From Rmb42 Million to Nothing: What Lessons Can We Learn from JV Disputes?

In the case here discussed, the foreign party did not pay its fourth and fifth instalments after paying its first three instalments, claiming that bad business operation and a lack of government support made the joint venture unviable. When the domestic party lodged a suit against the foreign party for a breach of contract, the Tianjin No. 2 People's Court and the Higher People's Court both accepted its argument. In the end, the foreign party's equity interest in the joint venture was transferred to the domestic party as compensation to the latter through the court's enforcement procedure.

In practice, it is often the case that parties to a joint venture have a similar attitude as the foreign party in the current case. One of the parties does not intend to inject more capital into the venture simply because the venture is falling short of expectations. What can parties in such a case do? Is it possible that a preliminary arrangement can be made in the joint venture contract?

We suggest that either party can put conditions on its capital contributions to the joint venture. In fact, many different such clauses have been used in joint venture contracts, including that the losses incurred by the joint venture cannot exceed a certain percentage of a JVs total registered capital, or that the joint venture should enjoy certain preferential policies or aid from the government. In these cases, either party has a good argument against contributing more funds to the JV, and may not necessarily be held liable for breach of contract. In the case mentioned here, the Supreme People's Court did not accept the argument on the right to suspend performance stated by the foreign party, but its judgment included the view that such rights are available under the PRC Contract Law(中华人民共和国合同法), and could be included in the joint venture contract.

After winning on the point that the foreign party defaulted on its capital contributions, the domestic party successfully gained the foreign party's investment interest as compensation through the court's enforcement procedure. Unilaterally changing the joint venture's ownership through the courts or administrative measures is a last resort possibility, but in practice, if either party wants to change the shareholding of the joint venture through administrative means other problems can arise.

In the hot administrative case of Beijing Er Shuang Group Limited Company v. the Ministry of Commerce,² the Ministry of Commerce held that the Beijing Foreign Economy and Trade Commission had unilaterally allocated, with no sufficient ground, one shareholder of the cooperative joint venture in question as the owner based on one party's application. The Ministry of Commerce cancelled the shareholder change in the cooperative joint venture that had been determined by the Beijing Foreign Economy and Trade Commission.

In another case from the Supreme People's Court,³ the high-level administrative body that acted as the domestic party to a joint venture transferred the shares belonging to the Chinese party to one of its subsidiaries by means of its administrative power. The court stated that such an administrative method to change ownership is not in line with law and actually that the joint venture partner has a priority right to buy the shares; without a resolution from the other party of the joint venture and the board of directors and without the requisite approval and registration procedure from the government authority, such a decision did not have a legally binding effect. Furthermore, the SPC invalidated an argument from the Chinese party that the applicability of a regulation (Determination of the Title to and the Handling of a Dispute of Ownership of State Owned Assets Tentative Provisions, issued in 1993)⁴ issued by the State Assets Administration Bureau held in the case. The Chinese party argued that the transfer involved state assets, and hence the ownership of the shares did not change after being transferred under the joint venture laws. The SPC held that the Equity Joint Venture Law and its Implementing Regulations are the applicable laws.

Capital Contributions and Transfer of Land Use Rights

In common practice in the set up of joint ventures, it is usual for the domestic party to inject its buildings and land into the joint venture while the foreign party puts in a monetary contribution. Generally, though, when the domestic party provides such buildings and lands to the joint venture for use, it doesn't transfer the title of the building and land to the ownership of the joint venture. In such a circumstance, can the foreign party to the joint venture ask for compensation for default of the domestic party?

The answer is YES. In the case above, the domestic party didn't transfer the title of the property (which was valued at Rmb5.303 million) to the joint venture. Although the Supreme People's Court did not think this was sufficient reason for the foreign party not to pay its fourth and fifth instalments of the capital contribution, it held that the domestic party was in default. In the judgment, the court stated that although the equipment for use as the capital contribution was transferred to the joint venture, title to the real property was not transferred before the registration body.

The Higher People's Court in Shandong province issued a final judgment on May 10 2002 regarding an equity joint venture dispute,⁵ which had the same view. It held that the fact that the defendant provided its land and buildings to the joint venture for use itself did not prove its fulfilment of its capital contribution obligation legally, and so it should bear the liability for the breach of the contract. Furthermore, the judgment of the court confirmed that, although it is not clearly defined whether a land use right is a capital contribution in a joint venture contract, based on the fact that roads and other property were part of the capital contribution pursuant to relevant laws, in such a situation, the joint venture should have the legal right to use the land. So the domestic party should transfer the title of the land to the joint venture to fulfil its obligation under the joint venture contract. The court also quoted the principle that the right to the land and buildings could not be separated, and that it is with the transfer of the ownership of the above-ground buildings and other attached objects by the land users, that the right to the use of the land within the limits of use of the said buildings and objects should be transferred accordingly.⁶

Foreign investors might be confused on this point. In the PRC, the ownership of land belongs to the state, while enterprises only hold land use rights generally. Enterprises can own buildings and other real property. But, according to the abovementioned principle from the regulation on assignment of state-owned urban land that the rights of land and buildings cannot be separated, the ownership of the building and the use rights for the land should belong to the same party. In practice, it often happens that the domestic party only assigns either ownership of the buildings or the land use right to the joint venture as its capital contribution, and then asks that the joint venture lease the land use right or the buildings; in such scenarios, disputes often arise.

Drafting a Good JV Contract

Although it might sound obvious, it is extremely important to draft and negotiate a good joint venture contract for both parties to get win-win results from the operation of their venture and for the venture to be properly governed.

In the case we have examined, another reason that the foreign party gave for not delivering on its capital contributions is that it could not adequately participate in the operation of the joint venture.

The problem here lies in the management control issue. According to the joint venture contract, the foreign party took a 51% stake with the right to appoint the president of the board of directors of the joint venture and five members of the board. The domestic party held 49%, with the right to recommend the general manager of the joint venture and four members of the board. During operations, however, the foreign party complained that even though it was the controlling party it could not check all kinds of original certificates and financial accounts and it was deprived of management rights. Further, it stated that the general manager of the joint venture also acted as the general manager of the domestic party, which is not in compliance with the law.

The judgment itself did not disclose much detail on how both parties participated in the management of the joint venture. But through the dispute itself, we suggest that as the majority party of the joint venture, the foreign party has learnt at least two lessons. First is that it is important to get the right to appoint a general manager. Since the daily operation and management of the enterprise fall under the power of the general manager, it is reasonable for the majority party to appoint the general manager. However, in this case, the minority party (domestic party) had the right to recommend the general manager, and so took the leading position in the operation of the joint venture, which also led to the dispute over management control. Secondly, it is important that power is divided between the board of directors and the general manager properly. A well-drafted joint venture contract would divide the power so that both parties' interests in the joint venture would be protected. It is even more important under the circumstance that the majority shareholder does not appoint the general manager. In this case, the foreign party had majority representation on the board. If the JV contract could reasonably limit the power of the general manager and put most of the management power with the board, the foreign party would still have the power to control the management of the joint venture and would not be kicked out of the company because of a default in the capital contribution, even if it has no right to appoint the general manager.

CONCLUSION

Generally speaking, capital contributions, corporate governance issues and early termination of contracts are three areas common to disputes, and we've seen many cases in these areas. We hope that both domestic and foreign parties shall draw lessons from disputes that have arisen in practice and draft better joint venture contracts in order to make the joint venture a win-win platform for both parties.

Endnotes

1 For the judgment, see the website of the Supreme People's Court:http://www.court.gov.cn/study/civil/200312220025.htm.

2 A brief introduction of the case can be seen at http://news.soufun.com/2004-02-01/236955.htm_.

3 For the judgment, see the website of the Supreme People's Court:http://www.court.gov.cn/study/civil/200303050035.htm.

4 See http://www.law-lib.com/law/law_view.asp?id=10054.

5 For the judgment, see http://www.ccmt.org.cn/ss/writ/
judgementDetial.php?sId=510.

6 See Article 24 of the PRC Granting and Assigning Leaseholds in State-owned Urban Land Tentative Regulations.