This is part 5 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 1 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 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 part 3 we discussed some of the things you need in your joint venture agreement if you are to reap benefits from your China joint venture. In part 4, we discussed why the China corporate attorneys at our firm both love and hate China joint ventures.
In this part 5, we discuss what is probably the biggest and the most common mistake we see foreign companies make when going into a China Joint Venture: believing they have control over the joint venture when in fact they do not. We also explain how to avoid this mistake.
Way back in 2008, 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 we have always assumed they did so because it would have been detrimental to Chinese companies seeking joint ventures that would greatly favor them.
AmCham Beijing did not have such constraints and it published the article Avoiding Mistakes in Chinese Joint Ventures. It provides a roadmap for avoiding what is probably the biggest and most common mistake that gives 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 then goes on to note 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 Chinese joint venture companies are 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.
The Chinese side to a joint venture usually will refuse to agree to any of the above three control measures by claiming it is more efficient to have them control day-to-day management of the company. The Chinese side will also often claim they cannot use their political connections unless their own people are the representative director and general manager. You should see these justifications for exactly what they are: red herrings used to disguise the Chinese company’s efforts to gain operational control over the joint venture company.
Relinquishing these three control mechanisms to your Chinese joint venture partner will almost invariably cause you long-term problems because once your Chinese JV partner has these controls you will essentially have relinquished all power to influence your own joint venture. When this happens, your best bet will usually be to either reduce your investment to a minority share or abandon it altogether. Once power over operations is out of your hands, it becomes very difficult to run a successful partnership in China.