DFW International, Inc.(DFW)
May 3, 2013
TO: The Chief Executive Officer
Cc:
FROM: The General Counsel
RE: Proposed China Operations
Alternative Business Structures
Equity-Joint Venture (EJV)
This is a structure involving two or more investors, at
least one of whom must be Chinese. It is governed by law the Law of the People’s Republic of China (PRC)
on Chinese-Foreign Equity Joint Ventures fast adopted in 1979.Investors
hold a joint operation and ownership of a limited liability corporation. Investors
intending to form this kind of business must enter into a contract for its
establishment. An EJV contract must get the approval from the Chinese Ministry
of Commerce (MOFCOM) or an equivalent body at the local government level.
Chinese law allows for EJVs to be financed by both equity
and debt within certain specifications as to respective debt to equity ratios. Unlike
the U.S law that makes a distinction between authorized and issued share
capital, the EJV law in China uses the term ‘Registered’ and ‘Total Capital. Investors
must pay up stated portions of Registered Capital depending on the level of
Total Capital which refers to the maximum investment allowed including debt
capital. For instance, an EJV whose total investment is less than $3 must have
70% of that comprised of registered capital.
Because they are legal personalities, the management of
an EJV is under a board of directors constituted according to the respective
capital contributions of the parties. The daily operations of an EJV are,
however, in the hands of a general manager. Besides, there is also a board of
supervisors which represent employees. It acts as an oversight on the senior
management of an EJV.
A major advantage of an EJV is that it gives the foreign
investor the benefits arising from the local partner’s knowledge, distribution
networks in the Chinese market. Thus, DFW would be enjoying these benefits if
it decides to enter an EJV with ST. Besides,
it is much easier for the Chinese partner to get the relevant regulatory
approvals. The foreign investor is also able to have more control of the
venture depending on their level of capital contribution. The partners also
share market development costs and risks.
A disadvantage with an EJV is that there is a risk of
giving away important technology to the Chinese partner. Even though China has
good intellectual property laws on books, enforcement still remains a serious
issue. A foreign investor intent on entering into an EJV would therefore be
advised to hold a majority capital so us to give it the necessary control. In
addition, the Chinese government overly scrutinizes EJVs which may lead to the
lose of important technology. EJVs are also not allowed in some sectors of the
Chinese economy.
Contractual/Cooperative Joint Venture (CJV)
The Law of the
Peoples Republic of China on Chinese-Foreign Cooperative Joint Ventures
governs this form of business structure. This law was first adopted in 1980 and
has been amended a number of times including in 2000. In the case of a pure
CJV, there is no separate legal entity from the parties and profits and losses
are shared directly by the parties. It would not be advisable for a foreign
entity like DFW to enter into an arrangement as risky as a pure CJV which does
not limit the extent of its liability. Parties can, however, enter into a
hybrid CJV when gives rise to a separate legal entity capable of registration.
This type of a CJV would be relatively appropriate for a conservatively managed
company like DFW.
CJVs are not a very common structure for companies coming
into China but they offer a certain level of flexibility not available with
EJVs. For instant, parties are free to negotiate the manner of their capital
contributions since even contributions in kind are recognized. Thus, DFW can
leverage on its advanced technological capabilities as an aspect of capital
contribution. The other advantage with a CVJ is that profit and loss sharing
does not have to be in proportion to the capital contribution by the parties. A
CJV shares most of the disadvantages with an EJV.
Wholly Foreign-Owned Enterprise (WFOE)
They are governed by the Law of the Chinese People’s Republic on Wholly Owned Foreign
Enterprises. This kind of business structure has since overtaken joint
ventures as the preferred entry mode for foreign investors into the Chinese
market. The change was occasioned by a revision of the relevant law which
removed some conditions which had previously acted as a barrier for foreign
investors through this structure. For instance, the law prior to the revision
required WFOEs to use advanced technology in their businesses. The idea was to
eventually replace the sourcing of advanced technological goods from outside
the country. WFOEs were also subject to export performance quotas under the
previous law. In addition, the law on WFOEs no longer requires the purchase of
local inputs. Instead, the Chinese government has reverted to achieving the
same goals under the previous law by introducing tax incentives.
Apart from the fact that WFOEs are limited liability
entities, the procedure for forming such businesses is similar to that of EJVs
and CJVs. This is because all business forms involve some level of foreign
participation. The financing is also similar with the exception that all the
capital is arranged by the foreign investor. With its $100 million limit on
capital, DFW can still find a way of getting into China through a WFOE. For
instance, it can team up with some American investors to get the difference in
capital it can commit and what the two projects actually requires. Similarly,
it can request the Shenzhen government to bear some of the costs involved like
the $ 20 million needed for the necessary infrastructure. WFOEs are managed by
a board of directors elected by their foreign shareholders. The daily
management of the business is overseen by a general manager.
The most significant advantage to choosing a WFOE as an
entry mode into the Chinese market is the level of control that the foreign
investor enjoys. The foreign investor enjoys complete control of the major
decisions, operations as well as corporate culture. Thus, DFW would be in a
position to align its Chinese operation with the parent company in Texas in
addition to reduced risk of exposure to partner disputes. WFOE also reduces the
risk of exposure to intellectual property rights (IPR) infringement. This is a serious consideration given that DFW
must ensure that any arrangement it opts for does not lead to the creation of a
competitor who may pass on its trade secrets and advanced technology which is
useful aspect of competitive edge in the integrated circuit (IC) industry. It
is also easier to establish a WFOE in China relative to a joint venture where
negotiations with a Chinese partner may be protracted. The simplicity of
procedure also extends to termination of an enterprise.
DFW must also contend with a number of downsides should
it choose WFOE as a vehicle of entry into China. For instant, it may have to
face more restrictions on project approvals relative to either a EJV or a CJV. Fortunately,
the Catalogue on Guiding Foreign
Investment 2007 does not list the manufacturing of PCs and semiconductors
among the restricted industries. In addition, settling on a WFOE would required
upfront investments on the part of DFW given that there will be no Chinese
partner to help with some of the related investment costs. Besides, a foreign
investor must also do without the valuable assistance of a Chinese partner in
important matters such as government approvals, recruitment of employees,
sourcing of raw materials, acquiring land and production facilities as well as
obtaining of marketing and distribution facilities. This should, however, not
be an important consideration given that ST has already stated its inability to
provide the necessary Wafer fabrication (fab)
facilities. Besides, DFW can still rely on the availability of highly trained
graduates from the nearby Shenzhen University will be able to work in its
facilities. Another factor that would have been a disadvantage is that it may
take significant time lags for a WFOE to commence operations. Again, this is a
moot issue given that ST also lacks the capacity to allow for immediate
operations even if both parties agree on a joint venture.
Recommended alternative
Much as DFW is working on a limited budgeted capital
commitment of only $ 100 million which will below the total project costs, I
would still recommend WFOE as the preferred business structure to enter the
Chinese market. For one, DFW’s cutting edge technology is an important
competitive edge and going into an EJV or CJV may make it lose this edge to its
Chinese partner or even nurture its own future competitor. Besides, foreign
investors have always had serious problems with their Chinese partners. Furthermore,
the industry in which DFW wants to enter into us encouraged according to the
Guidance on Foreign Investments.
Other Concerns or issues
Away from the type of business structure to choose from,
DFW must have to consider other factors before setting up in China. One of this
is the cultural barriers that may hinder the smooth running of its Chinese
operations. A noticeable difference between China and a western country like
the U.S is the former’s lack of an established culture of the rule of law. Notions
of morality and justice are highly valued in China than regulations. This has
often led to inconsistent interpretation of laws and regulations and with it
uncertainty that may not auger well for business.
Investment incentives
To make foreign invested enterprises (FIEs) like DFW’s
intended projects, the Special Economic Zones (SEZs) like SEZ can offer two
main investment incentives. The first of these, and which is directly related
to the needs of DFW to offer complete support infrastructure. This is indeed part of the package for which
these zones were created. Getting this incentive will see DFW reduce its
starting cost by a whooping $ 20 million. Taking the $ 20 million
infrastructure cost off DFW’s budget will see it achieve an acceptable rate of
return.
DFW can also expect generous tax incentives from the SEZ.
These are in the forms of tax exemptions and reductions. Foreign Invested
Enterprises(FIEs) setting up in SEZs enjoy a reduced tax rate of only 15% down
from the usual 30% and an additional 3% that other which is the normal tax rate
in China. In addition, DFW would also enjoy a full exemption of its tax
liability for the first two years with a further 50% exemption in the next
three years. Given that DFW would be investing in an advanced technology area,
it can request for a further extension of the 50% exemption for an additional
three years.
Intellectual Property (IP) issues
A major IP issue likely to arise is the potential for IP
infringement in China. As already noted, China seems not to be actively
enforcing its IP laws as it should and the authorities some times encourage
infringement. This must be a pressing concern for DFW. IP misappropriations in
the form of reverse engineering, counterfeiting, theft are still common in
China despite that relevant laws exist meant to deal with such issues (China
International Corporation Limited, 2011). Chinese Confucius tradition encourage
sharing of things as opposed to private property rights which is the hallmark
of IP. Recourse to the Chinese court system often results into decision
favorable local Chinese infringers.
Given that the conventional protection measures are
inadequate to protect DFW’s proprietary information in China, the company must
still take an all encompassing approach to protecting its IP. Thus,
conventional measures like copyrights, trademarks, patents and trade secrets should still be sought while
complimenting with where real protection actually lies and which has very
little to do with the law. Some of these challenges may not be so acute for a
company that has chosen to set up as a WFOE. Given the level of control it
offers to the foreign investor.
Focus for DFW should be on reducing IP leakage by
employees. It should also restrict the communication of its know-how and any
other proprietary information with Chinese suppliers to a need to know basis
only and must also be done only when confidentiality agreements have been
signed. Important drawing should also not be sent around in un-coded emails. Prospective
Chinese engineering employees should be trained on the need to protect
technology.
Dispute resolution mechanisms
In the event of an investor-state dispute, the Chinese
legal system provides a variety of resolution mechanisms (Guiguo, 2011). The Law
of the Peoples Republic of China on Administrative Reconsideration of 1999
stipulates that a foreign investor dissatisfied by an administrative action
should submit that dispute to for administrative reconsideration. A person
dissatisfied with a decision from administrative reconsideration can submit the
dispute to a People’s court. The Chinese legal system does not discriminate on
the basis of nationality when it comes to administrative litigation. Not all
administrative acts are, however, adjudicable. Thus, courts have no
jurisdiction of administrative acts of general application or involving matters
of defense or foreign affairs. Judicial review is also available on issues of
IP.
Much as administrative litigation is available, note
should be taken of the fact that Chinese culture does not encourage adversarial
dispute resolution mechanisms. The government is also keen on avoiding disputes
with foreign investors due to the reputational damages they are likely to
bring. As such, it has established Complaint Centres, Mediation Panels as well
as Working Panels throughout the country to deal with foreign investors. The
Interim Measures on Complaints from Foreign Invested Enterprises promulgated by
the Ministry of Commerce in 2006 establishes a National Complaint Centre for
Foreign Invested Enterprises. Mediation is also available for investor-state
disputes as China International Economic and Trade Arbitration Commission (CIETAC)
arbitrate such disputes.
China is also a party to several Bilateral and
Multilateral Investment treaties, many of which stipulate that disputes should
be submitted to the International Center for the Settlement of Investment
Disputes (ICSID) arbitration. This root has rarely been taken given the Chinese
culture that discourages adversarial approaches to disputes. Instead,
consultation is the default mode in solving disputes which is often
complimented by mediation.
References
China International Corporation Limited (2011).Multinational
Companies and China: What Future.
Economist Intelligence Unit Report.
Guiguo, W. (2011).Chinese Mechanisms for Resolving
Investor-State Disputes.Jindal Journal of
International Affairs, 1(1),
2004-233.
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