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Joint Venture Contract Negotiations and Approvals with Chinese Partner

Joint Venture Contract Negotiations and Approvals with Chinese Partner

wa mj ar pearls wholesaleJVs, either equity or cooperative, have dominated FDI projects into China till very recently, when with China’s WTO accession, foreign companies, encouraged by the increasingly rule-based foreign investment regime, started preferring wholly owned enterprises for conducting their operations. However, for many segments of the economy, including jewellery, JVs have been successful and remain an important vehicle. For labour contracts and provision of land and real estate, the Chinese partner in a JV can play a major role, as in liaising with the Chinese authorities. It is important, therefore, to learn how to conduct negotiations for successful Joint Ventures with a Chinese partner. The following is an indicative approach:

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From MOU to joint venture agreement

Initial discussions for a joint venture with a selected Chinese partner, if fruitful, will result in a Memorandum of Understanding (MOU) signed jointly. The MOU should contain a clear
statement of intent to develop together a feasibility study for a joint venture and to negotiate the terms of the joint venture to the mutual benefit of the parties. The MOU must be filed by the
Chinese party together with a ‘pre-feasibility study’ (in reality a checklist of the major parameters for the proposed JV) with the authorities to whom it reports. More detailed negotiations cannot proceed until the reporting authorities have given a preliminary indication of approval to the project.

Formal MOUs in China, in a joint venture context, are not legally binding but are considered to be a commitment to continue discussions and to carry out a serious feasibility study. Therefore, it is considered to be a breach of good faith for a foreign company to enter into negotiations for the same project with another Chinese enterprise once a formal MOU has been signed, unless it is first terminated by the mutual consent of the two original parties. It follows that the initial choice of preferred partner is crucial. Signing an MOU in haste with an ill-chosen potential partner imposes a major impediment to further progress. If in doubt, the foreign company should confine itself to a simple minute which records that discussions have taken place which will be reported to the boards of the two companies which will decide mutually within an agreed period of time whether or not to continue studying the project.

The pre-feasibility study

The pre-feasibility study usually takes the form of a standard checklist of the main parameters for the joint venture, some of which may be mentioned in the MOU but most of which are an expression of the initial ‘ballpark’ numbers which the parties may have discussed together. The checklist is not a joint declaration of the Chinese and foreign parties, but foreign partner input will certainly be requested.

Key elements in the pre-feasibility checklist include:

  • scope of business
  • total investment in the JV in US dollars
  • amount and shares of registered capital to be subscribed by the partners in US dollars
  • form of contribution for registered capital by each partner: cash, equipment, patented
    designs, technology, land use and buildings (proportions not usually quantified at this
  • nature of technology; must be to international standard, preferably advanced
  • planned production capacity (unit/volume output rather than value)
  • proportion of output to be sold in export markets (normally not less than 20 per cent)
  • surface area of facility and of covered factory space (existing or new building)
  • in what proportions equipment is to be imported or sourced within China
  • workforce to be employed (provisional numbers)
  • foreign partner’s commitment to training and continuing technical support

There is a ‘chicken and egg’ element in specifying these parameters at such an early stage, since most of this detail cannot be quantified with certainty in advance of a full-scale feasibility study. Indeed, it is advisable that the foreign party distances itself, as far as possible, from the pre-feasibility process so that responsibility for any major changes to the parameters which have to be identified to the authorities is limited.

The feasibility study

Assuming that the authorities’ response to the pre-feasibility study and MOU is positive, the
parties may now move forward jointly to a full-scale project feasibility study. It is quite possible that the authorities may reject one or more of the parameters in the pre-feasibility checklist — perhaps the form in which contributions to registered capital may be made, or a demand for a higher proportion of export sales. By this time, the relationship between the prospective partners should have advanced to the point where such obstacles are addressed together in the spirit of trying to find a solution which will satisfy the authorities and be acceptable to both sides.

The complexity of the feasibility study will be determined by the nature of the project, its technical content, procurement issues in respect of equipment, raw material and locally sourced components, quality assurance standards and sales potential. It is recommended that all phases of the study be carried out by a joint team and that the data provided by either side should have
maximum transparency. In the course of the study, the Chinese members of the team will certainly want to visit the foreign partner’s facilities and to inspect technology, equipment and manufacturing processes.

The amount of detail which the Chinese partner will require to complete the feasibility study for
its purposes and the scope of the study will be broadly similar to the foreign partner’s requirements. The Chinese side will focus particularly on the detailed specification and performance of any equipment and tooling to be imported, and if used equipment or tooling is involved will need to satisfy itself fully as to condition and market value.

Market studies are a necessary part of the overall feasibility study to satisfy both partners that the products which the JV is targeted to manufacture are saleable in both export and domestic markets in the proportions and at the prices planned. In the early days of JVs in China, Chinese partners were often content to rely on a commitment by the foreign partner to take full responsibility for exports with the amounts to be exported in the early years specified in the JV contract. Chinese partners increasingly demand a fully researched market study which demonstrates in which overseas markets and in what proportions the JV’s products can be sold at the projected export sales price.

Conversely, foreign partners, attracted by the pull of billion-plus Chinese consumers, used to be
content to rely upon government institutes’ published statistics or projections and the Chinese partner’s assurances of marketability. Increasingly today prospective foreign JV partners demand studies of key regional markets in China by professional research organizations.

The business plan

The feasibility study should culminate in the preparation of a business plan by the two parties
jointly. This is not a formal requirement by the authorities to whom the feasibility study must be submitted with the JV agreement or draft JV contract, although the Chinese partner needs to
include an income and expenditure plan showing profit projections for the first three to five years of the JV’s life. However, from the foreign partner’s perspective, the addition to the feasibility study of a business plan (in the western sense) and a draft budget for the period from company registration through start-up is strongly recommended. In particular, the business plan should include a cash-flow statement, as well as a profit and loss statement, and operating statements including analyses of fixed and variable expense and a manpower plan which specifies maximum staffing at each stage of development in the JV. In this way, the business plan becomes a financial blueprint, subject to review and amendment by the board of the JV after the company is formed, but a clear reference point for management discussion.

Negotiating the joint venture agreement

In the 1980s it was common for the designated JV partners to negotiate the detailed terms of the
JV in the form of a non-binding joint venture agreement which was then submitted to the local
reporting authorities for approval, together with the Chinese version feasibility study. Following approval, possibly with some amendment, the two sides would then reconvene, convert the joint venture agreement into a draft joint venture contract and, at the same time, draft the articles of association (or ‘statutes’ as they were sometimes called) for the joint venture company.

As the incidence of JV negotiations multiplied and the pace of joint venturing quickened, many
local authorities, notably the Commissions of Foreign Trade and Economic Cooperation in major cities, relaxed the procedure and permitted the partners to proceed direct to the drafting of the
joint venture contract and articles of association. Today, use of the preliminary joint venture
agreement is generally limited to very complex or contentious projects where some intermediary
clarification is helpful or the parties prefer a more protracted negotiation. In the sections which follow, it is assumed that the parties proceed direct to the contract stage.

At this point, the senior management of the foreign party entering into formal JV contract negotiations needs to select its negotiating and drafting team and to decide how it will conduct
the negotiations within the framework of standard Chinese practice. Normally, the principal Chinese party (always referred to as ‘Party A in the documents) will prepare a first draft of the
joint venture contract and the articles of association which it will submit, in advance of negotiation, to the principal foreign party (invariably referred to as ‘Party B’ in a bilateral

Perhaps the first issue to address is the force and practice of Joint Venture Law. The principal
applicable law on equity joint ventures (and other forms of foreign investment also) is published
in Chinese and in English in a single volume, entitled Investment in China, compiled jointly by the Foreign Investment Administration and China Economic and Trade Consultant Corporation of MOFCOM. The laws set out clearly (and generally, unambiguously) the content and principal clauses which must be included in both a joint venture contract and the articles of association.
Many of the detailed clauses which appear in the first drafts submitted by Party A are culled
direct from these laws, but the English language is usually not identical. One reason why the wording is often different is that copies of Investment in China with the official English translation are not generally in circulation among Chinese companies.

Variations of substance to the standard clauses of the Joint Venture Law, other than those dealing with the scope of the business, investment and registered capital contributions, scale of
production, export content and the specific responsibilities of the parties, are not generally
allowed by the authorities. Therefore, a commonsense approach to these secondary clauses is to
incorporate them in the joint venture contract and articles of association as drafted, and translated, in the law unless either party has some major objection. Taking this approach to its
logical conclusion, foreign companies negotiating a JV for the first time may be tempted to conduct the negotiations on a ‘do it yourself basis without external advisers, but such a course of action exposes the investor to unnecessary risk.

At the other extreme, the foreign investor may wish to engage a law firm to advise on the legal
documents and to participate in the negotiations. There are a number of leading international law
firms with offices in China, with experienced foreign and Chinese staff authorized to practice law in China. However, involvement of western law firms in joint venture negotiating sessions can be counter-productive and an ‘offstage’ involvement may be preferable. In most JV negotiations the Chinese party will not involve an external Chinese lawyer unless a western law firm is introduced. Mega-projects involving billion dollar investment, international financing or major infrastructure projects are a different matter where the contractual documents are susceptible to western legal drafting, but the routine equity joint venture does not involve international law and the contracts are rigidly controlled by the standard Chinese framework.
Joint venture contract negotiators are well advised to concentrate on substance rather than form.
However forcefully they may seek to interpose tightly drafted clauses in western legal language,
the final product will still contain wording through which the proverbial ‘coach and horses’ could be driven in a western court of law. Essentially, what matters is that the joint venture contract and articles of association are written in transparent business language, which is as unambiguous as possible to both parties.

The success of the JV will depend on a strong, enduring relationship between the partners. If
mutual understanding and respect fail, the joint venture firm should question what the remedies
are. Chinese contracts always provide for ‘the resolution of disputes through friendly consultation’ and, if that fails, by arbitration. Arbitration in China has a reasonable record;
however, many find third party arbitration attractive. Under a judicial system such as China’s
where there are no formal case law precedents to which courts can refer, litigation is hazardous
and an unattractive course of action. If the partnership relationship fails in China and becomes
confrontational, the ultimate recourse is to walk away. However, in the context of negotiating an
acceptable joint venture contract and articles of association drafted in layman’s language, the
foreign partner can benefit from the services of external advisers in language interpretation,
business consultancy and institutional intermediary. During the course of the negotiations, the foreign partner may also need to take advice on taxation or accountancy issues. The bigger international accountancy firms all have audit offices in China, mainly in Beijing and Shanghai, and their expert advice is readily available.

The negotiation process

JV contract negotiations are best conducted in the same city as the approving authorities to
whom the draft contract and articles of association have to be submitted for preliminary approval. Therefore, if the Chinese partner is part of a national corporation the negotiations are better held in Beijing where the relevant ministries are located so that informal opinion may be sought on the issues of substance. Whatever other ministry may be involved in the subsequent approval process, MOFCOM for major joint ventures or the appropriate local authority will certainly be involved, since all foreign investment projects require ultimate MOFCOM endorsement.

Assuming that the foreign party has studied the draft contract and articles of association (and
taken advice where appropriate) in advance of discussion, the actual negotiating sessions are
likely to take less than seven days. The negotiating procedures are well defined. As for the
original set of meetings, the representatives of the two parties will be ranged on either side of a meeting room table with up to ten Chinese representatives present. The composition of the
Chinese team may vary from day to day, but the same key members are likely to attend each
session under the leadership of a designated chief negotiator.

In spite of the apparent formality, the climate of the discussions should be quite relaxed. If the parties have reached a high degree of unanimity on the structure and financing of the JV during the joint feasibility study work together, there will be a presumption on both sides that the JV will go ahead. This does not mean to say that no serious differences of opinion will emerge in the course of formal negotiation, but a conducive atmosphere of mutual sincerity and flexibility will have been created. On many points of detailed drafting, the focus of discussion is more likely to be on satisfying the legal requirements and state policy guidelines, rather than resolving differences between the parties.
Articles source: Gems & Jewellery Industry in China, Embassy of India, Beijing
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