Restructuring Joint Ventures in China. Dr. Bernd-Uwe Stucken Beijing, October 2007

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1 Restructuring Joint Ventures in China Dr. Bernd-Uwe Stucken Beijing, October 2007

2 Content Introduction Preparation Phase Legal Restructuring Economic Restructuring Summary 2

3 Typical Problems of a distressed Joint Venture Conflicts regarding goals and strategies (often cost leadership vs. differentiation via quality) Dead-locks due to power fights for leadership and control Inflexible and partly paralyzed organization No or inefficient processes To many unqualified employees Top performers leave the enterprise Production equipment outdated Overcapacities Insufficient maintenance Severe quality problems Chaotic material flows and logistics 3 No market overview (only relationship management) Rapidly eroding prices and margins Insufficient after-sales services In-transparent financing No cost accounting Black accounts and unauthorized withdrawals Tax and social security evasion Liquidity problems

4 Content Introduction Preparation Phase Legal Restructuring Economic Restructuring Summary 4

5 The Restructuring Process 1. Develop clear objectives. Most foreign investors of a distressed joint venture do not have a clear perspective which unnecessarily prolongs the restructuring processes. 2. A thorough analysis of the situation (due diligence) helps to develop realistic options. 3. Strategic key decision: Exit the venture as there is no hope for improvement, or Continue the venture. 4. Develop negotiation tactics that work in China: Negotiation positions must be open as Chinese reaction difficult to predict Fall-back positions Well dosed Escalation Strategies (in particular gradual involvement of other stakeholders) 5. Reorganization Plan after completion of main transaction (in case of continuation option) 5

6 Analysis of Contract Documentation Corporate Governance Provisions Call/Put options Termination Clauses Equity Buy-Out Provisions Non-Competition Clauses Technology Transer Supply Arrangements Financing Arrangements 6

7 Information Rights under Company Law Shareholders have the right to examine and copy - articles of association - minutes of shareholder meetings - resolution of board of directors meetings - resolution of supervising board meetings - financial and accounting reports of the company A shareholder may request the company s accounts for examination - by written application expressing the purpose - right of rejection by company if request is made for improper purposes (15 days) - application to People s Court by shareholder 7

8 Stakeholder Analysis 8

9 Basic Strategies Exit Strategies Continuation Strategies Sell-out Capital decrease Liquidation Bankruptcy Go Away Buy-out Capital increase Merger Change in Corporate Governance Division Separation by Asset Deal Dry-out 9

10 Tactical Negotiation Plan (example) /1 Facts: - Foreign investor based on an initial analysis has decided that he wants to buy-out the Chinese partner, a privately owned enterprise. - Chinese partner is in financial trouble and has little room to maneuver. - Nevertheless, Chinese partner has tried to take over operational control, i.a. by collecting all chops required for the operation of the company. Phase 1 (Opening of Negotiations) - Foreign investor informs Chinese partner that present situation is not acceptable to him. - Under such circumstances the cooperation can not continue as the necessary basis of trust does not exist any more. - Nevertheless, the parties should try to solve the matter in a friendly manner. - Proposal, foreign investor purchases the shares of the Chinese investor or vice versa ( the second option is made for tactical reasons only) 10

11 Tactical Negotiation Plan (example) /2 Phase 2 (Initial Steps are not successful) - Chinese partner does not react because he feels to be in a strong position (He has the chops and the foreigner is far away). - Next escalations step has to be initiated. - Foreign investor informs Chinese partner that for legal and moral reasons his behavior is not acceptable. At the same time he states that obviously both partners are no longer in a position to solve their problems. Therefore, the foreign partner now intends to contact the local government to ask for support in the conflict resolution (indirect threat that the conflict may become public which usually the Chinese partner would like to avoid). Phase 3 (Involvement of Stakeholders) - If Chinese partner still is not ready to enter into substantial talks that may lead to a solution stakeholders have to be involved. - In this situation it may make sense to identify persons or institutions in the environment of the joint venture company and ask for support (e.g. local mayor in charge of foreign investment). 11

12 Content Introduction Preparation Phase Legal Restructuring Economic Restructuring Summary 12

13 Legal Tool Box for Basic Strategies Exit Strategies Continuation Strategies Sell-out [Capital decrease] Liquidation Bankruptcy Go Away Buy-out [Capital increase] [Merger] Change in Corporate Governance Division Separation by Asset Deal Dry-out 13

14 Options Sell-Out - sell-out in full or partly - to Chinese Partner or third party Why should Chinese partner buy foreign share? Design escalation strategy and escalate quickly Legal key problem: SAFE clearance for payment approval only possible after full transfer of shares (new business license for company) Art.75 Company Law: In the following cases a minority shareholder may force the other shareholder to purchase his stock - no profit distribution for 5 years - merger,division or assignment of major assets - continuation upon expiry of initial term Sell-out difficult if Joint Venture partner is an SOE. In this event mandatory evaluation of shares according to SASAC provisions and involvement of local asset exchanges is necessary. Sell-out risk: Company under Chinese leadership may develop into a competitor on the domestic and even international markets ( Products manufactured with German technology ) 14

15 Liquidation Foreign Invested Enterprises Liquidation Procedures of 9 July 1996 in connection with Company Law Ordinary liquidation if Chinese partner is cooperative Special liquidation by original approval authority if ordinary liquidation is not possible. If Chinese partner refuses to initiate liquidation, arbitration or court proceedings may be considered (e.g. if non-liquidation constitutes a breach of contract) Art. 183 Company Law: If due to serious reasons the continuing existence of the company causes substantial losses to a shareholder, shareholder > 10% may request dissolution at the People s Court Liquidation is performed by a Liquidation Committee Liquidation procedures require public announcements and notification of creditors! 15

16 Disadvantages of a Liquidation Losses carried forward can not be used to reduce taxation on future profits. Taxation of hidden reserves (if any) Repayment of taxes previously exempted under tax holiday provisions if FIE has operated for less than 10 years. Expenses for liquidation and establishment of new enterprise Complex structure of turnover taxes on the sales of assets Duties and Import VAT (at book values) on assets imported duty-free which are still under custom supervision Improper land use rights frequently constitute a problem in liquidation proceedings. Hostile stakeholders (in particular authorities) 16

17 Bankruptcy New Bankruptcy Law effective June 1, Three different proceedings: - Liquidation (applied by debtor or creditor) - Reorganization (applied by debtor or creditor) (temporary protection) - Conciliation (only applied by debtor) (proposal for settlement agreement) Prerequisite: Insolvency and insufficient assets to cover liabilities or debtor lacks the ability to discharge liabilities. Courts seem to have discretion whether or not to accept application. Proceedings are in the hands of an administrator. Foreign Shareholder does not have any direct influence on court decision and also no control over bankruptcy proceedings Bankruptcy procedures require public announcements and notification of creditors! 17

18 Simply go away? Risk of arbitration if breach of contract. According to Company Law shareholders shall not abuse their rights in a way that harms the interests of the company. Risks: - Almost world-wide enforcement of arbitration awards under New York Convention. - Penalty by PRC authorities (only enforceable against assets of the foreign investor in PRC) - Black Listing may fire-back when foreign investor applies for a new project. - If Chinese partner continues to operate abandoned FIE under the corporate name of the foreign investor there is a considerable reputation risk. 18

19 Buy-out Options - buy-out in full or partly - alone or together with financial partner Share purchase agreement usually straight forward Buy-out difficult if Joint Venture partner is an SOE. In this event mandatory evaluation of shares according to SASAC provisions and involvement of local asset exchanges which may order auctioning proceedings. 19

20 Change in Corporate Governance Change of nomination right for General Manager (possibly also the Deputy General Manager) Change of majority provisions for certain Board resolutions Exchange of top management Management Rules Reporting Systems Factual control via IT systems (e.g. bi-lingual accounting software) 20

21 Division Partners may try to separate by a division. Regulations on Mergers and Divisions of FIE (1999) in connection with Company Law. After divison resulting companies must both be FIE. However, disproportional split is possible (e.g. split of a 50:50 Joint Venture into a WFOE and a 75:25 Joint Venture with Chinese majority). Both companies may continue to enjoy the previous tax incentives. Both companies bear joint and several liability for predivision liabilities (unless dischared by the respective creditors in a written agreement) 21

22 Separation by Asset Deal 22

23 Dry-out Typical strategy in deadlock situations Foreign partner establishes a competing enterprise Check non-competition clauses Shareholder shall not harm the interests of the company according to Company Law. Risk: If strategy does not succeed quickly foreign partner is competing with the same brand against himself 23

24 Strategies applied in Practice 50 % Buy-Out of Chinese Partner usually complete buy-out occasionally partial buy-out and change of corporate governance 15 % Liquidation 15 % Sell-out to Chinese Partner completely or partial 10 % Dry-out Strategy 10% other strategies or combined solutions 24

25 Content Introduction Preparation Phase Legal Restructuring Economic Restructuring Summary 25

26 Emergency Measures New Top Management Liquidity Plan and Cash Management Task Force Claims Management (success bonus very effective tool) Modern financing instruments like factoring, sale and lease back, rarely available Capital increase or the provision of shareholder loans may be necessary, a debt-equity swap is almost impossible Chinese banks are used to financial stress and tend to trust foreign restructuring programs 26

27 New Orientation Develop new vision (corporate identity) Realign strategy Reestablish relationships with main stakeholders (in particular banks) Organizational Development (implement efficient processes, crack silo organizations, test cluster and guerrilla organizations, and involve people) Install suitable systems (reporting) Select and motivate the right people and train them 27

28 The Mental Framework for Restructuring or The big management issue for China in the end is always the question of how to manage an enterprise in China. There are numerous cultural issues to be considered for which no quick and easy answers exist. Nevertheless, anyone engaged in China will always face the organizational core question: How to get a holistic thinker in seeing, accepting and following sequential concepts developed in the West? Do we have as Westerners to change our sequential concepts to the holistic recognition and organization patterns of the East? 28

29 Content Introduction Preparation Phase Legal Restructuring Economic Restructuring Summary 29

30 Summary Develop clear objectives for the restructuring battle The legal tool box offers plenty of instruments After the legal parameters are settled (with the Chinese partner) the economic reorganisation will be the next challenge Adjust management concepts for linear thinkers to holistic thinking Have a look in the emerging concepts of complexing theory 30

31 Your Contact Partner in China Bernd-Uwe Stucken Partner SALANS Shanghai Office Room 2308, Jinmao Tower, 88 Centennial Boulevard, Pudong Shanghai, China Tel: (86 21) Fax: (86 21)