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China WFOE Legal Representative Liability. Just Enough To Keep You Up At Night.

Posted in Legal News

The other day, in “Personal Liability For Failed China WFOEs: The Law And The Reality,” we wrote about how Chinese law generally does not hold WFOE (Wholly Foreign Owned Enterprise/Wholly Foreign Owned Entity) general managers, legal representatives or directors responsible for the debts of a failed WFOE, but creditors and local government officials sometimes do. A few days later, in-house counsel for a United States company wrote us to inquire about the risks of an “absentee” legal representative for a soon-to-be formed WFOE.

Co-blogger Steve Dickinson responded (roughly) as follows:

You are right to be concerned about this. Too many employees sign up to be an “absentee” legal representative without fully understanding what they are getting into. I just published a piece on China Law Blog on this issue. It is entitled “Personal Liability for Failed Chinese WFOEs.”

The summary is: absent fraud on your part, you owe no liability to the company, creditors or employees from your normal work as a director of the WFOE. In particular, for closely held companies, I have never seen a case in China where a director was held liable to shareholders. In this case, the liability of a director of a Chinese company is less than that of a director of a U.S. company.

The reverse is true of liability to the general public. In general, directors of Chinese companies can be held liable for “bad acts” that they committed or that they supervised. Where severe damage occurs, there is strong pressure in China to make the legal representative a scapegoat, even where legal liability under the law is unclear. Common situations include all of the following:

a.  Losses to creditors due to diversion of funds/assets to the director.

b.  Willful failure to pay employees when funds are available.

c.  Violation of labor rules by the Chinese company. For example, most foreigners are not even aware that China has a 40 hour work week. It is routine for Chinese companies to break this rule. Your own Chinese advisers may well urge you to break all the labor rules. Later, when there is a major protest, it is the legal representative (the foreigner) who will be held responsible, not the Chinese party who gave the advice.

d.  Violation by the company of environmental or safety regulations where significant damage is suffered by the public. For this, note that the directors of the milk companies that sold melamine contaminated milk in China were prosecuted and imprisoned. This risk only applies, however, in cases where the director knew or should have known of the offending activities. In the cases of which I am aware, all directors held liable were actively involved in the offending activity. However, there is a strong inclination in China to impose liability on the legal representative based on the “should have known” standard, even when the legal representative was not directly involved. As with c. above, your Chinese advisers and employees will urge you not to follow the law. This will then leave the legal representative “holding the bag” when problems arise.

Note also the concluding paragraphs of my blog post. The legal representative is often the target of pressure tactics by government officials, creditors and employees in cases where payments are not made. This can be a major problem in China.

To summarize, the risk of a director/legal representative to the shareholders of a company is very low in China. The real risk in China is for liability to third parties. As you can tell from reading current press reports, the greatest risks arise from treatment of employees and from safety/environmental violations. The risk here is real since foreign companies are held to a high standard in these areas.

The above discussion is somewhat general. If you have specific concerns, I would be pleased to discuss the matter with you in more depth.

What have you seen out there in terms of WFOE legal representatives being held liable for the acts of their WFOE?

  • Adam R Murphy
  • Twofish

    I disagree that the legal liability of the legal representative is unclear.  Under Article 49 of the General Principles of Civil Law, the legal representative can be administratively sanctioned if the company does something bad.  Note here that there is no legal requirement that the legal representative actually *know* about the actions of the company.  The legal theory is that if you are the legal representative, you *should* know about what the company is doing, and if you can’t or won’t assume this responsibility, you should get someone else to take the position.

    Article 49 does not impose criminal responsibility for the legal representative for criminal actions of the company, but it does give the authorities the power to conduct an investigation, and merely being the target of a criminal investigation (whether in the US or in China) can turn your life into a living hell.

    The issue is not a legal ambiguity.  The problem is an educational problem in that a lot of Western companies don’t know that the Chinese law requires that the legal representative assumes administrative responsibilities for the corporate actions.

    As with many things, the issue is that corporate law is just different.  In the United States, corporations are required to have a “registered agent” but the only legal responsibility of this person is to essentially deliver legal documents to the corporation, and it’s usually a lawyer or secretary who is not involved in the operations of the corporation at all.

    Chinese corporations developed differently.  Originally Chinese companies were part of the Chinese government.  So they weren’t merely state-owned enterprises, they were part of the state.  When China reformed it’s corporate structure, what usually happened was that the Party Committee became the board of directors, the state official became the CEO of the company, and the Party Secretary became the chairman of the board, who was the legal representative of the corporation.  So Chinese corporate law is written with the assumption that the legal representative would be the Party Secretary, which means no specific duties, but a general recognition that person actually held the real legal power (and hence the legal responsibilities) of the corporation.

    ———–

    Article 49 Under any of the following circumstances, an enterprise as
    legal person shall bear liability, its legal representative may
    additionally be given administrative sanctions and fined and, if the
    offence constitutes a crime, criminal responsibility shall be
    investigated in accordance with the law:
    (1) conducting illegal operations beyond the range approved and registered by the registration authority;
    (2) concealing facts from the registration and tax authorities and practising fraud;
    (3) secretly withdrawing funds or hiding property to evade repayment of debts;
    (4) disposing of property without authorization after the enterprise is dissolved, disbanded or declared bankrupt;
    (5)
    failing to apply for registration and make a public announcement
    promptly when the enterprise undergoes a change or terminates, thus
    causing interested persons to suffer heavy losses;
    (6) engaging in other activities prohibited by law, damaging the interests of the state or the public interest.

     

  • Twofish

    One other thing to note is that even though China “corporatized” the large state enterprises and allowed a lot of private enterprise in SME’s, it’s still very much a “socialist market economy” and Chinese corporate law reflects that.

    If you look at the larger Chinese corporations, you’ll see that

    shareholder = government agency
    legal representative/chairman of the board = party secretary
    board of directors = Party committee
    CEO = government representative

    And a lot of this structure was copied from the Soviets.

    So the board/legal representatives don’t have liability to the shareholders because the Chinese government doesn’t want the Party groups to directly answer to the state owners, but they do have liability for general corporate actions because as Party officials the theory is that they are answerable to the “people” for their actions. 

    One other thing that is curious about Chinese corporate law is that US managers are insulated from the shareholders by the board of directors.  Shareholders can’t order managers to do certain things.  Whereas in China shareholders have a lot more power to intervene directly in the internal affairs of the corporation.  This makes sense because the shareholder is typically a government agency which gave orders to its representative which was the general manager.

    Now when it came time to create WFOE’s, China just took the structure that was designed for something else and just used that.

    One thing that fascinates me about Chinese corporate law is how weird it is.  Basically what China did was to take Soviet industrial organizations and then put them in a structure that was basically American all within a German legal infrastructure, with some indigenous practices that go back to the Song dynasty.  The amazing thing is that it more or less seems to work.

    The other thing that’s interesting is that corporate law is very fluid.  China is still experimenting with new corporate forms, but so is the United States.  The standard corporate structure for small businesses (the LLC), wasn’t widespread in the US until the 1990′s.