Introduction
There are several structures through which an investor can establish a business platform in China. One structure is a joint venture (a “JV”), which arises when a Chinese investor(s) and a foreign investor(s) own equity interest in the same Chinese limited liability company.
There are a variety of legal and operational issues that arise in the context of a JV that are very different from those that arise in the context of a wholly foreign owned enterprise (a“WFOE”)*. These JV-related issues, if not properly considered and addressed prior to and during the establishment of the JV, can leave an investor in the JV exposed to unnecessary risk, and loss of investment control.
Regulatory Issues
Set out below are some critical regulatory issues that a potential investor in a JV should consider.
Equity transfer If an investor in a JV wants to transfer its equity interest to a non-investor, all other investors in the JV must approve such transfer, and also enjoy a right of first refusal in reference to such transfer. Thus, the transferring investor’s counterparts can block the introduction of a new investor into the JV (and, correspondingly, the exit strategy of the current investor).
Unanimous approval Certain fundamental corporate events must be approved by a unanimously and duly convened board. As a result, if a minority investor’s director(s) is required for a quorum, such director could block a decision that requires a unanimous vote. Decisions that require a unanimous vote include:
(i) amendments to the JV contract or articles of association;
(ii) liquidation or dissolution of the JV;
(iii) increase, or transfer, of the JV’s registered capital; and
(iv) merger of the JV or sale or other disposition of a significant portion of the JV’s assets.
Pledge of equity interest Equity interest of the JV cannot be pledged without the approval of all investors. A pledge refers to the use of property ownership as collateral for debt, much like a mortgage.
Profit sharing Investors in the JV (if an equity JV**) must share profits based upon respective equity interest (i.e., contribution to the JV’s registered capital). Thus, any imbalance in practical or actual contributions to the JV in forms other than registered capital cannot be addressed by adjusting profit distribution.
Board appointment Board appointment is proportionate to equity interest. Thus, board control will be directly proportionate to each investor’s share of the registered capital.
Operational Issues
Set out below are some critical operational issues that a potential investor in a JV should consider. Bear in mind that operational issues must be addressed and resolved through the JV contract, articles of association and through each investor’s active involvement in the JV.
Accounting Selecting, understanding the work practices and understanding the work product of the external and internal accountants are critical for maintaining a real-time understanding of the state of health of the JV.
Taxes Active involvement in understanding and ensuring that the JV is properly paying its taxes (including employee-related social insurance contributions) ensures that hidden liabilities are not accrued due to different practices or standards of behavior of each investor.
Legal enforcement Obligations set out in the JV contract are only as powerful and effective as an investor’s ability to enforce such obligations. Enforcement raises a host of considerations – legal costs, judicial transparency, enforceability of a judgment.
Incentives, prevention, ongoing monitoring, and fast reactions are much more attractive than enforcement; therefore, active involvement in the JV’s operations (e.g., accounting, taxes, purchasing, sales) is critical to prevent material breaches and to promptly identify and mitigate contractual breaches.
Non-compete Entering a JV (and given the amount of intellectual property that may be shared by the investors) may give rise to non-compete agreements between the investors. While on the one hand such non-compete agreements are desirable because they (theoretically) can compel the investors to focus on the JV, monitoring and enforcing such obligations can be difficult at best, which gives rise to the question of whether a JV is an appropriate structure.
Obligations of investors to the JV Investors will have obligations relating to the JV, ranging from investing registered capital to overseeing the establishment and approval process of the JV. It is critical to ensure that obligations are assigned in a relatively balanced manner so that no one investor far exceeds the other in terms of making contributions to the JV.
Contract approval In order to ensure the transparent operation of the JV, investors can require that material or critical contracts of the JV be jointly approved or at least that all investors are timely notified of such contracts prior to execution. This should be coupled with corresponding language in the JV contract, articles of association and other relevant corporate documents.
Seals and corporate document protocols, access Company seals (i.e., company chops) as well as original corporate documents (e.g., business license) are critical items in maintaining corporate control. Significant thought should be given to how control of these items will be shared, and how the access and use of such items will be properly recorded.
Alternatives
Although the partnership of a joint venture has its negative aspects, a JV may sometimes be mandatory or the only option available.
In the 80s and 90s, China’s foreign direct investment regime required most foreign direct investment to be in the form of a JV. During the same period China’s economy was still quite restricted, meaning inputs, labor, distribution, land use rights, etc. were hard for foreign investors to access. In sharp contrast, in 2012 the foreign direct investment regime is (comparatively) much more liberalized and China’s economy is more accessible. Therefore, the WFOE structure is much more feasible.
Nevertheless, despite these developments (and despite a strong preference for the WFOE structure by most foreign investors), a JV may still be necessary if Chinese foreign direct investment law requires the JV structure (e.g., shipbuilding, car manufacturing) or if there is a commercially compelling reason.
If a JV is not necessary, there are various options to consider, such as a WFOE, an offshore parent company with Chinese representative office, a profit sharing or other commercial arrangement with a Chinese company. It is important to take a step back and consider your options prior to selecting a specific structure.
* A WFOE arises when a Chinese limited liability company is owned solely by a foreign investor(s), without the involvement of a Chinese investor(s) **An agreement between companies to enter into a separate venture together
©2013 All rights reserved by the original copyright holder. The contents of this article are intended to provide a general guide to the subject matter and should not be treated as a substitute for specific advice concerning individual situations. Readers should seek legal advice before taking any action with respect to the matters discussed herein.
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