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Special> China International Fair For Investment & Trade> Beijing Review Exclusive> Legal-Ease
UPDATED: June 30, 2008 NO. 27 JUL. 3, 2008
Joint Venture Structuring in Restricted Industries

When investing in China's restricted industries, it is essential to have a joint venture (JV) partner. Often the maximum percentage of equity allowed in foreign ownership can only be 50 percent. So what options are available to the foreign investor to mitigate the risk of not owning, on paper, a majority stake? All JVs are bespoke, so the situations and investment environment can vary considerably. But there are some well-proven guidelines to follow that can assist you get the most out of your JV.

50-50 ownership

The problem with this is the potential risk of getting into a static management position later with both parties disagreeing on a future direction. At worst, a board at loggerheads and unable to agree on a decision can effectively wreck an entire business. I find it best to build into the JV structure a mechanism that can provide a way out under certain circumstances. It is better to have made a bad decision that can be reversed than to have a board unable to move in any direction.

There are a number of ways in which this can be accomplished. Agree to give up 1 percent and have the Chinese side own the majority, which in the case of respected partners should not be an issue if the management team is healthy and the business able to declare dividends. A 1-percent loss of dividends is a small price to pay for a united board. Alternatively, other mechanisms can be enacted within the JV articles to permit the chairman, for example, the deciding vote in the event of a split vote. This needn't be immediately enacted-it could be triggered if three or four board votes on the subject were spilt, allowing both parties time to negotiate or better understand the issue at hand.

I have seen JVs fail because of a disunited board leaving the company stagnant. I have seen them fail due to poor management. I have never seen a JV fail because a particular decision in voting went the Chinese side rather than the foreign one. It takes far more than a difference of opinion at board level to make a JV fail.

Cooperative JVs

There are two types of JVs in China, the equity joint venture (EJV) and the cooperative joint venture (CJV). In EJVs, dividends (or liabilities) are divided up according to the equity ratio each partner holds. In CJVs, this can be changed. It means that although a foreign investor may only own a minority stake on paper, in practice the dividend payments can be weighted in their favor. This is a useful character of CJVs when investing in restricted industries that by law have to provide for parity or higher equity for the Chinese partner. If permitted (in some circumstances CJVs may not be allowed), a CJV allows for the majority equity to be held by the Chinese side, however, with the CJV's articles specifying the ratio of dividends to be given to each party-useful when despite the regulatory environment, it is the foreign partner who is bringing in the greater assets.

Penalty clauses

These, if necessary, can be inserted into the JV articles to provide motivation for sticking to previously agreed timeframes for certain issues relating to the JV's operations.

Mitigating risk

The JV horror stories we have all heard about can be mitigated against with the assistance of an experienced lawyer in the field of structuring JVs. Problems that can arise can include:

- Land use rights: You need to assess the value of the land properly as this will usually be a large part of the Chinese investment. Knowing whether the land is provided as granted (ownership) or allocated (non-ownership) is important. I have seen many cases where allocated rights were given, but the value assessed for it actually based on granted status.

- Human resources: You need to assess the financial and liability aspect of the JV workforce, especially if it is taking on staff previously engaged by the Chinese partner. It can be used to offload pension or termination liabilities of long-term employees away from the Chinese company and onto the JV.

- Related companies: You need to assess the entire business model and ensure all other companies vital to the JV are vetted and cleared and that contracts with them are above board and satisfactory.

- Supply chain fraud: You need to get your people into all aspects of the financial operations of the JV, including financing and accounting, human resources and procurement. Staff buying from other companies at enhanced rates rather than market rate can be very common.

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