Main Takeaways to Revise Your Joint Venture Contracts and...

Main Takeaways to Revise Your Joint Venture Contracts and Articles of Association under the New Foreign Investment Law (“FIL”)

Among the three types of foreign-invested enterprises (“FIEs”) that was first established in China since the 1980s, namely the so-called Sino-foreign equity joint ventures (“EJV”), Sino-foreign cooperative joint ventures (“CJV”), and wholly foreign-owned enterprises (“WFOE”), EJV is undoubtedly the prevailing form of corporate entity that foreign investors have adopted when they need to work with Chinese partners to open their Chinese market.  Comparing to the PRC Company Law (the “Company Law”) which applies to domestic companies, the previously governing EJV Law sets forth a unique regime on the various aspects of EJVs, including corporate governance, voting mechanism, profit sharing, and equity transfer restrictions, etc.     

Effective from January 1, 2020, the new FIL repealed the EJV Law and its implementing rules, and provides a transitional period of five (5) years for EJVs and other FIEs to comply with the Company Law.  Upon expiry of such transitional period (i.e. January 1, 2025), any foreign-funded enterprises that fail to adjust and register the change of their organizational forms and structures according to the Company Law will not be able to process other filings at the company registration authority.  As a result, foreign investors are suggested to review the joint venture contracts (“JVC”) and articles of association (“AOA”) of their EJVs, and initiate the discussion with the Chinese partners to identify the necessary changes as early as possible to meet the above requirements before the deadline.

The major takeaway points when negotiating and revising the bylaws include:

Author：Shihui Partners | Joe Lin

01Corporate Governance The most significant impact of the FIL on EJVs lies in the organizational and governance structure due to the substantial differences between the EJV Law and the Company Law.  In the past, the highest authority in an EJV was the board of directors, which should be adjusted to the shareholders’ meeting during the transitional period.  Under the Company Law, there is a 3-tier corporate governance structure in a limited liability company, consisting of (1) the shareholders’ meeting as the highest authority, (2) the board of directors acting as the intermediary between the shareholders’ meeting and management, and governing the daily management of the company, and (3) management personnel (including general managers and financial controllers, etc.) in charge of the company’s daily operation. The shareholders’ meeting has the power to determine the major issues of the company and their voting rights are based on each shareholder’s respective capital contributions unless the AOA of the company specifies otherwise.  The directors, or one single executive director in certain cases, will be appointed by the shareholders’ meeting to execute the resolutions of the shareholders’ meeting and manage the activities of the management personnel. Below is a summary of the major differences relating to the corporate governance structure in the EJV Law and the Company Law:

With the highest authority of an EJV shifting from the board of directors to the shareholders’ meeting, those key issues listed above which previously required unanimous affirmative votes by all the directors, will be escalated to the shareholders’ meeting and require approval by shareholder(s) representing 2/3 of the voting rights.  This means if the AOA does not provide otherwise, a single shareholder holding 2/3 equity interests or more in the company can effectively decide, at its sole discretion, the above issues which were subject to the unanimous approval by all the directors in the past.   As a result, minority shareholders holding 1/3 (or less) equity interests in an EJV may lose their protection on the key issues of the EJV under the new decision-making mechanism.

The issue here is how an EJV should design the voting mechanism in its JVC/AOA amendments, to not only comply with the Company Law but also maintain its existing voting and decision-making mechanism to the largest extent, which could avoid a lengthy re-negotiation process between the JV partners.  

Basically, there are two options for accomplishing this purpose:

(1)Delegating the power of shareholders’ meeting to the board of directors

Based on our initial survey, many EJVs may still want their appointed boards of directors to take the lead on decision-making, or at least initiate proposals for important matters. One practical solution is for the shareholders of an EJV to delegate certain powers to the board of directors for making proposals to the shareholders or making final decisions on certain matters to the extent permitted by the Company Law.

The Company Law does not expressly prohibit the shareholders’ meeting from delegating powers to the board. However, in practice, court decisions indicate that the following three types of matters may not be delegated from the shareholder level to the board for the board to make final decisions:

1. Any change to the following information that is required to be included in the AOA of a company, thus resulting in an amendment to the AOA:

   - name and address of the company;

   - the business scope of the company;

   - the registered capital of the company;

   - names of the shareholders;

   - form, amount, and schedule of capital contributions by the shareholders;

   - organization of the company and the methods of formation, authorities, and rules of procedure thereof; and

   - the legal representative of the company.

2. Any split, merger, dissolution, or change of corporate form of the company; and

3. If the matter concerns the right to dividends to the shareholders, that matter cannot be delegated to be decided by the board.

However, in practice, the EJVs can consider using the AOA to delegate to the board the power to initiate the discussions and propose solutions (in the form of a board resolution) related to the above matters as a procedural prerequisite for the final review and confirmation by the shareholders’ meeting.

For matters other than the above matters that must be approved by shareholders’ meeting, the shareholders’ meeting of an EJV may consider delegating to the board for final decision making.

(2)Creating special veto rights for minority shareholders

Article 42 of the Company Law provides that the shareholders of a company shall exercise their voting rights at shareholders’ meetings in proportion to their respective capital contribution percentages unless otherwise specified in the company’s AOA.

Based on our experience, some existing EJVs are choosing a more conservative approach to try to keep the voting rights of each shareholder the same as in the previous arrangement designed in accordance with the EJV Law, under which approach the above-mentioned important matters (which previously required unanimous approval by the board of directors) will be required under the amended JVC/AOA to be approved by all shareholders to be effective. As a practical matter, it is likely that foreign investors and their Chinese partners may want to establish alternative voting mechanisms to the extent not contrary to the Company Law. For example, the AOA may provide that a shareholder who owns a minority percentage of the equity interest (e.g. 25%) possesses veto rights on certain matters including those that must be approved by shareholder(s) representing at least 2/3 of the voting rights.  This approach is especially important for minority shareholders who have less than 1/3 of the voting rights.
However, deadlocks may occur easily at the shareholder level if the minority shareholders are given veto rights with a broad range, which could eventually lead to a suspension of operation, or even more severely, termination of an EJV when the shareholders fail to reach an agreement within a reasonable period. Therefore, most joint venture shareholders will face challenges to find a reasonable balance between improving the efficiency of the operation and ensuring the minority shareholders’ involvement in the decision-making process on major issues of the EJVs.

02Distribution of Profits

According to Article 34 of the Company Law, the default position is that the dividends shall be distributed to shareholders in proportion to their respective actual paid-in capital. However, the shareholders are allowed to agree otherwise.

The Company Law only provides for one class of equity for limited liability companies, and therefore the concepts of “common equity (shares)” and “preferred equity (shares)” do not exist under current PRC law and practice for limited liability EJVs. However, the AOA of a company may still provide “preferential rights” for shareholders.

For example, a shareholder may also be provided under the AOA of an EJV with the right to enjoy a larger share of the dividends (e.g. 70%) as compared to its shareholding percentage (30%).

Based on our consultations with the company registration authorities in some of the major cities in China, the officials normally will not interfere with or challenge profit-sharing arrangements that are not in proportion to the shareholders’ equity ratio of an EJV, as long as the shareholders reach mutual agreement on such arrangement.

However, the flexibilities for profit-sharing rights discussed above may not be feasible for EJVs that are engaged in businesses listed in the Negative List of industries for foreign investment. This is because that the JVCs and AOAs of the EJVs in such industries will still be subject to substantial review and regulatory approval by the Ministry of Commerce or its counterparts (as well as other governmental authorities if applicable).  During such substantial review and approval, the approval authorities may challenge the arrangement of flexible profit sharing rights that are not in proportion to the equity ratio, in particular for EJVs in which the Chinese shareholders are required to take controlling majority shareholding.

03Equity Transfer Restrictions

Under the EJV Law, the consents of all other JV partners must be obtained if one JV partner wants to transfer its equity interests in the EJV to a third party. The other JV partners had the right of first refusal to purchase the equity interest to be transferred to the third party. The terms and conditions of the proposed transfer to the third party could not be more preferential than those of the proposed transfer to the other JV partners.

The Company Law provides for more flexible conditions on equity transfer to third parties. Pursuant to Article 71, consent of more than half of the other shareholders is required if a shareholder wants to transfer its equity interest to a third party unless otherwise provided by the AOA. The term “half” as used in this article refers to the number of shareholders rather than the capital contribution percentage of the shareholders. For example, if an EJV has five (5) shareholders and one shareholder wants to transfer all of its equity interest to a third party, consent from at least three of the other four (4) shareholders is required absent any provisions to the contrary in the AOA. The shareholder that wants to transfer shall notify the other shareholders in writing for their consent.  Failure to reply by any of the other shareholders within 30 days upon receipt of the written notice shall be deemed as consent to the transfer. Where at least half of the other shareholders do not consent to the transfer, such non-consenting shareholders shall purchase the equity interest to be transferred. Failure to purchase the equity interest shall be deemed as consent to the transfer.

Given that the stability of the relationship between the foreign and Chinese shareholders is usually the foundation of a well-run EJV, the shareholders may consider if they would like to follow the above flexible mechanism under the Company Law or adopt the more restrictive approach as previously required by the EJV Law to prevent any unexpected exit by the other shareholder, either of which needs to be specified in the AOA of the EJV.

ConclusionConclusion

The implementation of the FIL brings in an air of change to the country’s corporate and investment environment with more benefits to foreign enterprises and incentives to enter this market. While the repeal of the previous foreign investment laws provides more opportunities, FIEs must now review contracts, bylaws, articles of associations, and organization structure and make any necessary changes to ensure they are compliant with the relevant regulations.

Shihui’s substantial experience in the field of foreign investment provides the support you need when drafting or amending the constitutional documents of your FIEs. Our experts have the in-depth knowledge and experience needed and are ready to offer any assistance to fulfill both your commercial goal and the compliance requirements. 

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林慕乔 合伙人

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林慕乔律师专注于为美国、中国和欧洲客户的国际公司和商业事务（例如并购、境内和境外的外商直接投资和其他综合公司事务）及私募股权投资项目提供咨询服务。林慕乔律师在跨境并购、私募股权融资和外商投资领域拥有丰富的经验，并主办了诸多有影响力的项目，涉及的行业包括能源、医疗健康、互联网/通信、影视传媒、制造业、清洁能源、零售及金融等诸多领域。林慕乔律师主办的代表性项目包括BP（英国石油）、美敦力、富达、济峰资本、保时捷、AIG、中国人寿、今日资本、上汽集团、上海文广集团等跨国公司和知名私募投资机构的境内外投资项目。

林律师先后毕业于中国政法大学和香港中文大学 ，并获得法学学士学位和法学硕士学位。加入世辉之前，林律师曾任职于美国GT国际律师事务所和通力律师事务所等国内外知名律所。

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