Despite the recent economic crisis faced by the world's major markets, China continues to be a relatively safe destination for Foreign Direct Investment ("FDI"). Statistics show that from their popularity in the late 80's, use of the Joint Venture ("JV") structure has declined in favor of the Wholly Foreign Owned Enterprises ("WFOE"). This is a result of both freer markets and the general preference for companies to wholly own and control their management operations in China. However, the use of JVs must not be disregarded as there are other factors to consider when establishing a company in China.
Not only do JVs have the benefit of increasingly few legal requirements but also provide foreign investors with the following: local knowledge, locally established distribution/marketing channels, local organization, industry expertise, cash, and facilities/land. However, such benefits must be weighed against the unfortunate fact that many past JVs which were established with the best of intentions have failed. Although this failure may, in part, be due to cultural differences, poor discussions or negotiations at the outset and the shortlisting of potential partners are largely to blame. Although there are many subtle factors to consider during preliminary discussions or negotiations, it is the author's hope that by outlining some necessary points to consider and advisably include when entering into Joint Venture Contracts ("JVC") will increase the likelihood of success in future JVs
Standard Form Agreements
The local Ministries of Commerce often have standard form agreements, in bilingual English and Chinese. While such contracts act as the base/format from which the signed contracts may start, it is unadvisable to use such contracts without making substantial modifications.
Major Terms of Agreement
Below, we highlight several major (though non-exhaustive) terms which should be included in a Joint Venture Contract:
1. Parties: The parties to the agreement and the Joint Venture should be clearly identified and defined.
2. Business Scope: All companies in China must define their business scopes prior to approval and establishment. While Chinese companies may broadly define their business scope, foreign investors must narrowly define their scope of business. That being said, the Joint Venture should define their scope as widely as reasonably permitted so as to allow for future expansion of operations (and the avoidance of subsequent filings in the future).
3. Total Investment/Registered Capital: Related to business scope and size of operations, registered capital must be a minimum of RMB 30,000 for the most basic (domestic) enterprises. Note that registered capital can be in the form of cash, land, buildings, intangible property, equipment and other assets, however, must be no less than 30% cash. Further, total investment must be capped as a maximum ratio of registered capital, depending on the size of the investment.
4. Party Responsibilities (before incorporation of the company): Generally the domestic party will assume the majority of responsibilities at this stage. For example, generally, the domestic partner will be in charge of making necessary filings with tax authorities, examination and approval authorities, registration authorities, labour authorities, and others.
5. Restrictions on Transfer: Based on the current status of failed and failing Joint Ventures, it is very important to carefully draft this section, allowing for the parties to transfer/purchase shares in the Joint Venture with minimal interruption to operations. Based on the Company Law, it is required that the Joint Venture partner(s) have the first right of refusal when one of its partner wishes to transfer its shares. While this provides a general framework for share transfers, it is prudent to outline the detailed mechanics of such a requirement.
6. Board of Directors: Generally, representation on the board of directors is proportional to the shareholders' equity ownership. Number of directors typically range from 3 to 5, though any number is possible, up to 13. Unless otherwise specified, the board of directors will be permitted to make all major decisions of the company, with unanimity only required by law for the most fundamental issues such as modification of the Articles of Association or dissolution. While this is the default by law, the parties are free to otherwise define the decision-making authority of the board. Typically, a prudent partner will insist on a minimum of several other key decisions which will require unanimous approval of the board, particularly when the investor is in a minority position.
7. Deadlock: It is very possible for Joint Ventures to reach an impasse on certain fundamental issues during operations. When this occurs, it is imperative that mechanisms are in place to optimize the probability of a quick and effective resolution. Further, in the event that resolution cannot be obtained, call/put options should be in place to allow for disposal of the company, and/or dissolution.
8. Operations and Management: Generally, a PRC company will have a General Manager, who is the highest corporate officer. A number of other corporate officers will often then support the General Manager. Typically, the majority shareholder will appoint the General Manager, while the minority shareholder will either appoint the Deputy General Manager or Chief Financial Officer in the company. At the outset, it is important to carefully define the scope of authority of the General Manager, at least for major financial transactions, which may either require consent of another officer or the board of directors.
9. Financial Affairs and Accounting: As the company is to operate in China, it is necessary to comply with China's accounting laws and principles. As a result, the bookkeeping currency must be in Renminbi, while an additional set of books may be kept in the currency of the foreign investor. It is also important to specify that the foreign investor is to be sent a monthly P&L statement, as well as an audited quarterly/bi-annual/annual report.
10. Intellectual Property: It is common for one or both of the investors to license their trademarks and tradenames to the Joint Venture. Although the major terms of such a license will be dealt with in separate agreements, it is important to include this as a fundamental issue for cooperation.
11. Non-competition: It must be stated that the parties may not in any way compete with the Joint Venture. Typically, the language used for restrictions are broad, so it is important to be clear and state any exemptions explicitly, so as to be clear with expectations and avoid potential disputes in the future.
12. Effective Date and Company Term: Although the Joint Venture Contract and Articles of Association may be signed on a certain date, the contracts are not effective until approved by the relevant authorities (the Ministry of Commerce or its local branch). As a result, if the parties consider that the other party may not comply with its obligations under the agreement, it may be advisable to include a liquidated damages provision, in the event of non-compliance prior to approval.
13. Insurance: Chinese companies are very much under-insured due partly to culture and to the developing nature of China's insurance markets and availability of cost-effective products. However, it is important that the shareholders require that the Joint Venture maintain an adequate level of insurance, at least what is common in the relevant industry.
14. Termination: Given the number of failures of Joint Ventures, it is important for shareholders to define what breaches allow for termination of the contract and the corresponding rights on termination.
15. Arbitration: As Chinese courts are often uneven, particularly in lesser-developed areas, we often advise clients to select arbitration as the method of dispute resolution. Arbitration can be conducted in China or internationally (in any New York Convention signatory state), though domestic arbitration allows access to Chinese courts for injunctive relief.
16. Applicable Law: Joint Venture contracts must be governed by the law of China.
17. Language: The controlling language of the contract may either be English or Chinese.
18. Conflicts: In such long documents, it is very possible that there may be conflicts between the Joint Venture Contract and Articles of Association. Typically, the parties to a Joint Venture spend the majority of time negotiating the Joint Venture Contract, with the Articles being an afterthought to the Contract. As a result, it is typical to state that the Joint Venture Contract will govern in the event of conflict with the Articles of Association.
Although the importance of negotiating and concluding a foolproof contract is well known, it is also equally, if not more, critical to ensure that there is supervision and enforcement of the agreed upon terms. More importantly, it is necessary to keep in mind that as this is a real business in China, its operations cannot be successful without real on-the-ground managers representing the interests of both parties. This requires regular time, especially by attendance of meetings, to be invested by the management of the Joint Venture. Too often do we see foreign Joint Venture partners, especially foreign investors, rely wholly on reports and directors' meetings for insight and management, rather than observing firsthand the day-to-day operations.
Gregory M. Sy is Of Counsel with Grandall Legal Group. His practice includes general corporate/commercial work in China, particularly in the areas of international corporate structuring and transactions. Representative clients include the Consulate of the United States of America in China (Shenyang), Embassy of Brazil, various publicly listed companies (NYSE, AIM, DAX, BSE), along with numerous other SME's operating in a wide range of industries. Mr. Sy obtained an LL.B. from the University of Victoria (Canada), and is admitted to the New York bar. Gregory publishes extensively on a variety of China legal issues for international and local publications, and has recently acted as chief editor for Martindale's China Law Digest and regularly contributed to Lexis-Nexis.
