Contemplating a China Joint Venture: Issues to Consider
- Nestor Gounaris, China Solutions LLC
There are several important issues and factors to consider before forming a Joint Venture in China. This article covers critical legal issues with equity and voting rights, operational issues, reasons for forming a China Joint Venture and alternatives.
Joint Ventures in the China Context
There are several platforms from which an investor may operate a business in China. One method is a joint venture (a “JV”). A JV arises when a Chinese investor(s) and a foreign investor(s) own equity interest in the same Chinese limited liability company. The terms and conditions of this shared ownership are set out in the joint venture contract and relevant law. Each investor contributes assets to the JV and shares in its control, operation, risk and profit.
There are a variety of legal and operational issues that arise in the context of a JV that are very different from a wholly foreign owned enterprise (the “WFOE”). A WFOE arises when a Chinese limited liability company is owned solely by foreign investor(s). These issues, if not properly considered and addressed prior to and during the establishment of the JV, can leave the foreign investor exposed to unnecessary risk, and loss of investment control.
Legal Issues
Below are critical legal issues that a potential JV investor should consider:
Equity transfer - If any investor in a JV wants to transfer its equity interest to a non-investor, all other investors must approve and have a right of first refusal in reference to the subject equity. Thus, the transferring investor’s counterparts can block the introduction of a new investor into the JV.
Unanimous approval - Certain fundamental corporate events require unanimous approval from a duly convened board. As a result, if a minority investor’s director(s) are required for a quorum, such directors could block a decision that requires a unanimous vote. Board decisions that require such a unanimous vote include:
(i) amendments to the JV contract;
(ii) liquidation or dissolution of the JV;
(iii) increase, or transfer, of the JV’s registered capital; and
(iv) merger of the JV with any other economic organization or any sale or other disposition of a significant portion of the assets of the JV.
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. Thus, an investor’s ability to leverage the value of the assets in the JV may be severely restricted if all investors are not in complete agreement.
Profit Sharing - Investors of the JV (if an “equity joint venture” or “EJV”) must share profits based upon each respective investor’s equity interest (i.e., contribution to the JV’s registered capital) of each investor. Thus, any imbalance in investors’ contributions to the JV in forms other than registered capital cannot be addressed by adjusting profit distribution.
There is another form of JV called the “cooperative (or contractual) joint venture” or CJV that allows the profits to be divided disproportionate to equity shares. However, the CJV is less common, and has certain drawbacks.
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
Below are critical operational issues that a potential JV investor should consider. Bear in mind that operational issues must be addressed and resolved through the joint venture contract and each investor’s active involvement in the JV.
Accounting - The selection of external and internal accountants is critical for maintaining a real-time understanding of the JV’s state of the health.
Taxes - Active involvement in understanding and ensuring that the JV is properly paying its taxes ensures that hidden liabilities are not accrued due to a controlling investor’s negligence or tax evasion.
Legal Enforcement - Obligations set out in the joint venture contract are only as powerful and effective as an investor’s ability to enforce such obligations. Enforcement raises a host of questions – legal costs, judicial transparency, enforceability of a judgment, etc.. Prevention and fast reactions are much more attractive. Therefore, active involvement in the JV’s operations (e.g., accounting, taxes, purchasing, sales) is critical to prevent material contractual breaches and promptly identify and mitigate contractual breaches.
Non-compete - Investing in a JV may give rise to non-compete agreements between the investors. While on the one hand such non-compete agreements are desirable because it (theoretically) can compel the investors to focus on the JV, monitoring and enforcing such obligations can be difficult at best. Such reality gives rise to the question of whether a JV is desirable.
Obligations of Investors to the JV - Investors will have a variety of 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 contributed 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, the investors should 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.
Why a JV
Although the partnership of a JV has its negative aspects, a JV may sometimes be necessary. In the 80s and up to part of the 90s, Chinese foreign direct investment law required most foreign direct investment to be in the form of a JV. Furthermore, during the same time period China’s economy was not as readily navigable as it is now; inputs, labor, distribution, land use rights, etc. were hard to secure. In sharp contrast, Chinese foreign direct investment law now allows WFOEs in many, if not most, areas of China’s economy. Furthermore, China’s economy is much more navigable and user friendly – even for recently arrived foreign managers of WFOEs. Nevertheless, despite these changes, a JV may still be required if Chinese foreign direct investment law requires the JV structure (e.g., shipbuilding, car manufacturing) or if there is a commercially compelling reason.
Alternatives
If a JV is not necessary, there are various options to consider, such as a WFOE, an offshore parent company with a Chinese representative office, a profit sharing or other commercial arrangement with a Chinese company. The key issue is to take a step back and consider your options prior to jumping into China.
China Solutions LLC offers legal and operational solutions to effectively pursue China-based commercial objectives. Our website is: www.chinasolutions.us.
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