Ten Tips for Successful Joint Ventures

Transcription

1 China Bulletin Ten Tips for Successful Joint Ventures Joint ventures in China as elsewhere - are notoriously difficult to manage successfully. Whatever the motivation for the combination, with control shared between often commercially competitive shareholders opportunities for conflict are rife. Not surprisingly, joint ventures have never been the preferred form of doing business in China. Other things being equal, it is almost always preferable to wholly own a subsidiary in China, as elsewhere. But other things are not always equal, and joint ventures are often entered into in spite of the risks. In certain sensitive economic sectors, foreign investments must be conducted through a joint venture wholly foreign-owned enterprises ("WFOEs") are not permitted. For foreign companies operating in such restricted sectors, as between a JV and no investment, a JV is preferred (at least, if its costs and risks can be managed). But not all JVs are compulsory. Sometimes foreign investors enter into joint ventures for economic or strategic reasons: in order to share risks, costs and resources, or because a particularly influential or attractive Chinese partner (e.g., an existing distributor) insists on it. In the acquisition context, Chinese sellers often are unwilling to sell 100% of their equity in the target. Since Chinese sellers can't yet easily take equity in foreign acquirers as consideration, partial acquisitions of domestic companies are an increasingly common source of new brownfield joint ventures. Given the ongoing prevalence of joint ventures, it is as important as ever to actively manage their risks and shortcomings. Fortunately, experience has taught many valuable lessons over the years. The following are some key lessons learned in our experience advising on joint ventures over the years. Though these suggestions won't guarantee success, they will help to mitigate the likelihood of disaster, or at least its consequences. Generate alternatives Because there are so many irreducible risks, the best initial advice is still to do a joint venture only if truly necessary. Early in the planning stage, a potential investor should actively explore any reasonable alternatives to a joint venture. Generally, that means a WFOE, and a commitment to going it alone. In restricted sectors, this might mean licensed manufacture onshore, and/or establishing a WFOE in a related sector to manage production here. In the acquisition context, it could mean exploring new alternatives for paying the target shareholders in shares of the acquirer (if a listed company). However, foreign exchange, accounting and tax rules inevitably create problems for any other than the most standard investment and transaction practices. Any more indirect, exotic or unnecessarily complex structures for example, so called 'variable interest entity' ( VIE ) or 'Sina model' structures - should be approached with caution. Focus on long-term competition Joint venture partners are often potential competitors. In fact, it often happens that foreign investors lose whole product markets to previous joint venture partners. So perhaps the greatest general long-term risk for foreigners in China joint ventures is the risk of establishing or enabling a competitor. It is therefore critical to evaluate all aspects of the joint venture in this light. Many of the following lessons revolve around managing the effects of competition. Know your partner's motives, and do your due diligence Unless the Chinese party's active participation is required for operational reasons, the best Chinese partner is a sleeping partner. Unfortunately, this is all too rare. Chinese partners' reasons for joint venturing rarely begin or end with the profit motive; usually, their motives are also strategic. In addition to profits, Chinese partners often want to gain technology, know-how and (ultimately) new products or processes. In this sense, Chinese partners' motives are often at least as much competitive as they are collaborative. If the Chinese partner will continue producing related products alongside the JV, or is a member of a state-owned group company, the competitive risks are amplified. It is essential to do due diligence on the potential JV partner, especially e.g., in regard to their reputation, bribery and anti-corruption policies (if any), and any track record of regulatory non-compliance, bribery or corruption, failure to pay taxes, or litigation.

2 Define products and markets Competitive risks come into stark relief in the definition of JV products and markets. It is critical to carefully and clearly define the JV's products and markets, to identify any overlap with the JV partners' own products and markets, and to specify any obligations of the partners not to compete with the JV. It is also often prudent and appropriate to demand non-compete commitments from the Chinese partner, prohibiting it from producing the JV products after termination of the JV. Calibrate technology transfer Technology transfer of some type is an almost universal element of greenfield joint ventures in China. Of course, this is the point where a foreign investor's products are most exposed. Therefore, all available contractual and practical safeguards should be utilized. As a practical matter, the technology should the segmented and distinguished, so that complete core technology is not exposed. If possible, the critical core technology should be embodied in components or materials produced elsewhere, to be sold or supplied to the JV by the foreign party. As a matter of contract, the foreign party should retain ownership over improvements, and the technology transfer contract should terminate with the JV. Detailed custodial and copy tracking measures should be mandated and monitored. The JV should be expressly prevented from disclosing the technology to the Chinese partner, and to subcontractors, consultants or design institutes, without approval. All relevant employees should be subject to confidentiality and non-compete agreements. Focus on IP Most first-time foreign investors in China have not already registered their trademarks here before they invest. At best, they tend to do this once investment planning or negotiations begin in earnest. Since China is a strict first to file jurisdiction, a trademark must be registered before anyone else in order to enjoy exclusive use rights in the mark. In fact, trademark squatting is quite common, with domestic parties registering foreign marks then offering to sell them to the original users. Both company and product brand names should be registered in all relevant industry classes, in Chinese and English, at the earliest opportunity even in advance of market entry. Manage Management To the extent that control over the business is shared, management structures and functions are the focus of both contention and cooperation between joint venture parties. Both board and executive positions must be allocated between the parties, and their functions and decision rules specified carefully, to establish the balance of power between the parties. Where either party has a substantial majority of equity, it will usually have clear board and management control, and the key negotiating issues will revolve around minority protections. The key minority protections are veto rights, requiring unanimous approval for certain board decisions. If expatriate managers will be required, due consideration should be given to their costs, and to the fact that qualified western managers are often unwilling to work outside of the most developed urban centres. To maintain actual management control, it is critical to appoint the general manager and legal representative, and to maintain physical control over the company chops. Commit to the process Joint ventures are complex entities, and the negotiation of joint ventures is a time and resource intensive process. The process cannot be completed without a real commitment of management resources by the parties. Ideally, the key structural and commercial elements of the deal should be agreed in an MOU early in the process, providing a road map for the rest of the process. Dedicated working groups should be established by both parties, and senior management should be kept appraised of progress and be available as required to decide on key issues. In deals among equals, where the parties are both actively engaged, several months and numerous rounds of negotiations and drafting are often required to reach agreement. Even so, you should be prepared to walk away if it becomes clear that you cannot get what you need out of the process.

3 Negotiate rigorously but flexibly It is always advisable to begin negotiations based on well-honed long-form dual language standard contract precedents. That will ensure a comprehensive treatment of all the standard structural and operational issues, and also provide a solid framework for any necessary variations in approach. Chinese parties often prefer much simpler and briefer forms of contract than is common in standard Western practice. It is said that, in the Chinese world view, the ebb and flow of events is considered too complex, too chaotic, to predict and regulate in advance by contract. Nevertheless, Chinese parties tend to have a keen instinct for risk, and to aggressively negotiate material aspects of detailed long-form contracts. Prepare for exit Apart from certain limited statutory grounds for termination, JVs cannot be terminated unilaterally by either party only by agreement. The parties should therefore agree in advance the range of grounds that might trigger termination. Termination for deadlock is an obvious example. Termination might also be triggered if the JV fails to meet certain sales or market share thresholds, or to obtain certain quality certifications. Foreign parties should ensure that there are cross-termination provisions in the technology transfer and JV contract, so that termination of one is grounds for termination of the other. Transfer rights and restrictions are also critical. Rights of first refusal, put and call options, and buy-out rights should be specified in detail. Foreign investors in restricted sectors ( joint venturing only because they must do so as a matter of law) should also expressly include rights to buy out the domestic party once foreign majority shareholding or WFOEs are permitted by policy. Protecting the Un-patentable As intellectual property right ( IPR ) protection improves in China, foreign businesses must take measures to protect their IPR in China in order to establish and maintain competitive advantages over their competitors. While most subject matter is patentable in China, certain things are excluded from patent protection for historical or public policy reasons. However, certain formal protections are also available for these forms of IPR. For example, inventions contrary to the laws of the State or social morality, or detrimental to public interest, are excluded from patent protection. In addition, scientific discoveries, rules and methods for mental activities, methods for the diagnosis or treatment of diseases, animal and plant varieties, substances obtained by means of nuclear transformation, and designs of two-dimensional printing goods which serve mainly as source indicators, are also excluded from patent protection in China. Careful examination of seemingly non-patentable subject matter may reveal specific patentable technologies and designs. Further, alternative IPR protection methods should be considered where patent protection is not available. As examples, we discuss below computer software, diagnosis or treatment of diseases, and designs of two-dimensional printing goods. Computer software Computer programs are considered to be rules and methods for mental activities, and therefore cannot be patented in China. However, if an invention involves a technical solution including execution of a computer program in order to solve a technical problem and create a technical effect via technical means, the invention may be patented. For example, a method of measuring real-time liquid viscosity by using a computer program to automatically control data collection, processing, and presentation may be patentable, because the method (technical solution) is to improve the measurement (a technical problem) through a process controlled by a computer program (technical means) to realize real-time measurement (technical effect). Additionally, computer software, both the source code and certain rendition of the programs (e.g., graphics), are protected by copyright.

4 Diagnosis or treatment of diseases Diagnostic methods refer to the processes of identifying, studying, and determining the cause or state of diseases in living human or animal bodies. Treatment methods refer to the processes of intercepting, relieving, or eliminating the causes or symptoms of diseases. While diagnostic and treatment methods are patentable in some countries, notably in the United States, they are not patentable in China. The practice in China is more in line with the European practice in this regard. However, certain protections are available. Typically, when a compound is found to be useful for treating a disease, the invention may be protected by a "Swisstype" use claim in China, for example, "use of compound X in the manufacture of a medicament for treating disease Y". Similarly, devices used in diagnostic and treatment methods may be patented. Designs of two-dimensional printing goods Two-dimensional printing goods mainly refer to two-dimensional packing bags, bottle labels, tags, and packaging papers inserted into or affixed to products but not independently sold to consumers. If the pattern, color scheme, or their combination of the two-dimensional printing goods is principally to allow consumers to recognize the source or manufacturer of the products rather than to contribute to the creation of aesthetic feeling that attracts consumers, it is barred from patent protection. This is a new exclusion of patentable subject matter introduced by the latest amendment to the Chinese Patent Law that took effect on October 1, In response to the amendment, design owners may consider patenting designs of stereoscopic goods like packaging boxes or removing source indicators from designs of two-dimensional printing goods. Alternatively, these designs are eligible for copyright protection. In summary, the scope of patentable subject matter in China has significantly increased since the enactment of the Patent Law in 1984, yet it is still somewhat limited, particularly in computer software and biopharmaceutical areas. Companies whose businesses rely heavily on patents therefore need to creatively exploit the law, to take full advantage of available protections under patent rules and practice. Strengthening Work-Related Injury Insurance According to China s State Administration of Work Safety, in 2010 there were 363,383 workplace accidents resulting in death or injury in China, with accidents at coal mines and construction sites responsible for most of the deaths. 1 In response to the persistent problem of work-related injuries, several laws and regulations have been promulgated since last year. The key developments include promulgation of the PRC Social Insurance Law (the "SI Law"), and changes to the 2003 Work-Related Injury Insurance Regulations, the issuance of companion Payment Measures for Work-Related Injury Insurance in Certain Industries, and changes to the Construction Law and the Coal Law. Overall, these changes are not groundbreaking, but instead represent an incremental strengthening and rationalization of the work-related insurance regime. In fact, though, not all of these changes increase compliance or coverage requirements. Actually, some requirements are abandoned - in particular those that have been found to be unfair, inadequate, or difficult to implement in practice. 1 (accessed 4 July 2011)

5 SI Law The SI Law, which came into effect on 1 July 2011, is the first national law, promulgated by the NPC, addressing workplace injuries. The SI Law complements and bolsters the existing Work-Related Injury Insurance Regulations, which were also amended (see below). Compared with the current regime, the SI Law extends compensation under work-related insurance with new reimbursement items, including a food allowance, reimbursement of accommodation and traffic fees for medical treatment outside the city where the employee works, as well as a one-off medical subsidy. To better protect employee welfare, these changes transfer to the social security fund part of what was previously the employers' compensation burden under the Work-Related Injury Insurance Regulations. The SI Law also mandates a new employee prepayment reimbursement guarantee, by the work-related injury insurance fund, in case the employer or a third party who causes the injury fails to reimburse related medical charges. In broad terms, the SI Law also calls for the simplification of administrative procedures for identifying work-related injuries. However, the details will need to be specified in further implementing rules. A strict enforcement protocol, with enhanced penalties for non-compliance, is also introduced in order to encourage employers to make contributions in full and on time. We expect to see further measures designed to strengthen compliance in the future, including perhaps inclusion of SI registration and compliance in the scope of regular company annual review procedures. Work-related Injury Insurance Regulations In parallel with the SI Law, the Work-Related Injury Insurance Regulations were also amended, effective 1 January 2011 (the "2010 Work-Related Injury Regulations"). To maintain consistency with the SI Law, the 2010 Work-Related Injury Regulations adjust the scope of work-related injuries in several respects: the scope of covered work related injuries is broadened to include injuries caused by motor vehicles, non-motorvehicle traffic, city rail, passenger ferry and train accidents occurring on the way to and from work (but there is also a new "primary responsibility" (" 本人主要责任 ") principle, under which a worker will be deprived of the benefit of work-related injury insurance if he/she is primarily liable for his/her injury in any traffic accident to or from work) deleted provision that the injury shall not be deemed as a work-related injury if it is incurred as a result of a crime of recklessness (" 过失犯罪 ") or violation of public security administration (hence, injuries incurred under these circumstances may now also be compensable as work-place injuries, if otherwise incurred in the course or scope of work) excludes from the covered scope any injury incurred as a result of drug taking or drunkenness by employees Procedures for claiming workplace injury compensation have to date been very cumbersome and slow. It could often take several months or even years to reach a final determination. In accordance with the principles established in the SI Law, the 2010 Work-Related Injury Regulations shorten the claims procedures. In particular, they do so by deleting the requirement to complete administrative reconsideration before the settlement of disputes over work-related injury determination. Where the facts are clear and there is no dispute as to the existence of a workplace injury, the procedure for determination is shortened from 60 days to 15 days. The 2010 Work-Related Injury Regulations also eliminate regional differences by unifying (and increasing) the standards of compensation for injury resulting in death. The new standard is 20 times the disposable income of state urban residents in the previous year. The regulations previously limited compensation to families of workers who died on the job to no more than five times the local average annual salary in the previous year. The 2010 Work-Related Injury Regulations also increase the lump sum disability benefit payment by one to three months salary, depending on the disability level. Benefits for workers with a first to fourth degree disability are increased by three more months' salary; benefits for a fifth to sixth degree disability are increased by two months' salary; and benefits for a seventh to tenth degree disability are increased by one month.

6 Payment Measures for Work-Related Injury Insurance in Certain Industries Since promulgation of the Work-Related Injury Insurance Regulations in 2003, all employers have been required to buy work-related injury insurance - but not all have complied. Covered employers of course included construction contractors. However, the complicated subcontracting structure and high turnover of staff in the construction industry have made it difficult for contractors to pay insurance premiums based on the total amount of all employees' salary as other companies do. Also, with lax enforcement of the requirements, contractors had little incentive to comply anyway. In practice, many construction enterprises failed to pay work-related injury insurance in full - especially for rural migrant workers. Now a new calculation method can be used by contractors. Contractors who have difficulty in calculating premiums based on the total amount of employees' salary can now alternatively pay on a project basis, at rates based on the total cost of the project. This is a pragmatic step that, along with strengthened enforcement, should over time help improve the rate of contractors' compliance with the workplace injury insurance requirements. Coal Law and Construction Law To unify the focus on work-related injury insurance in the coal and construction industries, the PRC Coal Law and PRC Construction Law were also amended with the SI Law on 1 July Previously the Coal Law and the Construction Law (enacted in 1996 and 1997, respectively) mandated that employers obtain private accidental injury insurance covering their employees. This was in addition to the requirement, since 2003, to participate in the public workplace injury insurance schemes. However, compliance with the accidental insurance requirement was highly uneven. The amendments to these two laws have removed the mandatory requirement to obtain accidental injury insurance. Instead, the Construction Law now merely "permits" contractors to obtain accidental injury insurance for workers in hazardous positions. The Coal Law now provides that the coal mine enterprises "may" obtain accidental injury insurance for workers in down hole operations. In fact, this represents a relaxation of the formal insurance obligations. It seems that the requirement to buy commercial accidental injury insurance was abandoned as a pragmatic move, both in recognition of previous enforcement difficulties and to re-focus and re-emphasize compliance with the strengthened public workplace injury insurance scheme. Hence, though it represents a relaxation of the formal requirements, this move is expected to bring better results, in terms of compliance and compensation, in practice. This note does not constitute legal advice. Specific legal advice should be taken before acting on any of the topics covered. LONDON DUBAI BEIJING SHANGHAI HONG KONG SINGAPORE OTHER UK LOCATIONS: BIRMINGHAM BRISTOL EDINBURGH GLASGOW LEEDS MANCHESTER T Pinsent Masons LLP 2011 Should you have any questions please contact Jonathan Reardon (jonathan.reardon@pinsentmasons.com) or your usual Pinsent Masons adviser who will be able to assist you further. Pinsent Masons LLP is a limited liability partnership registered in England & Wales (registered number: OC333653) and regulated by the Solicitors Regulation Authority. The word 'partner', used in relation to the LLP, refers to a member of the LLP or an employee or consultant of the LLP or any affiliated firm who is a lawyer with equivalent standing and qualifications A list of the members of the LLP, and of those non-members who are designated as partners, is displayed at the LLP's registered office: 30 Crown Place, London EC2A 4ES, United Kingdom. We use 'Pinsent Masons' to refer to Pinsent Masons LLP and affiliated entities that practise under the name 'Pinsent Masons' or a name that incorporates those words. Reference to 'Pinsent Masons' is to Pinsent Masons LLP and/or one or more of those affiliated entities as the context requires. Further information about us is available at