Miromar Lakes, FL 33913 USA T. 239.823.1151 F. 239.590.3026 www.thornhillcapital.net 1
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
April 2012 Newsletter
Miromar Lakes, FL 33913 USA T. 239.823.1151 F. 239.590.3026 www.thornhillcapital.net 5
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
Miromar Lakes, FL 33913 USA T. 239.823.1151 F. 239.590.3026 www.thornhillcapital.net 7
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
Miromar Lakes, FL 33913 USA T. 239.823.1151 F. 239.590.3026 www.thornhillcapital.net 8
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
Miromar Lakes, FL 33913 USA T. 239.823.1151 F. 239.590.3026 www.thornhillcapital.net 10
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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