Thornhill Capital April 2012 Newsletter · a Chinese partner. As in other areas of the world,...

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April 2012 Newsletter

Inside this issue:

Joint Ventures 1-2

China is Different 2

Align Expectations 2-3

Joint Venture Agreements - 4

Due Diligence 4-5

Contributions - 5

Employees 5-6

Purchasing- 6

Tax Breaks -6

Permits and Licenses 6-7

Going it Alone --7

Corporate Seal -7-8

Arbitration 8

Law Suits 8-9

Why Joint Ventures 9-10

Endnotes 10

Joint Ventures

Foreign investment in China first came of age in 1978

with the implementation of China’s Open-Door policy.

Since that time Foreign Direct Investment (FDI) has

fueled the tremendous economic and technological

growth in present-day China. One form of FDI is the

Joint Venture (JV), which arises when a Chinese

investor(s) and a foreign investor(s) own equity interest

in the same Chinese limited liability company. In a JV,

each investor contributes assets to the JV and shares in

its control, operation, risk and profit. The joint venture is

not a merger, but the creation of a new entity which is

owned by both parties. Moreover, both parties are liable

only to the extent of the assets each contributed, with

the liability not extending past the joint venture to the

parent companies.1

Originally, joint ventures were seen by the Chinese

as a way to increase exports and encourage high

technology manufacturing. However, as time went by,

the role of joint ventures expanded. There are two types

of joint ventures: Equity Joint Ventures and Cooperative

Joint Ventures. An Equity Joint Venture may be between

individuals or corporations and the profits are shared in

proportion to the capital contribution of each party. In a

Cooperative Joint Venture the partners have unlimited

liability and the profits can be distributed in any manner

agreed to by the partners. All foreign joint venture

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partners must contribute at least 25%

of the agreed capital in either cash or

business assets. This contribution

cannot be repaid during the life of the

joint venture.

Administratively, Chinese joint

ventures must be approved by The

Ministry of Foreign Trade and

Economic Cooperation (MOFTEC).

Once submitted, MOFTEC is required

to answer the joint venture proposal

within three months. When MOFTEC

gives its approval, they’ll issue an

Approval Certificate for Enterprises

with Foreign Investment. The

Administration of Industry and

Commerce (AIC) will then handle the

remaining stages of business

formation. Once the approval of

registration is received, the joint

venture books must be set up within

15 days and be kept in the Chinese

language. In addition, the business

license must be renewed annually

with the renewal application submitted

one month prior to expiration.6

China is Different

Chinese joint ventures are

typically different from other joint

ventures you may have completed.

Some feel that, because they’ve

successfully completed joint ventures

in other areas of the world, they’ll

complete them without issue in China.

But nothing could be further from the

truth. China is a unique business

environment. It offers substantial

upside to those who know how to

operate within its environs, but it also

carries substantial risk for those who

may not be as familiar in working with

a Chinese partner. As in other areas of

the world, Chinese businessmen often

take advantage of foreigners by

means of lies, false documents, and

inaccurate financial statements. From

the Chinese point of view, it is the

responsibility of the foreign investor to

determine the business truth within a

transaction, no matter what

representations are made. This is the

way they do business domestically,

and this is the way they do business

with foreigners.

Align Expectations

Therefore, from the outset, it is

critical to conduct due diligence so

that both parties know the facts and

can align expectations. In a joint

venture, each side expects to benefit

from the other and attain goals it would

otherwise have difficulty in attaining on

its own. Aligning expectations sounds

pretty basic, and it is. But, i t ’s

surprising how many times we see

joint venture partners with different

goals and objectives. Assumptions

are made on one, or both sides, that

s i m p l y a r e n ’ t a c c u r a t e . T h i s

April 2012 Newsletter

Miromar Lakes, FL 33913 USA T. 239.823.1151 F. 239.590.3026 www.thornhillcapital.net 3

misalignment of goals and objectives

is frequently caused by cultural

differences or, given the geographic

and language separation, the difficulty

in both sides communicating properly.

Consequent ly, one of the most

important factors we’ve seen in a

successful joint venture is when each

of the parties is in constant contact, so

that both sides are focused and able

to resolve problems on a real time

basis. When this happens joint

ventures tend to be successful.

Below are two tables, from

Jiaqin Yang and Huei Lee, identifying

key factors for a successful joint

venture in China. The first table

shows the differing expectations for

both the Chinese and foreign joint

ventures partners, while the second

table shows the tangible benefit each

party expects to receive.

2

2

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Joint Venture Agreements

By using a competent law firm

you’ll avoid some of the pitfalls that

others might experience in joint

venture contracts. There are a number

of problems that commonly arise in

joint venture agreements with Chinese

companies. First, the contractual

obligations sought by the foreign

partner may be attached to the

Chinese company and not to the joint

venture itself. Many times the Chinese

company involved has no real assets

and, if things go wrong, there is little to

no legal recourse against the Chinese

company.

In addition, the language in the

English and Chinese contracts

sometimes conflicts. Each contract

may say that its language prevails in

the event of dispute. However, the

Chinese translation may not always

be the same as the English version.

Some feel that, because they’ve said

the English version of the contract

prevails, that verifying the Chinese

translation of the contract isn’t

necessary, but that can lead to the

contract being unenforceable. You

should always engage a translator or

translation service that is well versed

with the vagaries of legal contract.

Lastly, make sure that your

attorney files the signed copy of the

agreement. I’ve seen a situation

where another version, other than the

one signed, has been filed with the

government. When it came to

enforcing the agreement through a

lawsuit, it was difficult to prove which

version was the one that should be

relied upon. 5

Due Diligence

Setting up joint ventures in

China begins with performing due

diligence on your Chinese partner.

You’ll want to examine your partner’s

books and records, inventory, number

of workers, and other business

aspects before accepting with the

documentation you’ve been provided.

This will present you with the true facts

so negotiations can then take place

from a known starting point.

We have found that it is best to

perform both formal and discreet due

diligence on the potential partner.

Formal due diligence would

encompass reviewing standard

diligence items to verify the validity of

the partner entity, such corporate

documents, business licenses, capital

verification reports, financial

statements, tax reports, and even

background checks on executives.

Discreet due diligence is

performed without the knowledge of

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the partner, to provide an objective

confirmation of facts discovered

during the formal due diligence.

Examples could include sending an

independent analyst to observe the

partner’s facilities to verify existence

of a plant or assets, that the plant is

operating, or to verify the approximate

number of employees, or verifying the

existence of key suppliers or vendors.

The type of work performed will vary

according to the facts and

circumstances, but this type of work

can be as valuable as, or sometimes

more valuable than, formal due

diligence since it does not allow the

partner control of everything you

observe.

Contributions

Your percentage ownership in

the joint venture will normally be

based on the value of what you and

your Chinese partner each contribute.

The most common contribution by a

Chinese partner is land which, in our

experience, they almost always

overvalue. Don’t assume that the

value of the land you’ve been provided

is real, even if verified by a

government official, a bank, or in other

“formal” documents presented to you

by your joint venture partner. Even

these institutions will often value lands

at an amount other than fair market

value. For example, a bank may

overvalue a piece of land to be used

for security for a bank loan, in order to

justify making the loan. An

independent third party valuation is

the only way to accurately determine

the value of the land and, as such, the

true value of your partner’s

contribution to the joint venture.

Employees

Joint ventures may employ

both Chinese and foreign workers.

Individual labor contracts are required,

must be in Chinese, must include at

least a minimum seven clauses as

prescribed by Article 19 of the Labor

Act, and must be submitted for

approval to the local labor bureau.6

When entering into a domestic

transaction, the Chinese will question

all data provided them by another

Chinese person or firm, and will

accept the data only after independent

verification. You should do the same.

We found that the most common

misrepresentation, after the financial

statements, is the number of

employees and, consequently, the

amount of social security that is being

paid to these non-existent employees.

Many Chinese business owners use

these misrepresentations as a method

for taking money out of the JV by

paying non-existent employees. Again,

third party due diligence should be

able to uncover this practice. However,

April 2012 Newsletter

Miromar Lakes, FL 33913 USA T. 239.823.1151 F. 239.590.3026 www.thornhillcapital.net 6

you can also do this yourself and verify

the number of employees by the social

security being paid to these

employees. If the payroll indicates that

the entity is paying 150 employees,

but only social security for 100, this is

a red flag that should be investigated

and reconciled.

Purchasing

Another method that local

Chinese investors could use to

remove profits from the JV outside of

the parameters of the JV agreement is

through the theft of raw materials or

inventory. Therefore, having a reliable

purchasing manager, and periodically

doing unannounced spot checks on

the inventory, is the best method for

preventing this type of theft. Even

after the JV is completed and

operational, ongoing due diligence

(both discreet and formal) is critical to

protecting your investment.

Tax Breaks

You’ll also want to speak with

the local government officials to

determine the extent of their

commitment to the joint venture, and

to verify any government support that

you’ve been promised. For example,

local government officials in China

share a common trait with their US

counterparts. They make promises

and they don’t always deliver.

Foremost among these promises is

favourable tax treatment. It’s not

uncommon for a local government

official, in order to attract business, to

promise tax breaks. However, these

don’t always occur. It’s not uncommon,

once the joint venture is formed, to

have the government apologize for a

misunderstanding, or a “change in

government policy”, that effectively

has you paying your full tax bill from

day one. Therefore it’s best to obtain

the government’s commitment in

writing prior to completing the joint

venture.

Permits and Licenses

In addition, when your partner

contributes land, you should verify that

the proper permitting is in place for the

type of business your JV intends to

operate. Don’t assume the proper

licenses and permits are in place just

because the partner company is

producing the same products that

you’ll be producing in the JV. Many

companies have a relationship with

the proper government officials that

make it possible to operate their

business without the required licenses

or permits. However, you may not be

able to continue operating your

business should the government

official, or your JV partner, leave. At

this point, even as the majority owner,

April 2012 Newsletter

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in order to obtain the proper permits

and licenses, you may be forced to

negotiate terms that may make your

joint venture much less profitable.

Furthermore, if you intend to exit your

investment through a public listing, all

licenses and permits will need to be in

order as part of the due diligence and

audit process.

Going it Alone

The day-to-day operation of a

JV is normally carried out by your

Chinese partner. Therefore, there’s a

temptation to have your partner run

the company while you judge his

performance through an examination

of the books and records. This

practice can result in a number of

problems, most of which are terminal.

For example if, at some point, your

Chinese partner determines that he

can make more money outside the

joint venture than continuing with it, he

may decide to manufacture the

product himself, especially if there’s

been a technology transfer. Having

day-to-day involvement with the

company, and demonstrating to your

Chinese partner that he can make

more money cooperating with you,

than against you, is the only way I

know of to prevent him from going it

alone.

Additionally, there are

countless ways (such as inventory

shrinkage, creating false vendors,

bank fraud, etc.) that Chinese

managers can skim substantial profits

from the business. The books and

records will almost always be

maintained in China by a Chinese

accountant loyal to the Chinese

management, and the Chinese are

highly skilled at financial misdirection.

So simply reviewing monthly or

quarterly financial reports will not give

an accurate view of what is really

happening. You must be involved in

the operations of the business, using

Chinese speaking representatives

who are loyal to you.

Corporate Seal

Also, unlike the US, where a

signature on a document is used on

corporate contracts, China uses a

corporate seal to denote corporate

obligations. When your partner has

control of the corporate seal, he

effectively has control of the company.

Let me give you an example of how a

lack of control of the corporate seal by

the foreign JV partner led to a major

problem. A number of years ago an

automotive services company entered

into a joint venture with a US partner.

The Chinese partner contributed land

and equipment (overvalued, as it

turned out), and the US partner

contributed cash. The US joint venture

April 2012 Newsletter

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partner wanted to approve all cash

distributions in excess of $25,000

USD and, consequently, required dual

bank signatures for all wires

exceeding this amount. At some point

during the relationship both sides

disagreed as to how the business was

being run, which was resulting in

decreasing cash flow from operations.

The US side, frustrated by the

answers they were receiving from their

joint venture partner and the sharp

decrease in revenue and earnings,

decided to conduct their own due

diligence. They decided to start with a

review of the bank accounts. However,

when they went to the bank and asked

the bank for a statement and account

balance, they were told they could not

receive this because they did not have

a corporate authorization (company

seal) or the permission of the CEO.

Moreover, the CEO wouldn’t

cooperate and give them the

information. The foreign partners

decided to sue. After spending quite a

bit of money on a law suit the US joint

venture partners finally obtained the

bank statements only to find out that

there were no funds in the account.

How could this happen? The company

had simply used the corporate seal to

provide the bank the documentation

the bank needed for the company to

remove the funds. Therefore, in any

joint venture, we recommend retaining

the corporate seal. If you have the

corporate seal, you effectively have

control of the company.

Arbitration

When you arbitrate, make sure

you designate China or Hong Kong as

your venues. Other international

locations may give you a false sense

of security since these venues don’t

always have the ability to resolve and

enforce their judgments, nor provide a

resolution if your JV partner simply

doesn’t show up.3

Law Suits

When the situation deteriorates

to the extent that your only option is a

law suit, then you should be aware of

some of the peculiarities of the

Chinese legal systems. First, foreign

companies can, and do, win

judgments against Chinese

companies in Chinese courts.

However, the courts in China tend to

be very different from those in other

Western countries. For example,

Chinese courts tend to base their

decision on the fairness of a case

rather than legal technicalities. In

addition, don’t count on discovery. It

seldom happens. You’ll have to use

the documentation you already have

as Chinese courts tend to base their

rulings on documentary evidence

rather than testimony.

April 2012 Newsletter

Miromar Lakes, FL 33913 USA T. 239.823.1151 F. 239.590.3026 www.thornhillcapital.net 9

Chinese companies rarely

settle a law suit. There are two primary

reasons for this. The first is that, unlike

the US, the cost for litigating in China

is relatively low. The second is that the

company will lose face if they settle.

They would rather lose the case and

blame the judge, than lose face by

settling.

However, if you think you’ll end

up with a large judgment, that’s

probably not going to happen.

Chinese courts don’t normally award

high damages for a number of

reasons. The first is that Chinese

companies operate on low margins

and awarding a large judgment could

harm the Chinese company and

cause layoffs. In addition, damages for

lost profits or pain and suffering are

seldom awarded.

Most Chinese companies,

when faced with a judgment that could

harm the company or cost them

substantial funds, simply shut down

the company and re-open it under

another name.4

Why Joint Ventures

In the 1980s, and through the

mid-1990s, Chinese foreign

investment law required most foreign

direct investment to be in the form of a

joint venture. Since that time Chinese

foreign direct investment law now

allows WFOEs (wholly foreign owned

enterprises) in most areas of the

Chinese economy. A WFOE is a

Chinese limited liability company

owned solely by foreign investor(s)

where the capital comes exclusively

from outside of China without a

co-investment by a Chinese entity.

Some investors prefer WFOEs

because they have autonomy to carry

out the strategies of their parent

company without consulting with their

Chinese partner. In addition, they

have full control (at least form a chain

of ownership perspective) over

management, production quality, profit

distribution and intellectual property.

A joint venture offers some

advantages over a WFOE in areas

that may be important to some foreign

investors. For example, joint ventures

generally have stronger local contacts

and relationships (guanxi), specifically

with the local government, to secure

access and authorization to profitable

projects. Moreover, Chinese partners

in a JV may have a better ability to

secure hard-to-obtain land use rights

to a particular site where local

connections are often the key to

approval. In addition, a JV will most

often provide the trained resources to

operate the facility upon completion as

well as a local sales network. Lastly,

and of importance to many investors

April 2012 Newsletter

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new to China, a JV lowers the financial

risk by having a local JV partner who

can provide not only capital to

supplement your investment, but

access to Chinese government

support and obtaining resources that

may be more difficult for foreigners to

obtain.7&8

According to the Chinese

Ministry of Commerce, China saw an

increase in foreign direct investment

of 9.7 per cent year-on-year in 2011 to

$116 billion USD. Between January

and February, 2012, China received

$17.72 billion USD in foreign direct

investment and approved 3,005

foreign funded enterprises. With

proper due diligence, legal

documentation, and a responsible

Chinese partner, savvy investors can

tap into the rich Chinese business

environment by utilizing the joint

venture structure.

Endnotes

1. http://chinaprimer.com/foreign-investment-china/china-joint-venture.html

2. http://www.faculty.de.gcsu.edu/~jyang/Publications/AHP-J.V.%20China%20Paper.pdf

3. http://www.foreignentrepreneursinchina.com/2012/02/a-joint-venture-survival-guide-22-

facts-and-22-practical-tips-3-posts-compiled/

4. How to Sue A Chinese Company, Part IV. Arbitration in the U.S. and suing in China By

Dan Harris on November 11th, 2010 Posted in Legal News

5. China Law Blog, How Not To Write A Joint Venture Agreement , Posted: 10 Jan 2012

6. http://www.lowtax.net/lowtax/html/asia_pacific/business/china_joint_venture.html

7. http://chinaprimer.com/foreign-investment-china/china-joint-venture.html

8. http://www.starmass.com/en/investment_in_china.htm

Alan Refkin David Dodge

© 2012 Thornhill Capital. All Rights Reserved

April 2012 Newsletter

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This publication is for informational purposes and reflects the personal opinions of Thornhill Capital. This publication is not

intended to convey any legal, accounting, or investment advice. The information herein should not be used or relied upon in

regard to any particular facts or circumstances without first consulting a lawyer, investment advisor, certified public

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