With China’s economy in a downturn and so much uncertainty regarding the future of US/China (and even EU/China) relations, our China business lawyers have of late been seeing a massive uptick in companies looking to do China joint ventures “to share in the risk.” When done right, China joint ventures do share risk. But when done wrong they actually increase the risk, but only for the non-Chinese company. This is part one in a series of posts intended to help you spot China joint venture risks and avoid them.
Fake and Exploitive China Joint Ventures
The first thing you should know is that Chinese companies will often use the false promise of a joint venture to entice foreign companies to provide them with the foreign company’s technology.
Our China lawyers have seen countless exploitive “joint ventures” but most of them start in the same way. The Chinese company convinces a foreign company to do a joint venture and then gets the foreign company to contribute money, technology, or know-how to the joint venture. The Chinese company is put in charge of setting up the joint venture because that only makes sense, right? Wrong.
Instead of actually setting up a joint venture that gives the foreign company an actual ownership stake in the joint venture company, the Chinese side takes the assets from the foreign company but never forms a joint venture. The Chinese company will then either go silent or — if it still needs the foreign company — it will provide it with fake documents showing the joint venture was in fact formed with the foreign company having ownership in it. The foreign company believes it owns part of the China joint venture even though it does not.
Eventually (usually many years later) the foreign company starts getting frustrated about never receiving any money or even news from the joint venture and contacts a China lawyer for help. Our law firm has handled at least a dozen of these matters where our ten minute search revealed there never was a joint venture. The good news is that this sort of thing never happens to foreign companies that use their own qualified China lawyer, as opposed to their joint venture partner’s lawyer or a lawyer not familiar with China. The bad news is that there is usually nothing that can economically be done to help a foreign company in this sort of situation.
In some circumstances it may be possible to sue individuals and companies outside China for fraud but for that to work you need for the foreign country to have subject matter and personal jurisdiction and you need to be able to serve process on the defendants under the Hague Convention and, perhaps most importantly, have some means of collecting on any judgment awarded. Foreign courts generally will deny jurisdiction in a case involving ownership of a Chinese company and even if they did, Chinese courts are not likely to enforce whatever judgment that foreign court renders. All this combines to mean that in most instances the duped party has no good recourse.
In this post, we are going to assume that your Chinese counterpart is legitimate and truly wants to do a legitimate JV with your company. But just because there is good potential for a profitable China Joint Venture and you are working with a putative China joint venture partner that is sincere and honest does not mean doing the joint venture will make sense. Before you do a joint venture with anyone you should make sure the two (or more) of you are truly on the same page regarding what will go into the joint venture and how it will operate once formed.
There is an old Chinese saying that applies to any sort of partnership without a meeting of the minds: “same bed, different dreams” (同床异梦). I applied this saying to China Joint Ventures (I was certainly not the first to do so) in a Wall Street Journal article I wrote back in 2007, titled, Joint Venture Jeopardy:
The much-publicized legal fight between French beverage maker Groupe Danone and its Chinese partner, Wahaha, calls to mind an ancient Chinese proverb often used to describe a bad marriage: “Same bed, different dreams.” Danone accuses Wahaha of breaking contracts and setting up competitor companies; Wahaha denies the allegations. The case is a highly visible test of China’s commitment to rule of law in matters involving foreign business. Whatever the outcome, China’s joint ventures increasingly look like unfruitful unions.
How to Avoid a Bad Joint Venture
How can you avoid a bad joint venture marriage? By putting your dreams to the test before you wed.
China joint ventures are notorious for their high failure rate. Foreign companies too often rush into China joint ventures without ever discussing their respective dreams with their China joint venture partner. The sooner you seek to discern whether you and your potential China joint venture partner share the same dreams, the sooner you will know whether it makes sense for you to keep spending time and money trying to do the joint venture deal.
To help our clients determine whether they have found their dream JV partner, we have compiled a list of questions they should ask their potential Chinese joint venture partner to determine whether there is sufficient commonality to press forward with their joint venture deal.
- What are you seeking to accomplish with our joint venture?
- What will you do for and with our joint venture?
- What will your company do to advance the business of our joint venture?
- What do you want our company to do to advance the business of our joint venture?
- Who will make business decisions for our joint venture?
- What mechanisms will we use for reaching JV decisions?
- Who will control what of our JV?
- Who will make what decisions for our JV?
- What will you contribute to our joint venture, both now and in the future? Property? Technology? Intellectual property? Money? Know-how? Employees?
- What do you expect us to contribute to our joint venture, both now and in the future? Property? Technology? Intellectual property? Money? Know-how? Employees?
- If our joint venture loses money, who will be responsible for putting more money in?
- How will we resolve our disputes? The common Chinese company response will be something like “we will work out any issues among ourselves and if that fails, we will have a special meeting to try to resolve everything. This answer is meaningless. You need an answer that explains exactly how day to day disputes will be resolved so your joint venture does not collapse
- Can either of us use confidential JV information for our own business?
- Can our own businesses compete with our JV?
- Can our own businesses do business with the JV? What is that going to look like?
- How and when will the joint venture end?
- What if one of us wants to buy the other one out?
- How do we end the JV?
If you get answers you like to the above, you keep moving forward. If you get too many answers you do not like to the above, you move on.
How to structure a China Joint Venture
Just as a quick aside: there is a 99.99% chance you will never see a dollar from your joint venture if you use your joint venture partner’s attorney or even any attorney chosen for you by your joint venture partner or you use no attorney at all. If you don’t realize this after reading the below, I don’t even know what more to say.
Many China joint ventures fail because the foreign partner made the fundamental mistake of believing its 51% (or more) ownership of the joint venture gave it effective control over the joint venture. Foreign investors too often assume Chinese joint venture companies are managed according to the common Western corporate model under which a board of directors has controlling power over the company. Since the board is elected by a majority vote of company owners, most foreign investors strive to obtain a 51% ownership interest in their China joint venture. As the majority owner, the foreign investor just assumes it has the right to elect the entire board, and thus effectively control the joint venture company.
After winning the struggle for percentage ownership the foreign investor will frequently give the Chinese side the authority to appoint the joint venture’s Representative Director and the company General Manager. But this concession cedes effective power and effectively renders the foreign investor’s struggle for board control meaningless. The Chinese side will intentionally angle to ensure this outcome, often by offering to concede majority ownership to the foreign investor in return for control over these two key management positions in the joint venture company. If you want effective control over a China joint venture, you must avoid this mistake. If you do not, you will not have control over the joint venture’s day-to-day management.
For you to maintain control over your Chinese joint venture you need the following:
- The power to appoint and remove the JV’s Representative Director. The party that appoints the joint venture’s Representative Director will have significant control over operations. The usual practice of conceding the power to appoint a key officer or director to the Chinese side is a mistake if you want to maintain control over your China Joint Venture.
- The power to appoint and remove the JV’s General Manager. The General Manager is an employee of the joint venture company and that person is employed entirely at the discretion of the JV’s Representative Director. The common practice of appointing the same person as both Representative Director and General Manager is usually a mistake.
- Control over the company seal, or “chop.” The person who controls the registered joint venture company’s 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. For these reasons, the power over that seal should be carefully guarded. Ceding control over it as a matter of convenience is a mistake. There is a long, documented history of this seemingly minor consideration dooming China Joint Ventures.
The Chinese side to a joint venture will usually refuse to agree to these three measures by claiming it is more efficient to have the Chinese side control day-to-day management of the company. The Chinese side will also often claim they cannot bring their political connections, or their guanxi, into play unless their own people act as the joint venture’s Representative Director and General Manager. These claims usually are used to disguise the Chinese company’s efforts to gain operational control over the company and your relinquishing these three control mechanisms to your Chinese counterpart will likely be problematic for you.
Once these three control mechanisms are under the control of your Chinese joint venture partner, you will likely quickly learn that you have relinquished power to run the JV and bad things will likely result. What sorts of bad things? The most common is that you will never see any money from the joint venture. Ever. This occurs because with its control over your Joint Venture your Chinese counterpart can always make sure the joint venture never makes a profit, but his or her company always does.
How can this be achieved? We often see this done by using one of the following two tactics:
- Suppose your Chinese JV partner can make the JV hiring and firing decisions. Now suppose your JV should have 200 employees but your JV partner hires 350 employees, thereby wiping out any profit for the JV. Why though would your JV partner do this and how does your JV partner benefit from doing so? Many reasons. The extra 150 employees can be some combination of 1) relatives who do or do not kick back a good portion of their grossly inflated earnings to your JV partner, 2) strangers who do kick back a substantial portion of their grossly inflated earnings, and 3) friends and relatives of Chinese government officials who are hired to increase your Chinese JV counterpart’s standing and thereby benefit your JV counterpart and its own companies, 4) friends and relatives of whomever else your Chinese JV counterpart wishes to increase his or her or its standing.
- Your Chinese JV counterpart chooses to buy (possibly inferior) products and services at inflated prices from his or her own companies, including from the company that is your JV partner.
Why We Both Love and Hate China Joint Ventures
For better or worse, our law firm has developed quite a reputation for not liking joint ventures and so it is not uncommon for us to get calls from potential clients that start with them saying they know we don’t like joint ventures and then explaining why their doing a joint venture is either necessary or will be different from the ones we write about. Are we losing joint venture legal work because of this reputation or do we get more such work because people believe that if we give their joint venture the go-ahead it really is as good as they think it is. Though we will never know, we can at least try to clear the air. So just to be clear: we like appropriate or necessary China joint ventures but we think it a mistake to consider a joint venture as the default method for entering China.
Of all the China legal work my law firm does, setting up and dismantling joint ventures is probably my favorite. I like it because each joint venture is so different and yet all are intellectually challenging. I also like them because they tend to be one of our most lucrative corporate matters we do. We charge a flat fee for about half our China work, but we always charge hourly for joint ventures because setting up a China joint venture can range from fast and easy to difficult and contentious.
Few joint ventures are fast and easy. A joint venture consists of two independent businesses — one foreign and one Chinese — going into business together. That alone ought to tell you how difficult they can be. The most difficult questions usually center around control. Which of the two companies will control what? What really needs to be done to ensure control? What can be done to ensure neither company goes out of control?
Just to be clear, we love forming joint ventures, but only when they truly do make sense and well over half the time we end up counseling our clients against doing the joint venture. Just today I had the following conversation with a potential client (modified ever so slightly for dramatic effect):
Me: I am not clear from your email about what exactly you want to do with your Chinese manufacturer but it sounds like you want to enter into a joint venture with them and that will almost certainly be a bad idea.
Potential Client: Well, we do want to further solidify our relationship with them and we have been thinking a joint venture might be one way to do that. Why do you think that is a bad idea?
Me: [Jokingly] Did I say I thought it a bad idea? I think it’s a great idea and here’s why. You will pay us anywhere from $15,000 to $85,000 now to set it up — the more you pay us the less likely it is to actually happen. And then the odds are good that in 3-4 years you will pay us another $50,000 or so to shut it down.
I hope I am doing a good job pitching this to you. Do you want to move forward?
Potential Client: I’ll take two.
Our China lawyers also love taking apart China joint ventures that have gone wrong, and again, not because it is in any way a good thing for our clients (who usually are in dire straits when they come to us with their joint venture problems) but because resolving joint venture disputes is like a championship chess game, but at our hourly rate.
The problem with China joint ventures is not China-specific; it is joint venture specific. Joint ventures simply tend too to be a bad way to conduct business. Our international lawyers have seen this up close and personal with Russian joint ventures, Vietnamese joint ventures, Mexican joint ventures, Korean joint ventures, Japanese joint ventures, even a Gambian joint venture. Marketing genius Seth Godin beautifully explains why this is the case in his post, “Why joint ventures fail so often“:
There are two reasons joint ventures fail. The joint part and the venture part.
All ventures are risky, because they involve change and the unknown. We set off on a venture in search of something, or to make something happen –- inherent in the idea of a venture is failure. It’s natural, then, for fearful people on both sides of a joint venture to back off when it gets scary. When given a choice between a risk and sure thing, many people pick the sure thing. So any venture begins with some question marks.
The joint part, though, is where the real problem arises. Pushing through the dip is the only way for a venture of any kind to succeed. The dip separates projects that begin from projects that finish. It’s easy and hopeful and exciting to start something, but challenging and often painful to finish it. When the project is a joint one, the pressure to push through the dip often dissipates. “Well, we only have a bit at stake here, so work on something else, something where we have to take all the blame.”
Because there isn’t one boss, one deliverable, one person pushing the project relentlessly, it stalls.
Every joint venture involves meetings, and meetings are the pressure relief valve. Meetings give us the ability to stall and to point fingers, to obfuscate and confuse. If a problem arises, if a difficulty needs to be overcome, it’s much easier to bury it at a meeting than it is to deal with it.
In my experience, you’re far better off with a licensing deal than a joint venture. One side buys the right to use an asset that belongs to the other. The initial transaction is more difficult (and apparently risky) at the start, but then the door is open to success. It’s a venture that belongs to one party, someone with a lot at stake and an incentive to make it work.
Only one person in charge at a time.
Godin is 100% right.
The Most Common China JV Mistakes
Way back in 2008, co-blogger Steve Dickinson was the legal columnist for one of China’s most prominent English language business publications. As part of his regular monthly gig, Steve submitted an article on how to avoid joint venture mistakes. The censors rejected it and we have always assumed they did so because it would have been detrimental to Chinese companies seeking joint ventures that would greatly favor them.
AmCham Beijing did not have such constraints and it published the article Avoiding Mistakes in Chinese Joint Ventures. It provides a roadmap for avoiding what is probably the biggest and most common mistake that gives Chinese joint ventures such a bad name.
The article starts out by noting that with “the exception of some market sectors, China is remarkably open to foreign investment, and in the past several years WFOEs [Wholly Foreign Owned Entities] have become the most common vehicle for foreign investment, partly due to investor skittishness as stories about past problems with Chinese EJV [Equity Joint Venture] partners made the rounds.”
The article then goes on to note how “thoroughly vetting your joint venture partner” will “dramatically increase your likelihood of success,” but states that most China joint ventures fail because the foreign partner made the “fundamental mistake” of believing its 51% ownership gave it effective control over the joint venture:
Foreign investors too often assume Chinese joint venture companies are managed according to a common Western model, under which a board of directors has controlling power over the company. Since the board is elected by a majority vote of company owners, most foreign investors will strive to obtain a 51% ownership interest in the EJV. As majority owner, the investor then assumes he has the right to elect the entire board, and thus effectively control the company.
After winning the struggle for percentage ownership, as a concession, the foreign investor will frequently allow the local side to appoint the representative director and the company general manager.
Unintentionally, this concession cedes effective power. As a result, the investor’s struggle for board control is rendered meaningless. Frequently the Chinese side intentionally angles to ensure this outcome. We know of cases where an EJV partner concedes on the percentage ownership issue in return for control over the two key management positions in the company.
In order to exercise effective control over a joint venture in China, investors must avoid this mistake. It is necessary to have control over the day-to-day management of the joint venture company.
The article then sets out the following basics for maintaining control over your Chinese Joint Venture:
● The power to appoint and remove the JV’s representative. The side that appoints the representative director will have significant control over operations. The usual practice of conceding the power to appoint a key officer or director to another investor is a mistake.
● The power to appoint and remove the general manager of the joint venture company. It must be made clear that the general manager is an employee of the joint venture company who is employed entirely at the discretion of the representative director. The common practice of appointing the same person as both representative director and general manager is a mistake.
● Control over the company seal, or “chop.” The person who 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 power over that seal should be carefully guarded. Ceding control over it as a matter of convenience is a mistake. There is a long, documented history of this seemingly minor consideration dooming EJVs.
The Chinese side to a joint venture usually will refuse to agree to any of the above three control measures by claiming it is more efficient to have them control day-to-day management of the company. The Chinese side will also often claim they cannot use their political connections unless their own people are the representative director and general manager. You should see these justifications for exactly what they are: red herrings used to disguise the Chinese company’s efforts to gain operational control over the joint venture company.
Relinquishing these three control mechanisms to your Chinese joint venture partner will almost invariably cause you long-term problems because once your Chinese JV partner has these controls you will essentially have relinquished all power to influence your own joint venture. When this happens, your best bet will usually be to either reduce your investment to a minority share or abandon it altogether. Once power over operations is out of your hands, it becomes very difficult to run a successful partnership in China.