2023.04.04 ZHOU, Feng (Frank)、CAO, Xiang (Shawn)、Zhilian Huang、Wenhan Cao
Introduction
In Episode II of our series, we answered some of the most common questions that foreign investors have when they set up business entities in China. In this episode, we discuss legal and practical considerations for setting up joint ventures in China.
1. Why choose a joint venture?
Before 1990, foreign investments in many sectors could only be achieved through setting up a joint venture in China. As the country gradually opened up and joined the World Trade Organization in 2001，wholly owned foreign enterprises were permitted in more and more industries. On July 28, 2018, the Special Administrative Measures for Foreign Investment Access (also known as the Negative List) came into effect. The Negative List sets out the general principle that foreign investors could enjoy “national treatment” in all sectors, except for those expressly named on the Negative List. After four rounds of revisions, the 2021 edition of the Negative List reduced the number of sectors restricted or prohibited from foreign investment, from 48 to 31. Important sectors such as securities brokerage, life insurance, and vehicle manufacturing now all allow 100% foreign ownership. Despite this, many foreign investors1 still choose joint ventures when entering the Chinese market, mainly due to commercial reasons: joint ventures can better utilize the resources of Chinese partners, (such as capital, technology, land lots, raw materials and distribution channels), thus reducing the investment of foreign investors as well as uncertainty of the project.
2. What have been the main trends and changes for joint ventures in China over recent years?
The pandemic has had a material impact on foreign investment in China. According to the Ministry of Commerce, 38,947 new foreign invested enterprises were established in 2022, down 19.2% from 20212. With the re-opening of China, consumption and investment is recovering. Wei Jianguo, the former Vice-minister of Commerce, in an interview earlier this year with China Daily, predicted that foreign direct investment may see double-digit growth and reach $220-230 billion in 20233.
For Sino-foreign joint ventures, the background of Chinese partners has diversified, and the partners are playing more active roles in the corporate governance of joint ventures. Traditionally, a foreign investor often chooses a company in its same industry as the joint venture partner. Today, many joint ventures introduce financial investors, suppliers, R&D teams, distributors, and even employees as joint venture partners. Shareholders are increasingly active in the management of joint ventures, making it more important to set up an effective corporate governance to balance the interests of all stakeholders.
3. What are the main forms of joint ventures in China?
In January 2020, the Foreign Investment Law replaced the Sino-foreign Equity Joint Venture Law and the Sino-foreign Cooperative Joint Ventures Law which had regulated joint ventures in China for several decades. Following this, a joint venture could only be established as a limited liability company, a joint stock company or a partnership. We analyzed the difference between the three forms of business in S1 E2 of this series -- How to Set up a Business Entity in China. A limited liability company is the most common form of foreign invested joint venture in China due to its straightforward registration process, flexibility in the shareholders' rights and obligations, mature legal regime, and the limited liability of the shareholders. This article focuses on joint ventures in the form of limited liability companies.
4. How is a joint venture established? How does it differ from establishing a wholly foreign-owned enterprise?
The journey to set up a joint venture begins with due diligence on the joint venture partner, particularly on its reputation, financial situation and capabilities. If the joint venture partner contributes technology, land lots or other assets to the joint venture, due diligence and appraisals on these assets is also required. Joint venture partners will usually negotiate and enter a joint venture contract, articles of association, and the legal documents related to the ancillary transactions, such as technology licenses and distribution agreements. Currently, only the articles of association are required to be submitted to the registration authority during the establishment of a company. The registration process and the timeframe to set up a joint venture company is like that of a wholly foreign-owned company. For further details, please refer to S1 E2 of this series -- How to Set up a Business Entity in China.
5. How are decisions made in joint ventures?
The governance of a joint venture in the form of a limited liability company is carried out through the shareholders' meeting, the board of directors (or the sole executive director), and the management (see the illustration chart below). The shareholders' meeting is the highest decision-making body of a company. It decides on important matters of the company and has the right to elect and remove the directors and supervisors4. The board of directors (or the sole executive director where there is no board of directors) reports to the shareholders' meeting. The board of directors has the right to make decisions on matters not reserved for the shareholders' meeting. The management, represented by the general manager and its executive team, is responsible for the daily business affairs and the daily operations, and can be appointed or removed by the executive director or the board of directors. The board of supervisors (or the supervisor(s) where there is no board of supervisors) have the right to inspect the company's financial conditions, supervise the performance of the directors and senior managers, and propose to remove them if they violate the laws, regulations, articles of association or decisions of the shareholders. According to the draft amendment to the Company Law5, legislators may permit small-scale companies to set up audit committees under the board of directors to assume the roles of the supervising body and make the board of supervisors or supervisor(s) an optional choice. A foreign shareholder can participate in the governance of a joint venture company by nominating or appointing directors, supervisors and senior managers to the joint venture company and by exercising its information rights, voting rights and other statutory and contractual rights.
According to the Foreign Investment Law and its implementing rules, a Sino-foreign joint venture company established before January 1, 2020, may continue to have its board of directors as the highest authority in the company, but must change the highest authority to the shareholders meeting and complete relevant filing before January 1, 2025. After January 1, 2025, the market regulation authority will reject the registration and filing applications of foreign-invested enterprises that do not adjust their corporate governance structure according to the law. We are halfway through the 5-year transition period and we have assisted many joint venture companies to change their governance structure while preserving their existing business arrangements as much as possible.
6. What are the key issues to be considered in joint venture negotiations?
According to our experience, the following issues are critical in joint venture negotiations:
(1) Capital contribution timetable: The parties to the joint venture need to clearly stipulate the timeline, amounts and conditions of capital contributions and the liabilities for failure of capital contributions. It is also important to agree on the denomination currency and mechanisms to deal with exchange rate fluctuations.
(2) Governance: The parties to the joint venture need to agree on the mechanism for the appointment and removal of directors, supervisors and senior managers and their obligations respectively. The decision-making mechanism of the shareholders' meeting and the board of directors also needs to be clearly set out.
(3) Deadlock: A deadlock breaking mechanism is essential where resolutions cannot be adopted at a shareholders' meeting or board of directors meeting. Common deadlock breaking mechanisms include: (i) escalating the dispute to the decision makers of the shareholders for a final decision; (ii) final decision by a shareholder unilaterally according to an agreed mechanism; (iii) final decision by a pre-agreed third party; (iv) one party buying out the other party or parties at an agreed price; or (v) dissolution of the company.
(4) Equity transfer: The parties will agree on equity transfer restrictions, such as the lock-up period and the right of first refusal.
(5) Information and inspection rights: The shareholders enjoy statutory information rights according to the Company Law, such as (i) reviewing and copying the articles of association, minutes of shareholders' meetings, resolutions of the board of directors and board of supervisors, and financial reports of the company, and (ii) reviewing the books and records of the company. Minority shareholders often request the right to inspect the company, including accessing its sites, facilities and offices, and engagement with the personnel of the company.
(6) Non-compete: Non-compete clauses are often heavily negotiated between shareholders. Shareholders typically undertake not to compete with the joint venture company and negotiate on the scope of the non-compete business, territories and restriction period. Such restrictions usually extend to the affiliates and close relatives of the shareholders. It should be noted that non-compete clauses should not contradict the requirements of the PRC competition law.
(7) Ancillary transactions: Negotiations regarding joint ventures often involve ancillary transactions, such as the supply of goods, provision of premises, licensing or transfer of IPs, and commitment to distribute goods, etc. During negotiations, foreign investors shall weave the ancillary transactions into the joint venture transaction by introducing appropriate deal structures, payment terms, conditions, and covenants, as well as cross-default and cross-termination mechanisms.
7. What are the key issues to be considered in a joint venture with a financial investor?
(1) Balance of voting mechanism
Financial investors are unlikely to pursue active control of a joint venture company, but they do want to have an appropriate level of control over important matters. Therefore, the founding shareholders shall assess the impact on the joint venture company if the financial investors exercise their veto rights. Where there are multiple financial investors, it is common to allow financial investors to vote as a single class on an important matter, and to veto such matters only if the financial investors holding a simple majority or a two-thirds majority of all shares vote against it.
(2) Valuation adjustment mechanisms and redemption rights
Financial investors often want to negotiate a valuation adjustment mechanism (VAM) or redemption right. They may ask the joint venture company or the founding shareholders to compensate them or buy back their shares when a certain event is triggered. The shareholders need to review the reasonableness of triggering events, the formula of VAM or redemption, and whether a liability cap is desirable. The parties should also pay special attention to PRC laws and judicial practices regarding the validity and enforceability of VAM and the redemption provisions.
8. What are the key issues to be considered in a joint venture with a state-owned enterprise?
When entering a joint venture with a state-owned enterprise, special attention needs to be given to the approval, appraisal, and process requirements which may be applicable when the state-owned enterprise contributes its capital or transfers its equity interests to a third party. In respect of corporate governance, the parties shall also consider if the state-owned shareholder has any special requirements, such as whether it is necessary to set up a labor union within the joint venture and whether any matter shall be subject to prior communication with the state-owned asset supervision authority, etc.
9. What can outside counsels offer to joint ventures in China?
Outside counsels with solid experience in joint venture transactions can help navigate the entire process through assistance with:
due diligence on the joint venture partners and the assets they will contribute;
the negotiation and execution of the joint venture contract and other legal documents; and
the application for licenses and permits for the joint venture and ensuring its legal compliance.
Please email us at China_Business_Support@junhe.com for more information regarding our experience and fee structure.
In our next episode, we will discuss “Essentials for equity divestments by foreign investors”, stay tuned.
1.According to the Ministry of Commerce in the last statistical results on foreign investment by Investment mode before the promulgation of the new Foreign Investment Law, 8913 joint ventures were established from January to November 2019 , accounting for 24% of all new foreign-invested enterprises.
2.Data from the Chinese government website; for more information, please refer to http://www.gov.cn/xinwen/2023-02/28/content_5743623.htm
3. Data from China Daily website; for more information, please refer to https://cn.chinadaily.com.cn/a/202301/19/WS63c8e826a3102ada8b22c11d.html
4. If the articles of association require a representative of the employees to be a director or supervisor of the company, the representative shall be elected by the employees.
5.According to Article 69 of the Company Law (Second Review Draft of the Revised Draft) for Comments, a limited liability company may set up an audit committee among the board of directors in accordance with the provisions of the articles of association and exercise the powers and functions of the board of supervisors as provided for in this Law, without having a board of supervisors or supervisors.
According to Article 83 of the Company Law (Second Review Draft of the Revised Draft) for Comments, a small-sized limited liability company can have no board of supervisorse and one or two supervisors to exercise the powers and functions of the board of supervisorse under this Law; with the unanimous consent of all shareholders, it can also have no supervisors.
If the above amendment is retained, in the future, a company is allowed not to establish a board of supervisors or to instead establish an audit committee if the conditions are met.
