May 10, 2019

Common Pitfalls and Practical Advice for Entering a Joint Venture in China

When exploring a joint venture (JV) with a Chinese partner, it is important to consider the legal and cultural differences that may contribute to the success or delay of your project. Below are some common risks associated with forming and operating a Chinese-foreign joint venture and some practical tips on how to successfully navigate those risks.

Due Diligence on Your JV Partner

Action: Conduct careful diligence on a partner, and plan for slower approval processes with a State-owned enterprise.

Evaluating a potential Chinese partner is an essential first step in exploring any JV. Reviewing the potential Chinese partner’s press releases, visiting its facilities and offices, and interviewing its staff members can help you understand its motivations, strengths and weaknesses to determine if it would be the right fit.

The National Enterprise Credit Information Publicity System is also a good resource for conducting preliminary research on your potential Chinese partner. The system contains information on the registration, good standing, administrative enforcement actions and permits of companies registered with the PRC State and local authorities.

If your potential Chinese partner is a Stated-owned Enterprise (SOE), be aware that the SOE’s decision-making process may not be as efficient as with a private company. Chinese law requires special approval processes for investments or transfers of State-owned assets, and the SOE may require multi-level internal approvals, plus approval from its upper-level State-owned Assets Management authority. Anticipate and build those approval processes into the JV establishment and operation timelines.

Negotiation Process

Action: Encourage Chinese partners to involve a lawyer early to avoid last-minute renegotiation.

Negotiating JVs in China can be time- and resource-intensive. It is worth noting that Chinese parties often prefer much simpler and briefer contracts than are common in standard western practice. Ideally, the important structural and commercial elements of the deal should be agreed in a memorandum of understanding or a term sheet early in the process (i.e., from the beginning of negotiations). Once both partners meet, they should discuss the long-term strategy and objectives of the JV.

Many Chinese partners do not involve their legal counsel until the very late stages of the negotiation, either for cultural or budget reasons, or they may send a litigation attorney who is not familiar with JV deals to represent them.

You should urge your Chinese partner to seek support from a corporate lawyer from the beginning of the negotiation to ensure that both parties can speak the same “legal language.” When Chinese partners wait until the eve of the signing ceremony to engage a lawyer to review the transaction documents, they sometimes request to renegotiate the deal terms because they allegedly did not understand the meaning of those clauses. This can delay the deal and cause frustration.

Technology Transfer

Action: Take steps to protect proprietary technology.

Technology transfer by the foreign party is an almost universal element of greenfield JVs in China, and this is where the foreign party’s intellectual property is most exposed. The foreign party should therefore use all available contractual and practical safeguards to protect its IP.

As a practical matter, technology should be segmented and distinguished so that the complete core technology is not exposed to the JV or the Chinese partner. If possible, embody the critical core technology in components or materials produced elsewhere which are sold or supplied to the JV by the foreign party.

As a matter of contract, the foreign party should retain ownership over improvements to the technology, and any technology license should terminate at the same time as the JV contract. Detailed custodial and copy-tracking measures should be created and monitored. The JV should be expressly prevented from disclosing the foreign party’s technology to any subcontractors, consultants, design institutes or the Chinese partner without the foreign party’s approval. Furthermore, all JV employees who may have access to the technology should be trained on protection of the JV’s confidentiality information, and confidentiality and non-compete agreements should be signed with those employees.

Government Relationship and FCPA

Action: Educate your Chinese partner and the JV on the need for FCPA compliance and implement compliance policies.

It is typically a major benefit if your Chinese partner claims that they have a good relationship with the local government, as this normally means the JV will receive government support and approval. However, you should be alert to any Foreign Corrupt Practices Act (FCPA) exposure that may be associated with such a “good relationship.”

Coordinate with your Chinese partner on the entertainment/gift standards of the JV. Giving low value gifts bearing the JV’s logo or moon cakes to the local officials is fine, but any cash, coupons, cigarettes, liquor, sponsorships, trips, entertainment or other benefits may violate the FCPA. The Chinese partner may have a different risk tolerance than the foreign party in terms of commercial bribery, and they may not be familiar with the requirements of the FCPA. Discussing this topic in the JV negotiation process, incorporating anti-bribery covenants into the JV contract and handbook, and providing onboarding and periodic FCPA training sessions to JV employees can help your Chinese partner realize that you are serious about this matter and avoid future non-compliance.

Corporate Governance

Action: Clearly define the decision-making authority of both partners, taking both minority protections and efficiency into account.

The ability to influence the operation of the JV depends largely on the partners’ ability to build trust-based relationships at the working level, the JV board level and even outside the JV with the government or other industry players. Successful foreign partners map out critical stakeholders within and outside the JV (from local management to central regulatory bodies) and assign relationship responsibilities at multiple levels of the organization.

To the extent that control over the business is shared, management structures and functions can be the focus of both contention and cooperation between the JV partners. Both board and executive positions must be allocated between the partners, and their functions and decision-making rules must be carefully specified to establish the balance of power.

If either partner has a majority equity stake in the JV, that partner will usually have clear board control, and the more important negotiating issues will revolve around minority protections for the other partner, such as veto rights. The PRC JV Law stipulates four types of matters which require unanimous board approval:

  1. Capital increases/decreases
  2. Mergers and splits
  3. Amendment of the JV’s articles of association
  4. Liquidation and termination of the JV

Other than these matters, the partners can negotiate additional matters that require unanimous approval. Requiring unanimous board approval for a broad scope of matters can help protect the minority partner’s rights, but it may also slow the JV’s decision-making process and could ultimately trigger board deadlock.

If foreign managers are needed, consideration should be given to the costs involved and to the fact that qualified western managers are often unwilling to work outside of China’s most developed urban centers. Today, experienced multinationals recognize that a successful JV requires credible, high-performing talent supported by strong local teams.

Company Seals – More Important in China Than Signatures

Action: Create policies regarding the custody and use of the JV’s corporate seals.

Following registration, the JV will be issued a company seal (a stamp or seal) that is generally presumed to be definitive proof of the JV’s approval of documents to which the seal is affixed. Other seals might include a financial seal (for tax and bank filings), contract seal (for contract signing), and a legal representative’s seal (for use in lieu of his/her signature). Once the JV’s seal is affixed to a contract, it becomes valid and legally binding on the JV even without any signature from a JV executive. The employee that possesses the company seals effectively has the power to give him- or herself a raise, transfer money from the company bank account or approve a self-dealing contract.

This means careful planning and management of signing authority, signing procedures, seal use records and physical custody of the seals are all critical aspects of internal control of the JV.

Real Property

Action: Conduct due diligence on any land use rights the Chinese partner will contribute to the JV.

PRC law does not recognize private ownership of land. All land is owned by the state or by rural collectives. Collectively-owned land is generally designated to be used for agricultural purposes and can only be used for construction after undergoing a complex conversion process.

Because of historical animosity to private property ownership, China’s land registration and transfer infrastructure are still underdeveloped. As a result, the process of obtaining land and buildings is often fraught with cost and risk. The situation is usually better on China’s east coast, in urban areas and in segregated economic development or industrial zones.

When a Chinese partner says it will contribute the land use rights and building as its capital contribution, before agreeing, you should conduct due diligence on the title, type and conditions of the land use rights and verify they are suitable for construction and operation of the JV’s facilities. It is usually a red flag if the Chinese partner says it cannot find the original land contract, but it has the consent from the local government to use the land for industrial purposes. This may indicate defects with the land use rights, so you should use extra caution and conduct additional diligence.

Responses to Change

Action: Establish an efficient reporting structure to adapt quickly to commercial and regulatory changes.

Once a JV is operational, you should try to manage it as if it were your own, putting in place short lines of reporting from the JV back to the parent company. This is important in any JV to give senior managers the information they need to timely assess the JVs performance. But this is especially critical in China where the fast pace in many sectors requires both partners to react quickly to changes in the marketplace or the regulatory environment. Some of the most successful foreign partners provide for direct reporting lines to their CEOs, whereas others have assigned responsibility for China to a member of their management boards (sometimes with a dual-reporting lines into the regional organization).This efficient arrangement ensures improved cooperation with regulators and therefore faster approval times, as well as more frequent interactions and deeper relationships between the senior management of the parent companies and closer alignment with the mixed management teams of the JV.

Exit Preparation

Action: Prepare for the end at the beginning. Agree early on each party’s termination rights.

Even in developed markets, JVs are often restructured within a decade of being formed. Other than on the limited grounds that JVs cannot be terminated unilaterally by either party, the parties should agree in advance on the range of grounds that might trigger termination. Termination due to board deadlock is an obvious example. Termination can also be triggered if the JV fails to meet certain sales or market share thresholds or to obtain certain quality certifications. Ensure that there are cross-termination provisions in the technology license and the JV contract so that termination of one is grounds for termination of the other.

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