China Joint Ventures: Negotiating the Contract

November 18, 2009 Posted by China Briefing Reading Time: 6 minutes

Part Five in our “Joint Ventures as a Strategic Investment” series

By Chris Devonshire-Ellis and Richard Hoffmann

Nov. 18 – Joint ventures by their very nature are intensely idiosyncratic creatures, differing so much depending on circumstances that the area of contractual negotiations is really best dealt with professionally on a case by case basis. They also attract a great deal of opinion; however often this is simply put, and relates to just one experience, good or bad. In dealing with Joint Ventures however our firm over the years has established numerous such entities and the comments below are taken from a median pool of JV experience, dictating what tends to work best. However this may not be applicable to all circumstances.

In providing these basic guidelines, we also make the assumption that the joint venture partner has been fully subjected to proper due diligence tests, and that his business integrity has been assured as much as possible especially in the financial due diligence modeling.

Equal equity positions
We are not big fans of equality in equity for JVs. We have seen too many eventually grind to a halt because a decision cannot be effectively taken. Depending upon the circumstances, the actual future business performance of the JV needs to be taken into consideration as primary objective, not necessarily the ownership of the company. Can the company reach its objectives without the foreign partner exercising full control? If so, then the equity issue assumes less significant status, yet many lawyers insist of dangers within. Concerns over the management of the company at such a juncture in our view demonstrate a lack of trust or knowledge of the partner – indicating insufficient due diligence has been undertaken.

If the local management of the business has stood up to due diligence testing, and the primary goals of the JV do not require a majority shareholding, then there is no reason to insist on 50-50 ownership.

The role of the chairman
The chairman is regarded as the figurehead; however in JVs where the equity is equal, deciding votes can be cast by him when the equity voting rights have demonstrated a division of opinion at the equity and board level. Our comments above apply; the very nature of the JV comes into question. If the JV relies on the Chinese domestic market for its performance, it makes sense for the chairman to fulfill his role as a local Chinese “ambassador” for the company. Having such stature may well assist him in complicated local business decisions or contractual negotiations with third parties. On the other hand, should the primary sales be overseas markets, then the question of who initiated these crops up. The role of the chairman, in our experience, should he be in a position of final say should reflect the balance of the strategic value of the business. If that value is on the Chinese side, it makes sense to appoint the Chinese partner as chairman. If not, then the foreign investor should take precedence. It is possible to rotate the roles, and have chairman from either side sitting in for say two years periods in a revolving chairmanship, however, we have never seen much added value in such arrangements. But if it helps solve the 50-50 equity position it may be a suitable solution.

The role of the general manager
The GM is a powerful position in the JV and often effectively controls the company. Attention to detail must be paid to the quality of this candidate and to the contractual terms of their employment, which are often detailed in the JV contract itself as well as by the labor law. The role is usually technical and, given the control the GM wields, carries with it a political aspect. We prefer the GM to either be a highly trusted local qualified Chinese national known to the foreign investor, or preferably a hire from the foreign investor.

Other managerial positions
In larger JVs, politics and temptation invariably raise their heads. Foreign investors should either appoint local management known to them in key positions such as procurement, sales, HR, finance and accounting, and even warehousing, or have competent company personnel on hand to inject into these positions. At a minimum, regular checks on each of these aspects of the business management should be conducted by an outside agent. It is relatively common for related persons to be injected into the supply chain and for the JV to purchase equipment at inflated prices above market norms, to the Chinese partners benefit. Such procurement matters need to be regularly tested, as do sales and inventory monitoring and consolidation.

Dispute resolution
This is always a matter of debate amongst lawyers and also within the JV contractual negotiation. In some industries such as shipping or maritime, arbitration can be fixed with a specific Chinese arbitration body. However, in most cases, the contractual parties are free to decide. Problems have occurred in the past with arbitration in China being partial to the Chinese partner; though in reality, such cases are rare. It does make sense for disputes generally to be heard in China if the JV is based there and the business operations are concentrated in China. However the foreign party may require arbitration overseas or to international standards.

By way of a compromise, we usually will recommend arbitration be heard by the Chinese International Chamber of Commerce, which is based in Beijing. The CICC is part of the International Chamber of Commerce, headquartered in Paris, and follows arbitration guidelines to international standards.

Employment of staff
It is important when inheriting staff from the JV partner that these are assessed for suitability and labor law contractual issues. Employees can carry with them termination liabilities not from the date they joined the JV, but backdated from the date they originally began work for the Chinese partner. This can have serious implications in terms of inherent liabilities if downsizing is required later. Also to be checked off are issues pertinent to their pension funds and so on if these have previously been administered by the Chinese partner. You don’t want to inherit any problems with staff acquisition.

Exit strategy
Businesses can and do go wrong, and it is sometimes necessary to admit defeat and exit. Usually this will be sales related, so it makes sense to instigate a liquidation trigger clause into the contract by linking the performance of the company output, which is also part of the contractual agreement, to the exit clauses. If production or profitability fall below a certain level, then the liquidation clause can, if required, be enacted.

Professional advice
These are just some of the contractual and managerial issues that need to be addressed when considering a joint venture in China; they vary depending upon each specific case. A good professional firm will be able to discuss all the issues with you, assess what needs to be checked through, and allocate dedicated on-the-ground staff to look into the specific contractual implications, assess these against known due diligence modeling and report back. Successful foreign investors understand this and get it right. We also do not recommend using any services firm that subcontracts out such legal and advisory work and only recommend using firms with a proven track record in handling joint ventures and with applicable resources and offices in China.

Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates and lived in China for 21 years. He has over 17 years of experience in establishing JVs in China. He is now based in Mumbai.

Richard Hoffmann is a senior associate of Dezan Shira & Associates and has seven years experience of foreign direct investment in China. Richard also writes for the Legal Ease column on the Beijing Review, China’s only English national news magazine. He is based in Beijing.

To contact Dezan Shira & Associates’ business advisory services division for JV advice and other corporate establishment issues email info@dezshira.com.

China Joint Ventures Part Two: Legal Due Diligence

China Joint Ventures Part Three: Financial Due Diligence

China Joint Ventures Part Four: Understanding the Intangibles

China Joint Ventures Part Six: Moving Joint Venture Contractual Liabilities Out of China – coming next week

China Briefing Books:

Setting Up Joint Ventures in China (available in hard copy and PDF)