Reorganization and Conversion of a Joint Venture into a Wholly Foreign-Owned Enterprise in the People's Republic of China

Article by Daniel C.K. Chow

In the early stages of foreign investment in the People's Republic of China (PRC), the overwhelming investment vehicle of choice was the equity joint venture. When China opened its doors to foreign investment after many years of isolation, foreign investors were attracted by the vast potential of China's market, but at the same time were apprehensive about China's unfamiliar political system, seemingly impenetrable language, and alien culture. As a result, early investors eagerly sought local partners to overcome these obstacles. As foreign investors have gained experience after more than a decade of investment in China, however, the early optimism created by these partnerships has been tempered by some sobering lessons.

Many foreign investors found significant problems created by their partnerships with local partners. Basic differences in management goals and philosophies can lead to frequent clashes, hampering the operation of the joint venture. In more extreme situations, problems such as competition between the local partner and the foreign investor may lead to a fundamental breach of trust between the parties, resulting in the abrupt termination of the joint venture. Aside from some of the unexpected difficulties caused by partnership issues, the movement away from the joint venture form as an investment vehicle is a result of the increasing sophistication of foreign investors. Some multinational enterprises (MNEs) have as many as a dozen or more joint ventures in China and have now gained sufficient knowledge and capability to be able to operate independently without relying on a local partner. As a result, in 1997, investments in wholly foreign-owned enterprises (WFOEs) for the first time exceeded investment in new joint ventures.

For foreign investors in existing joint ventures, dissatisfaction with the joint form has led some of them to seek alternatives. One possibility is for the foreign investor to increase its ownership interest in the joint venture to obtain management control of the enterprise and to relegate the local partner to the role of a passive investor. An even more attractive option is to buy out the interest of the local partner and to convert the joint venture into a wholly foreign-owned enterprise, where permitted by law. Until recently, many unresolved issues complicated the buyout process, but the enactment of new legislation has clarified this process and should lead to a greater number of buyouts in the near term.

This Article examines issues for foreign investors in the buyout and reorganization process. Part II of this Article examines some of the causes for termination of joint venture partnerships. Most of these problems can be traced to two different causes. First, the utility and value of the local partner's contribution to the joint venture tends to diminish over time as the foreign investor is able to develop and replicate the local partner's initial advantages in knowledge and experience. At a certain point, the foreign investor decides that the local partner is no longer making a valuable contribution to the partnership and that the disadvantages of continuing the partnership outweigh the advantages. Second, problems with the local partner become so acute that the foreign investor decides that the disadvantages of the partnership have reached a point where the partnership is no longer viable, practicable, or desirable.

Part III then sets forth the mechanics of the acquisition and reorganization process. In general, the foreign investor is exposed to substantially greater risks in the buyout process. The risk to the local partner is that the foreign investor will not perform its obligations, but the performance of the foreign investor is completed once payment is made and the local partner receives its funds. On the other hand, the foreign investor purchases the equity interest of the local partner and will continue to operate the company as an ongoing business concern after reorganization of the joint venture as a wholly foreign-owned enterprise. Any number of problems could arise in the process that would complicate or derail the plans of the foreign investor. In addition, some problems may not become manifest until the local partner has already received payment and has long departed the scene, at which time it will be difficult for the foreign investor to recover any part of the funds already paid. For these reasons, the foreign investor must anticipate these issues and structure the transaction and all contracts to protect its interests.

The final part of this Article examines the lessons learned and suggests how such lessons may be applied in the planning stages of new joint ventures. Ultimately, reasons leading to the termination of the joint venture and conversion into a wholly foreign-owned enterprise call into question the long-term utility of the traditional joint venture form and its appeal to foreign investors as an investment vehicle for China.


About the Author

Daniel C.K. Chow. Professor of Law, The Ohio State University College of Law; B.A. 1979, Yale College; J.D. 1982, Yale Law School. On leave 1997-99, People's Republic of China.

Citation

73 Tul. L. Rev. 619 (1998)