We started a China Law Blog Group on Linkedin with the goal of creating a spam-free source for China networking, information and discussion. We now have nearly 8,500 members and, more importantly, a number of lively discussions.

We have had some absolutely terrific discussions, both based on the numbers (a number of the discussions have received around 100 comments and some have gone over 200) and on their substance. Our discussions have ranged from practical (such as, how do I open a China bank account or what are the best practices for a China Joint Venture or what is the most important thing to do for doing business in China) to deep think (such as, what is the future of rule of law in China? or what are the differences in how Chinese companies and French companies are run).

What also boosts the group is its diversity of membership. We have a large contingent of members within China and without. Some members are China lawyers, but the overwhelming majority are not. We have senior personnel (both China attorneys and executives) from both large and small companies and a whole host of junior personnel as well. We have students and we have professors. This mix only contributes to the high level of discussions.

I am most proud of how (at least as far as I know) no spam item has yet lasted on the site for anything even approaching 24 hours.

If you want to learn more about China law or business, if you want to discuss China law or business, or if you want to network with others doing China law or business, I suggest you check out our China Law Blog Group on Linkedin and join up. The more people in our group, the better the discussions.

We will see you there. Click here and join us.

Not sure why joint ventures seem to go in waves, but our China lawyers have been getting more than usual lately. I suspect it has something to do with increased flexibility on the Chinese side as a reaction to recent fears regarding China’s economy.

In any event, our recent joint venture work has gotten me to thinking about what it takes for a China joint venture to succeed. Based on both our own observations and also on what we hear from others, we view the following four things as key to achieving a China joint venture that works.

1. Make ownership and control clear. Make ownership and control of the joint venture explicit from the very start. Most managers of Chinese companies see the joint venture company as their own property. They are not sensitive to issues of control that arise from percentage ownership interests. It is important to insist that the Chinese side recognize and formally agree to any structure that will result in the foreign partner to a joint venture exercising control over the venture, particularly of day-to-day operations. The foreign party should never assume the Chinese side understands the implications of a joint venture arrangement that flows entirely from purely technical legal rules. If the Chinese side feels it has been tricked or duped into signing away its rights, it will likely take action to “correct” the situation.

2. Do not expect a 51% ownership interest in a joint venture to provide effective control. 51/49 joint ventures are generally a mistake in China. The Chinese see 51/49 joint ventures as fundamentally no different than a 50/50 joint venture and they tend to view legal control afforded by 51% ownership as unfair. As a result, in ventures between Chinese participants where one side clearly intends to exercise control over the venture, a 60/40 or a 70/30 ownership structure is typically used.

Foreign investors that use a 51/49 joint venture structure should not count on their control of the board of directors as giving them control over the joint venture company because the board actually exerts very little control over the operations of the company. The managing director/representative director and the general manager of the company have the actual power to dictate the operations of the company and can act — and usually do — with little or no supervision from the board of directors. Therefore, if the foreign party intends to exercise actual control, it must structure the joint venture so it has the power to control and appoint both the managing director and the general manager of the joint venture company. These persons must be directly responsible to the foreign partner and not to the Chinese partner. If it is not possible to exercise direct control over these positions, then control over the board of directors is of little or no benefit to the foreign partner.

3. Do not proceed with a joint venture formed on a weak or uncertain legal basis. It is very common to find business arrangements in China that are of questionable legality under Chinese law. Going forward with a joint venture in the face of potential illegality may mean that the foreign party cannot enforce its rights in the joint venture because the Chinese courts will not enforce the terms of an illegal joint venture. Because of this, it is a standard strategy for the Chinese side to convince the foreign side to go forward with such questionable ventures. For the Chinese side, there is little or no risk. If the venture fails, the Chinese side has the advantage of having received funds from the foreign venture. If the venture succeeds, the Chinese side simply takes over. If your China attorney is telling you that your joint venture is illegal and your putative joint venture partner is urging you to go ahead anyway, listen to your attorney.

4. The foreign party must actively supervise or participate in the day-today management of the joint venture. If you are not actively involved in the operations of your China joint venture, the Chinese side will likely begin to feel as though it is doing all the work with the reward going to absentee owners. This produces resentment and the desire to take action to restore the “fairness” of the arrangement. Also, when not actively supervised, the Chinese side of the JV will frequently manipulate the JV for its own benefit. Active participation in the management of the joint venture and effective supervision of senior management can prevent such issues from arising. Active day-to-day participation in the management of the joint venture company by at least one senior manager appointed and controlled by the foreign partner is usually required.

No guarantees of success if you do the above, but an almost certain guarantee of failure if you don’t.

As regular readers know, both my co-blogger (Steve Dickinson) and I have written extensively on China Joint Ventures, both here and elsewhere. This is because we find them fascinating, mostly because they are so difficult to make work. Here are some of our previous writings on joint ventures in China that focus on when to enter into a joint venture and how to make one work:

What distinguishes the joint ventures that work from those that don’t?

According to a recent McKinsey article, Avoiding blind spots in your next joint venture, “even joint ventures developed using familiar best practices can fail without cross-process discipline in planning and implementation.” According to McKinsey’s own studies, JVs succeed only around half the time, even though JV best practices are well known:

When we interviewed senior JV practitioners in 20 S&P 100 companies—with combined experience evaluating or managing more than 250 JVs—they estimated that as many as 40 to 60 percent of their completed JVs have underperformed or failed outright. Further analysis confirmed that even companies with many joint ventures struggle, even though best practices are well-known and haven’t changed for decades. In fact, most of our interviewees endorsed several that have long been the gold standard for JV planning and implementation: a clear business rationale with strong internal alignment, careful selection of partners, balanced and equitable structure, forethought regarding exit contingencies, and strong governance and decision processes.

Why do so many joint ventures fail even when the Western company knows what it should be doing to make it succeed? Mostly a failure to follow best practices either initially or later on down the road when the company’s enthusiasm for the joint venture has waned:

Our interviewees suggest that in the rush to completion, even experienced JV managers often marginalize best practices or skip steps. In many cases, the process lacks discipline, both in end-to-end continuity and in the transitions between the five stages of development—designing the business case and internal alignment, developing the business model and structure, negotiating deal terms, designing the operating model and launch, and overseeing ongoing operations. Moreover, parent-executive involvement often declines in the later stages. Finally, many JVs struggle with insufficient planning to respond to eventual changes in risk. Such lapses, even in the early stages of planning, create blind spots that affect subsequent stages and eventually hinder implementation and ongoing operations. We’ll examine each of these issues, along with the approaches some companies are taking to deal with them.

The “rush to completion” is usually due to pressures to “get the deal done quickly.”  How can this be remedied?  “Companies must find ways to balance the pressure for speed with the demands of planning a healthy joint venture—especially allocating their time and resources in line with the potential for value and impact.”

I tend to agree.

If I look back at the China joint venture deals in which my law firm has been involved (and lets throw in the Russian joint ventures and the Vietnam joint ventures that we have drafted as well because why not?), I would say that there is a direct correlation between the time and planning and even difficulty of reaching a joint venture deal and the eventual success of the joint venture.  Put simply, the joint venture deals that were completed in one month are less likely to be standing today than those that took three months.

Why is that?

Joint ventures are incredibly complicated. Just by way of one simple example, who is going to be in charge of hiring, you the American company or the Chinese company? The quick answer is usually the Chinese company, because the Chinese company certainly knows better who to hire in Dalian or in Wuhan than you do. But then what’s to stop the Chinese company from hiring 100 of its relatives or from charging mediocre people for jobs at your joint venture? And if it does that, where do you think all of your profits are going to go? So now that you realize the importance of your having some say in hiring, what say are you going to require? Certainly you do not want to do the hiring, but do you want veto rights? Should you be limited in the number of potential employees that you have the right to decline? What about firing employees? Certainly your position will be different on managers than janitors. Speaking of janitors, are you going to want to limit the number of janitors the JV can hire? The issues on control can be endless, and this is just one of thousands of issues that joint venture partners might resolve before they ink  a deal.

Yet the more issues on which the putative joint venture partners agree before the joint venture is formed, the less room there is for arguments and disputes and wrenches being thrown in the works after the joint venture is formed.

So next time you are ready to kill someone (i.e., your China lawyer) during the third month of your trying to work out a joint venture deal, just remember that every day of delay is probably increasing your chances of the joint venture generating you money, as opposed to falling apart.

What do you think?

Buying a Chinese company?  Looking to do a China Joint Venture?  Looking to use a Chinese company to distribute your product in China?  Licensing your technology?  Just want some good widgets from a reliable China supplier?  Everyone will tell you that before agreeing to anything you should do your due diligence to make sure that your Chinese co-party measures up.

But how do you do that, especially now when it has become clearer than ever that much private investigatory due diligence in China is illegal?

The first thing we do, because it is so easy and so cheap, is to conduct an internet search of the company in English and, more especially, in Chinese.  Doing this sort of search will virtually never be enough to feel good about going forward with a $10 million deal, but it is sometimes enough to persuade you not to do so.

Then do your due diligence the old fashioned way.  Ask your potential Chinese counter-party for relevant documents showing its various registrations and financial condition.  In particular, get its tax returns.

And if your potential counter-party will not turn over what you reasonably seek?  Seriously consider walking away. In our experience, legitimate Chinese companies do not balk at providing documents that reinforce that they are who they say they are.

And if your potential counter-party does turn over the documents you reasonably seek?  Then get someone who truly knows what he or she is doing to thoroughly review those documents.

It is that simple.

What do you think?

UPDATE:  I should have mentioned that it is even more important than ever that you hire the right firms to conduct your due diligence in China.  This means hiring a company with experience in China and, most especially, a company that knows China’s investigatory laws and follows them.

During the first 25 years of China’s opening up process, joint ventures were the favored vehicle for FDI in China. In 2005, the favored form of investment shifted away from JVs to direct investment through WOFEs (Wholly Foreign Owned Entities). During the last year, however, foreign SMEs have been shifting away from WFOEs and back to joint ventures. An even more dramatic shift has seen SMEs decide not to have any direct involvement in China at all. For these companies, licensed manufacturing and sales has become an attractive alternative.

The shift away from WFOEs has occurred because of the worsening environment for small private businesses in China.  Consider just the following in terms of the shift that has occurred in the last ten years:

  • Taxes: In 2003, WFOEs operated in China tax-free. WFOEs are now subject to basic income tax, VAT taxes and a host of local taxes and fees.
  • Wages: In 2003, Chinese wages were some of the lowest in the world. Now, the wage for the average worker on the coast is higher than in Mexico. In 2004, a WFOE could hire and fire workers at will and employ them for as many hours a week as the workers would tolerate. Now, employment is subject to a strict employment contract law system that makes firing workers difficult or impossible and that requires overtime for work in excess of 40 hours per week.
  • Benefits: In 2003, foreign employers could safely ignore paying benefits to their workers. Now, foreign employers are required to pay benefits to both foreign and Chinese employees that amount to almost 40% of the employee wage.
  • Rent: In 2003, rent in Chinese cities was low by world standards. Employers who located outside the major cities often negotiated free rent merely by agreeing to locate in a rural or relatively undeveloped area. Now, free rent is unheard of and rents in general are some of the highest in the world.
  • Environmental and safety regulations: In 2003, a foreign manufacturer could operate in China with minimal concern about environmental and safety regulations. Now, in virtually all jurisdictions, the Chinese authorities require compliance with relatively strict standards.

As this list of major changes shows, the business environment for foreign investors in China has changed dramatically in just one decade. However, many foreign companies that are planning operations in China assume the situation is the same as it was in 2003. It is a nasty shock to most when they evaluate their potential China operation under the current conditions.

Stated simply, many small WFOEs simply do not “pencil out.” However, because China remains an absolutely critical market for countless foreign companies, simply abandoning the China market is not feasible for many. Companies that must operate in China are starting to shift their Chinese investment plans. We are seeing two trends along these lines:

First, joint ventures are experiencing a revival. In the most basic situations, what the joint venture means is that the foreign investor is saying to its Chinese partner: we cannot make this project work by ourselves in China. We need your help. We will provide you with funding and expertise. What we want from you is management and guidance to allow the venture to earn a profit in this difficult environment.

In addition, more complex forms of joint venture are being considered. Two variations we have seen lately are:

  • The foreign company has technology but no money and no ability to manufacture or market anywhere in the world. The foreign company seeks to do a Joint Venture with a  Chinese company that will provide both necessary funding and the support needed to commercialize the product based on the technology. The structures for these China Joint Ventures are complex and are made more difficult by the antiquated and inflexible Chinese laws on joint ventures, financing and IP protection.
  • The foreign company has an existing successful product that it wants to manufacture and then market in China. Licensing is one option. The other is a complex joint venture. As above, the Chinese side of the proposed joint venture is seen not just as a source of manufacturing expertise, but also as a source of funding.
Years ago, my law firm developed a reputation for not liking joint ventures and there was some truth to that.  We did not like joint ventures that were mainly based on the Chinese side claiming that was our client’s only option.  We did not like joint ventures for joint ventures’ sake when there were other, better options for our clients.  We fully recognize that Chinese landscape has changed and whereas six or seven years ago eight out of ten joint venture proposals that crossed our desk did not make good sense, that ratio has probably completely flipped today, to the point that in the overwhelming number of instances, we make no effort to talk our clients out of their proposed joint venture.
The second trend we are seeing is companies abandoning the concept of directly investing in China and instead moving to a contractual approach. We are seeing this especially with foreign SMEs that are determining they do not have the resources to do manufacturing WFOEs in China. Basically, they are determining that Chinese owned factories are better/cheaper at manufacturing in China than foreigners. This includes multi-nationals such as Apple and HP.

In response, the current trend is to work towards purely contract manufacturing (product outsourcing), with no JV and no WFOE involved. This often involves complex IP issues and can also involve complex issues of start-up funding for the Chinese manufacturer. In connection with this trend, the foreign parties are finding that they need to work with their manufacturers to bring up their level of product quality to obtain required certifications such as HACCP and GMP.

Non-manufacturing businesses are also following this trend. In the creative industries, foreign companies are licensing their expertise to Chinese companies who then do the work on the ground. The same approach is taken even where a final product will be produced, such as a magazine or website.  I estimate that my law firm is doing at least five times this sort of work as opposed to just a few years ago and I am seeing the same sort of numbers with China joint venture deals.

This approach also requires complex contracting. In 2004, few foreign businesses had any faith in the enforceability of contracts within the Chinese legal system. This (justified) lack of faith meant that these contract-based approaches to doing business in China were not considered feasible. China’s dramatically improving legal system (at least with respect to contract enforcement where it is now ranked 19th in the world) has made it possible to shift to contract-based approaches to doing business in China. As with WFOEs, many foreign SMEs and their lawyers are not aware of this improvement in the legal system and continue to make their decisions about their China investments based on outdated, 2003 conditions.

Not sure why (the still bad economy?) but my law firm has been getting a rash of China joint venture deals and possible deals over the last six months or so.  Many of these have involved a United States company that wants to enter into a Joint Venture with its China manufacturer so as to work jointly on manufacturing and marketing and selling some combined product or products around the world.

An email from one of our lawyers to a client doing such a China joint venture recently crossed my desk and I am setting it out below because it provides a good introduction to what is involved in “doing” a China joint venture.

There are two steps in forming an equity joint venture in China. The first is to enter into a written joint venture agreement between the Chinese and foreign participants in the joint venture. The second is to formally register the joint venture as a corporation under Chinese law.

With respect to these two steps, please note the following:

a. Since the JV agreement is required, we will move forward with drafting that document first. Issues related to the JV and its structure can be worked out in the process of drafting this document.

b. Please indicate at this time who you will want to use to actually register the joint venture company. There are several options:

  • The Chinese JV partner can be responsible for the registration process.
  • You can engage the services of the local investment development bureau to handle the registration.
  • You can engage our law firm to manage the registration process. If you want to use this option, I can begin working with you to obtain the required    documents and information required for JV company registration.

For the JV Agreement, I have the following questions:

  1. You have provided your desired company name. Please provide that name in Chinese. English versions of company names have no legal effect in China.
  2. Please provide a one or two paragraph statement of exactly what the joint venture company will do in China. In particular, please describe:
  • The proposed facility.
  • If you will manufacture, what will be manufactured and what will be the source of the materials.
  • If you will import, what exactly will be imported.
  • Where will product be sold? In China, for export or both? What entity will handle sales of product.
  • Will any foreign intellectual property be transferred to the JV?

Please note that, in general, Chinese JV companies are free to sell their own manufactured product. A JV company is also permitted to import product manufactured by its shareholder parent. However, in general, it is not possible for a JV company to operate both as a manufacturer and as an importer of product manufactured by companies other than the shareholder. In your emails, you indicate that you desire to obtain approval for what is normally prohibited. If this is the case, we will need to review this issue with the local governmental authorities. If they will provide you with a special approval, you should understand what that is and then make sure that you hold them to their agreement.

Please also note that a primary requirement for company formation in China is that you have a lease on a premises that is approved for the business approved for the company. For a manufacturer, this means a factory, for a trader, this means a warehouse. However, it is also possible to have an initial address that is simply an office in a case where the business plan contemplates later selection of an appropriate factory/warehouse site. Some jurisdictions will permit this, some will not.

Your proposed registered capital is $2,000,000. This means that the Chinese company will need to contribute the RMB equivalent of $400,000 in cash. Are they  aware of this requirement? Do they have the cash? I assume that your group is also planning to contribute cash. As you mention in a related email, it is best from the start to develop a basic plan for contribution of the capital. There should be a basic business plan that provides how much will be contributed, when it will be contributed and for what it will be used.

China’s legal rules for contribution of capital are as follows:

  • 15% of the total amount of the registered capital must be contributed within 90 days after registration approval.
  • The remaining amount must be contributed within two years.

It is common for local governments to impose even stricter requirements and we will need to check with the local government officials on this point. Note that they do not have the power to make the requirement LESS restrictive; they only have the power to make the requirement MORE restrictive.

You asked us how we plan to draft documents that provide for the contingency of your key Chinese counterpart dying.  Since the shareholders in the JV are corporations, the death of any one person is irrelevant to the future life of the joint venture. We will write the JV Agreement to say that your Chinese joint venture partner company has the right to select a single director for the joint venture and that the director will be Mr. ______ at the outset.  However if you believe that the participation of Mr. ______ in management of the JV is critical, you can provide the following:

  1. Mr. _______ agrees to act as a director.
  2. If Mr. ______ is not able to be a director for any reason (refuses to serve, disability, death, etc.), then the foreign shareholder [you] has the right but not the obligation to purchase the stock of the Chinese shareholder. The purchase price will be $400,000, which is the initial amount paid by the Chinese shareholder. It is your choice whether or not you want to add this provision to the agreement. You could also provide the following: in the event that Mr. _______ is not able to be a director for any reason, then 1) all three directors will be chosen by the foreign shareholder but 2) the Chinese shareholder will have a continuing right to 20% of the profits of the joint venture company. I personally prefer the second alternative since it does not require restructuring the stock ownership.

There are a number of alternative ways to deal with this issue. Please consider the options that I have proposed and let me know whether you need additional information in to make your decision on how to proceed.

You are right to ask about dispute resolution.  Dispute resolution should be in China. You can use the Zhanjiang Courts or arbitration at CIETAC in Shenzhen. Arbitration in Hong Kong will be of little to no benefit to you in resolving any disputes because Chinese courts do not recognize their decisions regarding the corporate governance of Chinese companies.  We will need to discuss the pros and cons of Chinese courts and Chinese arbitral bodies.

We also will need to discuss who you will want to be the Representative Director. The day to day business of a Chinese companies is conducted by the general manager, not the representative director. The representative director role is limited to executing important contracts. This can be done by that person without any need to be physically located in China. In any Chinese company with a foreign representative director, there is always a challenge in allocating responsibility between the two individuals. The key issue is usually control of the company seal (“chop”). However, it is always best to appoint officers who are willing and able to travel to China freely. This is not a requirement, but it does make it easier to operate the company.

In answer to your question about scheduling contribution of capital, yes you are correct that it is an important issue for China joint ventures and one that should be resolved before executing the joint venture agreement.

I trust that the above answers your initial questions and lays out a bit of what we will need to be working on over the next few weeks.  If you have any additional questions based on the above, please don’t hesitate.

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?

Not sure why (the bad economy?) but we have been getting a rash of China joint venture deals and possible deals over the last six months or so, many of which involve a United States company wanting to enter into a Joint Venture with their China manufacturer so as to work jointly on manufacturing and marketing and selling some combined product or products around the world.

One of the mistaken assumptions we are finding the American company is making is that it can contribute existing China-based equipment to this sort of equity joint venture (EJV) and receive “credit” for doing so.  Virtually every time, the American company is getting this wrong based on the bad advice of its putative Chinese joint venture partner.

Chinese law mandates that foreign companies doing equity joint ventures contribute a certain amount of capital to the joint venture.  Then, the voting power of each joint venture partner is proportionate to the capital each partner put into the joint venture. Since the foreign partner usually wants to control the joint venture it must contribute more than 50% of the capital to the venture. Since manufacturing operations are usually quite expensive, this means that the U.S. partner must make a significant capital contribution.

To avoid having to come up with the typically very large capital contribution required the U.S. side has been telling us: “We know the capital amount is large. But don’t worry about it, we have that part covered.” When we ask what they mean and what they will contribute as capital to the joint venture, their reply is “the equipment and molds and tooling we purchased and then placed in the XYZ China factory and have been using for the past year. XYZ acknowledges that we own these items and that we can just contribute them to the joint venture at full value. So we have the capital contribution problem already solved.”

Unfortunately, this does not solve the problem at all because China’s rule on foreign contributions to a joint venture (the same is true with respect to WFOEs as well) is that the capital contribution must come into China from outside China for the China Joint Venture.  Under Chinese law, it is very unlikely that the U.S. side has any ownership in equipment and tooling that is located in China. However, even if the U.S. side does actually own such items, they still cannot be contributed to the joint venture by the foreign partner because the foreign side of a China JV is not permitted to use RMB, cash, equipment and other goods, land or intellectual property that is located in China as its capital contribution to the JV. This is a black and white rule and there are no exceptions.

As we note above, the same rule applies to WFOEs in China. It takes an agonizingly long time to form a WFOE in China and we often get contacted by companies that have “jumped the gun” and started their China business operations before forming the WFOE. In doing that, they enter into leases and purchase equipment required for these operations. Consistently, they will want to contribute the lease payments and equipment (or the equipment costs) to the WFOE as a credit to the amount required for their capital contribution. For the same reasons discussed above, this is impossible because those contributions did not come into China from outside China for the WFOE.

For more on what it takes to succeed with a China joint venture, check out the following:

For more on what it takes to form a WFOE in China, check out the following:

Earlier this week, I was talking with a client regarding a potential China Joint Venture (JV).  In our initial conversation, I told him of how difficult and yet important it is to do joint ventures correctly from a legal perspective and of how negotiating joint venture deals can be so time consuming and then had to run off to a meeting.

A few days later, we resumed our call.

In our second call, the client told me that he had since spoken with a high school friend of his, who is the General Counsel for a large international auto parts manufacturer. The client told me that his friend had told him that for a Joint Venture to work in China, the American company would need to be able to have someone in China pretty much all the time to monitor the day to day goings on at the Joint Venture. Without this, said the General Counsel, the Joint Venture would be doomed to fail. The client asked me if I agreed with that and I immediately said “yes.” I then relayed how co-blogger Steve Dickinson and are of of the view that the successful China Joint Venture nearly always involves close monitoring of the joint venture by someone who both knows China and can be 100% trusted by the American joint venture partner. Without that, the chances of a joint venture working out for the American company are slim.

The Foreign Entrepreneurs in China blog recently did a post, entitled, “A Joint Venture Survival Guide. 22 Facts and 22 Practical Tips.” This post includes the need to monitor and a whole lot more. If you are in a Chinese Joint Venture or contemplating entering into one, you absolutely should check out that post, and to whet your appetite for it, I list my five favorites from it below:

  • “The foundations for your success will be laid before you sign the deal.
  • Put in writing what will happen to the JV and to your participation in it if and when things start going wrong.
  • Your potential Joint Venture partner’s “connections” can be a double-edged sword.
  • “Let me guess: your Chinese partner wants to contribute the land to the joint venture.”  I love this one because it is virtually always true and it is virtually always true that your potential partner will value it at more than double its true market value.
  • Your employees will be used to “suck your money away” from you.

For more on China Joint Ventures, I again urge you to check out the Foreign Entrepreneurs’ Post and also the following:

For more on what it takes to succeed with a China joint venture, check out the following:

What do you think?

As regular readers of this blog know, we are not generally fans of China joint ventures. Our view is that if you as a foreign company are not required Chinese law to form a joint venture with a Chinese company in order to accomplish your China plans, you would in most cases (but not all) be better off going it alone. We made our views on Joint Ventures pretty clear in a previous post, entitled, “How We Really Feel About China, Part II: Joint Ventures. We Love Them AND We Hate Them.” In that post, we had this to say about China Joint Ventures:

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 around half 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.

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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.

Over the last couple of months, I have spoken with three people involved in very successful long term China joint ventures (two of these people have been involved in more than one successful and unsuccessful China joint venture) on what it is about their joint ventures that have made them so successful. I have to note, however, that during this same time, the quantity of our work on behalf of Western companies seeking to bail out of failed China joint ventures was a major factor in our recent hiring of two new attorneys (both of whom will be going up on our website as soon as our re-designed website is complete).

Boiling down to their essence what these three people said about what it takes to have a successful joint venture with a Chinese company, I come up with the following:

  • You have to constantly monitor what is going on with the joint venture. Just deferring to your Chinese joint venture partner because “it knows China” is not going to work. Your Chinese joint venture partner may know China, but it almost certainly does not know marketing, production, management, finances, operations or anything much else as well as you do. All three told me that the amount of monitoring they ended up doing was at least double what they expected and all three stressed that if you are not willing to put in the time and money to do this, your joint venture will fail.
  • The Chinese joint venture partner will hold its foreign partners to a “what have you done for me lately” standard. If you are no longer making important contributions to the joint venture, or even if your Chinese joint venture partner wrongly believes you are no longer making important contributions to the joint venture, it will start acting to push you out. The Chinese joint venture partner typically does this by withholding information and by deliberately lowering profits in the short time.

I buy it.  Do you?

For more on what it takes to succeed with a China joint venture, check out the following: