the Chinese side has become bolder and will file a lawsuit seeking a refund of its initial (and any subsequent) payments, usually by alleging some breach by the American side.
c. The China Joint Venture never comes into existence because i) the Chinese side never planned to do it and b) the business/ownership/control terms do not comply with Chinese law in any event. But during the bogus formation process, the Chinese side will use the prospect of future cooperation in the China joint venture to extract more information from the U.S. target. The American side thinks it is working with the Chinese side on the joint venture when in reality they are working at cross-purposes.
Free Look Investment Scheme Number 3: The Chinese side offers to “invest” in the U.S. entity by providing working capital and by helping create a market for the product in China by acting as the PRC distributor. The Chinese side offers to provide a working capital line of credit and to enter into a PRC distribution agreement. Both are offered on extremely attractive terms, which is the bait for entering into the relationship.
As with the previous two free look investment schemes, the Chinese side conditions its “investment” on completing its due diligence concerning the product or technology owned by the U.S. target. And just as is true with the first two schemes, what the Chinese side really wants is access to confidential information it can then use for its own purposes. Once that purpose is achieved, the Chinese side bails.
This free look investment scheme usually works as follows:
a. The Chinese side will work hard to obtain the desired confidential information before providing any financing or entering into any form of distribution agreement.
b. If the Chinese side is forced to provide financing, it will structure it in such a to allow it to walk away from the financing at will. The Chinese will normally structure the financing as a monthly line of credit payments based on an informal agreement. A formal financing document is not used. Virtually no Chinese company or individual has U.S. dollars in the U.S. available for providing a monthly financing payment. The cash must be sent from China and this payment must be converted from RMB to dollars. The conversion is subject to approval by the Chinese government and the local foreign exchange bank. When the Chinese side decides it is time to default on its financing obligation it simply states that payment from China is no longer approved. They then use this denial/alleged denial by the Chinese government to claim they are no longer obligated to pay, using the familiar force majeure argument discussed above.
c. The standard procedure for the distribution agreement is as follows:
i. Endless delay in drafting even a first draft of the agreement.
ii. The attractive terms disappear, to be replaced by commercially unreasonable terms. Typical of this is that all profits on sales are earned in China, while the U.S. entity sells at cost to China and earns nothing.
iii. In the end, the Chinese side never orders any products.
As you would expect, all three of these free look investment schemes can be very damaging to U.S. companies. If you are confronted with one of these schemes, you have two ways to proceed. One, just walk away. Two, if you decide to move forward draft the terms of your deal in a way that is both commercially reasonable and that protects your company from the damage that results from the free look.
In my next series of posts, I will describe some of the ways our China lawyers work to render harmless the standard free look schemes. Note, however, that Chinese companies construct these free look schemes intentionally. They are not done by accident or because the Chinese side is inexperienced with the U.S. investment market.