View to China

I’ve been looking back at the deals I’ve assisted with over the years in Australia, the UK and of course China, and collected some observations on the things I have found about doing an M&A deal in China that are very different  from others. 

Some don’t seem so different anymore but really struck me at the time as being bizarre.   And some do stand out as having universal merit, while others are annoyances peculiar to China. 

Here’s my list, in order of where I think they appear in the negotiation process.  (I’m doing this in two parts by the way…)

1. The Sino-foreign joint venture.  A foreign investor starts trying to structure a deal in China, and finds he or she will need the on-going assistance of a Chinese party, to provide materials, land, funds, guanxi, whatever.  The “Sino-foreign joint venture” rears its head right then, and it is such an old and well-worn model of foreign direct investment in China, that many people get stuck into the process of negotiating it, without even thinking about what they are getting into.  In many jurisdictions, it is not unusual to have a privately held company with more than one shareholder.  But the Sino-foreign joint venture is an unusual beast.  If you think about it and return to first principles, negotiating an arrangement with a fellow potential shareholder calls for a good, well-drafted shareholders’ agreement to govern the respective interests of the main parties.  With everybody being rational and acting like grown-ups, there’s no reason why you shouldn’t get there.  But Sino-foreign JV contracts have an additional overlay of laws and regulations.  These should be familiar to those of you experienced in China (to name a couple: with board appointments, the chairman and the deputy chairman can’t be appointed by the same party and board distribution should be roughly in proportion to the respective equity holdings or investment).   The result is that the negotiation ends  up more adversarial than it should because it feels like two parties are trying to carve out their individual niches and protect their own turfs.  It can be easy to forget that the point of the exercise is to provide the basis for the ongoing management and governance (and success) of the jointly-held company.
2. Rigid capital and profit distribution structures.  Along the way, a foreigner discovers that certain issues are pretty rigid in China, especially when it comes to the Sino-foreign joint venture model.  One of them is the capital structure and how much one can derive from the investment relative to one’s investment.   Indeed, one obstacle that private equity firms found investing in China is that the Sino-foreign Equity Joint Venture structure requires that profits be distributed in accordance with the proportion of equity holdings.  If you own 50% of the company, you get 50% of the profits.  Since the raison d’etre for PE is that firms seek a greater return than they would get on public listed companies, preferred stock is a mainstay of most models, i.e. giving the investor a priority to dividends.  PE firms have got around this to an extent by using the Cooperative Joint Venture (CJV) model, which permits one shareholder a greater share of the dividends relative to its interest.  But this CJV model was intended for different purposes.  Its initial aim was to allow foreign investors who had invested heavily into energy and resources projects the ability to recoup profits early.  Applying the model to PE is a bit like fitting a square peg into a round hole.  You can imagine that the legal drafting starts to get more complicated once you enter into the realms of different priorities in preferences with different rounds of financing and “converting”  back to “ordinary stock” etc.   Plus, every such amendment to the joint venture contract and articles of association requires government approval… 
3. Reciprocity in negotiations.  I confess I used to find this one amusing.  I think it is less and less an issue, as Chinese counter-parties become more sophisticated and are less demanding of complete reciprocity in a contract.  Some years ago, however, it was not unusual that a Chinese counter-party, when asked to provide a certain undertaking, would insist on a reciprocal undertaking by the foreign investor to ensure “fairness”.  At times, the request didn’t make sense, e.g. when the foreign investor requested that the Chinese enterprise provide warranties regarding its assets because it was buying them from the Chinese.   Why should the buyer then provide a warranty on its assets??  Often, however, reciprocal undertakings are easy to give away, since they have no real meaning anyway.  (And from a philosophical viewpoint, in a negotiation, should you really be asking for something you would not give anyway?) 
4. Demands based on fear  of the other.  I put into this category demands about governing law and the dispute resolution forum.  Many foreign clients I have known had a fear of submitting to Chinese law and agreeing to dispute resolution in China.  Many Chinese parties seemed to feel exactly the same way about foreign laws and foreign arbitration and courts.  There is more to this than I can go into here, but essentially agreeing to arbitration or even the jurisdiction of a court in China is not such a bad idea, since (i) arbitration at the China-based China International Economic Trade and Arbitration Commission (CIETAC) is easier to enforce than a foreign arbitration award which can be simply ineffectual in China (just ask Danone) and (ii) foreign court judgments mean nothing if the Chinese party does not have assets in that jurisdiction.  Governing language clauses also fall into this category.  If a foreign investor is willing to submit to the jurisdiction of a Chinese court, then it follows that the Chinese language version should govern, since the court will not read anything else.  For many years, I used to automatically provide for both English and Chinese language versions to prevail, but I am no longer convinced this is workable.  You can find much more on this issue over at the China Law Blog, and I am indebted to them for making such good sense about these issues so many times that it convinced me they were right. 
5. Agreeing to agree.  Another personal favourite of mine, like the reciprocity requirement, chiefly because this had some lessons for me.  Many China-related contracts I’ve drafted contain a clause that there are outstanding issues that the parties haven’t yet entirely resolved and would agree on in time.  Often, the clause — or at least the princple — is handy when there is just some little detail the parties can’t quite agree on but feel like they’ve had enough and need to move on and sign the thing.  In the English system of law, clauses that don’t pin down an obligation on a party are called “agreements to agree”, and they are generally seen as worthless.  Yet, I have drafted many contracts with “agreeing to agree” clauses like that, that never needed to be readdressed.  The main thing is the deal got done and everyone moved on.  Plus, I’ve drafted “amendment agreements” so many times, that I know that even if parties have agreed something, they can change their minds or need to clarify things after the  fact.  It is just human nature.  So maybe the Chinese are onto something when they recognise it upfront and don’t try and dot every “i” and cross every “t”.

So, now our foreign investor has encountered and dealt with these little issues, he or she has signed the contract and thinks they’re home free. 

 Next post: getting into the approval process, and the things that are really different there…