How Chinese parties can prepare for increasing outbound disputes Shaun Z Wu and Andrew D Wang are lawyers at Kobre & Kim LLP Driven by a need to hedge against a slowing domestic economy and drawn by opportunities for access to technology and expertise, Chinese parties continue to invest increasingly large sums of capital into foreign ventures. Indeed, while 2015 was a record year for China outbound ventures with deal volume totaling US $109 billion, the US $101 billion figure for China outbound ventures in the first quarter of this year alone has almost matched that figure. By contrast, global activity elsewhere has been dropping precipitously. Thus, as the volume of China outbound ventures continues to rise, they will represent an increasingly large share of global activity as a whole, solidifying China’s position as a paramount economic power. However, greater opportunities also mean greater risks. As Chinese parties continue to park their capital on foreign shores, whether in the form of joint ventures or other structures, they will inevitably face more disputes or litigation arising from those investments, oftentimes in foreign and unfamiliar venues. Fortunately, while it is impossible to predict future disputes with any precision, Chinese parties can mitigate risks by including thoughtful dispute resolution provisions in their joint venture agreements that can help them deal with any later problems. By being aware of and planning for possible disputes down the line, Chinese parties can maximize value from their outbound ventures. China-foreign joint venture disputes and deadlock provisions As an alternative to an outright acquisition, a Chinese party can gain access to foreign markets through a joint venture with a foreign company. Joint ventures offer certain advantages over outright acquisition, such as avoiding the need to expend or commit as much capital, limiting losses by spreading risk across the partners, and ensuring greater flexibility for all parties. For Chinese parties, they may also provide similar levels of access to technology and expertise as in acquisitions. On the other hand, joint ventures may sometimes present an even greater risk of disputes, given that each parent company maintains its separate business identity, may have conflicting priorities, and has varying levels of decision making power. In the case of Chinese-foreign joint ventures specifically, the risk of disputes may be compounded by differing cultures, management styles, and working relationships within each parent company. Deadlock provisions for resolving discrete disputes Disputes between Chinese and foreign joint venture partners can take many forms, such as decisions over management and control, funding structure, dividend policy, etc. A well-drafted joint venture agreement will include deadlock provisions that will streamline the resolution of disputes. There are certain commonly used deadlock provisions designed to treat the partners fairly while at the same time allowing the business to continue. For example, in the event of a tie vote among the board of directors, a disagreement can be decided by a tie-breaking vote rendered by an independent, non-executive director. Another commonly used mechanism is stipulating that certain disagreements be resolved by mediation first. The provision may provide that in the case of a deadlock, the parties must engage an impartial mediator in an attempt to reach a compromise. Although a mediator does not have the power to impose a settlement on the parties, often he or she can help the parties reach their own negotiated settlement especially for Chinese-foreign joint venture disputes. Types of deadlock provisions for dissolving the China-foreign joint venture If a dispute between the Chinese and foreign parties cannot be resolved, oftentimes they may have no choice but to terminate the joint venture. However, many joint venture agreements require unanimous agreement among the board of directors for dissolution. What happens if a Chinese partner wishes to unilaterally dissolve the venture with a foreign partner due to changing market conditions, new business opportunities, or significant economic events in China? Without a clear exit strategy, the Chinese partner may have no choice but to continue participating in a joint venture that no longer suits its strategic needs. A Chinese party looking to enter into a joint venture with a foreign company can avoid such problems by incorporating into the joint venture agreement deadlock provisions entitling it to unilaterally terminate upon certain specified events, or to buy out interests from, or sell interests to, its counterparty at a designated price. The following are some commonly seen termination devices: Russian Roulette – One deadlocked partner serves notice on the other partner and names a price per share of the joint venture. The partner receiving the notice then has the option to either buy all of the notifying partner’s shares at that price, or sell all of its shares to the notifying partner at that price. Texas Shoot-Out – Each deadlocked partner submits a sealed bid stating the price at which it would be willing to purchase all of the other partner’s shares in the joint venture. The partner with the higher bid must then buy the other partner out at the price per share of its bid. Dutch Auction – Each deadlocked partner submits a sealed bid stating the lowest price at which it would sell all of its shares in the joint venture. Whichever sealed bid contains the higher price ‘wins,’ and that bidder must then buy the other partner’s shares at the price contained in the ‘losing’ bid. Adjusted Fair Market Value – One deadlocked partner serves notice on the other partner indicating that a deadlock has arisen. An outside third party, usually an expert or auditor, then determines the ‘fair market value’ of each share of the joint venture. Once a valuation is made, the partner triggering the termination provision must either buy the other partner’s shares at a set premium (eg. 10%) or sell its shares to the other partner at an equivalent discount. Rarely will a single deadlock provision be able to address all possible termination scenarios. Each joint venture has its own unique set of circumstances, so what may work for one joint venture may not be the best solution for another. Before executing joint venture documents, Chinese parties should carefully consider their own strategic positions and explore which deadlock provisions would best protect them. For example, if a Chinese party has a firmer liquidity position than its joint venture partner, certain deadlock provisions may offer more leverage in the event of a forced buyout. Ultimately, even the most thoughtful of joint venture agreements cannot predict every scenario, and some disputes will end up in litigation or arbitration. But even if a dispute ends up in litigation or arbitration, the more clearly defined deadlock provisions are, the easier it will be to resolve the dispute. Accordingly, Chinese parties should always take a broad view when thinking about how to structure their joint venture agreements and craft deadlock provisions as precisely as possible. Forum selection and solutions for Chinese outbound disputes Just as Chinese parties engaged in foreign joint ventures need to carefully negotiate deadlock provisions, they must also consider how best to protect their interests through dispute resolution provisions that may have an impact on future litigation. One of the most significant such provisions is the forum selection clause, which may specify a court in China, the foreign country, or an arbitral tribunal in a third-party state. For a Chinese party engaged in a foreign joint venture, the most natural forum is of course China, where familiarity with the court system and laws will offer a significant advantage. Moreover, in certain circumstances such as when the foreign partner uses a local Chinese subsidiary to enter into the joint venture and the joint venture is governed by PRC law, it may even be a requirement that any disputes arising from the joint venture be resolved in China. On the other hand, given the heavy interest in acquiring or partnering with companies in developed western countries, the default forum for resolving disputes will often be in common law jurisdictions, which may be unfamiliar to Chinese parties accustomed to settling disputes in a civil law legal system. Nevertheless, if a Chinese investor and its operations are based entirely in China, then selecting the foreign country as a forum may even be more protective of the Chinese party’s assets, due to the difficulties in recognizing a foreign court judgment in China. Alternatively, arbitration is a popular choice for cross-border business disputes, with the International Chamber of Commerce (ICC), Hong Kong International Arbitration Center (HKIAC) and Singapore International Arbitration Center (SIAC) being popular options for China-foreign joint venture disputes. Arbitration may afford the parties significant advantages including confidentiality, flexibility, and the right to choose their own arbitrators. China is also a signatory to the UN Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York Convention), which allows many arbitral awards to be enforced not only in China, but also across almost 160 states worldwide. Finally, it is worth noting that the vast majority of China’s outbound investment is structured via ‘offshore’ jurisdictions such as Hong Kong, the Cayman Islands, and the British Virgin Islands (BVI). Regardless of what the joint venture agreements themselves may specify, it can sometimes be worth considering out-of-the-box solutions in offshore jurisdictions to achieve commercial objectives. For example, in the Cayman Islands and BVI, it is sometimes possible to obtain a preliminary freezing order restraining another party’s assets if there is sufficient evidence that assets of the joint venture are being dissipated. Knowledge and strategic use of such solutions can enhance a Chinese party’s leverage. Potential regulatory risks Chinese parties interested in acquiring foreign companies outright also need to be aware of potential regulatory risks, both before and after the acquisition. Regulators in certain developed countries have the power to review proposals by a foreign company to acquire a local company. For example, in the US, proposed acquisitions of US companies by foreign companies are subject to an opaque review process by the Committee on Foreign Investment in the United States (CFIUS). Given political sensitivities, China outbound ventures sometimes receive more scrutiny, especially because such outbound activity has concentrated in strategic sectors such as natural resources, agriculture, technology, and finance. Unfortunately, in several recent proposed acquisitions, regulatory uncertainty has led Chinese parties to agree to larger-than-average reverse termination fees—an amount paid by the proposed acquirer to the target company in case the deal should not be consummated due to certain circumstances. For the moment, this trend appears likely to continue. Should a Chinese party successfully acquire a foreign company, it may then become subject to other countries’ regulatory requirements via the newly acquired subsidiary. Far-reaching anti-corruption laws in particular can expose a Chinese party to criminal prosecution or regulatory enforcement actions, either of which can lead to substantial fines and other serious legal consequences, based on the actions of a foreign subsidiary. Accordingly, part of the calculus for any Chinese party planning on acquiring a foreign company should be consideration of relevant local laws and regulations that may impose new and unfamiliar compliance responsibilities. The US Foreign Corrupt Practices Act (FCPA) is a prime example of a broad anti-corruption law with global reach. The FCPA has two main provisions: (1) an anti-bribery provision that prohibits corrupt payments to foreign officials to obtain or retain business; and (2) an accounting provision that requires accurate recordkeeping and adequate systems of internal controls. The accounting provision only applies to companies with securities traded on a US exchange or entities that are otherwise required to file reports with the US Securities and Exchange Commission. The anti-bribery provision is broader, extending to any company with its principal place of business in the US. Moreover, a parent company can face FCPA exposure based on the actions of a US subsidiary in unexpected ways. First, the FCPA covers the actions of US companies anywhere in the world, not just in the United States. Second, the FCPA may be implicated based on the conduct of a third-party agent acting on behalf of the US subsidiary. Given the breadth of laws such as the FCPA, a close study of local laws and the implementation of robust compliance controls are crucial for Chinese parties interested in acquiring foreign companies. But should problems arise, engaging with local regulators and conducting an internal investigation can often mitigate the damage. In such an event, Chinese parties should engage counsel experienced in handling such matters to ensure a smooth resolution. Conclusion The pace of China outbound ventures has exploded in recent years, and that trend will likely only continue. However, despite the risks that abound for Chinese investors, the good news is that they can avoid potential pitfalls ahead of time through careful planning. Ultimately, that will benefit all parties to outbound deals.
The pace of China outbound ventures has exploded in recent years, and that trend will likely only continue