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Planning for the End: Protecting Your Interest in a Joint Venture before the Worst Happens

20 February 2011

Joint Ventures (JVs) between Chinese and foreign companies have been a prevalent source of dispute and frustration. While these ventures provide advantages to both parties, at some point in the time the interests of the partners often begin to diverge, with at least one of the parties having less incentive to compromise its own interests for the benefit of the joint venture.

When the primary interests of the partners no longer point in the same direction, the company will become a battleground. Having an exit strategy ready to implement – and one that is enforceable – can be the key to leaving the venture with your assets and your money intact.

Recent developments in Chinese law will lend support to selling your interest and leaving an inoperable venture behind you. Under Chinese law and unless agreed otherwise in the JV Contract or other documents, one party is free to sell out to a third party. The joint venture partner only has the right of first refusal, giving it the first option at the stake that is being sold, but it does not have the right to refuse a sale altogether. In practice however, a joint venture partner can still block the deal by refusing its cooperation when completing the share transfer procedures: it is near impossible for one party to sell its shares without the support of its joint venture partner, since the competent approval authorities generally require the signatures / stamps of both parties before it will approve a share transfer. As a result, it is not uncommon for one party in the joint venture to pressure the selling party into accepting a price much lower than what a third party is willing to bid.

Recently-issued interpretations of the Chinese Supreme Court provide more guidance to a last resort to an investor that wants to sell its shares to a third party but is denied cooperation from its joint venture partner: by filing a lawsuit. Article XI of the Interpretations of the Supreme People’s court on Several Issues Concerning the Trial of Disputes Involving Foreign-Invested Enterprises (“Interpretations”), which came into force on 16 August 2010, deals with the validity of share transfer agreements, and will have particular effect on joint venture partners seeking to transfer their stake to a third party.

Chinese law already supported claims against a joint venture partner for unlawfully refusing cooperation in implementing a share transfer, but the Interpretations go one step further: the Supreme People’s Court determines specific circumstances under which a court should uphold such a claim:

  • The other shareholders have approved the transfer;
  • The other shareholders have received advanced notice of the share transfer, and have failed to respond within 30 days; or
  • The other shareholders do not consent to the transfer, but also refuse to purchase the shares from the transferring shareholder.

While this new rule may help an investor to exit a JV, the new regulations also add risk: where the Chinese partner is the party that wants to get out, a foreign investor may find itself forced into an unwelcome partnership with a third party. The use of this new regulation by the Chinese party to force the transfer to a third party inappropriate as a partner in the JV is entirely possible.

The best approach to minimize the risks of finding oneself in either undesirable circumstance is to come to a clear agreement, preferably when establishing the joint venture, on the conditions for the eventual sale of equity. Such terms can be included in the JV Contract, and will help to prevent a partner from turning to unfair means to obtain maximum benefit. For example, an agreement prohibiting the sale to certain competitors will be legally effective, while references to procedures for offer and sale, and even on how the price of the shares should be determined in case of a dispute, can be extremely useful. In this regard, parties should always remember that while combining strengths in a joint venture may well make commercial sense, such a combination always has a limited lifespan.

But even with a clear plan and agreements in place, the only way for one partner to press the sale of the shares to a third party without its partner’s cooperation (or to forcibly liquidate the company, for that matter) is through a lawsuit. In practice, forcing such an exit can be difficult, time-consuming and costly, and a prolonged battle between the shareholders may leave neither with any value. Except when the company or its remaining assets are very valuable (and will remain so for a while irrespective of any business), one must hope that the threat of such a lawsuit will be sufficient to negotiating an acceptable exit.

For more information about the establishment, operation and exit from joint ventures in China, we recommend that you read the chapters on joint ventures in Chinese Commercial Law: A Practice Guide by Maarten Roos.