The China Joint Venture Squeeze Out — How it Works and How You Must Respond

With China’s economy declining (particularly the portion that most interacts with foreigners), these are some really tough times for foreign companies that do business with or in China and our China lawyers have for the last year or so been seeing a massive increase in all sorts of foreign company problems including (but certainly not limited to) the following:

1. IP theft. See China Trademark Theft. It’s Baaaaaack in a Big Way.
2. Manufacturing quality control problems. See China Factory Disputes: The 101.
3. Sinosure problems. See China’s Sinosure: It’s Back and It Wants Your First Born
4. All sorts of disputes necessitating litigation or arbitration. See How to Sue a Chinese Company: The 101.
5. The Chinese government going after foreign companies (especially American companies) for not complying with all of China’s laws, more often and with greater ferocity than ever before in the last 20 years. See Want to Keep Your Business in China? Do These Things NOW and Doing Business in China Without a WFOE: Will the Defendant Please Rise.
6. Fake law firms. See China Lawyers: The Fakes and the Quasi-Fakes.
7. China employment law problems. See How to Avoid China Employment Law Problems, Part One, Part Two, Part 3 and Part 4, a series written by our lead China employment lawyer (Grace Yang) because, as she puts it, “now is not the time for employers in China (especially American companies) to be doing anything that does not fully comply with China’s employment laws.”
8. All sorts of sharp tactics and scams, old and new. See e.g., China Licensing Deals so Horrible They are Hard to Believe. See also our China Scam Week series, where In Part 1, we wrote about the scam of tricking someone to come to China to sign a deal. Part 2 was on the scam of getting money for supplying products and then supplying nothing or, more commonly, something that isn’t even close to what the foreign company bought and paid for. Part 3 was on the switched bank account, which is — by far — the most difficult to avoid scam. Part 4  was on the scam where a Chinese company gets you to provide it work or services (or perhaps even product) in return for stock or stock options you can never really own because you are a foreigner. Part 5  involved a fairly recent, increasingly common, and highly sophisticated scam whereby a Chinese company claims to be interested in investing in your foreign company to steal your IP. Part 6 was on fake joint ventures.

Speaking of China joint ventures, in the last six months or so our China joint venture lawyers have also been seeing a massive increase in what we call the China Joint Venture Squeeze Out. I personally have worked on so many China JV squeeze out deals in the last six months, I just have to write about what I have been seeing.

The standard fate for joint ventures in China is that once the Chinese JV partners either believe they no longer need their foreign joint venture partner or simply no longer want to share in the JV spoils with their foreign JV partner,  they will work to drive the foreign partner out of the venture.

In The China Joint Venture Squeeze Out: Coming Soon to a Public Company Near You, we set out the fundamental advice our China lawyers give to all foreign partners in a Chinese JV: do not transfer your ownership interest in the Joint Venture until after you have received fair payment in dollars or Euros for your shares in the JV. To be even more explicit. Do not relinquish your ownership interest unless and until the money you are to be paid for doing so is in your U.S. or European or Australian or Canadian or Latin American (or whatever) bank account. Please!

When we give this advice to our clients, they almost always reply that the Chinese side has told them that payment in advance of the transfer of ownership interest is not possible. The problem is that if the transfer is made from China, the Chinese side must convert their RMB to U.S. dollars or to Euros and then transmit the dollars/Euros from China. This requires making the currency conversion and bank transfer through a PRC foreign exchange bank.

The Chinese bank will then work with the local tax authority and local company registration authority and then report that the conversion and transfer cannot be made to the foreign company until after all the following are complete:

1. Conversion of the entity from a sino-foreign joint venture (a China JV) to a wholly Chinese owned entity (a China WFOE), with approvals for both the conversion and the payment to the foreign partner reviewed and approved by the local authority. This then requires an independent appraisal of the value of the entity and an audit of all the company books.

2. Transfer of the ownership interest to Chinese persons.

3. Payment of all back taxes and fees of the JV entity.

4. Payment of a substantial tax on the gain realized by the foreign partner.

5. Payment of an additional withholding tax on the overseas payment.

This procedure is complex and time consuming and its final result is also uncertain because the amount of taxes and other fees depends entirely on the unconstrained decision of the local authorities. There is also no certainty that the conversion and payment of funds to the foreigner will be approved under conditions that are commercially reasonable, and it almost never is.

When our client tells us the above, my response  is simply to state that what the Chinese side has told you is that it cannot buy your JV interest on reasonable terms. This means it cannot be done and so you should do nothing. We should stop charging you attorney fees and you should just walk away.

Clients will then often come back and ask what examples we have where the Chinese side conducted the JV buyout on normal commercial terms where payment comes first and transfer comes after payment is received? My response is that I do not have any such examples because that is not the way the Chinese joint venture system was set up to work and that is not how it works. The Chinese Joint Venture system was set up to make it essentially impossible to do a commercially reasonable buyout.

When pressed for more details, I explain that I have been working with Chinese joint ventures since 1981 and I have yet to see a China JV buyout conducted in accordance with international standards. The goal of the Chinese government was and is to force the foreign company to keep its JV investment in China and the rules and regulations I set out above were established by the Chinese government with this goal as its objective. Even when the Chinese side in your Joint Venture is acting in good faith and really wants to pay you ten times more than you invested, once they realize the tax and regulatory hurdles required to conduct a fair and equitable JV buyout, they give up.

What you are facing, however, is not a good faith buyout. What you are facing is a joint venture squeeze out. In this scenario, the foreign party is forced out of the JV without receiving fair compensation. There are two ways these China Joint Venture squeezes play out:

1. The foreign party finally just gives up and abandons its ownership interest in the JV entity. No payment is made to the foreign party.

2. The Chinese side uses funds located outside China (usually Hong Kong or the U.S. or maybe the British Virgin Islands) and makes a nominal payment to the foreign side. This payment is normally equal to the investment amount contributed by the foreign side, calculated without interest. Loans to the JV are ignored. After that nominal payment is made, the foreign party simply abandons its ownership interest in the JV entity.

After either 1 or 2 has worked to eliminate the foreign party, the Chinese owners do not go through the difficult conversion process described above. Instead, the JV entity is simply liquidated and its assets get . distributed to the Chinese side owners and their future Chinese investors. Normally the entity is simply absorbed into the entity owned by the majority Chinese side investor. In rare cases, a new entity is formed that takes over the assets. “Assets” means both the physical assets and also valuable intellectual property and trade secrets, most of which have been contributed by the recently squeezed out foreign partner. This new entity then takes over the market in China and also works to take over the market outside of China, displacing the foreign party from its traditional markets in North America and Europe.

I personally have never seen any alternative to that described above. Normally the best strategy for the foreign party is to sit tight and refuse to act until after a payment is received into its bank account in dollars or in Euros. This payment is never substantial, but oftentimes some payment is better than nothing.

The position to take is that it is the Chinese side’s responsibility to figure out how to get a payment to you and if they cannot do this, there is nothing for you to do but to sit tight. There are several stories commonly provided by the Chinese side as to why the foreign party must be removed from the China JV. One is that sales to PRC SOEs cannot be done if a foreign party is an owner. The other is that a PRC IPO is not possible if a foreign party is involved in the offering. These are simply justifications for squeezing out the foreign party. For the foreign partner, these stories are simply not relevant.

If the Chinese side wants to buy you out of your JV ownership interest it should pay you a fair price in dollars or in Euros to a bank account located in your home country and if it cannot do that, it was never really planning a buyout; it was planning a squeeze out where you relinquish your ownership interest for nothing. When faced with a squeeze out, there is nothing for you to do other than to insist on maintaining your ownership share in the joint venture entity. There is no other alternative.

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.