Drafting a JV Contract for an Effective Partnership in China

Teaming up with Chinese partners who have knowledge of local market contacts and conditions is seen by foreign investors as vital to gaining access to the Chinese market. At the same time, acquisition of technology motivates Chinese companies to enter into joint ventures with foreign investors.

The success rate of JVs is relatively low globally, so it’s not surprising that many Sino-foreign joint ventures have failed due to clash in culture, management style, long-term goals, etc. Foreigners contemplating making an investment in China should be aware of the various obstacles in the establishment, operation and dissolution of joint ventures, as well as how to tackle them.

Key points to include:

• Conditions for dissolution
• Deadlock provision
• Buy-sell option
• General Manager’s scope of authority
• China arbitration

Conditions for dissolution

There is always a risk that the JV does not work out, so you should provide for an exit strategy in the contract and articles of association to ensure that you can leave with your assets and money intact.

In practice, to dissolve a JV, the board of directors of the JV must meet and agree unanimously to dissolve the venture, and obtain approval from the relevant government authority. One of foreign investors’ main obstacles when they initiate dissolution is obtaining the agreement of the Chinese partner.

To facilitate an exit from the JV, it is important to clearly stipulate grounds for dissolution in the JV contract and articles of association. The JV laws provide various grounds for dissolving a JV, such as where the JV incurs “severe losses.” The parties should clearly define and quantify what constitutes “severe losses” and unacceptable levels of business (losses in consecutive years, production below targeted levels, etc.) in the contract and articles of association.

Investors can and should also provide for additional grounds for dissolution in the joint venture contract and articles of association, such as bankruptcy of the parent company, refusal of credit by a financial institution, or delay in the acquisition of land use rights.

Deadlock provision

Furthermore, it is prudent to incorporate a deadlock provision that allows one party to unilaterally initiate the dissolution of the JV. The deadlock provision should clearly define the various situations which constitute a deadlock and thus trigger termination. One example would be to specify that a deadlock is deemed to exist when a member of the board fails to attend a board meeting for three consecutive times.

The parties should stipulate in the contract that, immediately upon the occurrence of the deadlock event, a party is entitled to deliver a written termination notice to the other party of the joint venture. Should the other party refuse to cooperate with the initiation of the JV dissolution procedure, the dissolving party can then apply for arbitration or file with the court. Incorporation of such clearly defined deadlock provision helps the dissolving party to more easily obtain a favorable award or verdict.

Buy-sell option

Another alternative would be for the occurrence of a deadlock to trigger a buy-sell option, whereby one party has the right to sell its interest or to purchase the other party’s interest in the joint venture at a designated price, and the other party is required to buy or sell such interest at that price.

The method of calculating the value of the interests should also be clearly specified in the contract, e.g., based on the net asset value on the audit report by a professional and reputable firm. Note that where the buy-out would entail a conversion of the JV into a WFOE, it is subject to the limitations of the Foreign Investment Industrial Guidance Catalogue, which prohibits and restricts foreign investment in certain sectors.

General Manager’s scope of authority

In terms of management structure, joint ventures in China must consist of a board of directors/ joint management committee, which is the highest decision-making authority of the company. Usually, a general manager will be appointed by the board of directors to be in charge of daily operational matters of the company.

In order to maintain control over the business, the foreign investor should consider investing in a foreign manager to fill this role. If the parties do not wish to appoint a foreign manger, the scope of authority of the local general manager should be clearly defined in the articles of association and contract of the JV.

For example, it should be stipulated in the documents that, where the cumulative value of contracts over a certain period of time exceeds a certain amount, written authorization and unanimous consent of the board of directors is required before the manager is permitted to sign the contract, or the manager will be held solely and personally liable. This helps ensure that the foreign party, through director it appointed, is informed of all the major decisions made by the general manager. This helps protect the interest of the foreign party in the joint venture.

Third Party equity transfer

In some cases, the foreign or Chinese party may wish to consider transferring their equity interests to a third party. The JV laws require a party wishing to transfer its equity interests to a third party to obtain the consent of the other parties of the JV. The former is also required to grant the right of first refusal to the latter.

Where one party to a JV wishes to transfer its equity interests to a third party, but the other party to the JV refuses to grant its consent, the transferring party can file a lawsuit or refer it to the arbitration commission. The Interpretations of the Supreme People’s Court on Several Issues Concerning the Trial of Disputes Involving Foreign-Invested Enterprises (“Interpretations”), which came into force on 16 August 2010, provides it would uphold the equity transfer if:

(1) There is evidence proving that the other shareholders have granted their consents;

(2) The transferor has made a written notice regarding the equity transfer, but the other shareholders fail to give a reply within 30 days; or

(3) The other shareholders do not agree to the transfer but refuse to purchase the equity from the transferring shareholder.

The Interpretations also provide that, where the other shareholders fail to exercise the right of first refusal within one year after they are aware or should be aware of the conclusion of the equity transfer contract, the court will uphold the equity transfer.

These regulations can be advantageous to the foreign party wishing to transfer its equity to a third party, but may be disadvantageous to them where the Chinese party wishes to transfer its interests to a third party who is a competitor, or one that has not been proven to be reliable. To minimize this risk, the parties should stipulate clearly the conditions for equity transfer in the JV contract, such as forbidding equity transfer to certain competitors.

China arbitration

The JV laws provide that, in the case of failure of a board of directors to settle the dispute between the parties to a JV through negotiation, they can confer on an arbitration institution to settle the dispute. In this regard, the parties should stipulate an arbitration clause in the contract or reach a written arbitration agreement stipulating the exact name of the arbitration commission, venue and language for arbitration.

Many foreign investors tend to think it is to their advantage to stipulate an arbitration venue in their home country or in another foreign country. This may well be the case for disputes involving huge amounts or key IP Rights. However, for disputes where a lesser amount and only monetary issue is at stake, for cost purposes, foreign investors might consider stipulating a Chinese arbitration agency for the following reasons.

First, where a party knows of an impending arbitration, and finds itself in a less than favorable position, it may protect its assets by transferring them in advance. While most countries’ arbitration rules contain property preservation policies, these policies are usually only enforceable within the jurisdiction of the arbitration location. In addition, Chinese arbitration laws do not provide for the rights of parties to apply for property preservation with Chinese courts when conducting arbitrations outside of China. As such, having the arbitration conducted abroad may be risky in that there is no effective means of stopping the party in China from transferring its assets. Having the arbitration conducted in China allows a party to apply to the arbitration center in China to preserve the opposite party’s properties in China in advance, as long as it can be demonstrated that the arbitral award may not be enforceable, or that the applicant may encounter difficulties in its enforcement without the benefit of protective relief.

Second, Chinese legislation provides that Sino-foreign joint venture contracts are under the exclusive jurisdiction of Chinese law. As such, arbitrators with little or no knowledge of Chinese law will have to rely on their own legal background as well as the opinions of the lawyers hired by the parties involved in understanding the applicable law, and as a result they may misinterpret the law, leading to a judgment that is incompatible with Chinese law.  In addition, enforcing the award made by a foreign arbitration center in China can take a long time as the winning party needs to apply to the Chinese court for enforcement and translate all materials into Chinese.

In terms of arbitration venues in China, the China International Economic and Trade Arbitration Commission (CIETAC), which the Chinese Government established with the main purpose of settling international disputes, has a panel of foreign arbitrators with special knowledge and practical experience in the fields of law, economics and trade, science and other fields that the parties can choose from, and statistics have also demonstrated no bias against foreign parties.

Dezan Shira & Associates is a specialized foreign direct investment practice, providing business advisory, tax, accounting, payroll and due diligence service to multinationals investing in China, Hong Kong, India, and Vietnam. Established in 1992, the firm is a leading regional practice in Asia with nineteen offices in four jurisdictions, employing over 170 business advisory and tax professionals.

For professional advice regarding Joint Ventures and Mergers & Acquisitions in China please contact Dezan Shira & Associates at info@dezshira.com or visit www.dezshira.com.