URGENT ALERT: Register Your Company In China NOW, Part II
Three months ago, after hearing of mounting Chinese governmental efforts to crack down on unregistered foreign companies doing business in China, we issued our first and only "urgent alert." This is the same alert, but for different reasons.
Last time we warned about the Chinese government increasingly cracking down on unregistered companies. I have now come to realize that Chinese companies are at least equal to the Chinese government in the threat they pose to unregistered foriegn companies operating in China.
Two recent incidents in which my firm has been involved are instructive and each of them, standing alone, ought to be enough to scare anyone straight (the facts are slightly modified to protect the companies involved):
- U.S. company rents a downtrodden building in Shanghai and spends hundreds of thousands of dollars renovating it under a fifteen year lease. Two years into the lease, Chinese company kicks out the American company and says, "you cannot sue me because you are not registered and if you do sue me, I will make sure you get kicked out of the country for operating here illegally."
- US company buys product from Chinese company and then refuses to pay, claiming bad quality. Chinese company hires a crackerjack Chinese law firm who, in turn, hires my law firm, and tells us that if we cannot within 30 days convince the American company to pay its Chinese client every single Yuan owed, they will have the American company's China operations shut down. The American company has had a China office with four to six employees for years, but has never registered. These Chinese lawyers have a history of doing what they say.
Long ago, when I was a young lawyer, I wrote an article entitled, "Four Essential Principles of Emerging Market Success," positing that a failure to abide by the law in the country in which you do business is the surest way to lose your business without any basis for complaint:
The easiest way for a local rival to drive you out is for you to do something illegal. Neither you nor your government will have good grounds to complain if your rival gets your business closed down due to your illegal activity. It might even be your own partner who reports you so he can assume full ownership and control of your business.
China is hardly unique in terms of restricting the legal rights and recourse of unregistered companies. And China is also hardly unique in terms of having competitors and "partners" who would like nothing more than to take advantage of your less than stellar legal status.
Bottom Line: Chinese businesses and Chinese lawyers are very quickly getting wise to the power they can exert against unregistered companies and they are starting to use it. If you do not want them to use it against you, get legal now.
Comments (27)
Read through and enter the discussion by using the form at the endnanheyangrouchuan - February 13, 2007 8:53 AM
Would the PRC consider a company to have a fraudalent license if, for example, the company was run by a foreigner who married a local girl and filed the license under her name?
These businesses are very common in China and so is that practice. Foreigners often do it to 1. have a walking dictionary that can navigate the bureaucracy 2. save alot of money on start up costs and 3. their business cards will say that they are a chinese company and not a foreign one ( I ran into this reg doing IT work in Shanghai).
China Law Blog - February 13, 2007 10:02 AM
nanheyangrouchuan --
Need more facts.
If the company is truly owned by the wife and there is no side agreement saying it is not, then the answer is that this company is almost certainly completely legal.
We have seen these things many times (actually more common in Russia) where American has a "friend" own the company in Russia or China and then when the company gets successful, the friend tells the American to hit the road.
Interestingly, we have also seen that here in the United States with Korean and Chinese investors wanting to keep their name out of the investment for whatever reason back home. They go into "partnership" with a fellow Korean or Chinese here in the states and then when the company becomes successful, the fellow Korean or Chinese tells the Korean or Chinese still living in Korea or China that there is no deal and never was.
David Li - February 13, 2007 10:20 AM
Using local delegates to register company is common practice in China and often girl friends and wives are first choices. If registered under her name, the company is considered domestic. It's perfectly legal from the government. One can also make contracts with the delegates on the true ownership and Shanghai courts have ruled to honor those contracts.
Also, in the larger scale, companies like Shanda, the9 and Baidu are operating business restrict domestic companies but they are also public listed in NASDAQ. Shanda's SEC filing spilled out the trick they employee. The listed company Shanda isn't operating in China with contract agreement with the domestic Shanda Networking. Under the risk factors in their filing, this is made very clear:
"IF THE PRC GOVERNMENT FINDS THAT THE AGREEMENTS THAT ESTABLISH THE STRUCTURE FOR OPERATING OUR CHINA BUSINESS DO NOT COMPLY WITH PRC GOVERNMENT RESTRICTIONS ON FOREIGN INVESTMENT IN THE ONLINE GAMES INDUSTRY, WE COULD BE SUBJECT TO SEVERE PENALTIES."
China Law Blog - February 13, 2007 10:28 AM
Mr. Li --
Exactly. And that is why I hedged a bit on my answer. You say Shanghai courts have upheld side agreements on true ownership, but would you be willing to bet the house on that happening every time.
Speaking of betting the house, we see this a lot where a foreigner has a local buy a house/condo for them to escape the restrictions on foreign ownership. We are dealing with a case like that right now.
nanheyangrouchuan IMPOSTER - February 13, 2007 4:42 PM
I just asked as my instinct but lack of real legal knowledge would lead me to believe that such actions could be seen as an attempt to misrepresent the company as domestic or defraud the gov't of proper licensing fees (which is exactly what is happening). Fortunately for most of those types of foreigners, their wives/girlfriends are pretty passive when it comes to who runs the company.
David Oliver - February 13, 2007 4:45 PM
Dan,
As you know in the case of Internet companies like Shanda, Sohu, Netease etc (and many foreign VC-invested ventures) a foreign entity cannot hold an ICP (Internet Content Provider) license or operate online games so a local Chinese entity (usually run by the Chinese founder) holds the license but is contractually obliged to do what the WOFE or foreign entity instructs it to do. If everyone's interests are aligned e.g. the Chinese founder wants to get foreign investment or list on Nasdaq, then it usually works.
I have noticed that these agreements usually include a personal loan made to the Chinese national, such as the foreign entity makes a loan to help them setup the local company and then has the right to decide when this loan is repaid or has the right to receive repayment in the form of shares or similar.
This seems to verify what others have told me - that it is possible to enforce the repayment of a personal loan made to a Chinese national more easily than to a company. Is this correct?
China Law Blog - February 13, 2007 6:31 PM
nanheyangrouchuan --
The thing is there is a difference between ownership and control and so long as the ownership is domestic, it is domestic. Remember also that there typically are tax benefits in being a foreign company. Chinese nationals will sometimes form a company overseas (say in the US) and then that company goes into China as part of a joint venture with the Chinese national's Chinese company or as a WFOE.
China Law Blog - February 13, 2007 6:33 PM
Mr. Oliver --
Thanks for checking in and thanks for explaining how the internet companies handle this. I do not know of any legal difference in pursuing an individual as opposed to a company, but I certainly can think of many practical reasons why it is better to have an individual on the hook for a loan than a company.
David Li - February 13, 2007 9:29 PM
I would bet on Shanghai's court decision to uphold the contracts but its ability to enforce the decision is another story. My dad sued his delegate a couple years back without a contract and he won. The fixed assets were recovered but most of the liquid ones were lost.
Speaking of delegate, a lot people use wives or girl friends but that's probably not a wise choice in case of breaking up. Even the court uphold the contract, there are spouses related regulation extending protections even to girl friends without legal marriage. Chinese courts tend to side with the women in these cases.
China Law Blog - February 13, 2007 9:33 PM
Mr. Li --
Enforcement is a problem everywhere, but particularly in China. I did not know that about Chinese courts tending to side with the woman. That surprises me.
David Li - February 13, 2007 11:14 PM
China's court and regulation tendency to side with women surprised me at first as well. But a bit of digging reveal the rational starting with Mao's slogan that "Women owns half the sky" to promote women's social status at the ideology level and in the past twenty years of countless Taiwanese and Hongkongness having mistresses in China at the practical level. This has created a very favorable environment for legislation favoring women. Plus, there are no feminist movement to block some of the beneficial regulation that may be seen patronizing women at ideological level.
David Oliver - February 14, 2007 7:45 AM
Dan,
I brought up the loan issue in the context that (it seems to me) if you did business in China through a Chinese partner and/ or company then one way to cover yourself would be to make a personal loan to the Chinese national and include clauses in the loan agreement about repayment e.g. in return for giving the loan 50% of the Chinese company's profits must be paid as a dividend each year. Non-payment will result in certain penalties.
I was in this type of situation a few years ago and discussed something along these lines with a lawyer. Obviously you need your local partner to agree to this arrangement, but if they don't then that might be a warning sign.
China Law Blog - February 14, 2007 10:02 AM
Mr. Li --
Very interesting. So both the laws and the courts favor women?
China Law Blog - February 14, 2007 10:05 AM
Mr. Oliver --
One of the things I have learned by practicing law for so long is that, generally, the more complicated a deal, the more uncertainty you create. The problem with China and its laws, however, is that there are times where one has no choice but to enter into complicated deals as such deals are better than the alternatives. You are right to point out that sometimes the other side's unwillingess to agree to something can/should be seen as a warning sign.
David Li - February 14, 2007 1:47 PM
The loan for the Internet companies from VC are not just a China thing. Some recent deals in the Silicon Valley also do that. It's more common in China because the young entrepreneurs don't have access to capital but a lot of VC dreams. I have been seeing VCs prey on the naiveness too many times in Shanghai, especially during the online games boom in the past three years.
For a hot Internet company like Shanda, the table turn. Shanda's SEC filing is a interesting read.
"IF THE PRC GOVERNMENT FINDS THAT THE AGREEMENTS THAT ESTABLISH THE STRUCTURE FOR OPERATING OUR CHINA BUSINESS DO NOT COMPLY WITH PRC GOVERNMENT RESTRICTIONS ON FOREIGN INVESTMENT IN THE ONLINE GAMES INDUSTRY, WE COULD BE SUBJECT TO SEVERE PENALTIES."
The company IPOed in NASDAQ is a offshore company with contract to the domestic ones owned by the founders' families. In the case of governmental regulation change, the protection of the foreign investors is almost non-existence.
David Li - February 14, 2007 2:10 PM
Well, I don't have expertise to speak of the detail of the law but from what I have seen, the court and the law are on the women's sides. In custody case, men almost have to prove the women to be criminals to have a shot at the custody of the kids.
A friend wrote an comparison paper on the Unmarried Cohabitation.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=896860
David Oliver - February 14, 2007 4:46 PM
I totally agree that the simpler you can make things the better. An ideal situation for many foreigners doing business in China would be for them to setup a WOFE but this doesn't always work from a regulatory or financial cost standpoint.
As far as I can see in many cases a personal loan isn't made to the entrepreneur because he is short of cash - many of them have enough money - but because it is an important part of the overall deal structure and gives the foreign investor/ party additional control.
China Law Blog - February 14, 2007 6:21 PM
Mr. Oliver --
You are right on WFOEs. They are the way to go 9 out of 10 times, if allowed. I also am sure you are right about the loan.
Benjamin - February 14, 2007 6:41 PM
Putting the legal ramifications beside, not registering shouldn't even be a consideration in most cases.How many high-value clients want to do business with an unregistered company? Is your competition registered? At our company the average transaction is relatively low (between 1,000 RMB to 2,500 RMB), but many Chinese clients still demand to know if we're a registered entity. For this purpose we have a link on our homepage to a PDF of our business license.
China Law Blog - February 14, 2007 10:26 PM
Benjamin --
I know it sounds crazy, but we have had large companies (with names you have heard of) come to us and their companies in China have never been registered. They start out with a couple people, planning to register, and then they hire Chinese locals and then they start getting really scared. It is mostly manufacturers where we see this. They have people in China overseeing OEM manufacturing, QC, and shipping, but they can get quite large, quite fast, and still never register.
It should not be a consideration, but it is.
Oftentimes this is the case with companies whose business would have been illegal in China five years ago, but is legal now.
On the property side, the landlords seem to love dealing with unregistered companies because the lease is kept off the record and the landlord knows how easy it will be to boot out the unregistered foreigner when a better tenant comes to town.
omer salem - February 21, 2007 9:23 AM
we would like to register our company in china
could you please explain how and what is legal procidures required?
thank you
China Law Blog - February 22, 2007 10:52 PM
Mr. Salem --
It is impossible for me to give you any legal advice on this blog, for many reasons. First off, I have no idea what sort of business you are doing in China. It is quite possible you do not need to register in China at all. If you are not making money in China, there is the possibility you could register as a representative office, rather than a WFOE. If you are in a joint venture with a Chinese company, you will need to register as a joint venture. I strongly suggest you talk with your attorney and in concert with him or her figure out what you need to do (IF ANYTHING) to get legal in China.
Aljosa - February 26, 2007 7:33 AM
What do you guys think are the chances getting screwed by the following chinese venture ?
A chinese woman (eg. 32 years old, married with a chinese, wants to have a child in the next 3 years) to register a company in China that would suite my needs. Me / my company would have access to internet banking of this new chinese company. There would be often physical presence of me or my work collegue there in China. We are learning Chinese step by step as well.
This new chinese company would buy spare parts in china and aseemble the final product in a hall / bigger garage. We do know all the spare parts, where to buy and how much they cost.
The final product gets packed and shipped via container overseas.
The 32 y/o chinese woman to be a director.
Me / my company will determine everything that will be going on inside this company through this woman. Btw, she speaks english very well.
The monthly money running through this new chinese company would be around: spare parts (50.000 USD) + wages (5.000 - 10.000) + fixed costs (3.000 USD).
Can anyone tell me, by the "gut feeling" how much chances I have getting screwed ?
Aljosa
southernboy - May 4, 2008 2:25 AM
Interested in buying an apartment in China now that I have been here a couple of years and plan on retiring here.
Too old to get a mortgage so will pay cash. I understand that in order to purchase I need to prove I have lived here three years. That correct? In order to gain permanent resident status, do I have to be married to a local? Does marriage even insure that I could get permanent residence status?
leegc - June 7, 2008 12:27 PM
I intend to set up a company with my partner in China and we also intend to import edible birds nest from Malaysia. However, my understanding is that the China's custom officer is very strict on the edible birds nest where they sometime confiscate the products without giving reason. Now the question is how do we import the edible birds nest legally without been confiscated? What is the procedure to bring in the edible birds nest or what are the documents require from the other side of the exporter(Malaysia) so that there will not be problem passing through the china's custom officer?
Roman - December 22, 2010 4:08 AM
Okay, I didn't listen and now I am being told I have 3 days to leave the country. I have a business to run with seven employees. What do I do now?
Ooldooz - April 14, 2011 9:19 PM
I should have listened. It has happened to me.