China Brief Insight:

Dan Harris of Harris and Moure law firm, and co-author of China Law Blog, discusses the re-emergence of US-China joint ventures on the business scene.

Josh Gartner: Welcome to China Brief Insight. I’m AMCHAM China’s Josh Gartner. Today we are joined by Dan Harris, with Harris & Moure, and author of the China Law Blog. Dan, welcome back to the podcast.

Dan Harris: Hi Josh, good to be back.

JG: You wrote to me a few weeks ago and said that you’d be interested in doing our podcast on the return of joint ventures in China. What are the trends that you’ve seen in this area?

DH:  Well the trend I have seen is that there has been a marked increase in American companies wanting to go into China via the joint venture route, rather than going in as a Wholly Foreign Owned Entity. And I saw that pick-up starting, maybe, six to eight months ago.

JG: And before that, there were not many American companies doing joint ventures?

DH: Before that, we were not getting very many American companies doing joint ventures. And most of the American companies who came to us with an interest in doing a China joint venture did not realize how it would not be any more difficult, from a legal perspective, for them to do a Wholly Foreign Owned Entity, and that their better way of entering China would probably be to go in as a Wholly Foreign Owned Entity and just have contractual arrangements with the companies with whom they were thinking of doing a joint venture.

JG: And over the period where people were avoiding joint ventures what were the main concerns and reasons why they were avoiding them?

DH: Well, I think there are a lot of reasons, but I think that if you boil it down to one reason it was that they almost never worked. There’s the old saying that a joint venture is the same as two people in the same bed, but with very different dreams. And I think that’s a very good analogy. Our experience has been that joint ventures almost never work. Now there are exceptions to that rule—some very well known exceptions. One I always talk about is Caterpillar, and their joint venture has done phenomenally well in China. But it seems to me that most don’t work very well, and I’ve been doing international work for a very long time. And this idea of joint ventures not working is true not just of China, but it’s true of Russia, and it’s also true of virtually every country. And the reason joint ventures are inherently difficult for the foreign company is because—let’s take this bed analogy a bit further—the foreign company is getting into someone else’s bed, in someone else’s house. And so, they’re always going to be at a disadvantage because they’re in a company in a foreign land and their partner is going to have much better knowledge, much better contacts, and much more experience. And a lot of times, the foreign company is brought in by the Chinese company—although again, it doesn’t necessarily have to be China—but they’re brought in by that company because that company needs something that the American company has, and then once that company has taken that which the American company has and things are going really well, then it behooves the Chinese company from a financial standpoint, to get rid of the American company. And that’s what often happens.

JG: And in this uptick that you’ve seen recently, either from your own experience or the general market, are there particular areas you’ve seen more of the joint ventures or are there certain industries that seem to be more pre-disposed for joint ventures?

DH: No, and that’s the strange thing. We’re seeing this all across the map. We’re seeing it with respect to consumer products, we’re seeing it with respect to industrial products, and we’re seeing it with respect to technology, like software and gaming. Now, in the past what has usually happened is that these companies do not go forward with their joint venture; they usually do switch to a WFOE once they realize the benefits of a WFOE as compared to a joint venture. Except there are still certain industries, certain areas, in China, where one is required to go in as a joint venture, and in those cases, the companies have no choice but to go in as joint ventures, but those areas are declining. But what we’re seeing is that companies are going in across the map as joint ventures and I think the reason for it, and I’ve asked our clients why, despite the risks, they’re going in as a joint venture, and the reason a lot of them are giving (and the reason I think is true even when it’s not been given to me) is that going in as a joint venture is a way to share in the costs. So, whereas two years ago a company would borrow $5 or 10 million to build its own factory to manufacture, let’s say, a $100,000 industrial product, now it can’t get that financing so it needs the factory that’s already in place and so it is joint venturing with a Chinese entity, and they are going in with their eyes wide open. They know they are taking a risk, but they feel they have no choice.

JG: So you see this as primarily a, a post-financial-collapse phenomenon?

DH: That’s exactly how I see it. I don’t know any other way to look at it. As far as I know, nothing else has changed. There haven’t been changes in Chinese law in joint ventures. There hasn’t been enough of a change in the court system so that one could reasonably could say, “Well, you know, three years ago joint ventures were risky but they’re so much less risky now.” That hasn’t happened. They are probably a tiny bit less risky now, but certainly no major change in the law or the enforcement of the laws should be driving this. So I see it as purely economics. American companies, mid-sized companies, small-mid-sized companies (which are the companies my law firm mostly represents) they don’t have the access to capital that they had 2-3 years ago. And 2-3 years ago, it was amazing to me the easy access to capital, and now, capital is almost impossible to come by.

JG: So in the past one of the major obstacles, as you mentioned before, was that a lot of the major Chinese companies were taking a bit of a slash and burn strategy, in that they were bringing in foreign partners and then they were getting out of it what they wanted, and they weren’t that concerned with destroying the relationship if they could get a lot out of it. It sounds to me like you are saying that there hasn’t been, necessarily, a huge shift in that area and that it’s mostly, really, a financing issue. Is that correct?

DH: That’s correct. Not only has there been no shift in terms of the laws or the enforcement of the laws, but I don’t think there’s really been a shift—near as I can tell—in terms of Chinese companies deciding that it behooves them to stay in these joint ventures and make them work. In fact, at the same as our work in joint ventures has greatly increased -- right around the same time -- our work in dealing with joint ventures gone bad also greatly increased. And so, we are handling more of those matters than we ever had before, and I also think that is due in part to the economy as well. I think a lot of these Chinese companies are—some of them are suffering and some of them are doing well—but in times of great change, lawyers always seem to be the ones to do the best. And, because when there’s a big economic change, there tends to be either more happening on the upside or more happening on the downside. Even if, let’s say, the economy goes down, a lot more transactions, broadly defined, tend to happen. Not the big M&A deals but, let’s say, transactions falling apart, and we’re seeing that with joint ventures as well, which is good for our firm because the number of Americans going to China in the last, let’s say, year, has definitely declined. But the number of Americans going into China as a joint venture, at least in our firm, has increased.  And the number of Americans contacting us because of problems with their joint venture has also definitely increased.

JG: So if the problems, in terms of the relationships between foreign and Chinese companies, if that situation hasn’t really improved significantly, are you anticipating that when financing returns in the U.S. to more typical levels where it’s more easier to get capital, would you expect this trend to reverse?

DH: Yes, I absolutely would. These American companies are going to China in joint ventures because they feel they do not have the funding to go in by themselves. I think a lot of these American companies in joint ventures that we have done or are doing would be better off, in an ideal world, going in by themselves. And the example that I was talking about, where a company is going to be manufacturing high-level industrial equipment in China, there’s really no great benefit to doing this as part of a joint venture other that the fact the American company can take advantage of the Chinese company already having a factory ready to go. But the American company has the name, so they’re not getting the Chinese name. The American company has the technology, so they’re not getting the Chinese technology, and we’re not talking about a product that’s going to be sold at stores nationwide in China where the American company might need distribution assistance from the Chinese company or the distribution contacts, or whatever. It’s really that they need a factory, and rather than spending the money themselves on a factory, they’re essentially sharing their know-how in return for getting the factory.

JG: That’s another question I wanted to get to -- what do the Chinese partners bring to the table? You’ve covered most of the areas where they could bring something to the table, and the one area I wanted to ask you about specifically was dealing with the Chinese government. There have been some cases that some critics have said the Chinese government is targeting foreign companies. We’ve seen that with, some critics have said Rio Tinto and Coca-Cola, when they tried to buy Huiyuan, which we talked about on our previous podcasts. How much does it help if you’re in a joint venture with a Chinese company in terms of dealing with the government?

DH: Well, it has to help. But, in many instances, being able to deal with the Chinese government is really not that important. And the reason I say that is, if you’re going to be making a $100,000 piece of equipment in China, the Chinese government nine hundred and ninety nine times out of one thousand, will grant your application for a WFOE. And it’s not that tough to deal with the Chinese government at least enough to sell your $100,000 piece of equipment to, let’s say, auto manufacturers in China. It’s just not that big an issue. Now, obviously there are certain kinds of companies where being able to deal with the Chinese government is far more important than the kind of company I just described. But in most instances, it’s really not that big a deal. So these joint ventures that I’ve been talking about, these are not being done to try to get the guanxi or whatever it is that the Chinese company has. It’s really being done because the Chinese company has what would cost the American company a lot of money to get and the American company either doesn’t have the money or doesn’t want to spend the money to get it and to me that’s a radical shift. Because the joint ventures that I was involved in, let’s say, ten to fifteen years ago (not necessarily just in China but all over) were being done by American companies needing the-on-the-ground know-how or connections of the foreign company and the American company, what it was bringing to the table was the money. And now, what the Americans are bringing to the table are know-how and brand name and the Chinese are essentially bringing the money by taking in the factory.

And so it’s a complete reversal and it’s something I’ve--that’s completely new to me, because it has never been this way before when my firm has been involved in joint ventures because it’s always been the Americans who have the money and the only reason they were joint venturing in China or elsewhere was because they needed somebody who already had the knowledge on the ground, and that’s not the case anymore.

JG: I want to get back to one point that you made a moment ago concerning
the fact that you’re dealing with as many joint ventures gone bad as ever before. And specifically what I want to talk about is when you’re dealing with these companies that are starting up new joint ventures and new partnerships, what kinds of--what kinds of methods are you putting in place to insulate these companies from potential problems?

DH: Well, there are definitely certain things that can be done and there are certain things we always recommend be done, but in a lot of instances, the Chinese company will not go along with our recommendations, and the American company, nonetheless, goes forward with the joint venture. So, what we always recommend is that our client has certain powers so that it essentially controls the joint venture and that’s really the key: who’s going to control the joint venture. And the problem is that the Chinese know exactly what they’re doing also, and they’re fighting for control, and in a lot of instances they’re unwilling to give it up. One of the things about joint ventures -- lawyers love them and the reason lawyers love them is because they can be so difficult. My firm, most of what we do in China we do on a flat fee basis. We say, “Look, we’ll charge you ‘X’ dollars to form your WFOE.” We can do that because WFOEs [Wholly Foreign Owned Entities], the formation of a wholly foreign entity never gets out of control, because we’re dealing with our client, there are only certain limited things that need to be done and we know exactly what needs to be done. A joint venture is not like that. What can happen with a joint venture—we’ve done joint ventures where we have not done very much work at all because agreement is reached really quickly and, let’s say within three or four weeks, and after that it’s just basically doing the filings and sort of mop up work. But we’ve also done joint ventures that have gone on for six months and then one party walks away. They can be very contentious, and during that six months, you’ve got the lawyers and accountants billing. So joint ventures can be risky even in that respect.

JG: So, it sounds to me like when you’re talking to these different companies, at this point, there isn’t really a decision for the most part between forming a WFOE and starting up a joint venture, in that it’s really a financing issue. If they have the capital to start up a WFOE then they would do that. So I guess my question is if a company that you’re advising decides to go into a joint venture, what advice do you give them on how to make the final decision?

DH: Okay, I’m going to “sort of answer the question” and then I’m going to answer the question. When a company calls us, and this has been true since forever, they’ll often times call us up and say, “I need your help. I’m interested in starting a joint venture in China.” We’ll often talk to them and say, “Why a joint venture?” And a lot of times they’ll say “Well, because I thought I needed to do a joint venture,” and we’ll say “No. You want to work with this Chinese company? Why don’t we do it as a WFOE and enter into a contractual relationship with them where they’ll be your distributor, just like we do in the United States.” I have what I call the “Peoria test,” where I would say. “Look if you  were doing this deal with someone in Peoria, would you do it as a joint venture?” And they go, “No” and so I say, “Well why are you doing it with someone in China?” Sometimes they’ll say, “Well, because we’ve talked about doing a joint venture” and you get this long explanation that makes sense. A lot of times, however, you get this long explanation that doesn’t make sense. Probably nine times out of ten, we wind up convincing them that they’re better off doing it as a Wholly Foreign Owned Entity.

And we’re having these same conversations with our clients or potential clients now, but instead of making the decision to do it as a Wholly Foreign Owned Entity, they’re saying, “I hear what you’re saying. What you are saying makes sense. But we can’t go in alone. We can’t afford it,” or “We don’t want to spend ten million to build our own factory. We did think about that; it’s not a good alternative for us right now.” So it seems like a joint venture is the only way. And we’ll say, “Yes, you’re right, that does make sense with the limitations you’ve just given us.” And then, we start talking about, “Okay now that it’s clear we’re going to do it as a joint venture, let’s talk about the terms of a joint venture, and how are we going to make it so we don’t have a situation that we’ve seen a lot of, where you end up thinking you control the joint venture, but in reality, the Chinese company controls it. And you end up being in this Chinese joint venture for a long, long time, and you never make any money out of it. And you suspect the Chinese joint venture partner is getting rich out of it. So that’s what needs to be avoided and we talk about the ways to do that. And there are certain basic things that really influence control of a joint venture.

The first is the power to appoint and remove the joint venture’s representative, and that’s the representative director. And the representative director is the person who has a huge amount of control over the joint venture operations. American companies are used to thinking, “Well, if I own 51% of the stock, that’s it; I control the company.” Well that’s not true of a joint venture in China. I would rather own 49% of a joint venture and be the person, or I’m sorry, be the company that can appoint the representative director than own 51% and be the entity that cannot appoint the representative director.

The other one is the power to appoint and remove the general manager of the joint venture company. That’s very important. And Americans are not used to thinking that way. Another thing that is very important is control over the company’s seal or “chop.” That idea is completely foreign to an American entity, but in China, the person that controls the joint venture company’s seal is the person who has the power to make binding contracts on behalf of the joint venture company. That’s also the person who has the power to deal with the company’s banks and other service providers. In Jack Perkowski’s book, Managing the Dragon, he talks about a crisis that he had with a joint venture partner, where the joint venture partner controlled the company seal, and he and his company were plotting to get it back. And that happens. That’s one of my favorite chapters on any book on China because it’s so true to life. The company that controls the seal essentially controls the operations of the joint venture company. And if you were to talk to 90% of American companies…if you were to ask them, “How important is it to control the seal or the chop of a joint venture entity?” they would look at you like you had two heads, because they don’t know what a seal or a chop is. And yet it’s absolutely critical.

JG: So, would you—if you were advising a company and they were getting those specific powers that you mentioned, control of the chop, appointing certain key positions, are there situations where it would still be advantageous to enter a joint venture or would you still be extremely skeptical of any such arrangement?

DH: Well, our job as lawyers is to tell them what the risks are, and then the client makes the business decision. In many cases, we tell them, “Look, this Chinese company is essentially going to own everything, and so you may find yourself in a very bad situation a year or two from now, and you are taking a risk,” and they’ll say, “We understand. It’s a big risk, but we need to take it and we’re going to take it.” It’s not that different from a, I would say, an angel investor putting money into a start-up company in the United States. There are a lot of risks and yet people do it all the time, and it’s good that they do. And not every joint venture’s gone bad; some of them succeed spectacularly. And what also sometimes happens is--and I have seen this—is that an American company goes into a joint venture with a Chinese company, and things go neutrally, let’s say, for a couple of years while the company’s finding its feet, then things go very well for three or four years, and then things go very badly. And the joint venture falls apart. Well, it still was worth it for the American company, in many instances, because the American company gained so much knowledge during that time that they can now go off and have their own WFOE armed with that knowledge. And I’ve definitely seen that happen. And so, even when a joint venture goes bad, it doesn’t necessarily mean that it shouldn’t have entered into in the first place.

JG: Dan, we’re going to wrap up here in a moment, but I just want to, before we sign off, I want to give you a chance to let people know where to read your blog and how to contact your firm if they have any legal questions.

DH: Okay, I’m happy to do so. The blog is China Law Blog and it’s at www.chinalawblog.com, and to reach the firm, the firm is Harris Moure and it’s at www.harrismoure.com.

JG: Okay, we’ll put links up to both of those on the website. Dan, thanks very much for your time and for your insight.

DH: Thank you, Josh.