Using a Chinese Entity for an All-foreign Joint Venture in China _ Does it Make Sense?

Regardless of the considerations that led them to consider this option in the first place, before organizing a multi-party WFOE in China, the prospective shareholders should give consideration to, and rule out, the use of an offshore (i.e., non-PRC) joint venture entity, which in turn can be the 100% shareholder of a Chinese WFOE.

Summary

There are a number of areas where Chinese law will impact the ability of the parties to structure their relationship within the context of a Chinese entity, as opposed to using a non-Chinese joint venture vehicle:

• All shares equal - the requirement that all shares of a Chinese company carry the same voting, profit and other rights; no special rights, preferences and privileges are permitted;

• Voting follows capital contributions - shareholders vote strictly in accordance with their relative capital contributions; no special classes of stock or differential pricing are permitted;

• Shareholder meetings and voting requirements - some matters are reserved to the shareholders acting by majority vote; a smaller list of items requires a two-thirds majority;

• Shareholders' agreements - their nature and enforceability;

• Priority rights on capital increases - the priority right of shareholders to subscribe for new issuances of equity (increases in registered capital);

• Shareholder approval for any transfers -
the requirement that any transfers of equity by a shareholder be approved by more than one-half of the shareholders;

• Pre-emptive rights - the right of shareholders to pre-emptively purchase any equity proposed to be transferred by another shareholder to a third party;

• Rights of minority shareholders - as a general matter, there are few protections for minority shareholders under the Chinese Company Law;

• Board of directors - composition and powers; ability of the shareholders to appoint and remove members of the board of directors;

• Capital - minimum registered capital levels; types of property that may be contributed; and debt-equity ratios; and

• Profits and losses - definition of "profit"; restrictions on the ability to distribute operating profits to shareholders; and no ability to preferentially allocate profits and losses among shareholders.

The Issues

Multi-party WFOEs are specifically contemplated by the WFOE Rules.² However, neither the WFOE Rules nor the PRC Wholly Foreign-owned Enterprises Law (中华人民共和国外资企业法)itself (the WFOE Law)³ make any mention of shareholders, directors, or corporate governance. Thus the relations of the shareholders in a Chinese WFOE - even though they are by definition entirely foreign parties - are governed by the PRC Company Law(中华人民共和国公司法), without the benefit of special laws and regulations designed for foreign-invested enterprises.⁴ Chinese law dealing with shares and shareholders, boards of directors and corporate governance issues is less flexible than the laws of many other jurisdictions. It also gives less protection to minority shareholders. Still, in practice it may be possible for foreign investors in a WFOE to adopt many of the approaches applied to Sino-foreign joint ventures, although this would require a case-by-case negotiation with the relevant government approval authorities (which generally is the local COFTEC).

All Shares Equal

In many other countries, it is possible to fine-tune the relationship among shareholders by using different classes of stock, preferential voting rights, or preferential rights to profits or losses. None of these are permitted under the Company Law, where all shares of stock must carry identical rights.⁵ Subject to that restriction, the articles of association of limited liability companies are required to set out the rights and obligations of the shareholders.⁶

The PRC Sino-foreign Cooperative Joint Venture Law (中华人民共和国中外合作经营企业法)(CJV Law)⁷ permits special allocation of profits and losses, even where the joint venture is formed as a "legal person" - i.e., a limited liability company.⁸ The PRC Sino-foreign Equity Joint Venture Law (中华人民共和国中外合资经营企业法)(EJV Law) mandates certain protections for minority shareholders (assumed in many cases to be the Chinese party to a Sino-foreign joint venture).⁹ If the foreign investors can convince the local authorities to approve WFOE articles of association that generally follow the rules of operation of an equity or contractual joint venture, they may be able to build into a WFOE some of the operational and governance attributes of joint venture entities.

Voting Rights Follow Value of Capital Contributions

The requirement that all shares of a Chinese company be equal has implications for the control that can be exercised by the shareholders in a WFOE. In many other countries, the relative voting power of the shareholders does not necessarily track their capital contributions. For example, the founders of a company may pay $1 per share for a large number of shares; subsequent investors may pay $10 per share for the same class of stock. In this case, the founders would exercise more control than the value of their capital contributions would suggest. In other cases, subsequent investors may demand greater voting power than the value of their investment would suggest. This often happens in distressed companies.

Neither of these situations is possible under the Company Law. Every shareholder is entitled to vote strictly in accordance with the value of its capital contribution, regardless of when that contribution is made.¹⁰ (Again, if the parties can convince local authorities to allow their WFOE to be structured like a joint venture, it may be possible to vary this otherwise strict rule.)

Capital contributions may be in cash or in kind.¹¹ If the contributions are in kind, they must be independently appraised, valued and verified.¹² The WFOE rules also require that in-kind contributions must consist of property "required for production" by the WFOE.¹³ There are limitations on the percentage of a company's registered capital that can be represented by intellectual property and other intangibles.¹⁴ Detailed information must be submitted regarding any intellectual property that is contributed to the capital of a WFOE.¹⁵ A statutory investment verification organization verifies all capital contributions, whether in cash or in kind, and issues a certificate confirming the contribution and its value.¹⁶

Shareholder Meetings and Voting; Majority and Supermajority Requirements

The shareholder's meeting is "the organ of authority of the company".¹⁷ In contrast, the supreme authority in a Sino-foreign joint venture is the board of directors.¹⁸ Although the law does not explicitly contemplate this, the shareholders of a multi-party WFOE could propose to the relevant Chinese authorities that the board of directors rather than the shareholders be the supreme authority in their WFOE.

Unless changed by the articles of association with the approval of the relevant governmental authorities, shareholders' meetings have the following statutory powers and authorities:

(1) to decide on the business policy and investment plans of the company;

(2) elect and replace directors, and to decide on matters concerning the remuneration of directors;

(3) to elect and replace supervisors appointed from the shareholders' representatives, and to decide on matters concerning the remuneration of supervisors;

(4) to consider and approve reports of the board of directors;

(5) to consider and approve reports of the supervisory board or supervisors;

(6) to consider and approve the company's proposed annual financial budgets and final accounts;

(7) to consider and approve the company's profit distribution plans and plans for making up losses;

(8) to pass resolutions on the increase or reduction of the company's registered capital;

(9) to pass resolutions on the issue of company bonds;

(10) to pass resolutions on the assignment of capital contributions by shareholders to parties other than shareholders;

(11) to pass resolutions on matters such as the merger, division, restructuring, dissolution or liquidation of the company; and

(12) to amend the articles of association of the company.¹⁹

The method of debate and voting must be provided for in the articles of association of the company.²⁰

It is not clear whether shareholders can agree in the articles of association to modify this list of items, or subject some or all of them to a qualified majority (two-thirds, three-quarters, etc.) vote. Whether this will be permitted is entirely up to the discretion of the government authorities that must approve the WFOE's application for establishment.

Certain matters are subject to a two-thirds supermajority vote of the shareholders, which in a two-party joint venture often means unanimity. "Resolutions on the increase or reduction of the registered capital, division, merger, dissolution or restructuring of the company"²¹ and amendment of the articles of association are among these.²² Again, there is no legal authority for making changes to this list, but in practice it may be possible to do so.

As noted above, unless the parties convince local authorities otherwise, shareholders exercise voting rights at shareholders' meetings in proportion to their capital contributions;²³ and no special voting privileges may attach to any shares of stock or to any shareholder.²⁴

Shareholders' meetings are divided into regular meetings and extraordinary meetings. The articles of association must provide for the timing of regular meetings. The first shareholders' meeting must be convened and presided over by the shareholder who made the largest capital contribution. Subsequent meetings are convened according to the schedule in the articles of association or as called by a vote of one-third or more of the directors.²⁵ An extraordinary meeting may also be convened by any 25% shareholder.²⁶ Fifteen days' notice is required for any meeting.²⁷ Minutes must be signed by all shareholders attending the meeting.²⁸

Shareholders' Agreements

The foreign shareholders in a multi-party Chinese WFOE can of course sign a shareholders' agreement outside of China, governed by and enforceable under the laws of some other jurisdiction. Indeed, the law anticipates this, since when two or more foreign investors jointly apply for the establishment of a WFOE, the contract between them must be recorded with the examination and approval authority.²⁹ At a minimum, this provides the Chinese authorities with an opportunity to review whether some part of the agreement between the foreign shareholders would contravene the Company Law.³⁰

Whether such an agreement can modify fundamental aspects of the Company Law is not clear. In practice, the local government authorities have substantial leeway to approve or reject provisions of any agreement between foreign shareholders relating to the operation of a Chinese entity. In any event, if the shareholders' agreement is subject to the law of some jurisdiction other than China, the shareholders should be able to enforce its terms between themselves outside of China as a matter of contract.

Priority Right to Subscribe for Capital Increases

Each shareholder in a Chinese company has a "priority right" to subscribe for any new issuance of equity by the company.³¹ (The Company Law refers to a right to subscribe for capital contributions on a priority basis when a company increases its capital; the Company Law does not use the terms "equity" and "issuance".)

Equity Transfers

The Company Law provides generally that any transfers of equity by a shareholder must be approved by more than one-half of the shareholders, but that consent will be deemed given unless the non-consenting shareholders themselves purchase the equity proposed to be transferred.³²

In the case of a WFOE, the Changes of Equity Interest of Investors in Foreign-invested Enterprises Several Provisions (issued by the then Ministry of Foreign Trade and Economic Cooperation and the State Administration for Industry and Commerce and hereafter the MOFTEC Provisions) make it even more difficult for a shareholder in a WFOE or any other type of foreign-invested entity to transfer its equity to a third party. Articles 2 and 9 of the MOFTEC Provisions require the consent of all other shareholders to any proposed transfer or pledge of equity by a shareholder.³³ Moreover, the MOFTEC Provisions do not provide for a "deemed consent" where an objecting shareholder does not itself purchase the equity proposed to be transferred.³⁴

Pre-emptive Rights

All shareholders in a Chinese company have what the law refers to as a "pre-emptive right"³⁵ to purchase any equity interest proposed to be transferred by another shareholder to a third party.³⁶

Rights to Examine Minutes, Financial and Accounting Records

Companies must prepare financial and accounting reports at the end of each fiscal year and deliver them to their shareholders as well as recording them with the relevant authorities.³⁷ All shareholders have an independent right to the company's financial and accounting reports, as well as to the minutes of their company's shareholders' meetings.³⁸

Board of Directors

Chinese companies may have between three and 13 members on the board of directors.³⁹ There must be a chairman and at least one vice-chairman.⁴⁰ The articles of association must provide for the method of appointment of the chairman and vice-chair(men).⁴¹

In the case of Sino-foreign joint venture entities, Chinese law provides specifically for minority shareholder rights with respect to representation on the board of directors.⁴² In the case of WFOEs, which are governed by the same rules applicable to non-foreign-invested companies, there is no requirement for minority representation on the board of directors. As noted above, the shareholders to a multi-party WFOE conceivably could convince the relevant government authorities to permit them to structure their WFOE along the lines of a Sino-foreign joint venture, although there is no specific legal authority for them to do so.

The directors of a Chinese limited liability company are elected by the shareholders.⁴³ There is no counterpart to the process of cumulative voting that is provided for in the company laws of many other countries, which ensure some minority representation on corporate boards. Shareholders in a multi-party WFOE could draft their articles of association to provide for cumulative voting, appointment by the parties of specific numbers of directors, etc., but whether this would be allowed is entirely within the discretion of the local regulatory authorities.

The Company Law provides that the board of directors "shall be accountable to the shareholders' meeting", but the law also clearly states that directors may not be removed without cause.⁴⁴ Again, whether this could be changed by agreement would depend on the willingness of the approval authorities to permit it.

Minimum Registered Capital and Debt-Equity Ratios

A Chinese company must have a minimum registered capital amount, which is set by law and varies by industry sector. The minimum registered capital can range from quite low (US$12,500) to very high (US$30-50 million).

In addition, Chinese companies are subject to effective debt-equity ratios, which vary depending on the size of the parties' "total investment".⁴⁵ For significant ventures,⁴⁶ at least 30% of a company's total investment must be represented by its registered capital.

The amount of a company's registered capital drives a number of other concerns, including timing of profit distributions, size of reserves, and the like. For many foreign investors, the smaller the amount of registered capital, the better. If two or more foreign parties form an offshore joint venture, that entity has more flexibility in arranging the financial picture of its WFOE than the parties independently would have if their joint venture vehicle was the WFOE itself, largely because it is simpler to take advantage of inter-company relationships to fund and operate the Chinese entity.

Profits and Losses

The "all shares equal" requirement also means that there can be no special or preferential distribution of either profits or losses in a Chinese company. All profits must be distributed pro rata according to the parties' respective capital contributions.⁴⁷ This is not the case in a contractual joint venture; it is conceivable that government authorities would permit the shareholders to a multi-party WFOE to agree on a different allocation of profits, although this would be quite unusual.

Definition of Profit

The Company Law does not define profit. However, Chinese accounting principles may vary from the accounting principles with which a foreign investor is familiar. It may be more or less difficult in China to show profit and this naturally will affect the ability of the company to distribute those profits.

A Chinese entity owned by an offshore joint venture can take advantage of a transfer pricing schedule with its parent that will affect its profitability - and the ability of the parent and the parent's shareholders to draw excess cash out of the Chinese operations. Any such transfer pricing regime obviously must be in compliance with Chinese transfer pricing regulations and any other applicable tax and foreign exchange laws.

Restrictions on Dividends (Distribution of Profits)

In many countries a company cannot pay dividends if it is insolvent, or if the payment of the dividends would render it insolvent.⁴⁸ In China there are several other restrictions.

First, the Company Law speaks in terms of distributing profits, rather than dividends. In other countries, a company could have losses for some purposes and still be able to make dividend payments to its shareholders.

Second, there are priority claims on a company's profits that take precedence over any distribution to the shareholders. The Company Law requires that 10% of a company's after-tax profits must be allocated to a "statutory common reserve" (until the amount of that reserve exceeds 50% of the company's registered capital) and "5% to 10%" to a "statutory provident fund".⁴⁹ Within these general requirements, WFOEs can determine the rate at which allocations shall be made.⁵⁰

Annual profits must also go first to "make up" losses from previous years before any distribution can be made to shareholders.⁵¹ If those profits are insufficient to make up accumulated losses, the statutory reserve must be used for this purpose. When the company returns to profitability all prior years' losses must be made up, and the statutory reserve replenished, before any distribution to shareholders is permitted.⁵²

If a company has profits that may be distributed, the distribution must be made in accordance with a plan approved by the shareholders,⁵³ strictly in proportion to the parties' respective capital contributions.⁵⁴ No preferential dividend rights or other special rights with regard to the distribution of profits are permitted.⁵⁵ This is true during the life of the company, and upon liquidation as well.⁵⁶

Endnotes

1 The PRC Company Law (promulgated on December 29 1993 and effective as of July 1 1994; revised on December 25 1999) applies to all companies in China, domestic as well as foreign-owned, unless a more specific law contradicts the provision of the Company Law. Foreign-owned entities are subject to specific laws. The PRC Wholly Foreign-owned Enterprises Law will apply in the case of WFOEs, but in practice the authorities (the local COFTEC) will make reference to the PRC Sino-foreign Equity Joint Venture Law and the PRC Sino-foreign Cooperative Joint Venture Law as well. This results in considerable ambiguity and uncertainty for foreign investors.

2 The State Council approved the PRC Wholly Foreign-owned Enterprise Law Implementing Rules, on October 28 1990, and the rules were promulgated by the Ministry of Foreign Economic Relations and Trade on December 12 1990. See the State Council's revision in the PRC Wholly Foreign-owned Enterprise Law Implementing Rules (Revised), issued on April 12 2001 (the WFOE Rules), Article 10.

3 The PRC Wholly Foreign-owned Enterprises Law was adopted on April 12 1986, and revised in the PRC Wholly Foreign-owned Enterprises Law (Revised), on October 31 2000.

4 See the Company Law, Article 18. In contrast, Chinese law makes the board of directors of a Sino-foreign joint venture, rather than the shareholders, the supreme authority of the JV entity, reflecting an intent to concentrate the relationship between the joint venture partners at the board level rather than involving the sometimes more complicated relationship of shareholders under Chinese law. See the State Council's PRC Sino-foreign Equity Joint Venture Law, promulgated on September 20 1983, and amended in 1986 and 1987 (the EJV Law). Also see the State Council's PRC Sino-foreign Equity Joint Venture Law Implementing Rules, issued on July 22 2001, Article 30.

5 Company Law, Article 3. Of course, parties can enter into shareholders' agreements. However, it is not clear whether an agreement would be enforced if, for example, it effectively circumvented the Company Law requirements that certain matters be approved by a two-thirds vote of the shareholders, or gave a minority shareholder the ability to control other matters committed by statute to a majority vote.

6 Ibid, Article 22.

7 Promulgated on April 13 1988.

8 CJV Law, Articles 2 and 22.

9 See, e.g., the EJV Law, Article 6.

10 Company Law, Article 41.

11 Company Law, Article 24. Where the capital contributions are in kind, the legal procedures applicable to the transfer of the relevant type of property must be followed. See ibid, Article 25. Many foreign investors have contributed a licence to intellectual property; whether this satisfies the language of the Company Law related to the "transfer" of the property has not been officially determined. See also the WFOE Rules, Article 25: "Foreign investors may contribute capital in the form of freely convertible foreign currencies, or may capitalize items such as machinery, equipment, industrial property or proprietary technology according to the monetary value of such items. Upon approval by the examination and approval authorities, foreign investors may also use as capital contribution renminbi profits derived by them from other foreign-invested enterprises established in the People's Republic of China."

12 Company Law, Article 24; also see the WFOE Rules, Articles. 26 and 32. The WFOE Rules require that "the value at which [in-kind contributions] is capitalized may not exceed the current regular price [i.e., market price] in the international market" for the same type of property. The WFOE Rules also give the authorities the power to inspect and reassess the value of IP after it has been contributed to a WFOE, and if discrepancies are found compared to the information submitted (see the WFOE Rules, Article 28), "the power to demand that the foreign investor rectify such discrepancies within a specified period of time" (WFOE Rules, Article 29).

13 Ibid, Article 26.

14 In most cases no more than 20% of a company's registered capital may be represented by intangible property (Company Law, Article 24; WFOE Rules, Article 27). In the hi-technology sector, up to 35% may be permitted. In at least one hi-technology industrial park near Beijing, up to 100% of a company's registered capital may be represented by intangibles. The WFOE Rules require that any IP contributed by a foreign investor in a WFOE must be "owned by the foreign investor" (Article 27). It is not clear whether ownership of a licence satisfies this requirement, and thus whether a foreign investor can contribute to a WFOE a sublicence of technology that it has licensed from a third party.

15 Ibid, Article 27: "Detailed information shall be prepared concerning the industrial property or proprietary technology that is capitalized according to its value. Such information shall include copies of certificates pertaining to ownership and details of their validity, information on the technical function and practical value of the property or technology, and the bases and standards used for conducting valuation. The above information shall be annexed to the application for establishment of the wholly foreign-owned enterprise, and submitted to the examination and approval authorities along with such application."

16 Company Law, Article 26; WFOE Rules, Article 32.

17 Company Law, Article 37.

18 EJV Rules, Article 30.

19 Company Law, Article 38.

20 Ibid, Article 39.

21 Idem.

22 Ibid, Article 40.

23 Ibid, Articles 4 and 41.

24 Company Law, Article 3.

25 Ibid, Art. 43.

26 Idem.

27 Ibid, Article 44.

28 Idem.

29 WFOE Rules, Article 10.

30 Article 11 of the WFOE Rules permits the examining and approval authority to require that submitted documents be amended if they are "not in order".

31 Company Law, Article 33.

32 Ibid, Article 35.

33 Our communications with COFTEC in Shanghai have confirmed that it is very difficult for them to approve a transfer of equity if any of the other shareholders has not consented.

34 Article 9(6) of the MOFTEC Regulations requires consent to any transfer to be evidenced by signatures of the non-transferring shareholders on the share transfer agreement or a separate letter; this implies an active consent and does not seem to leave room for "deemed consent". Our consultations with the Shanghai COFTEC have confirmed that they would find the "deemed consent" approach difficult to apply and would in practice require the active consent of all the non-transferring shareholders.

35 In the US, this might be referred to as a right of first refusal; in most cases the term "pre-emptive right" refers to a right to take up new issuances of equity. Shareholders in a WFOE also have this right, which the law refers to as a "priority right".

36 Company Law, Article 35.

37 Ibid, Articles 175 and 176. The WFOE Rules specifically require that foreign-owned enterprises establish a finance and accounting system that is in accordance with Chinese law and record that system with the local finance and taxation authorities. See the WFOE Rules, Article 56. The financial and accounting reports must also be recorded with the authorities, pursuant to the WFOE Rules Article 62: "Wholly foreign-owned enterprises shall submit their annual balance sheets and profit and loss statements to the finance and tax authorities and shall record such sheets and statements with the examination and approval authorities and the industry and commerce administrative authorities."

38 Company Law, Article 32. Financial and accounting reports must be prepared at the end of each fiscal year, and must be examined and verified according to law. See ibid, Article 175.

39 Ibid, Article 45.

40 Idem. These positions are not particularly significant in most privately held companies in the United States. In China, however, the positions have significant legal consequences (for example, the chairman of the board is the company's legal representative), so the parties should be careful in their selection of directors to fill these two positions.

41 Idem.

42 For example, the EJV Law requires that the Chairman of the Board be appointed by either the foreign or the Chinese party, and the Vice-Chairman by the other party.

43 Article 38 of the Company Law lists the election and replacement of directors as one of the matters reserved to the shareholders.

44 Company Law, Article 47. The articles of association must specify the term of office of the directors.

45 "Total investment" is defined differently in different laws; however, in general terms it can be seen as the sum of a company's registered capital and its medium- and long-term debt, including shareholder loans.

46 Total investment in excess of US$30 million.

47 Company Law, Articles 33 and 177. Parties to a contractual joint venture, however, may agree on special allocations of profits and losses.

48 The definition of "insolvent" is often different from that used for accounting purposes, for purposes of the bankruptcy laws, and the like.

49 Ibid, Article 177. The "provident fund" is to be used for "the collective welfare of [the company's] staff and workers". See the Company Law, Article 180. The same rules apply to WFOEs; see the WFOE Rules, Article 58.

50 Idem.

51 Idem.

52 Company Law, Article 177.

53 Ibid, Article 38.

54 Ibid, Article 177.

55 Any distributions made other than in accordance with these requirements "must be returned to the company". See the Company Law, Article 177.

56 In the case of liquidation because of insolvency, the Company Law, Article 195 provides: "The property of a company remaining after full repayment pursuant to the preceding paragraph [relating to payment of creditors and other claims] shall be distributed, in the case of a limited liability company, in proportion to the capital contributions of its shareholders." The WFOE Rules contain their own provisions regarding dissolution and liquidation of a wholly foreign-owned enterprise, whether because of insolvency, heavy losses, expiration of its term, or any other reason that might be contemplated by the WFOE's articles of association. Article 76 of the WFOE Rules provides that, after all creditors' and other claims have been satisfied, the portion of the WFOE's net assets remaining "shall be regarded as profit", and presumably paid out in accordance with the other provisions of the Company Law and WFOE Rules.