This is part 3 of our series on China Joint Ventures. We are writing this series now because our China lawyers are seeing a record number of potential joint ventures, due largely to China’s declining economy, the belief that truly foreign companies will not be well-treated in China, and a desire to try to “share the risk” of all this uncertainty. In part one of this series, China Joint Ventures: The Long Version, we talked about fake and exploitive joint ventures. In part 2, we assumed your Chinese counterpart is legitimate and truly wants to do a legitimate JV with your company and we discussed how to make sure you are truly on the same page with your China joint venture counterpart(s) regarding what will go into the joint venture and how it will operate once formed.In this post, we discuss some of the things you need in your joint venture agreement if you are to reap benefits from your China joint venture.
Just as a quick aside: there is a 99.99% chance you will never see a dollar from your joint venture if you use your joint venture partner’s attorney or even any attorney chosen for you by your joint venture partner or you use no attorney at all. If you don’t realize this after reading the below, I don’t even know what more to say.
Many China joint ventures fail because the foreign partner made the fundamental mistake of believing its 51% (or more) ownership of the joint venture gave it effective control over the joint venture. Foreign investors too often assume Chinese joint venture companies are managed according to the common Western corporate 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 strive to obtain a 51% ownership interest in their China joint venture. As the majority owner, the foreign investor just assumes it has the right to elect the entire board, and thus effectively control the joint venture company.
After winning the struggle for percentage ownership the foreign investor will frequently give the Chinese side the authority to appoint the joint venture’s Representative Director and the company General Manager. But this concession cedes effective power and effectively renders the foreign investor’s struggle for board control is rendered meaningless. The Chinese side will intentionally angle to ensure this outcome, usually by offering to concede majority ownership to the foreign investor in return for control over these two key management positions in the joint venture company. If you want to exercise effective control over a China joint venture, you must avoid this mistake. If you do not, you will not have control over the joint venture’s day-to-day management.
For you to maintain control over your Chinese joint venture you need the following:
- The power to appoint and remove the JV’s Representative Director. The party that appoints the joint venture’s Representative Director will have significant control over operations. The usual practice of conceding the power to appoint a key officer or director to the Chinese side is a mistake if you want to maintain control over your China Joint Venture.
- The power to appoint and remove the JV’s General Manager. The General Manager is an employee of the joint venture company and that person is employed entirely at the discretion of the JV’s Representative Director. The common practice of appointing the same person as both Representative Director and General Manager is usually a mistake.
- Control over the company seal, or “chop.” The person who controls the registered joint venture company’s 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. For these reasons, 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 China Joint Ventures.
The Chinese side to a joint venture will usually refuse to agree to these three measures by claiming it is more efficient to have the Chinese side control day-to-day management of the company. The Chinese side will also often claim they cannot bring their political connections, or their guanxi, into play unless their own people act as the joint venture’s Representative Director and General Manager. These claims usually are used to disguise the Chinese company’s efforts to gain operational control over the company and your relinquishing these three control mechanisms to your Chinese counterpart will likely be problematic for you.
Once these three control mechanisms are entirely under the control of your Chinese joint venture partner, you will likely quickly learn that you have relinquished all power to run the JV and bad things will likely result. What sorts of bad things? The most common is that you will never see any money from the joint venture. Ever. This occurs because with its control over your Joint Venture your Chinese counterpart can always make sure the joint venture never makes a profit, but his or her company always does.
How can this be achieved? We often see this done by using one of the following two tactics:
- Suppose your Chinese JV partner can make the JV hiring and firing decisions. Now suppose your JV should have 200 employees but your JV partner hires 350 employees, thereby wiping out any profit for the JV. Why though would your JV partner do this and how does your JV partner benefit from doing so? Many reasons. The extra 150 employees can be some combination of 1) relatives who do or do not kick back a good portion of their grossly inflated earnings to your JV partner, 2) strangers who do kick back a substantial portion of their grossly inflated earnings, and 3) friends and relatives of Chinese government officials who are hired to increase your Chinese JV counterpart’s standing and thereby benefit your JV counterpart and his own companies, 4) friends and relatives of whomever else your Chinese JV counterpart wishes to increase his or her or its standing.
- Your Chinese JV counterpart chooses to buy (possibly inferior) products and services at inflated prices from his or her own companies, including from the company that is your JV partner.
In our next post we will explain why the China joint venture lawyers at our firm both love and hate them and what you can do if you are stuck in a bad one.