Buying Out Your JV Partner – Keep Cash On Hand, Just in Case

September 14, 2010 Posted by Chris Devonshire-Ellis Reading Time: 5 minutes

Op-Ed Commentary: Chris Devonshire-Ellis

Sept. 14 – China’s recent judicial interpretation of FIE disputes has resulted in some commentary over matters relating to the purchase of stock by partners in joint ventures. Generally speaking, in JV contracts, a right (which should be further embellished in the articles) in which the partners have the ability to purchase each other’s shares is recognized. A simplistic clause dealing with this typically reads: “Any parties wishing to transfer all or some of its investment to a third party must obtain the other parties approval and submit an application to the relevant authorities. The other party should have a priority in buying such equity.”

The issue concerning the recent judicial interpretation however goes on to clarify the position insofar as much that should the opposite party decline the purchase of shares, the selling party then has the right to sell elsewhere to a third party. Some comments have expressed surprise and concern over this, suggesting that it places the foreign partner in a potential position to have to immediately buy out the selling party’s shares or face the threat of sale to a potential competitor. However, this right has always in fact been understood to be in position, and has been since the original JV rules were introduced in July 1979. (For clarification, it should be noted that the equity JV “Law of the Peoples Republic of China on Sino-Foreign Equity Joint Ventures” was promulgated on July 1, 1979, while the “Law of the Peoples Republic of China on Sino-foreign Cooperative Enterprises” (contractual or cooperative joint ventures) was promulgated on April 13, 1988, using much of the original EJV structure as its basis).

So is there anything really new here? Not a great deal, other than it clarifies a 30 day period in which the shares on offer must be accepted or declined for purchase by the opposing party, or the right to sell exclusively to the partner is voided and can be offered to third parties. While the 30 day period may appear small, in reality, most negotiations over value and assets take considerably longer. It would be highly unusual for the government to ride roughshod over a foreign investor’s rights and permit a sale without allowing a reasonable amount of time for negotiations to take place. A legal challenge, citing “reasonable grounds” would almost certainly be raised to block such an action and would have a high chance of success. It is far more likely an extension to the 30 days be mutually agreed upon, and I have never come across nor heard of a case where an investor was forced to make a purchase after just a 30 day warning over pending sale of equity.

However, the issue of forcing the foreign partner to purchase does take on some significance, especially if presented with an essential fait accompli whereby negotiations have already taken place with a third party and a purchase price agreed. In such circumstances, the opposing partner is faced with little choice than to almost immediately respond. The judicial review then does potentially provide the Chinese side with leverage to spring a surprise and require the foreign partner to buy them out. However, it must also be mentioned – conveniently forgotten in certain “shock horror” China legal commentary – that the same also applies in reverse. It may also be noted that such actions – “unfriendly take over bids” being one just related example of this – are also not uncommon in the United States or Europe. It is therefore unreasonable to expect that foreign investors in China may indefinitely block a sale of equity by their China partners, even if they are reluctant to allow it to occur.

In our experience, the practical aspect of the judicial clarification doesn’t change the game plan very much and neither is it intended to. It merely sets a 30 day rule for the share acquisition to take place. However, that is also a negotiable point between partners and may be (and usually is) mutually extended until a deal can be hammered out. While it is possible that an unwanted or unexpected purchase of a Chinese partner’s shares could be foisted upon a foreign investor under threat of sale to a competitor instead, the inherent relationship, not to mention complexities that should exist elsewhere within the JV contract and articles over non-compete and related clauses, should mitigate against the sale to a competitor.

However, surprise acquisitions of another party’s shares can indeed occur. In one case handled by our firm several years ago, a sale was forced upon the foreign investor of a large JV when it was adjudged by the local Government that the Chinese investing partner had in fact stolen their capital contribution injected into the JV from a state-owned enterprise. That SOE had no intention (or business) of acquiring a stake in the JV, and purely wanted its money back. The foreign investor was expected to come up with it, and in return, equity provided. Add the police into the mix and it was quite a legal adventure. That deal was concluded after much to-ing and fro-ing and checking the legalities in five months (a similar original 30 day notice had been imposed), and while the head office had to stump up some fairly significant cash on short notice to do so, the deal was concluded and the business moved on as a WFOE.

As always in China, surprises can happen, and with JVs, it is always possible (in fact likely) that a cash demand could occur out of the blue. In terms of this affecting equity though, most sensible foreign investors in JVs recognize that other contractual issues over exclusivity clauses, anti-competition clauses, industrial relations and the continuing goodwill of the business will negate an expensive acquisition at short notice under threat. The specter of Chinese partners springing surprises on unwilling foreign partners to buy them out at 30 day’s notice or face equity sale to a competitor therefore remains, in practice, somewhat remote.

Chris Devonshire-Ellis is the principal and founding partner of Dezan Shira & Associates, establishing the firm’s China practice in 1992. The firm now has 10 offices in China. For advice over China strategy, trade, investment, legal and tax matters please contact the firm at info@dezshira.com. The firm’s brochure may be downloaded here. Chris also contributes to India Briefing , Vietnam Briefing , Asia Briefing and 2point6billion

The firm has also extensively contributed to the following publications on Sino-foreign joint ventures: