China JV Quality Problems: Time to Increase the Permissible Value of the Foreign Partner’s Brand

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By Chris Devonshire-Ellis

Dec. 26 – 2008 has brought with it an apparently never-ending slew of problematic quality issues from MNC’s with substantial JVs in China, with no signs either that this is set to end anytime soon nor any pointers to the phenomena being industry specific. While international management must also carry part of the blame for this – global manufacturers after all should be on top of QC issues, the fact still remains that the fallout from recalls, law suits or media exposure to problems hurt the MNC image far more than the Chinese partner.

Toyotas recent recall of close to 250,000 vehicles over the past three months from just one of its factories (Tianjin), Mattel’s continuing legal problems in the United States concerning lead paint in China-made toys, and the news that Sanlu, the JV that New Zealand’s MNC Fonterra Group invested in, has just filed for bankruptcy following the melamine milk scandal, indicate partial culpability of behalf of the foreign investors, all of whom one would have thought should have been more prudent in their own QC and production and supply chain due diligence. But have they been guilty of selling their brands short?

Chinese law permits foreign partners to inject “intangible” assets, such as brands, into a China JV. However, the amount is capped and subject to strict approval processes. And, as is typical in China, is a negotiable position. Foreign JV partners must inject at least 30 percent of the total investment in cash – and again, this minimum amount only following specific approval guidelines (usually it is in fact far higher). Of the remaining balance, a maximum of 50 percent can be injected in “intangibles,” which includes the value of the foreign partner’s brand. However, although this sounds high, only on very rare occasions is such a large amount permitted. Most negotiations over the component parts of the total investment will be balanced out by the need for plant and machinery, which reduces in terms of ratio the amount of intangible assets that can be provided as part of the deal. Clearly, the current method of structuring a JV within the existing rules is both convoluted and favors the Chinese party when it comes to brand evaluation as an injectable asset.

The result, understandably, is for executives to concentrate on getting the financials right in the JV structuring, but in doing so, a China risk creeps in. The amount that can be injected in as intangible assets is minimized. That is OK if the JV runs well, and there are no problems. But with all due respect to Mattel’s many JV partners, Sanlu and even FAW, they are hardly internationally famous brands. One doesn’t see FAW badged trucks or cars on the roads in Europe or the United States, but one sees plenty of Toyotas. The impact is that when a China QC problem crops up, if it’s serious, it’s the global brand name that gets the attention, not the Chinese one. Yet in certain industries, the Chinese possess the majority shareholding. It’s no skin off their nose if their partners share price nosedives or sales in other markets diminish due to a China problem, and neither are they compelled to assist or do anything about it. The Chinese liability is restricted to China. MNC’s liabilities and risks are far wider.

There are four ways around the problem and diminish brand risk in doing business with China JVs:

1) Insist on a higher capitalization from the Chinese partner in terms of a new business model perhaps linked to relative sizes of turnover between the MNC and the China entity. A Chinese partner with 1 percent of the total value of an MNC can wreak havoc upon the global MNC if QC problems arise that impact upon the global brand. Or alternatively, don’t JV with partners whose size can effectively diminish your own international standing if problems occur.

2) Contractual agreements that compensate for a percentage of lost global revenues sales if a QC problem that is the responsibility of the Chinese management impacts upon the larger global brand. This may not be financial – it could be equity based.

3) A re-assessment by the Ministry or Commerce over the clauses within Sino-Foreign Joint Venture Laws, and the Company Law, when it comes to the meaningful assessment of values of international brands being injected as part of the commercial arrangement with a Chinese partner. Corporate and diplomatic lobbying could help.

4) A directive from the State Council over getting meaningful awards for damages in Chinese courts against negligence by Chinese businesses to their international partners when such negligence causes damage or loss of reputation or income to the international brand. This isn’t likely to happen anytime soon, however!

Items (2) and (3) however are potentially feasible. During the New Year I will be discussing with the various international law firms in China their comments concerning contractual agreements and the feasibility of this, we’ll be featuring a variety of their answers on this site. Concerning (3), I personally will be bringing the issue to the Legal Committee of Amcham in Beijing for discussion, and then again with the Ministry of Commerce, at the ministerial level, during my annual meetings with government in February. In the meanwhile, readers comments are, as always, very welcome.