Sanctions designations should not affect enforcement of pre-existing third-party rights
Out-Law Guide | 22 Dec 2011 | 9:12 am | 5 min. read
Joint ventures in China – as elsewhere - are notoriously difficult to manage successfully. With control shared between often commercially competitive shareholders, the opportunities for conflict are rife.
However, China's strict commercial laws mean that joint ventures often have to be entered into despite the risks. In certain sensitive economic sectors, wholly foreign-owned enterprises (WFOEs) are not permitted. Foreign companies operating in these sectors have to choose between investing through a joint venture and not investing at all.
Not all joint ventures are compulsory. Sometimes foreign investors enter into joint ventures for economic or strategic reasons: in order to share risks, costs and resources, or because a particularly influential Chinese partner insists on it. In the acquisition context in particular, Chinese sellers are often unwilling to sell 100% of their equity in the target. Since Chinese sellers can't yet easily take equity in foreign acquirers as a condition of the sale, partial acquisitions are increasingly common.
Given the ongoing use of joint ventures, it is important actively to manage their risks and shortcomings. This guide gives some suggestions to successfully manage joint ventures in China.
Because there are so many risks, joint ventures should only be entered into if truly necessary. Potential investors should actively explore any reasonable alternatives, such as creating a WFOE, early in the planning stage. In restricted sectors this might mean licensed manufacture onshore or establishing a WFOE in a related unrestricted sector to manage production. In the acquisition context, it could mean considering alternative ways of paying the target shareholders in shares.
However foreign exchange, accounting and tax rules inevitably create problems for anything other than the most standard investment and transaction practices. Indirect, exotic or unnecessarily complex structures should be approached with caution.
Focus on long-term competition
Joint venture partners are often potential competitors. It often happens that foreign investors lose whole product markets to previous joint venture partners. Perhaps the greatest general long-term risk for foreigners in Chinese joint ventures is the risk of establishing or enabling a competitor. It is therefore important to evaluate all aspects of the agreement in this light.
Know your partner's motives
Unless the Chinese partner's active participation is necessary for operational reasons, the best partner is a sleeping partner. Unfortunately, this is all too rare. Chinese partners' reasons for entering into joint ventures rarely begin or end with a profit motive – their motives are usually also strategic. In addition to profits Chinese partners gain technology, know-how and, ultimately, new products or processes. In this sense, their motives are often at least as much competitive as they are collaborative. If the Chinese partner will continue producing related products alongside the joint venture, or is the member of a state-owned group company, the competitive risks are even bigger.
It is also essential to investigate your potential partner's records thoroughly in regards to reputation, bribery and anti-corruption policies and any track record of regulatory non-compliance.
Define products and markets
It is critical to carefully and clearly define the joint venture's products and markets. This will help both parties to identify any overlap with each other's products and markets, and to specify any obligations of the parties not to compete with the joint venture.
It is also often appropriate to demand non-compete commitments from the Chinese partner, preventing it from producing the joint venture products after the agreement has ended.
Calibrate technology transfer
Technology transfer of some type is an almost universal element of greenfield joint ventures in China. Of course, this is the point where a foreign investor's products are most exposed. All available contractual and practical safeguards should therefore be used. As a practical matter technology should be segmented and distinguished so that the complete core technology is not exposed. If possible the critical core technology should be embodied in components or materials produced elsewhere which are sold or supplied to the joint venture by the foreign party.
As a matter of contract, you should retain ownership over improvements and the technology transfer contract should end at the same time as the joint venture agreement. Detailed custodial and copy-tracking measures should be created and monitored. The joint venture should be expressly prevented from disclosing the technology to the Chinese partner - or to subcontractors, consultants and design institutes - without approval.
All relevant employees should be subject to confidentiality and non-compete agreements.
Focus on IP
Most first-time foreign investors in China have not already registered their trademarks there before they invest. At best, they tend to do this once investment planning or negotiations begin in earnest. Since China is a strict first-to-file jurisdiction, a trademark must be registered before anyone else can do so in order to enjoy exclusive use rights of the mark. Trademark 'squatting' is quite common, with domestic parties registering foreign marks then offering to sell them to the original users. Both company and product brand names should be registered in all relevant industry classes, in Chinese and English, at the earliest opportunity - even in advance of market entry.
To the extent that control over the business is shared, management structures and functions can be the focus of both contention and cooperation between joint venture partners. Both board and executive positions have to be allocated between the partners and their functions and decision rules will have to be carefully specified to establish the balance of power. If either partner has a substantial majority of equity, it will usually have clear board management control and the more important negotiating issues will revolve around minority protections such as veto rights.
If foreign managers are needed, due 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 centres. To maintain actual management control it is critical to appoint the general manager and company legal representative.
Commit to the process
Joint ventures are complex entities and the negotiation of them is a time and resource-intensive process. This process cannot be completed without a real commitment of management resources by the parties. Ideally the important structural and commercial elements of the deal should be agreed in a memorandum of understanding early in the process. Dedicated working groups should be established by both parties, and senior management should be kept aware of progress and available as required to decide on issues as they arise.
Several months and numerous rounds of negotiations and drafting are often required to reach agreement, particularly where both parties are actively engaged in the process. Even so, you should be prepared to walk away if it becomes clear that you cannot get what you need out of the arrangement.
Negotiate rigorously but flexibly
It is always advisable to begin negotiations based on dual language standard contract precedents. This will ensure the comprehensive treatment of all the standard structural and operational issues, and also provide a solid framework for any necessary variations. Chinese parties often prefer much simpler and briefer forms than is common in standard western practice. Nevertheless, Chinese parties tend to have a keen instinct for risk and will aggressively negotiate material aspects of detailed long-form contracts.
Prepare for exit
Other than on very limited grounds joint ventures cannot be terminated unilaterally by either party - only by agreement. The parties should therefore agree the range of grounds that might trigger termination in advance. Termination because of a deadlock is an obvious example. Termination could also be triggered if the joint venture fails to meet certain sales or market share thresholds, or to obtain certain quality certifications.
Foreign partners should ensure that there are cross-termination provisions in the technology transfer and the joint venture contract, so that termination of one is grounds for termination of the other. Transfer rights and restrictions are also critical.
Foreign investors in restricted sectors, who are entering into a joint venture only because they must do so for legal reasons, should also expressly include the right to buy out the domestic party once foreign majority shareholding or WFOEs are permitted in that sector by policy.
Sanctions designations should not affect enforcement of pre-existing third-party rights