By: Steve Dickinson

The economic slowdown in North America and Europe has left many WFOEs in China with insufficient funds to continue their business activities. These WFOEs often have to suddenly shut down, leaving numerous unpaid debts. We have received a number of calls from worried general managers and directors concerning their personal liability in these situations.

I will describe the normal scenario below, followed by the usual questions and the answer under Chinese law.

The story:

1. A WFOE is owned by a U.S. or European shareholder. The WFOE is engaged in small-scale manufacturing. The WFOE has 100 Chinese employees and numerous Chinese suppliers.

2. The WFOE has been in business for 3 years. The WFOE has never made a profit in China. The shareholder has been required to make repeated cash payments to the WFOE to cover the WFOE’s salary and other expenses.

3. The foreign shareholder suffers a financial setback. The foreign shareholder files for bankruptcy or the shareholder’s bank shuts down all loans or the shareholder’s investors refuse to make additional capital contributions to the WFOE. As a result, the shareholder cuts off all funds to the WFOE. The cash flow of the WFOE is not sufficient to cover the requirements of the WFOE.

4. The China based management of the WFOE is unprepared for the cut off in funds. The WFOE owes:

  • One month or more salary to workers plus severance owed to workers if their employment is terminated.
  • Debt to suppliers and rent to landlord.
  • Taxes.

The WFOE will never be able to repay these amounts because it is operating at a substantial loss and its shareholder will no longer cover it.

The questions:

We are then contacted by the China resident general manager/representative director/shareholder of the WFOE with the following questions:

Question: What is the personal liability of the foreign national general manager?

Answer: The general manager is simply an employee of the WFOE. A general manger is under no circumstances legally liable for the debts of the WFOE.

Question: What is the personal liability of the representative director?

Answer: The representative director is not liable for any of the debts of the WFOE either. The answer here is somewhat complex. The official interpretation of the PRC Company Law, issued by the PRC Supreme Court (最高人民法院关于适用《中华人民共和国公司法》若干问题的规定(二) Articles 18/19), is that a director of a limited liability company (有限责任公司) is never liable for the debts of a limited liability company. Only the shareholder is liable. But the shareholder is liable only in the case of intentional fraud designed to divert funds to harm creditors. Note that for companies delimited by shares (股份有限公司), the directors can be held liable, but only in the case of affirmative fraud. WFOEs are limited liability companies, so this provision does not apply. Note that this relief from liability for directors applies to all directors, without distinction as to whether or not the director is the legal representative of the WFOE.

Question: What is the effect for the general manager, legal representative or the directors if they want to obtain employment at a different WFOE in China after the failure of the WFOE discussed above? What is the effect if they want to be the director of a different WFOE in China?

Answer: Legally, there is no effect. Such persons are free to take up employment in any other organization located in China because, as discussed above, no personal liability of any kind is imposed on these persons.

Question: What is the effect for the general manager, legal representative or the directors if they want to act as shareholders in a different WFOE in China?

Answer: There is no effect. However, if the general manager, director or shareholder have been involved in a bankruptcy where it was determined that the bankruptcy occurred because of their intentional fraudulent actions, such persons will be prevented from acting as a director or general manager for three years.

Question: What is the effect for the shareholder of the failed WFOE if it wants to make an investment to form a different WFOE in China? We have been told that such a shareholder will be prevented from making a new investment. Is this true?

Answer: There is no legal restriction for a shareholder to form a new WFOE when that shareholder has been an investor in a previously failed WFOE.

Question: We have been told that it is a crime to fail to pay the salaries of employees in China and that the general manager and legal representative can be held liable for such crime. Is this true?

Answer: It is a crime for the “responsible persons” in a company to fail to pay workers when funds for such payment are available. It is not a crime to fail to pay workers due to insolvency, as described in the scenario we are discussing.

The analysis above is based on China’s written law. With respect to future employment and future investment, we have not personally encountered this kind of blackballing in China. We have heard a number of stories about this having occurred, but we have not been able to verify any of them.

On the issue of payments to employees and creditors of the WFOE, the situation is more complex. China is a rough place. Out in the real world, there are two problems to consider:

1. Many local governments do not care about the written law. Local governments are particularly concerned about payment of employees and payment of taxes. Where WFOEs fail and these amounts remain unpaid, the local government oftentimes will apply strong pressure on any locally based foreign staff to try to force payment. This can involve various threats of sanctions against the locally based foreign staff, regardless of their status in the WFOE. These threats, though not legally based, should be taken very seriously. For this reason, we recommend that when this kind of problem occurs, locally based foreign staff leave China (or at least the local area) as quickly as possible.  We have had to deal with this sort of situation many times, particularly in third and fourth tier cities.

2. The more serious threat in China is that Chinese creditors fully understand that locally based staff are not liable for the debts of the WFOE. They also understand that as a limited liability company, the shareholder is also not liable for payment of the debts of the WFOE. They also understand that WFOEs want to protect their staff and the remaining company assets and records. They therefore take matters into their own hands and threaten to or commit various violent acts against company staff and company property in an attempt to force payment. This usually involves taking staff hostage or wholesale destruction of company property. In many locations in China, government authorities and police will do little or nothing to prevent such violent acts. Again, for this reason, we recommend that staff leave China (or at least the local area) as soon as possible when it appears that there will it will be impossible to make payments to employees or local vendors. This kind of situation can get out of hand very quickly in China and this sort of situation is not at all rare, depending in large part on the locale.

What have you seen out there?