Until a couple of months ago, co-blogger Steve Dickinson was the legal columnist for one of China’s most prominent English language business publications. As part of his regular monthly gig, Steve submitted an article on how to avoid joint venture mistakes. The censors rejected it and I assume they did so because it might be detrimental to Chinese companies seeking joint ventures.
AmCham Beijing did not have such constraints and it just published the article in its China Brief publication, entitled, “Avoiding Mistakes in Chinese Joint Ventures.“[pdf] It provides a roadmap for avoiding the mistakes that have given Chinese joint ventures such a bad name.
The article starts out by noting that with “the exception of some market sectors, China is remarkably open to foreign investment, and in the past several years WFOEs [Wholly Foreign Owned Entities] have become the most common vehicle for foreign investment, partly due to investor skittishness as stories about past problems with Chinese EJV [Equity Joint Venture] partners made the rounds.
The article notes how “thoroughly vetting your joint venture partner” will “dramatically increase your likelihood of success,” but states that most China joint ventures fail because the foreign partner made the “fundamental mistake” of believing its 51% ownership gave it effective control over the joint venture:
Foreign investors too often assume that a Chinese joint venture company is managed according to a common Western model, under which a board of directors has controlling power over the company. Since the board is elected by a majority vote of company owners, most foreign investors will strive to obtain a 51% ownership interest in the EJV. As majority owner, the investor then assumes he has the right to elect the entire board, and thus effectively control the company.
After winning the struggle for percentage ownership, as a concession, the foreign investor will frequently allow the local side to appoint the representative director and the company general manager.
Unintentionally, this concession cedes effective power. As a result, the investor’s struggle for board control is rendered meaningless. Frequently the Chinese side intentionally angles to ensure this outcome. We know of cases where an EJV partner concedes on the percentage ownership issue in return for control over the two key management positions in the company.
In order to exercise effective control over a joint venture in China, investors must avoid this mistake. It is necessary to have control over the day-to-day management of the joint venture company.
The article then sets out the following basics for maintaining control over your Chinese Joint Venture:
● The power to appoint and remove the JV’s representative. The side that appoints the representative director will have significant control over operations. The usual practice of conceding the power to appoint a key officer or director to another investor is a mistake.
● The power to appoint and remove the general manager of the joint venture company. It must be made clear that the general manager is an employee of the joint venture company who is employed entirely at the discretion of the representative director. The common practice of appointing the same person as both representative director and general manager is a mistake.
● Control over the company seal, or “chop.” The person who controls the registered company seal has the power to make binding contracts on behalf of the joint venture company and to deal with the company’s banks and other key service providers. The power over that seal should be carefully guarded. Ceding control over it as a matter of convenience is a mistake. There is a long, documented history of this seemingly minor consideration dooming EJVs.
Steve then notes how the Chinese side to a joint venture will usually refuse to agree to these three measures of control by claiming it is more efficient to have them control day-to-day management of the company. The Chinese side will also often claim that “they cannot bring their political connections, or guanxi, into play unless their own people act as the representative director and general manger.” Steve sees these claims as red herrings used to disguise the Chinese company’s efforts to gain operational control over the company.
Relinquishing these three control mechanisms to the Chinese company will likely be problematic for the foreign company:
Once these three control mechanisms are entirely under the control of the partner, foreign investors will quickly discover that they have relinquished all power. When this happens, the investor should face the reality of the situation, and either reduce the investment to a minority share or abandon it altogether. Once power over operations is out of an investor’s hands, it becomes very difficult to run a successful partnership in China.
Steve will be speaking on China Joint Ventures at JP Morgan’s upcoming China Conference. This yearly conference, which truly is THE China conference, will take place at the Grand Hyatt in Beijing from April 23 to April 25 and it will, as always, include a huge roster of the leading China experts in various fields. Click here for the draft agenda. Steve is scheduled to speak on Thursday, April 24, from 17:00 to 18:00 in the Grand Ballroom Number 1. The title of his talk is “Pitfalls of Establishing Joint Ventures in China.”