Fairly regularly, we get an email from a foreigner living in China who wants to go into business in China with their girlfriend/fiancé/wife’s family (yes it is always a male). This person wants to know how they can do this and we tell them that there are really only two ways. One is as a joint venture and the other is as a WFOE, with the Chinese girlfriend/fiancé/wife’s family owning a portion of the foreign company that in turns owns the WFOE. Under this second scenario, the Chinese ownership of the foreign company is potentially illegal under Chinese law, but that should not put the foreigner at risk.

Here is what I typically say:

Legally, you pretty much cannot go into business with Chinese citizens without a joint venture. China recently started allowing partnerships, but the impact of that is still not clear.

You pretty much have two options:

1. You form a WFOE and you own it. Forming a company in Hong Kong is no different for China purposes than forming one in the United States, so forget about Hong Kong for a moment. Forming a WFOE can be very expensive, in large part depending on the Chinese city in which you will be forming it.

2. You let your fiancé, her mother and cousin own the entire business. You do this and you are exposing yourself to losing whatever you put into the business. Twice, I have had men break down and cry right in front of me because they went into business with their fiancée and her family and they put 3-8 years of their lives into the business, only to be completely and unceremoniously booted out once it really started to make the big money. These are just the ones who cried. I can tell you about the guy who invested millions in condos with his fiancée and her mother, only to leave China for a few weeks and return with all of the condos sold and his fiancée and mother in law gone. Vanished.

It goes on and on. The condo guy wanted us to sue the fiancée and her mother, but we didn’t see where he had a leg to stand on (assuming we could have found them) because the fiancee (via email) was claiming the condos were all gifts and his claim would have to have been that he bought all of the condos in his fiancée’s name because he didn’t want to spend the money to do things legally by setting up a business in his own name.  Even if there had been some sort of side agreement, that would have been illegal and it is generally not a good idea to sue to enforce an illegal contract.

Read about Kro’s Nest. Before Kro’s Nest there was Mark Kitto (whose famed ouster created the verb, to be kitto’e). These are the two best publicized instances where a foreigner went into business with a Chinese “co-owner,” only to get booted out once the money really started to roll in.

Sorry to be so negative, but I know no other way than to be blunt on these sort of things.

My emails often lead to pushback, with the person complaining of how China makes things so difficult for the “little guy” and then their explaining how they know of how these things usually turn out for the foreigner, but in their case it will be different because:

a. Their girlfriend/fiancé/wife’s family would never be anything but above board.

b. Their girlfriend/fiancé/wife’s family is so “connected,” it makes sense for them to go into business with them.

They then usually ask us to write up a contract that protects them “as best as possible.” We tell them that we will not do that because those contracts are usually not enforceable in China and we are not in the business of writing contracts we know will not work.

We had one of these the other day and it precipitated an email from my co-blogger, Steve Dickinson, to me, which went as follows:

If these people are going to go illegal in China, they should go 100% illegal. That is, enforcement either through really strong family connections (your father knows her father) or enforcement through gangsters and the like. I know people who have succeeded this way but I don’t know anyone who has succeeded with an illegal contract. This is not because contracts don’t work in China, because you and I have won enough China contract cases to know that they do.

It is because the Chinese judges are totally on to these sorts of arrangements and they know they violate or seek to evade Chinese law. They therefore have and will continue to deem such contracts void. Why do people live in this fantasy world thinking that somehow they are so different or that they have discovered the solution? Why do they think a Chinese court would enforce a contract designed to evade the law?

Take an alternative example. Remember John Smith’s [yes, it is an alias] company we formed in Beijing a few years ago? Not sure if you remember this, but that investment was with his Chinese wife. However, we did that as a very formally organized WFOE and left the wife and her family with the irregular side of the deal. His US company is the only shareholder and he runs the board. His company has had no trouble and he has had no trouble because he is legal and secure. His US LLC [and with it, the China WFOE] were just purchased by _______ [a pretty big name U.S. company]. The reason the purchase was successful is that the whole company was “clean” and therefore it could be purchased by a foreign public company.

As lawyers we are never going to tell our client to go full illegal, but in my role as a blogger, I have to think going full illegal would probably make better sense than paying a lawyer to draft a void contract. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that will allow them to justify (however falsely) their actions.

What do you think?

 

  • Agreed 100%. I get people asking me all the time for help to either get started (illegally) or get out of trouble because they are illegal and losing their shorts to a Chinese investor/family member.
    To the start ups, my answer is always the same: The Chinese don’t trust each other, why do you? Don’t do it. But rarely do they listen–everyone seems to think that for some reason they are the exception. The only exceptions I’ve ever seen are the guys that get nailed once and then are stupid enough to come back and try it again.
    To the guy (always a guy) already in trouble I tell them to take physical control of everything they can get ahold of (cash, assets, paperwork, etc.). At least at that point they have some leverage (or cash to run away with).
    Just this week I had two people ask me if they could just use their HK companies in China–since HK is part of China. They didn’t believe me when I told them that they could not. Both said “we know tons of people that are doing this.”
    Last year we helped a guy do some research for sales in China. He spent 10’s of thousands of $$ to do research (and paid us to do some too). He had a HK company and he then had his girlfriend do all of the China registration (no lawyers, no accountants). We told him he was asking for trouble, but he said that he was “in with daddy” and that the girlfriend and her father were going to make it all work out for them. They were to marry after the first round of orders (when they had “doubled their investment.”). In less than 10 months, he was out of the business. Girlfriend was gone and “daddy” was using his connections to get him kicked out of China for good. He still owns the (worthless) HK company.

  • Sizzle

    What you describe happens all the time and the guy (it is always a guy) always does insist that he is covered either by “love” or a “side agreement” or both. I know of at least three of these that went really bad, but only one guy started crying. I hate to say this, but I had no pity for any of the three, especially the guy who was balling his head off and saying “how could I have been so stupid?”

  • Twofish

    Something to point out is that it is perfectly legal to give a Chinese citizen a gift of money for them to start their own business and then hire you as an employee. The problem is not legality but enforceability. You have to realize that the transfer of money *really is a gift* and if something goes bad later, its completely impossible to enforce any agreement in court.
    If you really, really, really trust someone, this is a perfectly valid thing to do, and sometimes it works quite well. When it works well, it works really well. When it doesn’t work, it works really badly.
    However, when it does work well, lawyers don’t get involved, and when you pull a lawyer into a marriage, that usually means that something bad happened.

  • Twofish

    You get into interesting questions like “what does it mean to be illegal?” and something that people have remarked about Chinese law is that the legal/illegal distinction is not binary, and sometimes that can be important. For example, writing a contract that purports to give a foreigner ownership of a Chinese family entity will not land you in jail. It’s a totally unenforceable contract, but unless there is fraud involved, it’s not an offense under the Chinese criminal code to sign an unenforceable contract with your wife.
    If you start evading taxes, forging receipts, and moving money back and forth, then you *can* go to jail. So it’s really important to make a distinction between “illegal – you get laughed out of court” “illegal – someone has to pay a fine” and “illegal – you go to jail for 20 years.”

  • Out of curiosity, what are your thoughts on poison pill arrangements where there is a contract drawn up between an entirely foreign-owned entity and an entirely Chinese-owned entity and there is a steep monetary penalty assigned to the breaking of the contract?
    It is relatively easy and inexpensive to incorporate an overseas business through Hong Kong. I’ve heard of people taking this approach but have not heard of whether it has worked out.

  • Chredwa

    ALWAYS assume you are going to get screwed in China, ALWAYS!. Set yourself up legally not to get screwed. If you cannot afford to go legal, then dont do it at all, or accept the risks that you will get screwed.
    If you accept the risk you will get screwed, than dont cry when you do.
    If you choose to go full illegal, than do it well. Get your thugs and have the harrass whomever you want to intimidate. You gotta do one or the other. Half ass never works in China!

  • Twofish

    trevelyan: Out of curiosity, what are your thoughts on poison pill arrangements where there is a contract drawn up between an entirely foreign-owned entity and an entirely Chinese-owned entity and there is a steep monetary penalty assigned to the breaking of the contract?
    Unenforceable unless you write them very, very carefully.
    In general contractual penalty clauses are unenforceable both in Chinese and US law. What is enforceable are liquidated damages clauses, in which one side agrees in case of a breach of contract to pay for the damages incurred by the other side.

  • Chris

    Twofish – all good points. There are different types of ‘illegality’ — those where you invest through a local entity and do so utterly on trust with no legal protection and those where you operate a business that breaks Chinese law.
    Competitors in my industry (restricted investment) have aggressively invested in domestic entities via these unforcable contracts. My company has taken a more conservative approach, reduced our business scope to within permitted limits for a WFOE and manage our own business directly. I’ve had strong pressure from HQ to pursue the local entity approach to expand our range of activities and profitability or to exceed business scope within our WFOE structures. So far, I’ve managed to fend off both types of pressure.
    As I expected, competitor’s local entities have burnt their overseas investor’s cash at a rapid pace with little return to show for it. Without direct control and with local partners & management who see their fortunes being made through further capital injections and growth in turnover with no regard for profitability, these competitors risk losing their shirts and the businesses they thought they ‘owned’.
    I’ve seen legal opinions from law firms of the expensive global type on how to ‘acquire’ domestic entities in restricted investment areas. Not worth the paper they were written on, grossly irresponsible, and certainly not worth the inflated rates charged.
    It is not only foolish men in love making these mistakes in family businesses! Overe the next few years, we’ll see many larger foreign companies jilted by their domestic brides in a whole range of restricted industries.

  • Tim

    I believe every China consultant and lawyer has heard the excuses at some point if you are providing services to SME’s and entrepreneurs. The gamut of rationalizations I have run into:
    1. everybody else is doing it.
    2. I trust him/her because….
    3. Even if he/she steals the company, there won’t be any assets or clients for them to take!
    4. My friend who has been doing business in China for X years told me….
    5. All money will be collected offshore and [plug in complicated agreement here]
    6. The local government official assured me that…
    7. All local companies do this, so can I.
    8. When I setup a company X years ago, we did it this way.
    9. In [insert home-country here] we do it this way.
    10. Not a problem, I have great guanxi with ….

  • Twofish

    Just to correct something that I said above. The applicable law in China is Article 114 of the Contract Law which permits penalty clauses in Chinese contracts, but allows courts and arbitrators to revise the amount if they are excessive. The SPC has given some pretty specific guidance as to what is excessive.
    One thing I have also seen are contracts that require a party to do something when something becomes legal. This is often in a WTO context when the Chinese government has agreed to do something, so people write a contract saying that certain things will happen when the government makes something legal.
    Also I don’t think that contracts really will help that much in this situation. If you do marry someone and start a business and things go bad, then its going to be an extremely nasty mess and you are going to find yourself crying anyway even if you have a properly drafted contract.

  • TechyBoy

    It’s all true. People come over here and they want to stay and so they decide they want to form a business but the problem is that the Chinese government doesn’t want a bunch of solos running around with a business so they have minimum capital requirements to drive them out. Everyone knows this but they also don’t want to have to pay these things and, God forbid, pay taxes too, and so they do whatever they can to avoid it and if that means being illegal, so be it. The contracts are just something they think they can fall back on when they get caught. They don’t realize that in China like everywhere else in the world, ignorance of the law (and especially faked ignorance) are no excuse. A guy in my building just got deported last week for such a scheme.

  • David

    Dan,
    What about having some sort of loan agreement in place. As I recall loans against Chinese individuals are enforceable. For example you loan RMB100 (or 100,0000) to your Chinese partner, repayable at your discretion, and in return they are obliged to follow your instructions. This is basically the structure that many Internet companies used when they went to Nasdaq where only a Chinese national could hold the ICP license.
    Couldn’t a similar agreement be put in place if your local partner sets up a business/ buys an apartment on your behalf?

  • Moshaosen

    Just a thought. If you were wanting to go into partnership with a Chinese citizen (or citizens), would it be legal or practical to have a WOFE with a foreign holding company as the sole shareholder (as I think you describe in John Smith’s example above) – but then for the Chinese citizen to hold shares in that foreign company?

  • Twofish

    To David:
    I don’t think this is going to work. You run the huge danger that the court is going to find that the original loan was not a genuine loan (since it wasn’t) and refuse to enforce the terms of the loan. Also people did *try* to do this to get around the fact that Chinese law will not allow you to issue preferred stock, but most of that was “legal experimentation” (i.e. let’s try to see what happens), and in every situation that I can think of, the courts have refused to enforce these agreements, and my guess as to what’s going to happen is that you are going to end up with the Chinese investors having everything and the Western investors having nothing.
    You might argue that for the courts to act in this way discourages foreign investors from getting control over Chinese companies in clever ways, but that’s exactly the point. Whenever the courts strike down one of these schemes and someone loses a ton of money, that’s a message to everyone else not to try to circumvent the rules.
    As far as Chinese citizens having shares in foreign companies that own a WFOE. This is extremely dangerous. The problem is that having a Chinese national set up a “fake WFOE” is a favorite way for Chinese nationals to circumvent Chinese rules on tax, foreign exchange, employment restrictions as well as to illegally get subsidies for foreign investment. The government is cracking down on this sort of thing, and you are going to have to hire a ton of lawyers and compliance officers to make sure that you aren’t accidentally violating Chinese law.
    As I mentioned before, there is a big difference between “illegal-you get laughed out of court and you lose your investment” and “illegal-you end up in jail.” Starting a dummy WFOE puts you in serious danger of “illegal-you end up in jail.” If the PSB shows up with arrest warrants for tax evasion and illegal currency transactions, what’s your defense?
    This points out a problem with being “clever”. By formalizing things, you increase the risk that you’ll step on some sort of legal landmine. Also, you remove the sympathy element. If you give someone a gift and they take the money and run, then at least you can get people’s sympathy for being a poor ignorant fool that was taken advantage of, and if you get arrested for anything, at least you have that. You can go to the judge and the press and beg for mercy and sympathy, and you might get some of it. Going to a judge and showing that you are *trying* to follow the law, gets you a lot.
    If you start setting up complex overseas structures that are obviously designed to work around Chinese legal restrictions, you can’t claim to be a poor innocent. What’s your defense?
    Personally, I don’t think that the distinction is between illegal/legal but rather between informal/formal. It is perfectly legal to give someone a gift to start a company, and if that person wants you to be an adviser, that’s fine to. The thing that you have to realize is that it is *really* is a gift (i.e. they can take the money and run) and you *really* are an adviser (i.e. they can get rid of you the second they don’t like you). As long you are clear on the reality of the situation and you are good with that, then everything is fine.

  • Twofish

    The “pseudo-loan” strategy is going to be tricky under Chinese law. Chinese contract law is different from US contract law. In the US what is not prohibited is allowed, whereas in Mainland China, what is not allowed is prohibited. So in order to have a valid contract in Mainland China, you have to find a specific law that authorizes the contract. Now under the Contract Law
    Article 196
    A contract for loan of money is a contract whereby the borrower borrows a sum of money from the lender, and returns the sum borrowed and pays interest thereon at the prescribed time.
    Now if you don’t have a definite time for repayment, then under Chinese law it is not a loan contract. So if you create a pseudo-loan in which you can demand payment whenever you feel like it, then what may well happen is a Chinese court rules that there was no contract between you and the other guy, so you no have no grounds for getting your money back. Sorry…..
    You might be able to do something clever with multi-jurisdictions and alternative theories of law, but you will have to hire a ton of lawyers, and you still might get smashed in the end. There are firms that do this sort of thing, but you have to realize that people that invest in venture capital are willing and able to lose tens of millions of dollars, and the fact that a Chinese court might well rule their contract invalid and they lose all of their investment is “just another risk” to them.
    One final thing…. And this is more marriage and interpersonal relationship advice rather than legal advice.
    It’s understandable and a good thing that a US lawyer advising an American client might be less worried about legal risk to the Chinese party because it’s a job and they work for the American client. But if you are thinking seriously about marriage for it to work, you have to put the interests of the spouse above your own, and so you if enter into this sort of relationship and you worried more about protecting yourself legally than you are about protecting your partner, the marriage is not going to work.
    If I’m in a standard business relationship, and the other side is doing something that is legally questionable that may get them into serious trouble, then it’s not my problem. If it is someone that I’m sleeping with, then I’m going to be more concerned about their situation than I am for my one.

  • It is definitely high risk, but choosing to form a domestic-owned enterprise is far more common than one would expect. I’ve met quite a number of people whom I thought run a WFOE just to find out afterwards there is a “trusted Chinese investor”. The possibility to avoid all the limitations associated to foreign companies has attracted a good amount of entrepreneurs. Fortunately for those I met, they were not yet in the list of “disaster stories”.
    One of the most famous expat successes but a Chinese business after all is Sherpa’s (the founder used a Chinese partner to set up the company). I live in Shanghai and Sherpas delivers my dinner no less than 3-4 nights a week! I’m sure they own the complete expat community data base in Shanghai)…. Sherpas example I read in a book entitled “China Entrepreneur. Voices of Experience” by J.A. Fernandez and L. Underwood and it describes experiences of 40 entrepreneurs in China. 7 out of those had chosen to form a domestic owned enterprise through trusted Chinese partners.
    …..I would personally not risk it.