China Law Blog

This is part II of our series on what are commonly referred to as non disclosure agreements or NDAs. In Part I, "Why Non Disclosures (NDAs) Alone Are Not Enough For China," we talked about how far too many companies are using inadequate, off the shelf American NDAs in China. Those agreements are inadequate for three primary reasons. First, they typically fail to cover internal disclosure within a network. Second, they oftentimes fail to prevent the Chinese signing party from manufacturing or using the product or information sought to be protected. To remedy this, non-use provisions are required. Third, they usually fail to prevent the Chinese signing party from circumventing the foreign company by going directly to the foreign party's customers or clients. To remedy this, non-circumvention provisions are required.

But even if these NDA agreements were to account for the three issues discussed in Part I and more briefly above, most of the ones we see would still not be worth the paper on which they are printed because they are pretty much unenforceable in China. Let's let co-blogger, Steve Dickinson, explain:

Most NDA agreements I see are just modifications of the standard NDA used in the U.S. The non-disclosure provisions do not deal with the special problems of related parties in China and the non-use/non-circumvention is treated inadequately or not at all. Only a carefully thought out NNN Agreement (non-disclosure, non-use, non-circumvention) that treats all the issues is of any real use in China.

Even the best agreement is of no use if it cannot be enforced. This is the other major defect of the typical NDA agreements I review: the agreement is usually not enforceable. It is absolutely required that an NNN Agreement be enforceable in China. And yet, most of the NDA agreements I read are governed by U.S. or English law with enforcement by litigation in the U.S. or England or by arbitration outside of China. This approach is almost always useless. U.S. courts have no jurisdiction over Chinese companies, so a judgment from a U.S. court is of no value. Arbitration outside of China is expensive and slow and proof is difficult or impossible and denies access to injunctive type remedies that would be available for arbitration in China.

To greatly increase your chances of an NNN Agreement that will actually be enforced, the following nearly always makes sense:

1. The Agreement must include an accurate translation into the Chinese language.
2. The agreement must provide for enforcement through litigation in a Chinese court or through CIETAC arbitration.

To further ensure that the NNN Agreement will be enforced, the NNN Agreement should provide for specific monetary damages that will be awarded in the case of a breach. Though U.S. and other common law systems sometimes discourage using this sort of liquidated damage provision, the Chinese system is the opposite. Specific contract damage provisions are encouraged since they ease the court's work.

Most NDA type agreements rely almost exclusively on injunctive relief as the primary enforcement mechanism. This is a a major mistake in China. The preference for injunctive relief in common law systems (such as the United States or England) is because it is often difficult or impossible to prove the amount of economic damages that result from a breach. This is not really an issue under Chinese law where parties to a contract are encouraged to set a fixed amount for damages that will result from a breach. If written correctly, the liquidated damage amount sets a floor on damages, but if actual damages exceed that amount, it is permissible to seek damages for the excess. In addition, money damages and injunctive relief are not exclusive. A court or arbitrator is free to order that damages be paid and that the infringing/breaching party terminate the infringing action.

NNN Agreements that set forth a specific damage amount that will result from a breach make the cost of a breach clear to the Chinese manufacturer and if set high enough, will go a long way towards discouraging a breach. Having a properly written liquidated damages provision in your NNN Agreement also makes for quick and effective litigation/arbitration, which is much to the advantage for the damaged party.

Many Chinese manufacturers quickly sign the traditional poorly drafted and unenforceable non disclosure agreement without even thinking about it. Why is that? Because they know that their signing it comes with little to no risk.

When a Chinese manufacturer sees a well drafted NNN Agreement, they will sometimes resist signing. For some manufacturers, the reason is simple. Their whole reason for doing your outsourcing work is to acquire your technology and designs to use for their own products. So long as your technology is not protected by patent or trade secrecy law, and you have failed to require the Chinese manufacturer sign a strong NNN Agreement, the Chinese manufacturer is free to use your technology for its own purposes. Absent an agreement that prevents them from doing otherwise, it is perfectly legal for a Chinese manufacturer to use your unprotected information for their own products manufactured under their own trademarks. However, if an NNN Agreement makes clear that the Chinese manufacturer cannot appropriate your technology and contacts, then the manufacturer who wanted your OEM manufacturing solely for these reasons no longer has the motivation to enter into the arrangement with you.

Sometimes the manufacturer has more complex reasons for refusing to sign a well drafted and enforceable NNN Agreement. A well drafted and enforceable NNN agreement shows the Chinese manufacturer that the foreign party knows its way around China and that it plans to hold the Chinese manufacturer to the terms of their contractual commitments. For this reason, the Chinese manufacturer may reasonably decide it would be better off just manufacturing for those foreign companies that do not manifest an intent to hold the Chinese side to their commitments.

Therefore, using a well drafted and enforceable NNN Agreement does actually increase the risk that the Chinese side will refuse to sign. However, we see this as a good thing. If the Chinese side has a good reason for not signing, they will say so and the agreement can be modified to account for that. If the reason for the Chinese side refusing to sign is not a good one, the Chinese side will be forced to make this clear also. In either case, the foreign company benefits from finding out in advance what is really going on. This “advance notice” function is one of the main advantages of a good NNN Agreement; it forces both sides to face up to the real situation and to engage in a frank discussion of what is really required for a successful and long term relationship. This is a much better situation than ritually executing a meaningless agreement.

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The other day, I did a post on why non disclosures are so often critical for those doing business with China. Within a few hours of that post, entitled, "China Non Disclosure Agreements (NDA). A Really Good Thing," my co-blogger, Steve Dickinson, was pointing out how if we were going to talk about non disclosure agreements (commonly referred to as an NDA), we should also discuss how and why we nearly always recommend such agreements also non-use and non-circumvention provisions as well. I agreed with Steve, suggested he write such a post, and, voilà, here it is:

Most lawyers tell their clients who are doing outsourcing work in China that they need an NDA. Many businesses I work with see this as an example of an attorney demand with little practical application. They see the typical NDA as an unnecessary and unenforceable “piece of paper” that they only use if their legal department forces them to do so. The normal comment I receive is “1) how can I prove the information was revealed, 2) how can I prove what was revealed was actually confidential and 3) how can I enforce the agreement even if I could prove the facts?” I am usually dealing with experienced business people and, frankly, their concerns are well founded. In fact, most of the NDAs I see in China are useless because they are both directed at the wrong issues and are unenforceable. Pulling your English language NDA and having it translated into Chinese is pretty much a complete waste of time.

When we work with sourcing companies and related OEM manufacturing arrangements, we almost never just draft a "straightNDA." Instead, we draft a “non-disclosure/non-use/non-circumvention agreement” that we refer to as an NNN Agreement. When a foreign company contracts with a Chinese company to manufacture a product, the NNN focuses on the three primary “bad acts” that the foreign company needs to prevent:

1. The foreign company does not want its design revealed to a third party. To prevent this, a non-disclosure agreement is required. Though this is an important issue in China, disclosure to an entirely unrelated third party is actually fairly uncommon. The bigger risk is disclosure to a related party. Many Chinese businesses have multiple subsidiaries and manufacturing is often done through a large network of subcontractors. Chinese companies are quite relaxed about passing around information within this network. A good non-disclosure agreement must focus on control of information within a network that the Chinese manufacturer itself may not consider as falling within the scope of a non-disclosure requirement.

2. The biggest concern of the foreign company is usually not disclosure to a third party. The real concern is that the foreign company does not want the Chinese manufacturer to make use of the product design to compete with the foreign company. For this purpose a non-use agreement is required. A good non-use agreement focuses on two issues. First, the agreement identifies the applicable intellectual property or confidential information of the foreign company and then authorizes the Chinese manufacturer to use that property/information solely to manufacture the product for the foreign company. Second, the agreement requires the manufacturer agree not to manufacture the product or any similar product under any circumstances, other than for the foreign company. This second provision is the most important as it prevents the Chinese manufacturer from manufacturing a similar product under its own trademark. Since many products are not covered by patent or other IP protections, the only way to prevent such “copy-cat” manufacturing is with such a non-use provision. Normal IP protections will not work, so a contractual agreement is essential. Virtually all "off the shelf" NDAs fail to account for this.

3. The foreign company also does not want the Chinese manufacturer to go the foreign company by selling the product directly to the foreign company's existing or future customers. After the Chinese manufacturer has manufactured the product for some time, it will likely have learned about the market and the customers for the product. It is only natural for the Chinese manufacturer at some point to go to the ultimate customer and say: “Look, WE are the company ACTUALLY making this product and since there is no patent or other IP protection applicable to the product, why don't you just buy the product from us, for less?” This is called circumvention and it is extremely common in China. If you want to avoid getting “cut out” in this way, a non-circumvention agreement is required. Again, an "off the shelf" NDA is not going to cover this.

Most non disclosure agreements I see are just modifications of the standard NDA used in the United States or in England and those agreements simply do not deal with the special problems of related parties in China and they treat non-use/non-circumvention either inadequately or not at all. Only a carefully thought out NNN Agreement that thoroughly resolves treats all of these issues is of any real value in China.

Stay tuned, as the day after tomorrow we will talk about the other typical fatal flaw of "off the shelf" NDAs and why those NDAs are usually not enforceable in China.

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This latest recession has only caused even more small and medium sized businesses to look to cut costs by outsourcing their product manufacturing to China. Unfortunately, many of these companies now engaging in OEM (original equipment manufacturing) outsourcing to China are failing to take some or all of the minimal legal steps necessary to protect themselves. When problems arise, they can do little or nothing to protect themselves because they have no legal basis for protection.

China's legal system for resolving commercial disputes has improved greatly over the past ten years and taking a few basic legal steps can greatly reduce your risk. The cost of such protection is modest compared to the protection it will provide.

The following five basic steps will greatly reduce your problems with Chinese manufacturers, while improving your chances of recovering should any problems arise.

1. Create and properly register your intellectual property rights in the United States or whatever country or countries in which you sell the bulk of your products. If you do not have a firm basis for your IP rights under U.S. law, you will have nothing to protect in China. Before you go to China, be sure your intellectual property is protected under U.S. law or the laws of whatever country or countries in which you sell your products. Protect your brand identity by creating and registering your trademark, slogan and/or logo. Register your important copyrights. Carefully identify and protect your trade secrets, proprietary information and know how. Patent what you can.

Doing the above will mean that no matter what happens in China, you will at least be able to protect your product to the fullest extent possible in the country or countries in which you sell your products.

2. Register your trademarks in China. Registration can protect your future access to the Chinese market, prevent the export of counterfeit goods from China, and prevent a competitor from registering your mark in China, which would prohibit you from exporting your own product from China. For more on the necessity of registering your trademark in China, check out, "WHEN To Register Your China Trademark" and "China Trademarks -- Do You Feel Lucky? Do You?"

3. Use a written agreement to protect your know how and trade secrets in China. Small and medium sized companies usually do not have an extensive portfolio of patents. Their most valuable intangible assets typically are their know-how and their trade secrets, which cannot be protected by formal registration. Chinese law, however, permits companies to contractually protect their know how and trade secrets by contract. Such agreements may (and in most cases should) also address issues such as non-competition and confidentiality. Without such a written agreement, no such protection is available. For more on using non disclosure agreements (NDA) in China, check out, "Why Non Disclosures (NDAs) Alone Are Not Enough For China."

4. Product Quality and Payment Terms. The rule here is simple. Do not make final payment to your Chinese manufacturer until you are confident you will be getting an on time shipment of the correct items and quantities at the quality standards you require. This usually means you must incur inspection costs in China and provide for a clear procedure for dealing with these problems as they arise. You must take the lead on this. You cannot depend on the OEM manufacturer to do this for you.

5. Use comprehensive OEM Agreements with each manufacturer. Small and medium sized businesses often enter into OEM manufacturing transactions with a simple purchase order. This is a mistake. The purchase order will not protect you. Your protection depends on your securing a signed written OEM manufacturing agreement with each Chinese manufacturer with which you deal. The ideal OEM agreement will address all of the issues discussed above while also addressing other basic legal issues such as jurisdiction and dispute resolution. This agreement should be in both Chinese and English, since the Chinese language version will control in China. For more on this, check out, "China OEM Agreements. Why Ours Are In Chinese. Flat Out."

If you do the above, you will greatly increase the chances of good results from your China outsourcing. For some more tips on China product outsourcing (including non-legal ones), you should also check out, "The Six (Not Five) Keys To China Quality" and "Six More Keys To Quality Product Made In China."

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Someone over on the China Law Blog Linkedin Group just posed a question about using non disclosure agreements (NDAs) in China. My first thought was to refer them over to one of our posts on the subject, but then I realized we have not really written anything on them since 2006. That is far too long for something so important and so effective.

We love NDAs. They are fast, cheap, easy, telling and effective. Let me explain.

If you are going to be revealing anything in China that you do not want dispersed into the public sphere, you should consider an NDA. If you are going to be showing your product, prototype or designs to a Chinese factory, you should consider an NDA. The most important thing to know about using NDAs is that they are far more effective when signed before you reveal the information than trying to get someone to sign one after they have the information you are trying to keep quiet.

They are fast, cheap and easy because they do not require much customization from company to company or from product to product. We like putting in an attorneys' fee provision and a provision regarding injunctive relief so that if the other side violates it, we will be able to act quickly to stop them from continuing to do so and we will get our attorneys fees in the process. Just putting in these provisions makes a violation less likely. We always do our NDAs in both English and Chinese. We make the Chinese version the official one and the English version just a translation for our clients. Making them in Chinese means that the Chinese courts will be able to better understand them and enforce them more quickly. It also takes away the other side's argument that it did not know what it was signing.

Well-crafted NDAs are effective in China for two reasons. First, they greatly reduce the likelihood of your information being revealed. Chinese companies are no different from anyone else and if they can help it they will seek to avoid a lawsuit where the odds have already been stacked against them. Second, the Chinese courts are pretty familiar with them and they will generally enforce them.

We also like how much we can learn from the reaction of Chinese companies to the NDAs we draft. This is the "telling' part and it is telling because we have found that if a Chinese company refuses to sign one, it is probably not the Chinese company with whom you want to do business. NDAs have become so common in China that it is truly the rare company that will not sign.

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By Steve Dickinson

Chinese employment law presents many challenges to U.S. employers. One issue that causes much confusion is the proper use of non-compete agreements with Chinese employees. Before China adopted its Labor Contract Law (“LCL”) in 2008, it was common for foreign employers to require all of their Chinese employees to enter into non-compete agreements. This blanket use of non-compete agreements was never a good policy under Chinese law. This is because the Chinese labor arbitration board and the courts view non-competes with great suspicion as an infringement on the basic employment right of the employee. This is not unlike how US courts view these agreements.

Consistent with this basic hostility towards employee non-competition agreements, the LCL provides for clear provisions on such agreements. On the positive side, the LCL makes it clear that “reasonable” non-competition agreements are enforceable. On the other hand, the LCL provides a set of rules for non-compete agreements that significantly reduces their utility for employers. We find that many employers ignore the new rules and continue to operate under the old system. This has two bad results. First, the employer believes it is protected when it is not. Second, the inclusion of a provision that openly violates the terms of the LCL weakens other provisions that arguably comply with the law. The only rational course of action is to proceed in careful compliance with the law.

Non-competition agreements are authorized by Articles 23 and 24 of the LCL. The basic rules are as follows:

* An employment agreement may include provisions intended to protect the trade secrets of the employer. A non-competition agreement may be included in support of such protections.

* The employer must pay reasonable compensation on a monthly basis to the employee during the term of the non-competition period. There is no definition of “reasonable compensation.” Commentaries suggest employees should be compensated in a manner equivalent to their salary with the company. Others suggest that compensation is only required at the level of the current minimum wage in the relevant jurisdiction.

* Non-competition agreements are limited to executives, technical personnel and other personnel who have access to trade secrets. Cases have held that senior sales staff are included in this category. On the other hand, blanket agreements that apply to all employees are invalid.

* The terms of the restriction must be “reasonable” in length of restriction, business scope and geographic area. A term in excess of two years is prohibited. The scope requirement is strictly interpreted. It is not sufficient that the employee is working in the same general area as the former employer. Competition must be specific and direct.

* If the employee violates the terms of the non-compete agreement, the employee can be held liable for a payment of contract damages to the employer. The amount of contract damages must be reasonable. Excessive damages that are clearly punitive will be rejected.

We have seen many cases where employment agreements contain provisions that violate the requirements of the LCL. By far the most common issue is failure to pay compensation to the employee during the non-competition period. Many foreign employers strongly object to the notion of paying an employee to abide by the terms of a non-compete agreement. This is especially true when an employee voluntarily resigns and then goes to work for a potential competitor. However, the law is very strict on this issue. Reasonable compensation must be paid on a monthly basis. Failure to pay or a delay in payment voids the entire noncompetition provision. The vast majority of employee non-competition claims are rejected for failure to make payment. The requirement applies even if the employee has found employment elsewhere and does not “need” the compensation for not competing.

Employers simply need to face the fact that non-competition agreements have very limited utility under Chinese law. The better approach is to deal with the whole issue under the terms of a trade secrecy agreement. Employees are bound by the terms of any trade secrecy agreement they execute. Employees who will truly be exposed to trade secrets should be required to execute a non-disclosure and non-use agreement. Such an agreement will make the use of trade secrets in their new employment a contractual violation subject to action by litigation. The main issue is that the employer must prove that the employee is actually making use of trade secrets in the new position.

The most common reason such claims fail is that there is in fact no trade secrecy violation. For example, a common claim is that sales personnel are making use of the client list of the former employer. However, client lists that are kept in an open Rolodex or in an open file or in an open access computer file are not secrets. In other cases, the employee in fact had no access to trade secrets applicable to the claim. For example, a common claim is made against sales personnel, but the trade secret is highly technical information concerning the product. In this case, sales personnel can successfully argue that though the product is the same, they had no access to or ability to use highly technical information related to the product.

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For every roughly 100 China WFOEs and Joint Ventures (total) my firm helps set up in China, it does one Representative Office. Why so few Rep Offices, when it is generally agreed they are the easiest entity for foreigners to form in China? Because the inherent limitations on China Rep Offices mean they seldom make sense.

Rep Offices “represent” in China the foreign company back home. Rep Offices are not a separate legal entity; they are the China representative of the foreign company. Most importantly, they are not allowed to engage in profit making activities. Chinese law limits them to performing "liaison" activities.They cannot sign contracts or bill customers. They cannot supply parts and after-sales services for a fee. They simply cannot earn any money in China or take any payments from a Chinese person or business for any reason.

NOTE: This post does not discuss branch offices for banks, insurance companies, accounting firms or law firms, all of which are permitted to engage in profit-making activities in China.

Rep Offices are pretty much limited to engaging in the following:

-- Conducting research.
-- Promoting their foreign company.
-- Coordinating their foreign company’s activities in China.
-- Other activities that do not and are not intended to generate a profit.

Because forming a Rep Office in China is faster, cheaper and easier than forming a Wholly Foreign Owned Entity (WFOE), companies oftentimes consider forming a Rep Office in China to test the waters there, with the intention of switching over to a WFOE once it becomes clear China will be viable for them. We generally discourage this because “switching” from a Rep Office to a WFOE is not really a switch at all. It involves both shutting down the Rep Office and forming a WFOE pretty much from scratch. Because the cost of forming a Rep Office, shutting down the Rep Office, and then forming a WFOE, will be considerably higher than just forming a WFOE, forming a Rep Office with the later intention of forming a WFOE seldom makes sense. Companies will usually be better off just biting the bullet and forming the WFOE straight away.

Other times, companies have come to my firm believing they need a China Rep office because they need a Chinese entity to sell their product into China. Oftentimes though, these companies can sell their product into China without having to create any in-china footprint at all.

There are definitely times where a Rep Office makes sense. By way of one example, my firm set up a Rep Office for a US company that sells US made equipment for around $2 million each. This company has no plans to start manufacturing its equipment in China so there would be no need to form a WFOE for that. It already had an arrangement with a Chinese company to repair its equipment sold into China, so no need to establish a WFOE for that purpose either. This company merely wanted an on the ground China presence to improve its sales and to let its customers and potential customers know it is serious enough about China to commit to having an office there.

There are three basic requirements for forming a Rep Office:

1. The most important requirement is that there must be a lease on an approved space for a period of at least one year beyond the approval date of the Rep Office. Care should be taken with this requirement, since many jurisdictions accept leases only from a small group of approved office buildings. Shanghai, for example, is one such jurisdiction. The lease must be registered, which can also cause problems in some jurisdictions.

2. There must be a designated Chief Representative who will manage the affairs of the Rep Office.

3. There must a foreign entity (typically a limited liability or a corporation) that the local office represents; private individuals and partnerships cannot establish a Rep Office in China. In addition, some jurisdictions in China do not allow newly formed entities to form a Rep Office.

The local approval authorities usually issue their decisions on Rep Office approval within around thirty days, at which point the Rep Office must do many of the other things typically required of businesses in China. However, in some areas, the decision can take much longer, depending on the whims of the local officials.

There are two major issues that make working with Rep Offices unattractive:

1. Even though Rep Offices are not permitted to earn income in China, they are nevertheless subject to taxation.There is a 10% tax on the GROSS EXPENSES of the Rep Office. If the Rep Office is large and has a number of employees, this tax can be quite high.

2. A Rep Office is not permitted to directly hire Chinese nationals. All hiring of Chinese nationals must be done indirectly through contracting with a Chinese employment agency such as FESCO. Recent changes in the Chinese labor contract law have made such contracts extremely unattractive. Rep Offices can directly hire foreign nationals.

The bottom line on Rep Offices is to think before you leap and not get seduced by their relative ease of formation. Every once in a while my firm will get called by someone who formed a Rep Office (usually through a formation company) within the last year or so who tells us they are now ready to "switch over" to a WFOE so they "can start making money" in China. These people believe this "switch" will involve little more than a one page notice of change and are shocked to learn that it will actually involve a shutdown and a new formation. Do not let yourself become one of "these people."

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On January 1, 2006, China implemented its New Company Law. At around that same time, China Law Blog's own Steve Dickinson wrote a scholarly article on the new law for the Pacific Rim Law & Policy Journal, entitled, 'Introduction to the New Company Law of the People's Republic of China." At around the same time, Steve wrote the China corporate law section for the international corporate deskbook, International Corporate Procedure We are reprising Steve's Pacific Rim article now as part of our new series, setting out the basics on China business law. This article was written in 2006, but we have noted where the statements that have become glaringly out of date.

I. INTRODUCTION

On October 27, 2005, the People's Republic of China adopted a new Company Law. This law became effective on January 1, 2006.' The New Company Law replaces the Old Company Law, which had been adopted in 1993. The New Company Law is a complete revision of the old law. Almost nothing of the old law survived the revision. Drafters estimate approximately ninety percent of the provisions of the new law are unique.

The New Company Law governs two types of corporations: limited liability companies (youxian gongsi) and joint stock companies. The changes to limited liability companies are especially important to foreign investors in China because the statutes governing foreign direct investment in China require foreign investors to operate through a Chinese limited liability company.

For existing foreign invested limited liability companies, the rules on operation of such companies have substantially changed. Potential new investors must realize the old rules no longer apply and consider the new regime. Because foreign investors are currently prohibited from investing directly in China through joint stock companies, the discussion below will be limited to the New Company Law's changes regarding limited liability companies.

II. IMPORTANT CHANGES INTRODUCED BY THE NEW COMPANY LAW

A. Management and Articles of Association

Under the Old Company Law, the articles of association for a limited liability corporation was not a living document. Article 22 of the Old Company Law provided a list of items to be included in the articles. As a matter of practice, companies were required to include those provisions and no others. As a result, articles of association were virtually the same for every company regardless of its size or nature. There was no freedom to revise or adapt the articles to meet the specific needs of a particular company. Under the Old Company Law, the roles of shareholders, directors, and officers were taken as mandatory provisions to be followed by all companies. As a result, the articles of association became little more than a "Fill in the blanks" form document adopted by every company without regard to the actual management needs of that company.

The New Company Law abandons the rigidity of the old law and encourages shareholders of limited liability companies to take a flexible approach to company management. The articles of association now are intended to be adaptable to meet the specific needs of each company. The New Company Law provides for management of the company by the shareholders, directors, officers and supervisors and provides default provisions concerning the duties and scope of authority for each. However, with respect to many important provisions related to management of the company, the New Company Law specifically provides that the shareholders are free in the articles of association to adopt specific provisions to meet the needs of the company. There are virtually no provisions related to management that cannot be altered or expanded in a manner determined by the shareholders in the articles of association.

The New Company Law also encourages shareholders to include provisions in the articles of association related to the financial management of the company. For example, the Old Company Law required profits earned by the company to be distributed among shareholders strictly in accordance with the shareholders' ownership interest in the company. Under the New Company Law, shareholders are entitled in the articles of association to provide for distribution of profits in any manner agreed to by the shareholders, even if that distribution differs from the ownership percentage of the respective shareholders. This provides significant flexibility in financing of limited liability companies that was entirely absent under the Old Company Law.

Under the former company law system, officers and directors often used their companies to secure financing of other businesses with which the officers and directors were involved. To restrict such behavior, the New Company Law provides that the shareholders may impose limitations on the authority of the directors and senior management. If officers or directors exceed the authority given them, their actions are void and the shareholders may file suit to compel compliance and for damages.

B. Reduced and Simplified Minimum Capital Requirements

Chinese company law emphasizes registered capital requirements as a means to protect creditors. Since credit reporting is still primitive in China, the New Company Law emphasizes registered capital reporting and full capitalization of all new companies. It simplifies and significantly reduces minimum capital requirements in an effort to make the corporate form available to more individual investors and to more investors from China's less developed regions. The Old Company Law imposed minimum capital requirements of 500,000 RMB for manufacturing and wholesale trade businesses, 300,000 RMB for sales businesses and 100,000 RMB for service businesses. Though these limits did not significantly restrict state owned enterprises or individual investors in China's wealthier coastal regions, they imposed significant barriers for individual investors and for businesses in the less developed regions.

The New Company Law eliminates both the high minimum registered capital requirement and the system of capitalization based on the type of business. Under the new system, the minimum capital requirement for limited liability companies with two or more shareholders is reduced to 30,000 RMB. For single shareholder limited liability companies, the minimum capital requirement is set at 100,000 RMB. The minimum capital requirement is the same for all types of business activities. The intent of this change is to channel as much economic activity as possible into companies formed and registered under the New Company Law. The hope is that the protection of limited liability will encourage economic activity, particularly in currently underdeveloped regions of China.

C. Single Shareholder Limited Liability Companies

The New Company Law now allows natural persons or legal persons to form single shareholder limited liability companies. Under the Old Company Law, a limited liability company was required to have two or more shareholders. In contrast, the new statute provides for a simplified management structure appropriate to single shareholder entities. However, in order to prevent abuse of the corporate structure in single shareholder companies, the New Company Law provides for a number of restrictions:

* the registered capital requirement is increased to 100,000 RMB;

* the entire registered capital amount must be paid in a single installment;

* a single investor may form only one single shareholder company; and

* if the shareholder fails to maintain adequate distance between the finances of the company and the shareholder's personal finances, the shareholder will lose the protection of limited liability and will have joint financial liability for company debts.

These single shareholder provisions illustrate the manner in which the New Company Law attempts to balance the benefits of limited liability status to potential investors while still providing protection to creditors.

D. Public and Shareholder Access to Company Information

The Old Company Law was silent regarding public access to information about companies, and in practice, access was extremely limited. Without the assistance of an attorney or other legal professional, it was generally not possible to access a company's basic registration information.

The New Company Law takes an entirely different and much more public approach. The New Company Law provides that the public has the right to access basic company registration information and further provides that the registration authority must provide consulting assistance in accessing that information. The public will now have access to the following information on limited liability companies:

* name

* registered address

* legal representative

* registered capital

* business classification

* scope of business

* termination date

* identity of shareholders

Under the Chinese system, all of this information is considered essential for creditor protection. The New Company Law takes the reasonable position that creditor protection requires this basic information to be freely available to the public. Since the identity of shareholders is freely available, it is now impossible to use a Chinese limited liability company to conceal the identity of the true party in interest.

The New Company law also significantly expands shareholder access to company information. Under the former system, shareholders had no practical way to obtain information about company operations. This allowed the directors and officers to operate the company for their own benefit and without any effective supervision by the shareholders. Under the new law, the company must maintain the following basic records and make those records available to the shareholder at the shareholder's request:

* articles of association

* minutes of meetings of the board of directors

* minutes of meetings of the board of supervisors

* tax returns and financial reports

The statute also provides for shareholder access to the company's full financial records. In this case, though, the company has the right to deny access if it believes such access will damage it. This could occur, for example, where a shareholder is also a competitor of the company. If the company willfully withholds information from the shareholder, the shareholder may file suit to force the company to release information.

E. Abuse of Shareholder Rights and Piercing the Corporate Veil

The New Company Law introduces the new concept of the abuse of shareholder rights. This concept is intended to protect both the company and third party creditors. The new law provides that shareholders must exercise their rights in accordance with the law, the regulations, and the company articles of association. The shareholder must not abuse the independent legal person status of the company or his own limited liability rights in a manner that harms the interests of the company or its other shareholders or creditors.

Where such abuse damages the company or other shareholders, the offending shareholder is liable for such loss. Where such abuse is used by the shareholder to escape liability for his own debts in a manner that seriously damages the interests of a creditor of the company, the shareholder is jointly liable for such debts. A similar provision is contained in the single shareholder company section. It provides that the shareholder of a single shareholder company who cannot prove that the finances of the company are independent of his or her own finances will have joint liability for the debts of the company. This "piercing the corporate veil" concept is entirely new to China and though it may be useful to prevent obvious abuses, it could also be used to undermine the concept of limitation of liability, which is the foundation of the corporation law concept.

F. Limitations on Third Party Loans and Guarantees

Unrestricted debt guarantees to unrelated companies were a major problem under the former company law system. Large companies that appear to be financially solvent are often actually insolvent because they used their profits to acquire unrelated companies or to guarantee the debts of companies related only through the private financial interests of directors, officers, or controlling shareholders. To the detriment of legitimate creditors, the extent of such loans, guarantees, and other security arrangements are oftentimes not exposed until bankruptcy or insolvency proceedings are commenced.

Articles 15 and 16 of the New Company Law seek to remedy this. Article 15 permits a company to invest in another company, but prohibits it from doing so in a manner such that it becomes jointly liable for the debts of the other company. Article 16 provides additional rules concerning the providing of investment or debt guarantees to third party companies:

* the investment or guarantee must be approved by either the board of directors or by the shareholders, as provided in the articles of association;

* where the articles of association limit the amount of investment or guarantee, such limit may not be exceeded; and

* the shareholders must approve a guarantee provided to a shareholder or to the person actually controlling the company, In such cases, the benefiting shareholder may not participate in the decision and approval must be by a majority of the remaining shareholders.

Under this approach, the senior management of the company and individual directors have no authority to make investments or to provide guarantees. This is a significant departure from former practice. This is also an example of the new approach to the articles of association, where shareholders are encouraged to limit potential abuses by specifically limiting the authority of directors and officers.

G. Legal Remedies for Improper Acts of Directors and Senior Management

As noted above, a major problem affecting companies in China has been that individual directors and senior management operate the company to benefit themselves while disregarding shareholders' interests. The New Company Law seeks to address this matter directly. First, Article 149 expressly prohibits directors and senior management from engaging in the following acts:

(1) Misappropriating company funds; (2) Depositing company funds into an individual account; (3) Loaning company funds or providing a company guaranty without shareholder approval; (4) Signing a contract or trading with another company in violation of the articles of association, unless the shareholders expressly consent; (5) Without shareholder consent, seeking business opportunities for oneself or for any other person by taking advantage of one's authority, or operating for oneself or for any other person any business similar to that of the company for which one works, without shareholder consent; (6) Taking commissions on a company transaction ; (7) Disclosing company secrets without permission; (8) Other acts inconsistent with the obligation of fidelity to the company.

This detailed list of prohibitions is a good summary of the kinds of problems that occurred under the old system.

The Old Company Law did not provide any clear method for shareholders to protect their rights when directors and managers behaved improperly. It was silent on the power of the shareholders to take action in the court system if such activities occurred. As a result, some courts refused to hear shareholder complaints on the ground that the Old Company Law did not authorize them to interfere in a company's internal affairs.

The New Company Law provides a clear set of procedures for shareholder action and specific authority to appeal to the courts to resolve such matters. Article 152 provides that when a director or senior manager violates the provisions of Article 149, noted above, the shareholder(s) holding one percent or more of the total shares of the company may require the company to file suit in the people's court. If the company refuses to file suit, the shareholder may file suit on behalf of the company. In addition, if the interests of the shareholders are directly affected, then the shareholders may file suit on their own behalf. Article 153 further provides that if any director or senior manager damages a shareholder's interest by violating any law, administrative regulation, or the company's articles of association, the affected shareholders may file suit for compensation.

Under the New Company Law, the court system is intended to be the final authority for protection of shareholder rights and for ensuring that companies comply both with government regulations and with the provisions of their articles of association. These provisions in the New Company Law further underline the importance of the articles of association in governing the company and in protecting shareholder rights.

III. THE NEW COMPANY LAW'S IMPACT ON FOREIGN INVESTORS

Direct foreign investment in China may be carried out in three forms: a wholly foreign owned entity, an equity joint venture, or a contractual joint venture. [UPDATE NOTE: come 2010, it appears we will be adding limited partnerships to this list] These forms of foreign invested enterprise are typically organized in China as limited liability companies. The statutes and associated regulations provide for specific and unique provisions concerning each of these three forms of foreign investment in China. Where the unique provisions do not apply, the provisions of the New Company Law will control. The foreign invested enterprise statutes and regulations are concerned with approvals and investment percentages, but not with day to day management issues. Accordingly, the fundamental changes introduced by the New Company Law will significantly impact both existing and future foreign invested enterprises in China.

The three foreign invested enterprises laws provide for special treatment of investors in a limited liability company based on the status of the investor. In this case, the status is foreign nationality. Similar status based distinctions formerly existed for domestic enterprises. For example, wholly state owned enterprises and town and village enterprises were governed by their own unique statutes and regulations. A primary goal of the New Company Law is to eliminate such status-based distinctions for domestic enterprises. As a result, all Chinese companies are in principle formed under the provisions of the Company Law, regardless of the status of the investor.

This change in principle is not the case for foreign investment, primarily because China still provides significant tax benefits and other incentives to foreign invested enterprises. It is essential to be able to characterize a limited liability company as a foreign invested enterprise to maintain these special benefits. [UPDATE NOTE: Most of the tax law distinctions and special benefits for foreign companies no longer exist.]

For example, an extremely favorable tax regime provides foreign invested companies with benefits not available to domestic enterprises. This foreign invested enterprises tax regime provides for numerous tax reductions, including the following:

* a reduced fifteen percent tax rate instead of the normal thirty-three percent rate

* exemption from all income tax for certain periods

* rebates of taxes paid upon reinvestment of profits

* exemption from import duty on imports of equipment

In addition, local authorities are authorized to provide additional tax and related incentives to foreign invested enterprises.

This special regime for foreign investors has survived adoption of the New Company Law. These tax and related benefits give foreign invested enterprises a significant business advantage over purely domestic Chinese competitors in the Chinese market, which makes investment in China more attractive for foreign investors. [UPDATE NOTE: Most of these special benefits for foreigners no longer exist]

IV. CONCLUSION

The New Company Law intends to make a revolutionary change in the practice of formation and management of corporations in China. However, a mere change in the law is not sufficient to bring about such change. The change will come only if the principles and procedures embodied in the new law are actually adopted and used by entrepreneurs, attorneys and the courts. There is much that suggests that the process of change will be slow and difficult.

Some elements of the New Company Law will have an immediate impact. These are elements that can be applied automatically by local government officials and that do not require the participation of legal professionals or the courts. There are three such provisions that should have such immediate impact: the reduction in the amount of registered capital, the provision allowing single shareholder limited liability companies, and the provisions that allow for a simplified management structure for limited liability companies with a limited number of shareholders.

It is realistic to presume that these provisions will be implemented within the existing Chinese system. Each of these provisions can be implemented without the commitment of resources and in a way that is entirely automatic. For the reduction in registered capital and single shareholder companies, this is obvious. The changes are uniform and are applicable throughout the system without the need for local officials to make discretionary evaluations. Management structure is similar. Local authorities can devise a check box form that allows the party forming the company to choose one of two options: either a full board or a single director. Once the choice is made, the local authorities can then proceed in a rigid and formalized manner that does not require discretion or judgment.

The other, more dramatic changes introduced by the New Company Law will encounter implementation problems. As with most Chinese laws, the New Company Law was drafted by a group of sophisticated legal professionals at the top levels of government but with little input from the public or lower levels of the bureaucratic structure. These changes require demand from the public, legal professionals for implementation, government officials for registration, and a court system for enforcement. Given the weak judiciary system and a bureaucracy unaccustomed to handling complex corporate law questions, the New Company Law likely will have little impact on closely held limited liability companies in China. Absent public or institutional demand for such sweeping legislation, the only way the legislation may have any impact is through a combination of massive, government-imposed education and vigorous government enforcement. Since neither of these may happen in China, the New Company law likely may fail to have the significant impact the drafters hoped for. [UPDATE NOTE: Steve's predictions have generally come true. The new law has improved corporate governance in China, slowly but surely.]

V. BIBLIOGRAPHY

1. Company Law of the People's Republic of China (promulgated by the Standing Comm. Nat'1 People's Cong., Oct. 27, 2005, effective Jan. 1, 2006) LAWINFOCHINA (last visited Nov. 5, 2006) (P.R.C.) [hereinafter New Company Law].

2. Company Law of the People's Republic of China (promulgated by the Standing Comm. Nat'l People's Cong., Dec. 29, 1993, amended Dec. 25, 1999 and August 28, 2004), translated at www.lawinfochina.com/dispecontent.asp7db= l&id=3656 (last visited Nov. 5, 2006) (P.R.C.) [hereinafter Old Company Law].

3. See the discussion on foreign invested companies, infra Section III.

4. See New Company Law art. 37-57 (giving the provisions for management of limited liability companies).

5. See, e.g., id. art. 42-47, 49-51, 54, 56.

6. Old Company Law art. 33.

7. New Company Law art. 35.

8. See id. art. 38,46, 50.

9. See generally id. art. 26-32.

10. Old Company Law art. 23.

11. New Company Law art. 26.

12. Id. art. 59.

13. Id. art. 58-64.

14. Old Company Law art. 20.

15. New Company Law art. 59.

16. Id.

17. Id.

18. Id. art. 64.

19. Id. art. 6, 7.

20. Id. art.7, 25.

21. Id. art. 23(3).

22. Id. art. 165,166.

23. Id. art. 34, para. 2.

24. Id. art. 20.

25. Id art. 64.

26. Id. art. 16.

27. Id. art. 149.

28. See generally Law of the People's Republic of China on Enterprises Operated Exclusively with Foreign Capital (promulgated by the Standing Comm. Nat'l People's Cong., Apr. 12, 1986, effective Oct. 31, 2000) LAWINFOCHINA (last visited Nov. 7,2006) (P.R.C.).

29. See generally Law of the People's Republic of China on Chinese-Foreign Equity Joint Ventures (promulgated by the Nat'1 People's Cong., Mar. 15, 2001, effective Mar. 15, 2001) LAWINFOCHINA (last visited Nov. 7, 2006) (P.R.C.).

30. See generally Law of the People's Republic of China on Chinese-Foreign Contractual Joint Ventures (promulgated by the Nat'l People's Cong., Oct. 31, 2000, amended Oct. 31, 2000) LAWINFOCHINA (last visited Nov. 7, 2006) (P.R.C.).

31. New Company Law art. 218.

32. See generally Income Tax Law of the People's Republic of China for Enterprises With Foreign Investment and Foreign Enterprises (promulgated by the Nat'l People's Cong., Apr. 9, 1991, effective Jul. 1, 1991) LAWINFOCHINA (last visited Nov. 7, 2006) (P.R.C.).

33. Id. art. 7, 8, 10.

34. New Company Law, art. 26, 59.

35. Id. art. 58-64.

36. Id. art. 61, 62.

37. The transparency of the legislative process in China has been studied and criticized by many legal scholars. For a brief treatment of this issue and the Chinese law-making system generally, see generally, Congressional-Executive Commission on China, Legislative Transparency of China's NPC, http://www.cecc.gov/pages/virtualficad/govnegistransp.php.

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This post is part of our new Basics of China Business Law series, where we discuss, usually in a bare bones sort of way, the basics of what it takes to do business in China legally. This post focuses on the different sorts of visas one can use to get into/stay in China.

My law firm almost never involves itself in Chinese visa issues because it typically does not make sense for our clients to pay law firm rates for us to do so. Chinese visa matters are typically better handled internally or by a reputable visa assistance company. My law firm and I usually use a visa company to secure our visas to China because we find it easier to do so and because the company we use has been coming through for us for more than a decade (and not just with China, but with many other countries as well) and it definitely seems to have a very good relationship with the Chinese consulate in SFO.

China visa information will always be at least somewhat dependent on the country in which you are seeking to secure your China visa, the country of your own citizenship, and even things such as the particular Chinese consulate or embassy from which you are seeking the visa, the visa service you are using, and even general political conditions at the very moment your visa shows up for approval.

The following are the most commonly secured visas

-- The L visa is the tourist visa and it is typically issued to someone who is coming to China for tourism or to visit with friends or relatives. These are typically for 3 to 6 months.

-- The F Visa is the business visa and its length and entry limits typically track that of the L visa. They are typically issued for 6 months with a single-entry, or for 6 months or longer with multiple-entry. My goal is always to go for a multiple-entry visa for as long as possible.

-- The Z Visa is given to foreigners (and typically their accompanying family members as well) entering China to work. These visas typically are for 30 days only and require the holder to go through various residential formalities with the public security department within thirty days upon entry into China to secure a residence permit that typically lasts for 12 months.

-- The X Visa is to study in China for more than six months. If you want to study in China for less than six months.

-- The D Visa is a permanent resident visa, typically issued to those who marry a Chinese citizen.

If you have the time and the experience, it is definitely possible to get a Chinese visa on your own (I have gotten a bunch of mine at the Chinese Embassy in Seoul and never had a problem, including the time I begged them to give me one within an hour!), but generally, it is easier to have someone who does nothing but visas do it for you, especially since there are plenty of good and inexpensive such people/companies out there both within China and outside of it.

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Yesterday, in a post entitled, "How to Start a Business in China -- WFOE," we discussed the basic requirements for forming a wholly foreign owned entity (WFOE or WOFE) in China. One of the questions we are most frequently asked about how to form a WFOE in China is is how much the Chinese government requires in minimum capital.  This post follows up on yesterday's post by addressing the minimum capital requirements issue.

Every company in China must have a stated registered capital. This amount is provided in the Articles of Association of the company and is also noted on the company register. Beginning in 2006, this company register is available to the general public. The registered capital includes all of the components of the initial investment in the company, including its start up cash, contributed property, and transferred intellectual property. Where the registered capital is small, the entire amount must be contributed immediately upon formation of the company. If the amount is large, it may be contributed in installments. There are a number of schedules for the percentage and timing of large amounts of registered capital. It is a crime to state a registered capital amount and then fail to contribute. The purpose of registered capital is to provide some notice to creditors of the capital adequacy of the company. Because of this, Chinese regulators take very seriously the rules regarding registered capital.

Registered capital is an initial investment that is intended to be immediately used in operating the company. It need not just sit in a bank and never be touched. It can be used to pay salaries and rent, to purchase product, or for any other normal start up operating expense. Registered capital may include contributed real and personal property used in operating the business. Many foreign investors think registered capital is some sort of security deposit that they can never utilize. This is not true. On the other hand, some foreign enterprises believe they can simply withdraw their registered capital after the Chinese company begins normal business operations. This also is not true. Once the capital is contributed to the Chinese company, it can never be withdrawn for anything other than paying company expenses.

The only way to get funds from the Chinese company out of China is by repatriating profits or by liquidating the Chinese company. Both of these methods will work, but they both require paying Chinese taxes and meeting other requirements under Chinese law. Investors should also note that the RMB is not a freely convertible currency. For companies that will earn RMB income, the issue of conversion to U.S. dollars or other foreign currency should be carefully considered and a failure to abide by Chinese law all the way along the process will likely lead to an inability to get money out of China at some point down the road.

Under the new Chinese Company Law, the minimum capital requirement for multiple shareholder companies has been reduced to 30,000 RMB (less than $5,000 USD). For single shareholder companies, the amount is 100,000 RMB (around $13,000 USD). However, these numbers have no real meaning for the formation of a WFOE in China.

The real question is what the Chinese authorities will consider as adequate capitalization for the specific project. Of course, that answer varies by type of business and location. For example, it is very expensive to operate a business in Shanghai. On the other hand, it can be very inexpensive to operate the same business in a rural area of China. It is expensive to operate a capital intensive business like manufacturing, but relatively inexpensive to operate a knowledge based consulting business.

The Chinese regulators usually consider all of these issues. To complicate matters, each local regulator has its own basic standards on what constitutes adequate capital for certain types of business activities. These numbers are not published, but when asked they will almost always be provided. They can only be determined through direct contact with the regulator and only after providing a clear explanation of the project. The local regulator virtually never considers the statutory minimum in making a determination regarding adequacy of capital. Rather, the local regulator will determine what it believes is an adequate amount of capital based on all the circumstances. Once the investor has a clear idea of the outlines of a project, it is usually a good idea to engage an attorney to contact the local regulator to see what their response will be to the proposed amount of investment. This initial screening can save a lot of time if the investor's idea of the proper amount of capitalization is dramatically different from that of the local regulator.

In determining what constitutes adequate capital, one needs to consider the peculiar situation in China that building rents are virtually always paid in advance, that payment for products for sale are virtually always paid in advance, and that a reasonable advance reserve for salaries is also required. Thus, the initial start up costs are much higher than in a location like the United States, where credit and time payments are more common. In addition, the foreign investor needs to take into account the risk aversion of the Chinese regulator. The Chinese regulator will not approve a project that looks risky or under-funded. The regulator has no incentive to do this, especially for a 100% foreign owned entity.

The government sometimes permits the minimum capital to be paid in installments over up to two years, though the first installment must be at least 15% of the total amount required and it also must be at least the statutory minimum for total capital. The capital contribution can be made in money, equipment, intellectual property, or other transferable property, but the monetary contribution must be at least 30% of the total capital amount. The government will appraise the value of any non-monetary contribution and our experience has been that it will come in fairly low in its valuation.

We frequently see two big mistakes being made by foreign investors when it comes to their putting in the required minimum capital. Foreign investors hear that assets can be used as a contribution towards the minimum capital requirement, so they go ahead and ship certain assets over to China, with the expectation of then using those assets towards minimum capital. The problem with this approach is that unless the proper authorities have been notified and granted their approval in advance of the shipping, the assets you just shipped to China will not be applied towards minimum capital, and you will have a huge problem on your hands.

The other common mistake we see is the foreign investor putting a value on its assets (including its intellectual property) and assuming the Chinese regulators will put the same value on those assets in determining the contribution towards minimum capital. The Chinese regulators will require their own appraisal (at your expense) l of anything other than monetary contributions towards the minimum capital requirement, and those appraisals tend to come in low, particularly for IP.

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This post is a re-hash of a post Steve did more than three years ago. We are re-running it now as part of a series of posts we will be running over the next few weeks on the Basics of China Business Law. We are even forming a new category for this series, the first since we started this blog!

This post focuses on the forming of a Wholly Foreign Owned Entity (WFOE) in China. I am starting with this type of entity because it is the one we do most often. Subsequent posts will detail the steps required to register other forms of entities in China, such as a representative office (RO) or a contractual or equity joint venture (JV). Each of these forms of foreign invested enterprise (FIE) is subject to its own specific laws and to numerous regulations that apply to all FIEs. Every FIE is formed as a Chinese limited liability company (LLC).

Where the special laws and regulations of an FIE do not apply, the provisions of the Chinese Company Law control. The Company Law was recently completely rewritten to conform more closely to international standards for company formation and management.

The steps for forming a WFOE in China typically consist of the following:

1. Determine if the proposed WFOE will conduct a business approved for foreign investment by the Chinese government. For example, until recently, China prohibited private entities from engaging in export trade. All export trade was handled through certain large, state owned trading companies.

China recently abandoned this system, and now both foreign and domestic companies can set up trading companies.  Restrictions on export oriented trading companies have essentially been eliminated, but there are still controls on import oriented trading companies that can increase expense and raise costs. Because these rules were only recently changed, the local regulators who must approve these projects do not have a great deal of experience with the attendant issues. This can lead to some delay in the approval process. It also results in an extremely cautious approach towards adequate capitalization even for export oriented trading  companies. I discuss capitalization requirements in greater detail below.

2. Determine if the foreign investor is an approved investor. Basically, any legally formed foreign business entity is authorized to invest in a WFOE in China. China especially welcomes investment that promotes the export of Chinese manufactured products. The investor must provide the documentation from its home country proving it is a duly formed and validly existing corporation, along with evidence showing the person from the investor who is authorized to execute documents on behalf of the investor. The investor also must provide documentation demonstrating its capital adequacy in its country of incorporation.

To meet these requirements, the following documents are normally needed from the investing business entity:

a. Articles of Incorporation or equivalent (copy)

b. Business license, both national and local (if any) (copies)

c. Certificate of Status (Original)(U.S. and Canada) or a notarized copy    of the Corporate Register for the investor or similar document                 (original)(Civil Law jurisdictions)

d. Bank Letter attesting to sound banking relationship and account status of the company (original).

e. Description of the investor's business activities, together with added materials such as an annual report, brochures, website, etc.

a-d are translated into Chinese. e is either translated into Chinese or summarized in Chinese.

Many investors created special purpose companies to serve as the investor in China . The Chinese regulators have become accustomed to this process. However, the Chinese regulators will still seek to trace the ownership of the foreign investor back to a viable, operating business enterprise. Investor secrecy is not an option in China. However, the corporate register for the Chinese company will merely state the name of the foreign, special entity investing company as the owner. In that sense, as far as public disclosure is concerned, the investor privacy can be maintained. The foreign investor should also understand that this tracing process will add some time and cost to the Chinese company formation process.

3. Chinese government approval for the project. In China, unlike in most countries with which Western companies tend to be familiar, approval of the project by the relevant government authority is an integral part of the incorporation process. If the project is not approved, no incorporation is permitted. The two are inextricably linked.

The following documents must be prepared for incorporation/project approval:

a. Articles of Association. This document will set out all of the details of management and capitalization of the company. Nothing can be left for future determination; all basic company and project issues must be determined in advance and incorporated in the Articles. This includes directors, local management, local address, special rules on scope of authority of local managers, company address, and registered capital.

b. Feasibility Study. The project will not be approved unless the local authorities are convinced it is feasible. This usually requires a basic first year business plan and budget. We typically use the client produced business plan and budget to draft up the feasibility study (in Chinese) that will satisfy the requirements of the Chinese approval authority.

c. Leases: An agreement for all required leases must be provided. This includes office space lease and warehouse/factory space lease.   It is customary in China to pay rent one year in advance and this must be taken into account in planning a budget because the governmental authorities will be expecting this.

d. Proposed personnel salary and benefit budget. If the specific people who will work for the company have not yet been identified, one must specify the positions and proposed salaries/benefit package. Benefits for employees in China typically range from 32% to 42% of the employee base salary, depending on the location of the business. Foreign employers are held to a strict standard in paying these benefit amounts. The required initial investment includes an amount sufficient to pay salaries for a reasonable period of time during the start up phase of the Chinese company.

e. Any other documentation required for the specific business proposed. The more complex the project, the more documentation that will be required.

All of the above documents must be prepared in Chinese.

4. It usually takes two to five months for governmental approval, depending on the location of the project and its size and scope. Large cities like Shanghai tend to be slower than smaller cities. The investor must pay various incorporation fees, which fees vary depending on the location, the amount of registered capital and any special licenses required for the specific project. Typically, these fees equal a little over 1% of the initial capital.

On large and/or complex projects, the approval process often involves extensive negotiations with various regulatory authorities whose approval is required. For example, a large factory may have serious land use or environmental issues. Thus, the time frame for approval of incorporation is never certain. It depends on the type of project and the location. Foreign investors must be prepared for this uncertainty from the outset.

Tomorrow's post will discuss a WFOE's minimum capital requirements. 

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