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China Joint Ventures: Legal Due Diligence

Strategy

Part Two of the China-Briefing.com “Joint Ventures as a Strategic Investment” series.

Legal due diligence is a complex and contentious issue when it comes to joint ventures in China. Many investors seem to regard it as a waste of time and money; they’ve developed a relationship with an existing supplier, feel the guy can be trusted and see no need for delving deep into the Chinese company’s position. Yet it is as this stage that the foreign party can be most vulnerable.

By Chris Devonshire-Ellis and Richard Hoffmann

One of the issues about foreign investment in China is that the business, as partially foreign owned, is “upgraded” in status by the Chinese authorities in terms of attracting a higher level of official scrutiny. Operational, administrative and legal issues that the Chinese company may have been able to get away with are less likely to be unpunished or tolerated as soon as a foreign investor steps in.

Legal due diligence prior to investing in a joint venture in China is therefore a prerequisite not just to find if there are any skeletons lurking, but also to determine where the current managerial operations are in the existing company and what needs to be changed to bring it into compliance both with an increased amount of interest from the Chinese authorities but also with the international standards the foreign investor must adhere too. Accordingly, legal due diligence both provides peace of mind over the actual situation, can raise any areas of concern, and also provides a blueprint for what needs to be done to upgrade the potential businesses future integrity.

In this article we explore some of the issues that often crop up in legal due diligence areas:

Business licensing

Is the Chinese companies’ current scope of business compatible with the intentions for the joint venture? Are all the required operational licenses in place? Are they transferable to the joint venture? These are all issues that need to be clarified, and the mechanism for these licensing rights carried out to transfer them where necessary to the JV. It is also useful for the investor to note expiry dates on these, and ensure that renewals are carried out in time. The same is true of the Chinese company. Business licenses in China have to be renewed. If his license to operate expires in 12 months and you are committing upfront finance for a 20-year joint venture, you need to assess the risk factor of his own licensing renewal situation. It is also wise to check that the name of the legally responsible person on the Chinese business license is the same as the person you are dealing with, and if not, determine why.

Corporate structure

It is also sensible to check that all the facilities you believe are being transferred to the JV are in fact all within the same Chinese business. They may not be. If you set up a JV and then find you’ve omitted to realize the finishing function is actually carried out by a workshop belonging to a separate company, you can be in for a world of hurt. Check that all facilities you require are part of the agreement and that they are all included. If not, it is possible to bring more than one Chinese company into a JV to correct this, or at least to be able to negotiate supplier contracts from a position of pre determined strength.

Land use rights

There are two types of land use rights in China, Granted and Allocated. Granted rights mean you own the land, while allocated mean you have the right to use it. Granted rights sell at a premium. Chinese businessmen will often include the land use rights valuation as their contribution to the JV equity. You need to ensure that he really does have these rights, that the pricing is correct and that the rights operational term is intact. These issues can be cross-checked independently at the local land bureau; all Chinese towns and cities have one. Difficulties however can occur under certain circumstances; subsidiaries of state-owned enterprises in China may not have a land use rights certificate for verification, they will need to obtain one from their parent. Also, fairly common in rural areas are when the rights are held by a “village collective.” The head of the collective needs to sign his approval over the transfer of rights. A very common fraud in China is to “sell” allocated land use rights to the JV, but inflate their equity position by using the costs of granted rights as their contribution. This is a means to get the foreign investor to inject more cash. Attention to detail needs to be paid in this area if an expensive mistake is to be avoided.

Pollution

It may also be wise to have core samples taken if the ground has been used for industrial purposes. Labs exist in Hong Kong now to process these. Regrettably, most industrial land in China is polluted, however the concept of polluter pays is still in its infancy in China. It makes sense to find out the extent of damage in the ground, then use any untoward findings as either a means to negotiate a lower land value, or at least reach agreement over whose liability clearing it up will be. Local governments are starting to assess pollution damage, and if your JV is sitting on such land you may have to pay to have it cleaned up.

Access and utility rights

Not all land is directly accessible to major roads, and other relevant connections. In this case, access rights need to be obtained to ensure the JV property is easily accessible. In terms of utilities, especially electricity and water, these need to be identified and specific usage meters arranged exclusively for the JV. Otherwise overcharging is likely.

IP

You need to ensure that all IP you may have been using in a supplier relationship is still under your ownership. Suppliers have been known to ‘helpfully’ register your own brand in China, and then omit to give it back. If you’ve been using your supplier also to help get you established, these types of issues need to be checked. IP agreements and technology transfer we will cover in a later article.

Valuations

Valuations of equipment and buildings can be notoriously erratic in China, not least because there may be a relationship between the valuer and the owner. It can be a tough negotiating position over which valuer to use. If you wish to insist on an independent valuer who is not known to the Chinese partner, you will usually be expected to pay the costs. However, this is usually worthwhile. Professional valuers such as American Appraisal or the major Real Estate firms in China will have a valuations department, and will usually be accurate, fair and use internationally accepted standards in carrying out work. Using them is to your advantage.

Background checks

Under some circumstances it would be prudent to know exactly who your partners are. There may be political and legal ramifications if you are not fully aware of their background. This can be difficult to find out in China, as there is no public records office. However some diligent, low key questioning may reveal details. If not, or if you suspect potential issues, there are low-key investigations agencies in China that are able to provide a dossier on identities, backgrounds, and any legal problems pending or previous.

Professional advice

These are just some of many legal due diligence issues that need to be addressed; they vary depending upon each specific case. A good professional firm will be able to discuss all the issues with you, assess what needs to be checked through, and allocate dedicated on the ground staff to look into and report back. We do not recommend using any firm that subcontracts such work, as if they are not in control of, or managing the process directly, the margin for error is significantly increased. We recommend only using firms with a proven track record and with applicable resources and offices in China.

Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates and lived in China for 21 years. He has over 17 years of experience in establishing JV’s in China. He is now based in Mumbai.

Richard Hoffmann is a senior associate of Dezan Shira & Associates and has seven years experience of foreign direct investment in China. Richard also writes for the Legal Ease column on the Beijing Review, China’s only English national news magazine. He is based in Beijing.