by Dan Harris
The most common ways that companies start doing business in China (legally) is by forming a WFOE (A Wholly Foreign Owned Entity) or by partnering with an existing Chinese business through some form of joint venture. Media reports to the contrary, China remains quite open to foreign investment and in the past several years WFOEs have become the most common vehicle for foreign investment, partly because of investor skittishness as stories about problems with Chinese equity joint venture partners have made the rounds.
Yet many foreign investors still wish to enter the Chinese market through equity joint ventures, and the particular risks involved with this type of arrangement require careful planning. One way to reduce your risk is by conducting due diligence on your potential Chinese joint venture partner before you tie the knot.
Another way is by making sure that you will control the joint venture. Since most foreign investors wish to maintain control over their Chinese joint venture entity, this issue is usually paramount.
Yet our China lawyers have far too often seen foreign investors make a mistake that effectively leaves them without control—a mistake so fundamental that it accounts for most of the failed equity joint ventures in China. The mistake is assuming that Chinese joint ventures are managed according to a Western model, under which the board of directors has controlling power over the company.
Most foreign investors strive to obtain a 51% ownership interest in the equity joint venture, assuming this gives them the right to elect the entire board and thereby control the company. After winning the struggle for percentage ownership of the joint venture, foreign investors will frequently allow the Chinese side to appoint the equity joint venture’s two key management positions, the Legal Representative and the General Manager. But these “concessions” are all part of the Chinese side’s plan, and effectively render board control meaningless.
Control over a Chinese joint venture actually comes from the following:
The Chinese side to a joint venture will typically refuse to give the foreign party the above three measures of control. It will argue that it should control the joint venture for reasons of both efficiency and expertise. In many cases, it also will claim that it cannot bring its political connections, or guanxi, into play unless its own people fill the Legal Representative and General Manager slots. This argument is usually just a smoke screen for the Chinese side trying to secure the true levers of joint venture control. For more on the difficulties of China joint ventures, check out How We Really Feel About China Joint Ventures. We Love Them AND We Hate Them.
Using a Chinese lawyer or a “China consultancy” increases your risks. Chinese lawyers are not bound by the same duties of loyalty as American lawyers and it is not unheard of for them to work on behalf of your Chinese counterpart to get the joint venture deal done. This may be because the Chinese lawyer is getting paid by the Chinese company or it may simply be because the Chinese lawyer knows he or she will make more money if the joint venture deal concludes. We are aware of consultancies that have represented American and European companies on joint ventures while getting a percentage of the deal from the Chinese side if it goes through.
If you want control over your China joint venture, you should follow the rules set forth above. Otherwise you might find yourself in a venture with no legal right to guide it.
You have been warned.