If retaliatory tariffs make U.S. products more expensive, it’s reasonable to expect customers will look to other countries to source their purchases. American companies who want to stay in the game are forced to consider putting at least some of their own operations offshore, so their overseas customers can continue to buy from them without paying the higher prices imposed by the tariffs. The Washington Post reported on June 25, 2018 that Harley Davidson, a quintessentially American brand, is considering doing exactly this—moving some operations to Europe—to soften the impact of the tariff wars that seem to be looming.
How to respond quickly to this challenge? Joint ventures may provide a solution.
U.S.-China joint ventures as a solution
The current trade wars are causing businesses to look at repurposing an old and well-understood legal structure. For many years, foreign manufacturers were required to enter into a Chinese joint venture to establish manufacturing operations there, and China was the factory of the world.
Today, China is just as important—perhaps more important—as a market for U.S. products. Some of those products are shipped as finished goods and others as parts or inputs for other products. The products involved range from high-technology items, robotics and heavy equipment, to soybeans, hogs, wine and whiskey. Altogether, American companies sell over $100 billion of goods to Chinese customers annually.
Some production can’t be moved; think hog farms or soybean fields. But companies frequently can ramp down in one country and ramp up in another, to manufacture, farm or develop their products elsewhere. After NAFTA, many California agricultural businesses bought land in Mexico or entered into joint ventures, and moved or expanded operations south of the boarder, shipping the produce back to the U.S., to take advantage of the new labor/tariff arbitrage (in that case, it was low wages and low or no tariffs, but the arbitrage concept is equally pertinent now).
One challenge is to find a way to execute on this strategy quickly and without excessive capital cost. Building a new manufacturing facility, starting an R&D center from scratch, or planting grapevines or an avocado grove in another country could mean a long wait for the benefits of the strategy. Joint ventures can provide a solution.
If an American company can identify a trustworthy partner in China, it may be possible to shift operations and output quickly so that sales to customers are not unduly interrupted. This may require some transfer of non export-controlled technology (not yet prohibited in the trade wars), but at the same time may attract capital investment from the Chinese partner, as well as distribution channels, contacts and relationships that would be beneficial even without the motivation of impending tariffs.
No doubt it is an unintended, and paradoxical, consequence of Washington’s new protectionist trade policy that it is forcing companies to consider shifting operations and jobs overseas. For policy-makers, this paradox should be a concern. For companies, it is simply a matter of hanging on to their market.
Setting up a joint venture in China
In its simplest form, a joint venture in China is a company in the PRC which is co-owned by one or more Chinese parties, and one or more foreign (non-Chinese) parties. In practice, a JV can take many forms. In the context of responding quickly to the trade war challenge, it probably will have the following characteristics:
- The Chinese partner is likely to be in the same or similar industry and able to ramp operations quickly.
- The U.S. partner probably can offer technology or know-how (including processes and methods) the Chinese partner will find attractive.
- The Chinese partner may have the financial strength to make a significant capital investment in the process, an added benefit if managed properly.
- The Chinese partner may also have distribution channels, vendor or supplier relationships, or government contacts that are another added benefit.
- The Chinese partner is likely to require a significant ownership interest, perhaps 51 percent, in the joint venture; this is another issue that must be managed carefully in the legal set-up.
Formation of a U.S.-China joint venture requires the formation of a joint venture entity. The Chinese party itself can become the JV; otherwise a new Chinese or offshore company is required. PRC approvals will be involved, and there are both the usual concerns involved in joint ventures and special Chinese concerns.
Virtually all Sino-foreign joint ventures take the corporate form of a PRC limited liability company. There are several structural aspects of such entities that foreign parties may not anticipate.
- There must be a “joint venture agreement” between the parties. It is required to be governed by PRC law, the operative language must be Chinese, and it must be filed with the authorities.
- The formation of any foreign-invested entity requires three major approvals (Ministry of Commerce, Administration of Foreign Exchange, and Administration of Industry and Commerce). The applications are detailed, approvals are discretionary, and the process can take 30-90 days.
- The official name of the joint venture must be in Chinese characters and follow certain statutory naming conventions.
- Every company has an amount of “registered capital,” which must be paid in, immediately or over time, by the parties. The amount will be established by the authorities when the foreign-invested entity is approved; it often is as high as US$100,000.
- Contributions to registered capital may be in cash or intangibles, but some local jurisdictions have trouble accepting a technology license (as opposed to a transfer of outright ownership) as a capital contribution.
- There are no “shares,” only percentage equity interests; if the parties want, “certificates of equity ownership” can be issued, but are they are unusual.
- There is only one class of equity—no common stock, no preferred stock.
- Profits and losses are allocated pro rata; it is not permitted to specially allocate profits or losses to the parties.
- The parties’ ownership is calculated by reference to the value of their respective contributions, even for later investors (so a later investment would effectively come in at the founders’ valuation; this can be worked around, but special techniques are required).
- Every company must have a “legal representative,” usually the chairman of the board of directors, who has essentially unlimited powers to bind the company (subject to board restrictions, but those restrictions are not likely to be effective as against third parties).
- The legal representative is the custodian of the “chop,” or corporate seal. This is an official stamp and is the legal equivalent of a binding signature. There is only one chop. If the legal representative becomes uncooperative and will not surrender the chop, it is difficult to get it back.
Joint venture agreement
Every joint venture must have a joint venture agreement. There are customary forms in China, but they are more cursory than a Western party may be accustomed to. The parties are free to negotiate a more Western-style agreement and should pay special attention to:
- What is the business purpose and scope of the joint enterprise?
- In what percentages will ownership be allocated between the parties?
- What will each party contribute, how will contributions be valued, and will the relative values match the parties’ agreed ownership percentages?
- What other obligations will each party have to the joint venture that are not valued for purposes of calculating their contributions to registered capital?
- How will the parties handle the JV’s possible need for additional capital in the future? Can there be capital calls? What happens if one party is not able or willing to match the other party’s injection of further capital?
- How will control be allocated between the parties? Will certain items be subject to a requirement of unanimity or some kind of supermajority vote?
- What happens if the parties cannot agree on important matters (a “deadlock”)? Will those matters be submitted to arbitration? Will the parties have a right to buy each other out?
- Should there be ancillary agreements between the JV and one or both parties, and what should the economics be (for example, leases of real property, IP licenses, sales and distribution agreements, management or technical support agreements)?
- Do the parties need to include exclusivity or non-competition provisions so their only pursuit of the agreed scope of business, at least within a defined territory, is through the joint venture?
- Will the parties agree to mandatory, binding arbitration to resolve disputes? Where will it take place: within or outside of China?
- What happens if one party wants to leave the venture? Will there be a put/call mechanism or a right to cause the dissolution of the JV? What happens to the business and its assets upon dissolution?
The organization of any foreign-invested entity in China requires a number of government approvals, and the entity is subject to ongoing supervision and regulation. In all but the largest joint ventures, the approvals are made on a local basis, and the officials have considerable discretion, so each step of the process should be pre-checked with the relevant local government offices to be sure their own procedures are being followed.
- The entity must have a physical place of business, which cannot be provided by a third party as is done in Hong Kong and other jurisdictions. The place of business must be suitable for the operations to be conducted; the authorities will visit the premises to confirm this. The various applications described below are filed with the offices of the government agencies in the specific local area in which the place of business is located; this can be a particular neighborhood or part of a city.
- The local office of the Ministry of Commerce (MOFCOM or MOC) will review a detailed application, which must include pro forma financials for the joint venture and details about the parties and their authorized representatives. This review can take up to 30 days.
- The local office of the State Administration of Foreign Exchange (SAFE) will review MOFCOM’s approval and authorize the joint venture to engage in currency transfers in and out of China. Keep in mind that each individual currency transfer is subject to further case-by-case approval.
- The local office of the Administration of Industry and Commerce (AIC) will review the first two approvals and grant a “business license.” This is the equivalent of a certificate of incorporation. It will list the equity owners, so their identities are a matter of public record. It will also indicate the amount of registered capital and the extent to which it has been paid in. When the business license is issued, the entity comes into existence. As changes to any of the information on the business license occur, the business license must be updated.
- There are a number of post-organization formalities and filings (tax and labor bureau, social benefits administration, etc.) and bank accounts must be opened. This can take several months.
- An annual “audit” as well as a physical inspection will be conducted by the local authorities.
- Profits can be distributed if there are earnings remaining after payment of all taxes, social contributions, and recovery of early-period losses. Case-by-case approval is required for distribution of profits. Distributions must be pro rata between the parties; it is not permitted to allocate profits and losses differentially.
A number of concerns have arisen time and again in the context of Sino-foreign joint ventures. Not all are peculiar to China, and not all have easy solutions.
- Due diligence on the other party is important; a good deal of trust will be required for a successful joint venture and the better the parties know each other, the more they can judge how much they trust each other.
- Alignment of interests is key; many joint ventures founder because the parties did not discuss and agree in advance on their intentions for forming, running, and exiting from the joint venture.
- If personnel are seconded from the parties, their loyalties may remain with the parties instead of the joint venture.
- Control of the venture is not only a matter of being sure the joint agreement reflects the parties’ arrangement; the practicalities of enforcing the rights of the minority partner should be thought through in advance.
- Protection of IP is always a concern. The parties should consider sharing IP in “black box” form if possible. Policies and procedures governing access to sensitive IP should also be considered.
- Compliance with laws, especially in remote areas of China, can be less predictable than in more developed areas or economies. Parties should put in place agreements, policies and procedures with regard to improper payments.
PRC corporate law differs from the laws of the U.S., Hong Kong, most European countries, and all the offshore jurisdictions, as can be seen from the discussion above. The parties should consider whether their joint venture relationship can be more easily legislated if the JV entity were to be organized in a non-PRC jurisdiction. Doing so can make enforcement of both contractual and charter provisions between the parties more predictable.