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China Joint Ventures: Meet the Free Look Scheme, Part 3

Thursday, June 14, 2018 4:03
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China joint venture schemesThis is part 3 in our series of posts detailing the current methods Chinese companies use to get a “free look” at the intellectual property and trade secrets of foreign companies. In part 1 of this series, we looked at how Chinese companies use their purported interest in investing into a foreign company to convince the foreign company to give the Chinese company access to the foreign company’s IP. In part 2, we explained how Chinese companies use Memoranda of Understanding (MOUs) to get free looks at foreign technology. And in this part 3, we explain how Chinese companies use Joint Ventures (real, fake and non-existent) to get at foreign technology without paying for it.

Chinese companies dangle the formation of a joint venture as a means to view (and then use) foreign company intellectual property. Just to be clear, I am not saying all China joint venture proposals are made solely to get a free look at foreign technology. As dubious as our China lawyers are about most (but not all) China joint ventures, plenty of them are legitimately proposed and formed. Here I am not so much talking about real joint ventures as I am about proposing a joint venture with no real intent to form one and doing that to get at your IP.

The Chinese side wanting a free look at your IP will normally propose forming a joint venture in China for developing and marketing a product. In these cases, however, even if a well formed Chinese joint venture would be commercially reasonable, this is not the case when a free look joint venture scheme is being employed. Normally, the type of joint venture proposed by the Chinese side is not permissible or practical under Chinese law and business conditions. In these situations, it is normally best to accomplish the commercial objectives of the U.S. side through a well drafted license agreement rather than by creating a JV company.

As a quick aside, if you want to learn more about China joint ventures, I suggest you read China Joint Ventures: The 101 and China Joint Ventures: Testing the Dream.

The basic issues related to Chinese companies using a Chinese joint venture to garner a free look at your IP are as follows:

1. Forming a JV means forming a separate legal entity pursuant to the PRC Sino-Foreign Joint Venture law. This means establishing a separate company with a separate address, separate facilities and separate officers, directors and employees. It is rare that the Chinese side really intends to do this.

2. When the entity is formed, the stock must be issued to both investors. All of the stock must be issued to the foreign side on the date the JV entity is formed; here can be no waiting for issuance of the stock. Issuance of the stock cannot be triggered by some event such as authentication of the technology or government approvals.

3. The Chinese side normally will offer the foreign company share ownership in the Joint Venture in exchange for the foreign company licensing the foreign technology to the joint venture and for general cooperation in the future. The Chinese side does not require the foreign side to contribute cash or to contribute the technology to the JV company. The proposal is that the U.S. side will get “something for nothing.” It will get ownership in the China Joint Venture without having to pay anything for it, beyond licensing its technology to the Joint Venture and getting licensing fees for that. Of course, no successful business gives something for nothing. In China, however, this would also not be legally permissible.

China does not allow “sweat equity” or equity issued based on some separate benefit conferred on the Chinese entity (say, preferred investment in a foreign company). Stock must be issued for cash or for a hard asset like equipment. A license to technology does not qualify as equity in a China joint venture. For technology, the investment only counts if the technology is formally contributed to the JV entity as an asset. Since a license is revokable, a license is not treated as an asset under China Joint Venture law. Even where technology is contributed as an asset, the value of the technology must be independently appraised and normally the contribution of IP by the U.S. side is limited to a maximum of 15% of the foreign company’s total investment in the Joint Venture.

This means the Chinese company that is offering the above “something for nothing” terms is doing so as a ploy to convince the foreign side to drop its guard and reveal confidential technical and business information. The argument by the Chinese side to facilitate this intellectual property look-see is: “We will be partners soon, so why hide anything from us.” But since the terms of the JV are not legally permissible you really won’t be partners soon and the result of this ruse is either that the JV never forms and the Chinese side blames this on the government (always beware of force majeure clauses in Chinese contracts) or the JV is legally formed but never actually does any business.

4. It takes at least three months to form a JV company and it often takes six months or more. Forming a Joint Venture in China is expensive and time consuming and this timing and expense should be taken into account in the business plan. And as noted above, it is entirely possible the Chinese government will not approve the formation of your JV company, especially if — as described above — the equity structure is not allowed. Often, however, the Chinese side will draw the joint venture formation process out for a year or more. During this entire period, the Chinese side is working to extract confidential information from the foreign side. One standard trick at this stage is for the Chinese side to say that it is bringing other “big player” investors into the JV company and these new investors are skeptical and need to see proof of the technology before they will invest. Of course, these big players will assist in taking the JV public in China, resulting in a major returns for the foreign side. So in a case where the foreign side is not required even to pay for its shares in the JV, this becomes “something for nothing” squared. Like all good con games, this one too plays on greed.

5. If the Chinese side scheme involves actually forming a Joint Venture, rest assured that you will own less than 51% of it. And with your less than 51% JV ownership, you will have no control over the JV and no meaningful rights of any kind. Many (most?) foreign investors believe that their ownership in a Chinese JV entity will allow them to exercise at least some control over the operations of the entity, but exactly the opposite is true. China has no effective minority shareholder protections. The management of the JV will simply ignore the “rights” of any minority investor, including the “rights” of the foreign investor. So, in the end, the foreign investor in a Chinese JV has less power and control than a foreign party that simply licenses its technology to the Chinese side.

6. Nearly all commercial reasons for doing a JV in a technology development and sale project can be duplicated with more certainty via licensing. For example, a license can be drafted where the JV entity pays a royalty that provides exactly the same economic benefit as a percentage ownership in the JV entity. If the foreign side truly believes in the prospect of a PRC IPO (even though these are incredibly rare), the license agreement can be drafted to provide for the Chinese company licensee to pay a royalty in the event of a sale of the Chinese entity that will provide the exact same financial return to the foreign licensor that it would have gotten had it had an equity interest in the Chinese entity. For more on China technology licensing agreements, check out China Technology and Trademark Licensing Agreements: The Extreme BasicsChina Technology Licensing Agreements: The Questions We Ask, and China Licensing Agreements – Look Before You Leap,

7. The control benefits of a license can be considerable. As noted above, if the foreign entity is a less than 51% owner in a JV company, the foreign entity basically has no remedy at all if the Chinese side does not perform. There may be remedies on paper, but Chinese company law is defective in this area and minority shareholders pretty much have no effective rights. On the other hand, a well-drafted license gives the licensor very powerful rights. If the Chinese side does not perform, the licensor can both terminate the license and sue the Chinese side for damages. This is exactly why Chinese entities prefer the JV approach and why they avoid licenses.

Bottom Line: In considering cooperation with a Chinese company, a standard technology transfer agreement/license is nearly always better than forming a PRC joint venture entity.

We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.



Source: https://www.chinalawblog.com/2018/06/china-joint-ventures-meet-the-free-look-scheme-part-3.html

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