China

China Joint Ventures: You Are Not in Kansas Anymore

Many foreign investors still choose to enter the Chinese market through an equity joint venture, and the particular risks involved with this type of arrangement require careful planning.

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You can invest in China on your own by forming a Wholly Foreign Owned Entity (WFOE) or by partnering with an existing Chinese business through some form of joint venture. China is fairly open to foreign investment and in the past several years WFOEs have become the most common vehicle for foreign investment, partly due to investor skittishness as stories about past problems with Chinese equity joint venture partners have made the rounds.

Yet many foreign investors still choose to enter the Chinese market through an equity joint venture, and the particular risks involved with this type of arrangement require careful planning.

One way to reduce your risk is by thoroughly vetting your potential Chinese joint venture partner ahead of time. Another way is by making sure that if the joint venture deal goes through, you control the joint venture’s levers of power.

Chinese joint ventures are formed as limited liability corporations under PRC company law. The fundamental issue in forming such an entity revolves around which party ultimately controls company operations. Since most foreign investors wish to maintain control over the Chinese joint venture entity, this issue is usually paramount.

Yet foreign investors frequently make a fundamental mistake that effectively leaves them without control—a mistake so critical that it accounts for most of the failed equity joint ventures in China. The mistake is assuming that Chinese joint ventures are managed according to a Western model, under which the board of directors has controlling power over the company. Most foreign investors therefore strive to obtain a 51% ownership interest in the equity joint venture, assuming this gives them the right to elect the entire board and thereby control the company.

After winning the struggle for percentage ownership of the joint venture, foreign investors will frequently allow the Chinese side to appoint the equity joint venture’s two key management positions, the Legal Representative and the General Manager. But these “concessions” are all part of the Chinese side’s plan, and effectively render board control meaningless.

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Control over a Chinese joint venture actually comes from the following:

  • The power to appoint and remove the JV Legal Representative.
  • The power to appoint and remove the General Manager of the joint venture company. The joint venture agreement must make clear that the General Manager is an employee of the joint venture company employed entirely at the discretion of the Legal Representative (whom you have the power to appoint and remove).
  • Control over the company seal, or “chop.” The entity that controls the registered company seal has the power to make binding contracts on behalf of the joint venture company and to deal with the company’s banks and other key service providers. The annals of history are filled with foreign companies getting shut out of their China joint ventures after losing control of the seal.

The Chinese side to a joint venture will typically refuse to the foreign party getting the above three measures of control. They will argue that they should control the joint venture for reasons of both efficiency and expertise. In many cases, they will also contend that they cannot bring their political connections, or guanxi, into play unless their own people fill the Legal Representative and General Manager slots. This argument is usually just a smoke screen for the Chinese side trying to secure the true levers of joint venture control. For more on the difficulties of China joint ventures, check out How We Really Feel About China Joint Ventures. We Love Them AND We Hate Them.

Using a Chinese lawyer or a “China consultancy” increases your risks. Chinese lawyers are not bound by the same duties of loyalty as American lawyers and it is not at all uncommon for them to work on behalf of your Chinese counterpart to get the joint venture deal done. This is because the Chinese lawyer is getting paid by the Chinese company or simply because the Chinese lawyer knows he or she will make more money if the joint venture deal goes in that direction. We are aware of consultancies that represent American and European companies on joint ventures while getting a percentage of the deal from the Chinese side if it goes through.

If you want control over your China joint venture, you must follow the rules set forth above. Otherwise you might find yourself in a venture with no legal right to guide it.

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You have been warned.

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