The China Joint Venture Squeeze Out

Well I was stranded in the jungle
trying to take in all the heat they was giving
The night is dark but the sidewalk’s bright
And lined with the light of the living
From a tenement window a transistor blasts
Turn around the corner things got real quiet real fast
I walked into a Tenth Avenue freeze-out
Tenth Avenue freeze-out

Bruce Springsteen, Tenth Avenue Freeze Out

For more than a decade, companies have told us that one of the reasons they want to do a China Joint Venture (as opposed to just contracting with their putative JV partner) is because they “want to share in the upside when the joint venture goes public.” I don’t know about the rest of you, but I don’t think any of our China lawyers have ever seen that happen.

Instead, what we so often see is what we (and others) call the China going public squeeze out or, as I prefer to call it, the China going public freeze out.

The below is an amalgamation of emails we have written in these situations over the years, with anything that could even remotely identify any client or Chinese company either changed or removed.

We have completed our basic research and understand the situation regarding [China Joint Venture Company A}.

The most recent data we obtained was for 3/5/2018. This is based on the annual report for 2017. JV Company events for 2018 have not yet been reported.

1. Under PRC law, [China Joint Venture Company A] is a Sino Foreign Equity Joint Venture. In the most recent documentation available to us, there are THREE foreign shareholders [Note that at least half the time our client believed it to be the only foreign shareholder:

a. You hold 1,122,000 shares.

b. {XYZ LLC], a California LLC formed in June 2015: holds 2,200,000 shares.

2. [ABC LLC], a Texas LLC formed in March 2016 holds 780,000 shares.

2. [China JV Company was listed on the NEEQ over the counter exchange about 15 months ago. The purpose of these listings is to sell shares to the investing public as an unlisted public company.

3. The Chinese owners of [China Joint Venture Company A] want to convert the entity from a FIE (foreign invested enterprise) to a wholly Chinese invested enterprise. To do this, they must remove all three foreign shareholders as owners.

4. It is not clear what their plan is for the other two shareholders as the plan you provided us is the proposal just for you. This is known as a “squeeze out” of the foreign owners of a PRC JVC. This is a very common final result when joint ventures are successful. The result for the foreign owner is seldom economically attractive. The current proposal is an example of that.

You seek to sell your stock in [China Joint Venture Company A] in a way that will allow you to participate in any increases in company/stock value over the next several years. You want to receive the proceeds of sale of the stock in U.S. dollars paid to your U.S. account after deducting the appropriate taxes. In a JV shareholder squeeze out it is normal for the Chinese side to make a cash payment to the foreign shareholder at a substantial discount to actual value. We have to encounter an instance where the Chinese side paid full value and also committed to making payments for future value of the foreign shareholder’s ownership interest.This has been true of both big and small joint ventures.

Even in cases of a buy-out with an immediate payment, the Chinese side will often claim to be unable to transmit its payments out of China. The Chinese side will push for the foreign party to open a Chinese bank account where it can deposit the payment funds in RMB. It is then incumbent upon the foreign side to converting the RMB to U.S. dollars and then transmit those funds from China to its home country. This has always been difficult to do and with China’s heightened concern regarding offshore payments, this has become even more difficult. For this reason, you should not allow yourself to be removed from [China Joint Venture Company A] until after you receive payment.

To protect you interests and achieve your goals, you should structure a simple program as follows:

a. A Chinese party you trust buys your stock at its current value and pays for it in U.S. dollars by wiring those funds to you in the United States after deducting applicable taxes.

b. After you receive the funds in the United States, you will resign as a director at [China Joint Venture Company A]. The paperwork can be done in advance and deposited with legal counsel to be executed when you receive confirmation of successful wire transfer into your U.S. bank account.

The above two procedures are the standard way to structure this sort of buy-out. This structure is the best way to ensure you will actually receive payment for your shares. Using a delayed payment structure or a nominee relationship would expose you to near infinite risk and it is not appropriate for you to have to take that risk when you are being “squeezed out” as a benefit to the company (but not to you).

To achieve your additional goal of sharing in future stock appreciation, the purchaser of the stock will be required to pay you annually an amount equal to the increase in the value of the stock as measured over the previous year. You will have to determine how many years this payment rule will be in place: five to ten years would be appropriate. To make these payments, the party who purchases your stock will be able to sell a portion of the stock purchased to cover this increase in value. Your payment would be received after deduction of all taxes. This is an unusual arrangement and though it will be relatively easy for us to draft the appropriate document, it holds the following risks:

a. The buyer of the stock should be an entity you trust. In this case, the buyer of the stock should be ______ since it is not likely to disappear and it will likely to honor its commitment to make a payment now and to make the later payments for any increase in stock value. If you enter into an agreement with one of the investment limited partnerships, there is a significant risk they will default or simply disappear at some later date. This happens regularly in China.

b. Though the commitment to pay can be clearly documented, since the procedure is unusual, there is always the risk that the foreign exchange bank or the Chinese tax authorities or the NEEQ exchange will block the payment. This risk can be mitigated by structuring the additional payments as part of the purchase price for the stock: some form of installment payment sale. It is always difficult to say what the Chinese authorities will do, particularly where the paying entity has no reason to be a strong advocate for approving the payment.

The way to mitigate this risk is to require the initial buy out payment to be priced to include a projected increase in value and then price the shares at that increased value. This increased price is your compensation for agreeing to allow yourself to be squeezed out of a profitable joint venture.

The deal structure proposed by the Chinese side does not meet your goals. Nominee shareholding arrangements are disfavored under Chinese law and this is particularly true when the purpose of the nominee arrangement is to hide the true ownership structure of a company that holds itself out to the public as a wholly Chinese owned entity. In addition, the NEEQ rules require absolute transparency of ownership structure and nominee arrangements violate NEEQ rules.

To summarize:

1. You should not give up your position in [China Company A] until after you receive a cash payment (via wire) into your U.S. bank account.

2. The issue is the sale price. You can set the price equal to an estimate of the growth value of the shares over some period, say five years to ten years. That premium over current price would then be your compensation for agreeing to the buy out. Or you can accept a riskier arrangement where you get annual payments reflecting the increase in stock value over the prior year.

3. You should not agree to a nominee arrangement that does not involve a substantial pay out to you now. If you do agree to a nominee arrangement, you should use a formal shareholding trust agreement which is possible under Chinese law. The risk of your using nominee shareholding cannot be eliminated and the experience of Taiwanese, Korean and Hong Kong investors who have used nominee shareholding arrangements over the past 15 years has not been good. Contracts intended to avoid Chinese law requirements or that mislead the public are void and that is what the courts usually decide when such contracts are challenged. You don’t want a law suit: you simply want to receive fair payment for your stock.

Please let us know how you wish to proceed. We can draft the documents (in Chinese as the official language and in English for you) appropriate for whatever structure you decide to follow.

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