Joint Ventures in China: Equity and Capital Requirements are Not the Same Thing
Op-Ed Commentary: Chris Devonshire-Ellis
Jun. 4 – Over the years, our firm Dezan Shira & Associates (and the China Briefing publication it produces) has provided a wealth of on-going legal, tax and operational material concerning doing business in China. We’ve been able to continue that due to the fact that the practice is extant in China – since 1992 – and has 12 offices spread across the country. We not only have that 20 years’ worth of experience, but we’ve also been directly involved with thousands of cases involving foreign investment into China.
Of all the items that we’ve written and commented about, one of the most contentious is the role of the joint venture in China. Some people love them, others hate them. But rest assured, almost everyone has an opinion about them. The reason for this is the very nature of the beast – two corporate entities coming together, often from completely different backgrounds and levels of expertise. The Chinese investor from a highly socialist-driven society with a shaky rule of law, and the foreign investor (especially if they are from the West), from a highly democratic society with a well-defined legal and judicial supporting structure. Both know how to play the game in their own backyard, yet understanding each other can lead to confusion and requires patience on behalf of both. It’s when these confusions are deliberately orchestrated by either party to gain the upper hand that problems occur.
Another drawback concerning joint ventures in China is that they are also very often misunderstood. Even other lawyers and consultants can get the law wrong, and the type of advice given concerning China from individuals and firms not extant in the country is often incorrect; mainly due to the fact they have never operated in China themselves and sub-contract their work to firms that are.
One example I would like to point out deals with negotiations an overseas-based lawyer had with several American clients concerning joint ventures in China, and how to go about structuring them. It’s an important point as it affects financing, capital injections required, the use of machinery as a declared asset on behalf of the investors, and the provision of equity.
The lawyer said: “Chinese law mandates that foreign companies doing Chinese joint ventures contribute a certain amount and a certain percentage of capital to the joint venture. More important, the voting power of each joint venture partner is directly proportional to the capital contributed by each partner.”
That’s quite specific. It is also wrong.
In actual fact, China possesses two types of joint ventures: the equity joint venture (EJV) and the cooperative joint venture (CJV). While the lawyer is correct in identifying a strict relationship between capital and equity when it comes to EJVs, the CJV does not require capital or assets to be in the same proportion as equity. And that is a problem, as firstly CJVs are the most common type of joint venture in China, and secondly because the advice given is actually working against the client’s best interests. The advice is actively discouraging an investment from being made, and with it, the potential for the client to make money and expand their business.
So let’s have a look at the cooperative joint venture, and what you can and cannot do as regards equity and the injection of assets into such a structure.
Firstly, it’s important to note the name “cooperative.” It indicates an agreed cooperation by the Chinese and foreign partners over the structuring of the joint venture and specifically allows that capital or other contributions do not have to be linked to the equity holdings of each. This was originally designed (and is still used) for real estate and property development deals, where the Chinese partner has land but no money, and the developer has cash to spend but needs the land. Cash is usually king, and the developer would agree with the landowner as a JV partner to develop the property, with the actual JV contract providing the bulk of the equity to the developer, even if the land was worth an equal or greater amount. This position makes sense because otherwise the developer cannot properly conduct his work, and is in a better position to safeguard the financial investment aspect of the development to which the land owner is not contributing. The property development is then completed. However, within the terms of the CJV, an additional cooperation is inserted, meaning that the landowner can take some of the developed property in kind, upon completion. This then matches up the total investment in an appropriate way that ultimately satisfies both parties. The CJV can then either be cashed out or remain in control of the development according to the original wishes.
Such structures were extremely common in the late 1990s and early 2000s when joint property developments in China were at a peak. They’ve probably reached their high point as Chinese landowners have begun establishing their own development companies, negating the need for foreign participation, however when foreign involvement is required, the development is nearly always on a CJV basis.
But CJVs do not just have to be applied to property developers. They can also be applied to certain manufacturing instances. Let’s suggest again that the Chinese partner has no cash available for development purposes, but does have land and available factory space. However he needs an injection to help develop his business. Step forward a foreign investor, who can both inject more modern technology as part of his capital investment into the CJV, as well as other capital as required, and take the majority position in the operation. However, to make up that difference in equity, the Chinese side is allowed to take a certain proportion of manufactured product as his own and for his own sales. In such instances, equity may in fact be offset by a production agreement – allowing both the foreign partner effective control, and both sides with a guaranteed production. The working arrangements of such CJVs are usually very effective and long term. I have rarely seen problems with CJV structures, and one that we established for a client in the northern Chinese city of Shijiazhuang is now being sold back to the Chinese partner in full, after 15 years of successful cooperation, profits and guaranteed production for both sides (the foreign partner concerned wishes to retire). This type of structure can also be useful for providing control of a JV when foreign technology is part of the deal – owning control equates to some degree of protection as to what happens with the technological asset.
CJVs then are extremely useful structures and very relevant to many projected foreign investments in China, especially if it makes sense to use existing facilities, upgrade them, and if both partners have different markets requiring similar product lines that can be jointly produced. The only drawback with them at present appears to be a lack of understanding of the complexities, even by local government bureau handling the approval of foreign investments into China – many are simply unaware that the CJV route exists and will steer investments down the less flexible EJV route as a result. This remains another reason why experience counts in China – your legal counsel needs to be able to debate such issues directly with the local authorities, and that means the firm and its own staff need to be on the ground and licensed in China.
Joint ventures may be complicated and diverse animals, but they can be immensely useful and profitable. Lawyers and consultants with long-term, proven track records in China know this and should remain the principal advisory contact when dealing with the more complex legal structures that are available – including cooperative joint ventures.
Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates. Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.
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