Last week, I wrote about how Chinese companies use fake investment scams to trick foreign companies into turning over their IP. This post goes into additional detail regarding the China fake investment scam, but it also goes beyond it to ecompass the various IP theft schemes our China lawyers have been seeing in the last couple of years.
That post generated a surprising number of emails from readers wanting to know more about these scams, especially who is getting hit with them and exactly how it is that they go down. This post is a response to those emails.
The era of large scale “take over” type Chinese investment in foreign companies is mostly over. However, our China lawyers still see a lot of interest in smaller investments from China in U.S. and EU companies involved in emerging technologies. Though it is possible this interest from the Chinese side is completely legitimate, much of the time that is not what we are seeing. What we usually see is what our China attorneys have taken to calling “free look schemes”. My previous post focused exclusively on what we call the fake investment scam.
1. Fake Investment Free Look Schemes
The free look investment scheme usually applies to when a Chinese company or individual purports to want to invest in a U.S. or EU company but actually has no interest in a long term investment. Instead, what the Chinese side is seeking is a “free look” The goal of the Chinese side is to investigate the American/European company’s innovative technology and then appropriate that technology for its own use. The Chinese side uses the promise of investment and financing to convince the US/EU side to drop its guard. The Chinese side then takes what it wants and disappears when it is time to make the full investment.
Our firm is seeing these free look investment schemes virtually every month and we are seeing these schemes become more refined. The result is always the same: no investment from the Chinese side and lost time, money and confidential information from the US/EU side. Though losing confidential information is always a disaster, the lost time and money is oftentimes even more damaging for smaller US/EU target companies, particularly for start-ups that cannot afford to wait around for magic.
The free look investment scheme is usually organized in one of the following three ways:
Free Look Investment Scheme Number One: This scheme is normally limited to smaller but established US/EU companies. The Chinese side proposes to make a substantial investment in the US/EU target company. The amount to be purchased is either a controlling interest in the stock of the target company or substantially all of the stock in the target.
The Chinese side enters into a stock subscription agreement to purchase the stock, but insists on performing extensive due diligence before making the purchase. During the due diligence period, the Chinese investor works to obtain as much confidential information about the operations of the US/EU target company as possible. Often, the proposed closing date is extended several times as the Chinese side seeks more and more sensitive information. The US/EU side provides the information, believing that since the Chinese side will eventually own the company, it cannot hurt to provide them with what would otherwise be considered information that should not be disclosed. But in the end, when the closing date arrives, the Chinese side announces the deal cannot close because the Chinese government will not allow for payment to be made from China. The Chinese side then argues that it cannot be held liable for breaching the subscription agreement because the actions of the Chinese government constitute force majeure and therefore frees them from having to close on the deal. In some cases, the Chinese side will have paid a modest initial deposit or down payment. In those situations, the Chinese side will then argue that the American/European company must refund its deposit due to its force majeure defense. If the deposit is not refunded, many Chinese investors will file suit demanding the refund. Litigation is always expensive, and that is even more true of this sort of complicated cross-border type of litigation.
Free Look Investment Scheme Number Two: The Chinese side proposes to invest in a US/EU company. The focus of the investment is not the US/EU company itself, but rather the technology either currently owned by the US/EU target company or (more often) the technology the US/EU target company is developing. The Chinese side offers to make a substantial investment in the U.S. company, but conditions its investment in one of two ways: First, the US/EU target must prove to the the Chinese side that its technology is commercially viable. Second, the US/EU target company must enter into a China Joint Venture with the Chinese investor to develop and market the technology in China.
Normally this scheme is structured as follows:
1. Minimal initial investment amount.
2. Payment of the remaining investment amount will be in a series of small installments, often five or more.
3. The China Joint Venture business structure is presented in a way that appears very attractive to the US/EU target company, but this attractive structure is not permitted under Chinese law. The usual “bait” is either a) no financial investment from the US/EU side in exchange for the US/EU company getting a large percentage ownership interest in the China Joint Venture and b) the false promise of an early IPO on one of China’s public markets.
What then actually happens is the following:
1. The Chinese side delays making the initial payment and then delays making each installment. The Chinese side then presses for more and more confidential information, even though it has not made the required payments.
2. At some point in the process, the Chinese side decides it has obtained enough information and it then defaults on its remaining payments. In the old days, that would be the end of it. More recently, the Chinese side has become bolder and will file a lawsuit seeking a refund of its initial (and any subsequent) payments, usually by alleging some breach by the American side.
3. The China Joint Venture never comes into existence because a) the Chinese side never planned to do it and b) the business/ownership/control terms do not comply with Chinese law in any event. But during the bogus formation process, the Chinese side will use the prospect of future cooperation in the China joint venture to extract more information from the U.S. target. The American side thinks it is working with the Chinese side on the joint venture when in reality they are working at cross-purposes.
Free Look Investment Scheme Number 3: The Chinese side offers to “invest” in the U.S. entity by providing working capital and by helping create a market for the product in China by acting as the PRC distributor. The Chinese side offers to provide a working capital line of credit and to enter into a PRC distribution agreement. Both are offered on extremely attractive terms, which is the bait for entering into the relationship.
As with the previous two free look investment schemes, the Chinese side conditions its “investment” on completing its due diligence concerning the product or technology owned by the U.S. target. And just as is true with the first two schemes, what the Chinese side really wants is access to confidential information it can then use for its own purposes. Once that purpose is achieved, the Chinese side bails.
This free look investment scheme usually works as follows:
1. The Chinese side will work hard to obtain the desired confidential information before providing any financing or entering into any form of distribution agreement.
2. If the Chinese side is forced to provide financing, it will structure it in such a to allow it to walk away from the financing at will. The Chinese will normally structure the financing as a monthly line of credit payments based on an informal agreement. A formal financing document is not used. Virtually no Chinese company or individual has U.S. dollars in the U.S. available for providing a monthly financing payment. The cash must be sent from China and this payment must be converted from RMB to dollars. The conversion is subject to approval by the Chinese government and the local foreign exchange bank. When the Chinese side decides it is time to default on its financing obligation it simply states that payment from China is no longer approved. They then use this denial/alleged denial by the Chinese government to claim they are no longer obligated to pay, using the familiar force majeure argument discussed above.
3. The standard procedure for the distribution agreement is as follows:
a. Endless delay in drafting even a first draft of the agreement.
b. The attractive terms disappear, to be replaced by commercially unreasonable terms. Typical of this is that all profits on sales are earned in China, while the U.S. entity sells at cost to China and earns nothing.
c. In the end, the Chinese side never orders any products.
As you would expect, all three of these free look investment schemes can be very damaging to US/EU companies. If you are confronted with one of these schemes, you have two ways to proceed. One, just walk away. Two, if you decide to move forward draft the terms of your deal in a way that is both commercially reasonable and that protects your company from the damage that results from the free look.
2. MOU Free Look Schemes
Our China attorneys see the following MOU free look schemes, which include the following:
1. The US/EU company negotiates and signs the MOU before they speak to an attorney who knows and understands China. In most cases the US/EU company does not speak with an attorney at all before signing an MOU. In some cases though, they speak only with their in-country (not China) investment counsel. These attorneys focus on the domestic (not China related) investment issues and they usually do an excellent job. However, they know little to nothing about China, so the China side of the MOU is not properly reviewed before it is signed.
2. The Chinese side will nearly always draft the MOU. This virtually always means the Chinese side is using an attorney who knows and understands Chinese laws relating to MOUs. Where the MOU is drafted by the Chinese side, it normally is drafted as a formal, binding agreement with dispute resolution and penalties for default included. This is of course exactly the opposite of what is required for an MOU. The MOU must be written as a non-binding document, with no dispute resolution and no penalties. See In China, Treat A Memorandum Of Understanding Like A Binding Contract.
3. The MOU usually provides for two sets of terms to ensure the success of the free look scheme. First, it will propose a large investment, but with non-standard investment terms that require the foreign side to reveal technical information not normally in an investment project. Second, it will suggest forms of cooperation that are illegal under Chinese law.
The US/EU side assumes the Chinese side simply does not understand how investment works in the US/EU but does understand Chinese law and therefore would not be proposing a China business structure that is either illegal or impractical. Both assumptions are incorrect and what the Chinese side does here is done intentionally as part of its free look scheme.
4. The MOU will normally be open ended and vague in terms of the time for completing the various steps required to complete the project. This is a major mistake. In any project working with a Chinese company, it is essential to set clear and strict deadlines and to be willing. Most MOU documents contemplate eventually drafting a definitive agreement. The date for drafting and execution should be set for 30 days, 60 at the very most. The reason for setting a tight deadline is because the foreign party must be prepared to deal with the standard Chinese approach to drafting the definitive agreement, which goes like this:
a. The Chinese will offer no input. If the foreign side provides an outline or a term sheet, the Chinese side will simply state that it looks “OK,” with no further response and thus force the foreign company to do all the drafting of the definitive agreement. This document is then submitted to the Chinese side early, giving the Chinese side ample time to respond. But, the foreign side hears nothing.
b. As the deadline for completing the definitive agreement approaches, the foreign side begins to get concerned about the deal collapsing due to a failure to agree on a final definitive agreement. The Chinese side then responds, usually 4-7 days before the deadline. Note that it does not matter whether the deadline is 30, 60 or 90 days; the Chinese side will respond hard against the deadline, with the hope that the pressure of the deadline will soften the resolve of the foreign company in holding to its terms.
The Chinese side’s right up against the deadline response will usually provide for changes in the definitive agreement that completely reverse the terms of the MOU and any subsequent term sheet. No explanation is ever given for these massive changes. The foreign side often will simply capitulate and the Chinese side prevails. In other cases, the foreign side will respond and there is a tense period of last minute and significant revisions to the definitive agreement. Again, the Chinese side’s strategy is that the last minute negotiations will force the US/EU side to make drafting mistakes that will prove beneficial to the Chinese side.
4. The result is either that a) the parties ultimately draft a definitive agreement so flawed that it is never implemented or b) after months of unproductive negotiation, the parties walk away. But during this period, the Chinese side will have been working to gain access to technology of the foreign party. Walking away is exactly what the Chinese side planned from the start and impossible terms guarantees this in the end. The Chinese party succeeds in obtaining the free look, with no risk that it will be burdened with making a substantial investment or working with the foreign party at any time in the future.
You can prevent this by doing the following:
a. Not entering into a binding MOU. A simple term sheet is best. Even using the MOU term exposes the foreign entity to risk in China.
b. Separate the investment from any cooperation project. Do the investment on a very short time frame pursuant to a standard Western-style investment agreement. Do not tie the investment to future cooperation in China. Do not do the investment in installments. Require the Chinese side invest the entire amount in a very short time frame. Limit due diligence to the financial condition of your company. Do not allow any due diligence on your technology or your trade secrets or your business plans.
c. If there will be future cooperation, require all discussions on future cooperation occur only after the full amount of the investment has been received.
Of course, a Chinese company planning to employ an MOU free look scheme will not agree to these terms above. But, that tells you what you need to know and if the Chinese side will not agree, you should probably send them on their way.
3. Fake Joint Venture Free Look Schemes
Chinese companies dangle the formation of a joint venture as a means to view (and then use) foreign company intellectual property. Just to be clear, I am not saying all China joint venture proposals are made solely to get a free look at foreign technology. As dubious as our China lawyers are about most (but not all) China joint ventures, plenty of them are legitimately proposed and formed. Here I am not so much talking about real joint ventures as I am about Chinese companies that propose a joint venture with no real intent to form one and doing that to get at your IP.
The Chinese side wanting a free look at your IP will normally propose forming a joint venture in China for developing and marketing a product. In these cases, however, even if a well formed Chinese joint venture would be commercially reasonable, this is not the case when a free look joint venture scheme is being employed. Normally, the type of joint venture proposed by the Chinese side is not permissible or practical under Chinese law and business conditions. In these situations, it is normally best to accomplish the commercial objectives of the US/EU side through a well drafted license agreement rather than by creating a JV company.
As a quick aside, if you want to learn more about China joint ventures, I suggest you read China Joint Ventures: The Long Version.
The basic issues related to Chinese companies using a Chinese joint venture to garner a free look at your IP are as follows:
1. Forming a JV means forming a separate legal entity pursuant to the PRC Sino-Foreign Joint Venture law. This means establishing a separate company with a separate address, separate facilities and separate officers, directors and employees. It is rare that the Chinese side really intends to do this.
2. When the entity is formed, the stock must be issued to both investors. All of the stock must be issued to the foreign side on the date the JV entity is formed; here can be no waiting for issuance of the stock. Issuance of the stock cannot be triggered by some event such as authentication of the technology or government approvals.
3. The Chinese side normally will offer the foreign company share ownership in the Joint Venture in exchange for the foreign company licensing the foreign technology to the joint venture and for general cooperation in the future. The Chinese side does not require the foreign side to contribute cash or to contribute the technology to the JV company. The proposal is that the U.S. side will get “something for nothing.” It will get ownership in the China Joint Venture without having to pay anything for it, beyond licensing its technology to the Joint Venture and getting licensing fees for that. Of course, no successful business gives something for nothing. In China, however, this would also not be legally permissible.
China does not allow “sweat equity” or equity issued based on some separate benefit conferred on the Chinese entity (say, preferred investment in a foreign company). Stock must be issued for cash or for a hard asset like equipment. A license to technology does not qualify as equity in a China joint venture. For technology, the investment only counts if the technology is formally contributed to the JV entity as an asset. Since a license is revokable, a license is not treated as an asset under China Joint Venture law. Even where technology is contributed as an asset, the value of the technology must be independently appraised and normally the contribution of IP by the US/EU side is limited to a maximum of 15% of the foreign company’s total investment in the Joint Venture.
This means the Chinese company that is offering the above “something for nothing” terms is doing so as a ploy to convince the foreign side to drop its guard and reveal confidential technical and business information. The argument by the Chinese side to facilitate this intellectual property look-see is: “We will be partners soon, so why hide anything from us.” But since the terms of the JV are not legally permissible you really won’t be partners soon and the result of this ruse is either that the JV never forms and the Chinese side blames this on the government and then uses a force majeure defense to walk away liability-free.
4. It takes at least three months to form a JV company and it often takes six months or more. Forming a Joint Venture in China is expensive and time consuming and this timing and expense should be taken into account in the business plan. And as noted above, it is entirely possible the Chinese government will not approve the formation of your JV company, especially if — as described above — the equity structure is not allowed. Often, however, the Chinese side will draw the joint venture formation process out for a year or more. During this entire period, the Chinese side is working to extract confidential information from the foreign side. One standard trick at this stage is for the Chinese side to say that it is bringing other “big player” investors into the JV company and these new investors are skeptical and need to see proof of the technology before they will invest. Of course, these big players will assist in taking the JV public in China, resulting in a major returns for the foreign side. So in a case where the foreign side is not required even to pay for its shares in the JV, this becomes “something for nothing” squared. Like all good con games, this one too plays on greed.
5. If the Chinese side scheme involves actually forming a Joint Venture, rest assured that you will own less than 51% of it. And with your less than 51% JV ownership, you will have no control over the JV and no meaningful rights of any kind. Many (most?) foreign investors believe that their ownership in a Chinese JV entity will allow them to exercise at least some control over the operations of the entity, but exactly the opposite is true. China has no effective minority shareholder protections. The management of the JV will simply ignore the “rights” of any minority investor, including the “rights” of the foreign investor. So, in the end, the foreign investor in a Chinese JV has less power and control than a foreign party that simply licenses its technology to the Chinese side.
6. Nearly all commercial reasons for doing a JV in a technology development and sale project can be duplicated with more certainty via licensing. For example, a license can be drafted where the JV entity pays a royalty that provides exactly the same economic benefit as a percentage ownership in the JV entity. If the foreign side truly believes in the prospect of a PRC IPO (even though these are incredibly rare), the license agreement can be drafted to provide for the Chinese company licensee to pay a royalty in the event of a sale of the Chinese entity that will provide the exact same financial return to the foreign licensor that it would have gotten had it had an equity interest in the Chinese entity. For more on China technology licensing agreements, check out China Technology and Trademark Licensing Agreements
7. The control benefits of a license can be considerable. As noted above, if the foreign entity is a less than 51% owner in a JV company, the foreign entity basically has no remedy at all if the Chinese side does not perform. There may be remedies on paper, but Chinese company law is defective in this area and minority shareholders pretty much have no effective rights. On the other hand, a well-drafted license gives the licensor very powerful rights. If the Chinese side does not perform, the licensor can both terminate the license and sue the Chinese side for damages. This is exactly why Chinese entities prefer the JV approach and why they avoid licenses.
4. How to Guard Against Chinese Free Look Schemes
There are plenty of legitimate Chinese companies seeking legitimate deals with foreign companies and so it is important you know what to look for in determining whether the Chinese company with which you are dealing is serious about doing a real deal or just trying to get a free look at your IP. There is no doubt there are a large number of Chinese companies, fund managers and investors who see the potential in bringing Western technology and know-how to China and are willing to pay Western companies for that and/or share the profits from that with Western companies.
The core of the free look scheme is the proposal of a Chinese company to make an investment in a foreign technology focused entity. To prevent the Chinese side from playing out a free look scheme, it is essential to work out a “clean” investment agreement. The basic features of a clean agreement are as follows:
1. U.S. and European style investment agreements are normally too vague to be effective in working with Chinese investors. For Chinese investors the investment agreement should include at least the following:
a. An exact date when funds must be paid.
b. Funds must be paid free and clear, in cash, to the company bank account on the closing date. Any claim that funds have been or will be wired from China or Hong Kong or wherever should be ignored. Only cash actually in your bank account, free and clear, counts as an investment.
c. Require the Chinese side to agree that no approval from the Chinese government or any other foreign government is required to make the investment and that no decision of a foreign government or foreign bank will excuse the Chinese side’s obligation to make the payment by the closing date.
d. To give teeth to these provisions, you should require your Chinese counter-party to make a substantial good faith escrow deposit on the date the investment agreement is executed. Provide that the escrow deposit will be forfeited if the investor does not make payment on the closing date. Absent this hard deadline with a substantial penalty, the Chinese investor is almost always late in paying, even when payment is made from a Hong Kong or a U.S. or a Canadian account.
Using the above approach will usually prevent the Chinese side from making use of the free look approach and tell you whether they are real or not. This is because no Chinese company planning to use the free look approach will agree to the above terms. In refusing to agree, the free look schemer will argue that you need have to prove the viability of your technology before it (or its so-called outside investors) can make any payment or investment. At this point, the best thing to do is usually to walk away.
But most U.S. and European companies choose to continue working with the Chinese side, attracted by the potential of substantial investment and developing the massive PRC/Asia market for their product. The U.S. or European side will at this point agree to a due diligence period before the final investment is made. This due diligence period is where the free look scheme is executed. The U.S. or European side should enter into an agreement with its Chinese counter-party that is specifically designed to prevent the free look scheme from succeeding.
Some of the following issues arise from this:
1. Who will be the actual investor in your company or your technology? Many Chinese companies find it difficult to transmit funds from China for making an investment. Even for good faith investors, it is often impossible to to make the investment directly from the PRC. To get around this problem, Chinese investors often provide that “their” funds will be paid by some other entity located outside China. This raises a number of issues. First, under U.S. and European know your investor and anti-money laundering rules, it is critical you know from exactly where this funding is coming. Second, payment from a different party is a common source of delay and delay must be avoided in this kind of transaction.
2. Most investment agreements prohibit ownership of stock by nominees. This follows on the know your investor and anti-money laundering rules discussed above. But when the actual PRC investor proposes to use funds provided from another entity, they often then request that this other funding entity own the stock in your company on behalf of the PRC entity as some sort of nominee. This kind of nominee ownership is common in the PRC, but the practice should generally be avoided in the West.
3. If the Western company is working with other potential investors, it is usually important it make sure any special terms provided to the Chinese side do not conflict with agreements with other investors. For example, it is often provided that for a single round of investment, the round will not close until after all investments have been made. If the Chinese side is given a substantial due diligence period prior to being required to invest, this may conflict with the basic requirement imposed on other investors.
4. In this setting, the standard Western style investment agreement is not adequate. You need a separate and specialized escrow/due diligence agreement with the proposed PRC investor. The following are some of the key points for these due diligence agreements:
a. Who will be the final owner of your company’s stock? Will it be the PRC entity with which you are negotiating or will it be some Hong Kong or Canadian or Cayman Island or Isle of Man or Luxembourg company you have never heard of nor ever dealt with? Even if your due diligence agreement is with a PRC entity, it is not unusual for that PRC entity to demand provisions giving rights to some third party you do not know. Are you willing to issue stock in your company to an entity of which you know nothing?
b. Even riskier is the situation where the PRC entity requires the investment/due diligence agreement be done directly with their non-PRC nominee. Since these nominees are usually mere shells with no assets it is judgment proof. This renders meaningless the entire due diligence agreement.
c. The US/EU side must describe with reasonable clarity what access and information will be provided to the putative investor during the due diligence period. First, the information disclosed should be strictly limited. The Chinese side will nearly always demand more and it is important you set and maintain your disclosure limits. Second, the participants in the due diligence process must be carefully controlled. The Chinese side usually works with a group of related companies. A standard technique is for the Chinese side to negotiate a provision that allows them to disclose your information to one of its related companies. When an infringement of your IP later occurs, it is done by that related but independent company with which you have no contractual relationship. This means you have no contractual basis for making a claim against the actual infringer and your Chinese counter-party thus can walk away with a free look.
d. If you are going to require other investment conditions you must list those with hard deadlines. For example, if PRC government approval of the deal is going to be required, you should put in your contract that such approval must be received by the end of the due diligence period. If a license is required, drafting must be complete at least one month before the end of the due diligence period. If a JV company will be formed, the Joint Venture’s registration must be complete by the end of the due diligence period, with only capitalization remaining — this means the JV registration process must start immediately after execution of the due diligence agreement.
e. At the end of the due diligence period, the Chinese side must be required to “go hard,” meaning all of the conditions to closing the investment must be met or waived by the end of the due diligence period. That is, the Chinese company either walks away or enters into a formal investment agreement that provides for either payment in full in five days or payment of a non-refundable escrow deposit with closing to occur within thirty days. Chinese companies that are working the free look scheme will usually not agree to this quick close. They will instead seek a process where negotiating and drafting the investment agreement and other collateral agreements begins only after due diligence is completed. To avoid the free look scheme, you should insist the investment be made immediately after completion of due diligence. It is not uncommon for Chinese companies to stretch the approvals/documentation period out for several years with no investment in the end.
f. As noted above, the investment and due diligence agreements should provide that no action of the Chinese government or of any Chinese bank or any other Chinese agency will be a defense to the requirement that the Chinese investor perform and if the investor does not perform, its escrow deposit or advance payment will be forfeited. Chinese companies often will insist on including a long force majeure provision in an otherwise simple investment agreement. If you allow for this sort of provision, you are all but guaranteeing there will never be any Chinese government approval. It is actually a good idea to include the exact opposite provision whereby the Chinese side warrants that its investment has already been or will be approved by the Chinese government and that no action of the Chinese government can used by them as a defense.
There are a number of ways to neutralize the free look scheme, even in cases where you agree to prove your technology to the Chinese side. Legitimate Chinese companies will work with you to resolve the issues, but Chinese companies that are in it for the free look will not. It is important you determine where they stand as soon as possible. You do that by providing clear and reasonable terms to the Chinese side along the lines discussed above.
If the Chinese side has problems with the straightforward terms outlined above, you should ask them to outline their specific concerns in writing. If their concerns are legitimate, you probably can deal with them. If the Chinese side does not respond or if its concerns are not legitimate you know where you stand. Chinese companies can run you around for a very long time — years in some cases. You cannot afford that. You need to quickly get to a reasonable arrangement with the Chinese side or move on.
It is possible the investor from China is what we can call standard financial investors. These are venture capital or private equity funds focused on financial return. It is relatively easy to identify a financial investor. Their interests are not focused on the content of technology; they are interested in making money. Negotiations with a financial investor will focus on business terms: price, payment schedules, control, board representation, exit strategy and related. Negotiations on these critical issues with Chinese investors is usually quite difficult. In particular, Chinese investors like to make a last minute bid for a reduced price.
But their motivation remains clearly financial. Such an investor will not seek to investigate the technology. Such an investor will not propose joint ventures and tie ups in China. Discussion will be limited to hard nosed business terms. U.S. companies and their advisors are used to this type of investor. The approach is the same all over the world. So the standard deal techniques and documentation generally will apply.
Note, however, that just because the Chinese investor bills itself as a private equity or VC fund does not mean it is not focused on technology. In fact, in today’s China, the opposite is most likely to the be the case. Beneath its indigenous innovation rhetoric, the Chinese government understands that Chinese companies and academic institutions do not have the capability to develop modern technology quickly enough for Chinese government plans. For example, the deadline for a program like Made in China 2025 is already drawing quite near and to jump start development the Chinese government has made acquiring foreign technology a primary goal.
To implement this acquisition program, the Chinese government has taken two approaches. First, it has pressed Chinese companies to make acquisitions in their areas of business that are not focused on financial benefit but rather are focused on acquisition of technology. Second, the Chinese government has instructed private investment funds and banks to quit investing in non-essential sectors such as foreign real estate and media and instead to concentrate on the acquisition of technology. Existing Chinese funds have changed their focus. New funds are being created that are focused solely on acquiring foreign technologies in government mandated key sectors.
In the old days, the way you spotted a technology focused investor was to simply ask whether the Chinese company directly competes with your company? Now though far more research is required. If the investment comes from a Chinese based fund, you have to ask whether the goal of this fund is limited to financial return or is its goal to acquire advanced technology for the benefit of China as a whole, rather than for the financial gain of the holders of the fund.
Once you determine the potential investor is focused primarily on technology you then have another set of decisions to make.
Our China attorneys typically see three types of investor that should be rejected because they are only planning on a free look:
1. The investor has no intention of investing. They only want a free look. This type of investor should be rejected as soon as possible.
2. A more clever Chinese investor strategy is to seek to access to the technology of the target company in exchange for a modest investment. It is common for Chinese investors to take this position. Their position will go even beyond the standard free look. They will say: “We are now part owners of the company so the company should provide us with free access to all the technology information owned by the company and it should follow our direction in doing business in China. Joint ventures, distributors and business partners should be selected by us.” This is a violation of basic company law. A minority investor usually does not have a right to access confidential information or to direct the operations of the company. This is particularly true when that minority investor directly competes with the company. When Chinese investors make this kind of demand, this usually shows they are just planning on following the free look strategy. When they reveal their real intention, they should be shown the door.
3. The more difficult type of investor is the investor who at least claims it intends to purchase a majority interest in the company. As is generally known, acquisitions by Chinese investors face a number of obstacles: a) agreement on the business terms, b) approval by the Chinese government, and c) approval by the U.S. government. So even when the Chinese investor is sincere in its intent, an acquisition from China can take a lot of time and may never happen at all. The risk here is that the investment from the Chinese side will turn into a free look scheme. This is a very common result and must be resisted.
The conversion into free look centers on the due diligence period and the content of due diligence demanded by the Chinese side. The sequence generally works like this:
The Chinese side starts the negotiation agreeing to a very high price. Then, just before the initial closing date, the Chinese side pushes for a substantially lower price and give one of three reasons: a) It no longer has faith in the technology, b) The Chinese government will not allow the investment, or c) The ultimate backers of the Chinese side (banks and funds) will not agree. In each case, the solution proposed by the Chinese side is that the investment target provide inside data about the technology or it enter into a cooperative project in China to demonstrate and prove the technology.
The process continues, as the Chinese side pushes for more and more technical information. In the end, if the U.S. side finally agrees to substantially reduced prices, the Chinese side will close on the deal since it has acquired the technology at a bargain price. Sometimes the deal simply fails, with this failure never attributed to the decision of the Chinese investor. Instead, the Chinese company usually blames the failure of the deal on a decision of the Chinese government or the unknown Chinese “backers” of the deal.
In the end, the Chinese investor either acquires the technology at a bargain price or converts the deal into a free look scheme. So what looks like a legitimate investment proposal turns into a free look scheme or an absurdly cheap one. This common situation, where a failed Chinese acquisition turns into technology theft, is often reported in the financial press. See, for example this 2018 New York Times story, Inside a Heist of American Chip Designs, as China Bids for Tech Power.