Basics of China Business Law

China expat employment contracts
China expat employment contracts: make ’em real

If you are an expat working or seeking a job in China, your China employment contract really matters. Let me be clear. Your final executed China employment contract really really matters and if you plan to travel all the way to China to take a new job there, or even just take a new job there, you should do all of the following

  • Have your proposed employment contract checked by a China employment lawyer to make sure it fully protects you and includes EVERYTHING you need or want to be included. Oh, and please do this before you sign it, not after.
  • Make sure the final version of your contract is the same version as your approved version and make sure gets fully executed by both parties: On the employer side, this means it should have the signature of your employer’s legal representative and your employer’s company chop or seal;
  • Hold on to one original of the fully executed employment contract for your records. Please.

In China, it is fairly common for employers to deliver an offer letter to a potential employee stating the employer’s intent to enter into an employment relationship with that employee. When delivered to an expat, this offer letter is virtually always in English. Most expats check this document carefully but far too many stop there, believing their acceptance of this offer letter fully “covers” them. It doesn’t and if this is all you have, you pretty much have nothing at all. Others, realizing this, ask for a full-on contract but then get that in just Chinese and then just assume it includes everything set out in their offer letter. If you are someone who believes that, you obviously have not been reading this blog long enough. This assumption goes astray pretty much every time for one of two reasons: (1) the final employment contract does not include everything from the signed offer letter, or (2) the Chinese in the contract does not match the English in the offer letter (or even in the contract itself). And let me tell you, when there is this disconnect it favors the employer 99.9% of the time.

You would be surprised (or maybe not) how often we see the following when it comes to China expat employment contracts:

  • The expat’s employment agreement never was executed. This may work in your favor in that you may (but not always!) be able to collect damages as a result of the employer’s failure to enter into a written employment contract. On the other hand, it can also work against you in that none of the benefits you negotiated with the employer are in writing.
  • The expat’s final executed contract contained NOTHING to which the parties agreed in their negotiations. This may happen for a couple of reasons. First, the employer has to submit a completely different form to the local labor authorities to secure a work visa for the expat and the employer does not bother to explain this to the expat when he or she signs such submitted form. The employer never got the expat to execute the “real” contract, perhaps because they were sloppy or disorganized or the people in charge of it did not care. Second, the employer intentionally cheated the expat by having the expat sign a completely one-sided contract (favoring the employer, of course) even though the parties had agreed on a different set of terms. There may be other reasons, but in our experience, these two are by far the most common.
  • The expat agreed to sign a fake contract knowing the real deal was not on paper. In this situation, the paper was for “official purposes only,” but not necessarily for securing a work visa. For example, it may have been intended to show the tax authorities that the expat is making a much lower amount than orally agreed. This is done to lower everyone’s tax burden and the plan is for the employer to make up the difference in cash or by some other illegal means.

Now imagine you get into a dispute with your employer regarding your salary or your bonus and there is no enforceable written agreement of any kind that supports your claim. You should assume (though even this to a certain extent can depend on your locale) that you will be held to a higher standard because you are a high-level expat, not an “ordinary” Chinese employee and the odds are overwhelming that you will lose.

And though you’ve probably heard this dozens of times, but when your Chinese counterpart assures you “mei wen ti” (no problem), there usually will be plenty of problems and it will be you who will be the recipient of them. Rest assured, if your China employer tells you it is no problem that you have a fake agreement, there you WILL have a problem.

Last but not least, if you do have a well-crafted employment contract that has been executed by both you and your employer, you should make sure any amendments to that contract are done by signed and chopped writings as well; not verbally or by WeChat or email.

Bottom line: Check your offer letter. Check your proposed employment contract. And check your final, to-be-executed employment contract, and make sure it gets fully executed.

China and Hong Kong legal systems
For commercial law purposes, think of Hong Kong as a different jurisdiction from the Mainland

In an effort to reduce the challenge of manufacturing in Mainland China, many foreign companies decide not to go direct. They instead make use of intermediary companies that act as the sellers in the transaction. These intermediaries deal with the buyer, but the messy business of manufacturing is done in the PRC. These intermediary companies are often located in Hong Kong. We have seen that most foreign buyers do not understand the risks involved in dealing with Hong Kong companies and this too often causes them to unknowingly take on significant risks. One of those significant risks arises in the area of intellectual property protection.

From the standpoint of legal jurisdiction, Hong Kong and the PRC are two entirely different countries. The most important result of this legal distinction is that foreign investment in the PRC by Hong Kong companies and individuals is restricted in the same way it is restricted for American and European and Australian companies. This means Hong Kong companies cannot operate directly in the PRC. To operate legally in the PRC, a Hong Kong company must form a WFOE or an Equity Joint Venture, in the same way as for any other foreign entity. See How to Form a WFOE in China, Part 3: What’s Hong Kong Got to Do With It?

What does this mean in the manufacturing setting? The foreign buyer enters that enters into a contract with a Hong Kong company is (999 times out of 1000) not entering into a contract with the actual manufacturer because the actual manufacturer is a company located in the PRC. The actual manufacturer is a legal entity entirely separate from the Hong Kong company. To make this clear, in the manufacturing contracts drafted by the China lawyers at my firm, we call the Hong Kong company the “Seller” and the PRC manufacturer the “Factory.”

Now consider what all of this means from the standpoint of intellectual property protection. The foreign buyer provides its proprietary design to the Hong Kong seller. Complicated molds embodying the proprietary design are fabricated. Extensive engineering and production design work is conducted to develop a working product prototype. But, none of this work is done by the Hong Kong-based Seller because all of this work is being done by the factory in the PRC. This work is almost always being done by entities unknown to the buyer and with which the buyer has no contractual relationship. The molds and tooling and product prototypes are physically located in the PRC.

The result is that the buyer has given away its most valuable intellectual property to persons and entities it both does not know and cannot control. So what happens if something goes wrong? What happens if the buyer wants access to the molds to transfer production to another factory. What happens if the buyer learns the molds are being used to make “knock off” products? What happens if the buyer learns the product prototype is being used in the PRC to manufacture a competing product? These are not trivial questions as these things happen every single day in the PRC. The answer is that the buyer has no recourse at all in the PRC. The only legal action the buyer can take is against the Seller in Hong Kong. In the intellectual property area, this means the only thing the buyer can do is to sue for damages. The buyer can take no direct action against the infringer nor does it usually have any good legal basis to prevent the infringement happening in the PRC.

Now add to this that in most cases (at least most instances — by far — where companies have retained my law firm to investigate the above sort of situations), the Hong Kong Seller has no real assets. The Seller is no more than a small office with a phone and computer and sometimes a small sales staff. All the productive assets are located in the PRC, in the hands of companies and individuals with no direct legal relationship to the Hong Kong entity. Cash received by the Hong Kong entity is regularly swept into separate accounts with no direct relationship to the Hong Kong entity. In litigation terms, the Hong Kong entity is judgement proof.

What this all means is that the foreign buyer has essentially given away its intellectual property. The intellectual property is in the hands of a company in China and nothing can be done in China if the intellectual property is misused in some way. For physical items like molds, tooling, and prototypes, the items are gone forever. The PRC entity may refuse to return the items. The PRC entity may pass the items on to its subcontractors, who then further pass the items on to a subcontractor or family friend. In the end, it is not unusual to find that no one knows the ultimate fate of the items. But what is known is that the items are located in the PRC and the buyer has no legal recourse in the PRC. The buyer has nothing more than a claim for monetary damages against a Hong Kong entity likely to be judgment proof.

A foreign buyer that fully understands the risks may make the business decision to incur the risk. However, in our own work in Asia, we pretty much never encounter U.S. or European buyers that understand the situation. Most simply assume that when they contract with a Hong Kong entity, their legal situation is no different than if they were contracting with a PRC entity. They have already decided to incur the risk of manufacturing in the PRC and they see working with a Hong Kong entity as a way to reduce that risk, not increase it. They assume the Hong Kong entity will be easier to communicate with and that because Hong Kong’s legal system is better, they and their IP will be better protected this way.

But in reality, the foreign buyer has not reduced its risk. It has instead dramatically increased it. If the increase in risk is intended, that is part of the commercial calculation. But when the increase in risk is based on a fundamentally incorrect understanding of the law and the facts, it is nothing more than a mistake.

For more on why it is important to distinguish Mainland China from Hong Kong, check out the following:

Negotiating China contracts
Negotiating contracts with Chinese companies

When negotiating a contract with a Chinese party, firm deadlines are essential, but also dangerous. They are dangerous because many (most?) Chinese companies have mastered the technique of manipulating deadlines to their advantage.

There are many reasons to set a deadline for concluding a contract with a Chinese party. In any deal where the Chinese side will be required to make a payment, such as the purchase of an offshore asset, the Chinese side will tend to delay making a final decision. Setting a tight contract deadline controls this tendency. On the other hand, when the money is flowing in the other direction, the Chinese side will often impose an artificial deadline unrelated to the deal. In my experience, the most common is for the Chinese company to assert that the deal must be done on a specific date because a public signing ceremony has already been scheduled.

If you are negotiating with a Chinese company that has set a deadline for completion, you need to be prepared to deal with what is now the fairly standard Chinese program for manipulating contract deadlines. Without regard to who set the deadline and without regard to why the deadline has been set, you must be willing to simply walk away from the deal if all of the terms and all of the drafting is not complete on the deadline date. If you are not willing to simply walk, then you will be manipulated by the Chinese side.

The standard program Chinese companies use for manipulating a deadline usually works in three stages, as follows:

Stage One: The first draft of the contract is always submitted by the foreign party. The Chinese company never provides the first draft because that would require they “tip their hand.” The foreign party works overtime on a tight timeline and provides its draft thirty days before the deadline. This is done under the assumption that thirty days is sufficient to work out all the deal issues and arrive at a final draft agreement on the deadline date.

The foreign party hears nothing, not even an acknowledgment of receipt. This causes concern and after three or four days the foreign party asks the Chinese side about receipt and comments. The Chinese side responds that it did a quick review and everything looks okay. The foreign party is relieved and begins preparing to implement the project on the terms stated in the draft contract.

Stage Two: Seven or so days before the deadline, the Chinese side finally sends its comments on the draft agreement. At this stage, the Chinese side proposes two or three changes. However, these changes are designed to make the contract completely unenforceable against the Chinese side. Here are my three current favorites:

1.  The key to the contract is that the obligations provided in the contract are absolutely binding on the Chinese party for a period of three to five years. The Chinese side makes no revision to the 35-page contract. Instead, they insert a single article that provides that the Chinese side can terminate the contract at will on 30-days notice.

When challenged, the Chinese side claims mutual termination is common in international contracts.

2.  The Chinese side adds what it calls a force majeure provision. The standard force majeure provision provides that neither side can be compelled to perform in situations where performance is impossible due to matters outside the control of that party: war, strike, typhoon, earthquake. The key to a standard force majeure provision is that neither party is required to perform. If the force majeure condition continues, the affected party is required to return the matter to the pre-contract status quo.

The Chinese provision is always written in a way that stands the standard force majeure provision upside down. In the Chinese version, the Chinese side is concerned only with the actions of the Chinese government. The Chinese force majeure provision will provide that if the Chinese government or its agents (foreign exchange bank) makes performance by the Chinese side impossible, the Chinese side is not obligated to perform. But the foreign party is still obligated to perform and the Chinese side is not obligated to return the matter to its pre-contract status quo.

When challenged, the Chinese side replies: force majeure provisions are standard in international contracts.

3.  In the critical provisions of the contract, in every place where it says “the Chinese party shall be obligated to do” the contract is revised to say “shall not be obligated to.” This is usually done where the revisions are not redlined or otherwise identified in a cover memorandum. The added word is only located after careful review of the contact. The longer and more detailed the contract, the more difficult it is to find this kind of revision.

When challenged, the Chinese side replies: we only inserted one word. What is your problem with that?

When the foreign side objects, the Chinese side will complain that the foreign side is being unreasonable. If well advised the foreign side will hold the line and refuse to agree to revisions like these that will essentially render the contract meaningless. The Chinese side then agrees to back down and the foreign side then feels relieved, assuming the agreement as drafted will be executed on or before the deadline. The unsuspecting foreign party does not realize that the opposite will almost certainly happen, leading to stage three.

Stage Three: Two to four days before the deadline, the Chinese side returns the contract with extensive revisions throughout the entire document, usually with no redline of the revisions. Some Chinese parties will redline some but fail to redline others. No explanation is ever given for the large number of revisions. No explanation is ever given for why these revisions were provided so close before the deadline when it is clear the Chinese side was aware of the issues weeks earlier when the draft was first provided to it.

Most foreign parties at this stage fall directly into the trap laid by the Chinese side since day one The foreign party works desperately to revise the document in the face of the by now ridiculously short deadline. In this setting, the Chinese side is hoping two things will happen. First, the foreign side will make concessions just to get the document signed. Second. the foreign side will make drafting mistakes due to the short timeline and the need to work in two or more languages. The Chinese side will then ruthlessly take advantage of those mistakes at a later date.

It is always a mistake to fall into the deadline trap. The better response is to realize from the start that the deadline is not relevant to the Chinese side. The Chinese side is merely using the deadline as a tool to gain an advantage over you. The first step when faced with this trap is to refuse to make the revisions and execute the agreement under this time pressure. Instead, tell the Chinese side that since they are the ones who responded late, you view their response as a contract rejection and for this reason, the deal is off.

Then simply walk away. Do not propose a new deadline. If you propose a new deadline, the Chinese side will go through exactly the same steps (as above) in almost exactly the same way. The only useful course of action is to tell the Chinese side that if it is still interested in doing the deal it should come back with a reasonable set of proposals and if we are still interested, we will take a look. But, since the deadline has passed, we may never come back to you. It is your risk.

In that situation, some Chinese parties will simply capitulate and come back with a reasonable set of proposals quite soon, often within one week. However, the most common response is that the Chinese side will continue to act in a manner designed to force the foreign party into making an unreasonable concession or a mistake. The only way to prevent that is to treat the deadline as a hard date and to walk away when the Chinese side is unreasonable.

It is impossible to predict what the Chinese side will do when you walk away. The Chinese side is not using this three-stage technique because it is inexperienced. The opposite is true. These entities are very experienced and they have learned that the deadline manipulation technique works very well. The only appropriate response from the foreign side is to call the bluff by walking away. But like a poker game with a stranger, you never know what will happen when you call the bluff. The response from the Chinese side is entirely unpredictable.

Be prepared.

China employment lawyersLast week, in Terminating a China Employee: Why Mutual Termination is so Often the Key, I wrote of how getting your China employee to agree to a mutual termination (with a settlement agreement) greatly minimizes employer risk. But sometimes, a mutual termination is not possible. Though China is not an employment-at-will jurisdiction, its laws do permit employers to unilaterally terminate a China employee that has committed a serious breach of the employer’s rules and regulations.

If you are going to unilaterally terminate an employee for violating your rules and regulations, it is important your rules and regulations have written provisions explicitly justifying the termination. And just moving a list of forbidden behaviors from your oversees employee handbook to your China employer rules and regulations rarely cuts it.

Suppose your employee does X and you think X is terrible and you now want to terminate that employee. You check your rules and regulations and X is listed as a basis for termination and so you terminate the employee. The employee then sues you for unlawful termination.

Let me digress a minute to discuss something our China lawyers are getting more often these days, especially on the employment law front. As China’s laws get more complicated, our China attorneys are getting more calls from companies contacting that have been sued or are being threatened with lawsuits. They are calling for our help because they “did exactly what we told them to do on China Law Blog,” and so they believe we can easily win these lawsuits for them. Sadly, they are nearly always mistaken. They failed to realize that the information we provide on this blog is information; it is not legal advice specific to their situation and it is the “specific to your situation” part that matters most. On the employment front, the applicable laws will vary depending on the size of your company, the type of employees at issue, the exact language (in Chinese) in your employment contracts and in your rules and regulations, your location, and potentially a hundred other things as well. See China Employment Law: Local and Not So Simple. Our goal with this blog is NOT to tell you exactly how to do things in your specific situation, but rather to alert you to various key issues so you can know when you need to seek out proper help for dealing with them.

This advice is particularly true with China contracts and legal documents, including your employer rules and regulations. My law firm has been drafting China contracts for so long that we — and I am not kidding about this — have at least twice been contacted by companies given one of our contracts by “friends” and now want us to help them deal with their Chinese counterpart that has “breached” the contract. Interestingly, in both instances, the contracts were so far off the mark for what these two companies needed that we declined to help them as we thought it would be pointless. In China Contract Templates: the Cons and the Cons, we wrote about why any contract not tailored to your specific situation is a really bad idea:

We don’t use “templates” for our agreements. After a lot of analysis, IF we find what the foreign buyer is trying to do fits into a pattern from a previous transaction, then we will, of course, use an agreement from a previous transaction as a model. But even in the most basic transactions, what we do is to customize it for the current transaction.

In drafting pretty much any contract for China there are literally dozens of variables that can, in turn, be combined in a nearly infinite number of configurations. So the final contract from one transaction may have no application to any other transaction. This is why providing a contract from a past transaction will have no benefit to the Western side and would likely only harm it.

As you note, our clients also need at least one of our China lawyers involved in dealing with the Chinese response. Did the Chinese side change the Chinese and not the English as they so often do? Did they redline in a way that the changes to the Chinese portion are even apparent? More important is whether their changes are the normal technical changes that are part of normal business practice (45 days to deliver a product instead of 30 days) or are their changes destructive to the whole approach, such as: “no, you do not own the technology, we do.” Or, “no, we won’t provide any warranty at all.” Or, “no, we own the molds, not you.” I do not see how anyone without a deep understanding of Chinese law and Chinese business could even begin to deal with these sorts things.

In drafting our contracts, we do of course usually pull some language from other contracts, such as confidential information language. However, the core agreement is almost always completely unique to the specific client before us and when we do use prior language, we nearly always revise it to customize it for the specific client and the specific transaction.

From our having written thousands of China agreements we know there are certain issues that need to be resolved pretty much every time. So we work with our clients to identify those issues and then we work them on how they want to deal with those issues and then we put the agreement together to achieve the goals our client has told us it has. Of course, for some of these components, we use as a base some of the language that has worked in the past in China. This is the benefit of working with us: we know what works and we know what fails. But the resulting contract in each case is unique.

So in that sense, there is no template. There is just decades of experience in drafting agreements for doing business in China or for doing business with China. This is why whenever someone asks me to send them a “template” agreement I tell them I cannot because I have no way to know which of the nearly infinite number of alternatives they should follow. How will they pick and choose from a dozen options for a relatively simple provision? What is unique about their situation? Will the most common solution we have used in the past even make sense for them? Does it make sense for their industry? Their business? Their product? Their location? What if the law has changed? What if the law changes two days after we start drafting?

I usually propose to each client three options for every important issue and I usually come up with those three from about a dozen possible. Say there are ten critical issues for their contract. Each selection of an option affects all of the other options, often in ways we have previously encountered. Before the client answers the questions, we don’t know even what structure to use. After they answer the questions, the agreement that meets all their needs does not exist.

It is also true that in-house counsel cannot write an agreement that can serve as a basis for what our client wants us to craft. Our approach to China contracts is based on three supports: 1) Decades of China experience, 2) A deep understanding of the Chinese civil law system and the Chinese court system, 3) A deep understanding of how contracts actually work in China. Any company with an in-house lawyer who combines all three does not need to come to us for a contract and they don’t. It is not helpful to us to have a common law contract [China is a civil law system] based on a highly idealized and impractical American/European practice that has no applicability or use in China.

Whether your employee termination was lawful is incredibly fact specific. Among other things, it depends on what the employee did. It also depends on exactly what your rules and regulations say (in Chinese) and how they say it. It also depends on where you are located as it is critical that your rules and regulations fully accord with the reality on the ground in your specific locale in China. If the rule on which you relied in terminating this employee is not reasonable for your locale, your termination likely will be deemed to have been unlawful. For example, your rules and regulations may say that your employees cannot date a supervisor and anyone who does so will be subject to immediate dismissal. This rule is unenforceable in most of China because China’s labor authorities and courts do not want employers restricting their employee’s freedom to date and marry. So even if your rules and regulations prohibit inter-office dating, your terminating an employee for dating probably will mean you will need to pay your employee damages and also immediately reinstate him or her.

We often see employers list grounds for termination in their rules and regulations that do not work in most China. For example, employers in China typically can only govern their employees’ behavior during work time. So though you as an employer can in most locales prohibit your employees from being a “WeChat merchant” during normal working hours, you typically cannot prohibit your employees from doing that in their spare time. Unless what an employee does in his or her personal time leads to criminal liability you typically cannot unilaterally terminate them for what happens outside the office.

Consider this hypothetical. You as an employer host an after-hours holiday party to celebrate the Chinese New Year. One of your employees attends after getting off work that day. This employee gets into an altercation with a supervisor and hits the supervisor. Your employee and your supervisor go to the police station and your supervisor decides not to press charges and no administrative or criminal charges are ever brought against your employee. You then fire the employee because you think what he did “checks the box” in your rules and regulations prohibiting any fighting at work.

How will this be resolved? In a real case in Beijing with similar facts, the employer lost. The court held that the holiday party did not count as work time and because the employee was never criminally charged the employer had no legal basis for the unilateral termination.

Bottom line: Without well-crafted rules and regulations that work for your specific business and your specific locale it is usually impossible to justify a unilateral employee termination.

China employment lawyer
For more on China employment law, go to Amazon and get my book!

As I have previously written, mutual termination is usually the safest path to take when you have chosen to terminate one of your China employees. This is because anything other than a mutual termination is fraught with risks because China is not an employment-at-will jurisdiction. Even unilaterally terminating an employee who has engaged in misconduct can be difficult. And things get even more difficult if the employee you wish to terminate has a special status (e.g., pregnancy). Though you generally can unilaterally terminate an employee for good cause (for example, the employee has committed a serious breach of your rules and regulations), grounds for termination of Chinese employees are highly circumscribed and that is what makes mutual terminations so appealing.

Consider the following situations:

  • Your employee did something terrible, but you don’t have a set of China-centric rules and regulations, so you basically have no written basis to terminate your employee;
  • Your employee did something bad, but not terrible enough to trigger termination under your own rules and regulations. Maybe it was her first offense and your document provides for “three strikes;”
  • Your employee did something bad and it was not her first time, but you have no good proof she did all those things in the past;
  • Your employee never signed an acknowledgment form confirming she received a copy of your rules and regulations.

Under any of the above circumstances, it is usually best not to pursue a unilateral termination, but instead, seek to work out a mutual termination. The below hypothetical should prove helpful.

Suppose you have an employee who makes a mistake at work without causing significant damage. Nonetheless, you think this mistake causes you to want to terminate the employee and so you issue a termination notice to the offending employee, citing the mistake as the basis for your termination. You give the employee a small severance payment and the two of you execute a settlement agreement. The severance amount is much lower than the minimum statutory severance and your by now ex-employee sues you, claiming it is an unlawful termination.

How will this case be resolved? In a real case based on similar facts, the employee lost on his unlawful termination claim. The court noted that it would have been too harsh for the employer to have unilaterally terminated the employee for a one-time mistake, but went on to hold that because there was an agreement where the employer paid the employee a severance in exchange for the employee’s voluntary departure, the termination was mutual. The court then held that the mere fact that the agreed severance amount was much lower than the minimum statutory minimum did not change the outcome because the employee failed to show that the settlement agreement was a result of coercion or deceit by the employer. Because the termination was mutual and because the employer-employee settlement agreement was sound, the court upheld the settlement agreement and ruled against the employee’s unlawful termination claim.

The employer prevailed because it signed an enforceable settlement agreement with the employee, in a circumstance where it would not have prevailed had it terminated the employee unilaterally. However, please do not emulate what this employer did. Had this employer actually paid its terminated employee more, it likely would have avoided the lawsuit and ended up paying considerably less overall. How much to pay a mutually terminated employee is one part art and one part science. When one of our China employment lawyers is called upon to craft a mutual termination settlement, we look at all sorts of factors in determining the just-right amount, including our own experience.

Bottom line: An enforceable AND reasonable mutual termination agreement will not only help you prevail in any lawsuit, it will go a long way towards preventing you from getting sued in the first place.

 

 

 

 

 

 

China WFOE Formation
China WFOE Formation. It’s complicated.

Yesterday, in the first part of this two-part series, I discussed how China is requiring foreign companies reveal all layers of WFOE ownership in the WFOE formation stage, I talked about how just as so many foreign companies are realizing the importance/necessity of forming a China WFOE, China has made it nearly impossible to form a WFOE without a full list of its owners. I first wrote about this issue in China’s New Foreign Investment Law: The “Actually Controlling Person” Requirement is Going to be Tough, but it is now at the point where the China lawyers at my firm are very clear with our clients who seek to retain us to help them form a China WFOE: you either reveal pretty much all owners of the WFOE-to-be (through the various layers of ownership) or your chances of getting a WFOE are not good. Clients unwilling or unable to make the required ownership disclosure in the exact form required by the PRC government authorities cannot proceed. There are no exceptions to the rule.

As noted in my earlier post, this is a threshold issue and this issue must be resolved before it makes sense to incur the time and expense required for aWFOE formation application.

China’s intent with this new [ownership disclosure] system is clear. The PRC government will no longer allow the use of special purpose vehicles and related entity structures to hide the actual ownership of the investors in PRC foreign-invested enterprises. And any attempt by a foreign investor to invoke a foreign law that allows secrecy with respect to ownership will [almost surely] be ignored. MOFCOM has plans to carefully audit all FIEs and that audit will include carefully reviewing their ownership structures. More important, however, is that a response that does not list out owners will simply not be accepted by the automated system. A response is therefore forced. A false response is a violation of law that can result in penalties and other legal/administrative action by the PRC government and its agencies.

Consider a typical private equity fund/venture capital type of ownership structure. The investor in the WFOE is Operating Company A. The owner of Operating Company A is a Holding Company B. Holding Company B is in turn owned by three private equity funds: Equity Funds C, D and E. The largest of the funds is owned by Equity Fund Z. As you can see, there are four layers of ownership.
For the MOFCOM information report, it is certain we will be required to disclose the following:
  • Operating Company A as the investor. This will require disclosing the officers and directors of Operating Company A.
  • Holding Company B is a 100% shareholder of Operating Company A. This will require we disclose Holding Company B, together with its officers and directors. We usually argue that Holding Company B is a “private equity fund”, and for that reason, we should not be required to disclose the shareholders of Holding Company B. Some MOFCOM offices will accept this argument. Some will not. Even if the local MOFCOM accepts, the higher level MOFCOM that does the later audit may not accept and then require all shareholders of Holding Company B be disclosed.
  • The local MOFCOM office may require disclosing the three shareholders of Holding Company B. If MOFCOM makes this demand, it will also require disclosing the directors and officers of Holding Company B. For the past several months, most MOFCOM offices have required this level of disclosure and foreign investors should plan on this disclosure being required.

The big question is whether MOFCOM will require moving up the chain to mandate disclosing the shareholders of the three shareholders in Holding Company B (Equity Funds C, D and E).  We have in the last few months been asked by various MOFCOMs for this level of disclosure, but we have so far been able to convince them that this should not be necessary. In one instance, we provided MOFCOM with an organization chart showing nearly 75 owners of an LLC (including many private equity funds) but ended up convincing it not to require our client disclose the names of these nearly 75 owners, as originally requested. When MOFCOM requests/requires this sort of disclosure, we normally argue that the C, D and E entities are “private equity funds” and disclosure of their ownership should not be required for the same reasons public company investors are not required to disclose their shareholders. Several local MOFCOM offices have recently tentatively accepted this argument, but this decision is not binding and the higher level of MOFCOM could demand more disclosure, either as part of the initial WFOE formation process or later as a result of their audit.

China has rejected shareholder secrecy and its requirement of full shareholder disclosure imposed on foreign investors is simply the consistent application of PRC law to all legal persons. The shareholder disclosure requirement is contrary to European and North American legal principles and on that basis many shareholders will refuse to consent to disclosure. However, under PRC law, there is no exemption. Moreover, as noted in Part One of this series, PRC local governments and MOFCOM offices are authorized to require even more sensitive private documents, such as the shareholders’ tax returns and tax returns of the WFOE’s foreign employees.
Bottom Line: If you are unwilling or even legally unable to comply with China’s ownership disclosure requirements you cannot proceed with a China WFOE formation. It is that simple and resistance is futile.
China Manufacturing Contracts
China WFOE Formation Ownership Disclosure: Like a Maze

Just as so many foreign companies are realizing the importance/necessity of forming a China WFOE, China has made it nearly impossible for a WFOE to be formed without a full list of its owners. I first wrote about this issue in China’s New Foreign Investment Law: The “Actually Controlling Person” Requirement is Going to be Tough, where I predicted what has now transpired.

It has reached the point now where we are very clear with our clients who hire us to help them form a China WFOE: either you reveal pretty much all owners of the WFOE-to-be (through the various layers of ownership) or the odds of your getting a WFOE are not good. Clients unwilling or unable to make the required ownership disclosure in the exact form required by the PRC government authorities cannot proceed. An Anti-Money Laundering Letter will be ignored and insisting on such a letter will only produce a hostile response. There are no exceptions to the rule.

This is a threshold issue and this issue must be resolved before it makes sense to incur the time and expense required for aWFOE formation application.

I provided the explanation for this in my earlier post:

China’s intent with this new [ownership disclosure] system is clear. The PRC government will no longer allow the use of special purpose vehicles and related entity structures to hide the actual ownership of the investors in PRC foreign-invested enterprises. And any attempt by a foreign investor to invoke a foreign law that allows secrecy with respect to ownership will [almost surely] be ignored. MOFCOM has plans to carefully audit all FIEs and that audit will include carefully reviewing their ownership structures. More important, however, is that a response that does not list out owners will simply not be accepted by the automated system. A response is therefore forced. A false response is a violation of law that can result in penalties and other legal/administrative action by the PRC government and its agencies.

Since I wrote that post, the China lawyers at my firm have found the local MOFCOM authorities are becoming even stricter about enforcing its WFOE ownership disclosure rules. The current trend is to require full disclosure all the way up the line of ownership. The only concession we have recently received is that some local governments will agree to end the disclosure at the level of what can be called a private equity or SICAR type fund. That is, some (not all) local MOFCOM offices will not require disclosing investors in private equity fund/SICAR type entities. However, other local MOFCOM offices DO require disclosure of private equity fund/SICAR investors.

There are though two levels of disclosure and getting past MOFCOM just means getting past the first level. The first disclosure is made in the information report provided to MOFCOM as part of the formation process. However, the new system includes an elaborate auditing process, so even if a local MOFCOM office allows for limited shareholder/ownership disclosure, an expanded disclosure may be required as a result of an audit. This is because the audit is done by a higher level office of MOFCOM. Such higher level offices are almost always stricter than the low-level offices.
So even if you are able to convince a local MOFCOM office to accept a limited disclosure of the shareholders of the investor, this is not a final decision. The initial MOFCOM decision can be overturned at any time and the demand for full disclosure can be made at any time. This demand would likely be made after your WFOE has started operations and if you then fail to comply with the demand your WFOE would be at great risk of being shut down.
Our European clients are usually the most taken aback by China’s new ownership disclosure requirements and we therefore often must spend extra time explaining the situation to those clients. Investor secrecy is at the heart of the European investment system. Most SICAR entities do not even disclose the identity of directors and officers. However, this form of secrecy has been rejected by the PRC government. For domestic companies that are not publicly listed entities, all shareholders are listed on publicly available websites. It is now possible to trace every PRC corporation up to the point of either a natural person shareholder or a public company shareholder. This is the system the PRC government intends to impose on foreign investors in China.
The investor disclosure requirement has become a fundamental policy in Chinese law. The PRC government fully understands that its policy of full investor disclosure is exactly opposite the investor secrecy systems standard in Europe and North America. Accordingly, any argument from a foreign investor that invokes European or international law is simply ignored as irrelevant. As noted above, as foreign entities have tried to resist fully disclosing their ownership, the PRC authorities have become more demanding, not less. We expect this trend to continue.
Note also that there are other disclosure risks, including the following:
  1. As part of the audit procedure, the PRC government may demand the tax returns of the disclosed shareholder(s) to confirm the accuracy of the reported information.
  2. It is nearly certain the PRC government will at some point require the WFOE provide three years of personal tax returns for each foreign individual employed by the WFOE.
  3. Other intrusive requests for what you likely will consider very private personal information may also be required during the life of the WFOE.
If you are not willing to provide the required information you should not move forward in trying to form a China WFOE because there is no way around these requirements. The PRC laws in this area are clear and the fact that those laws conflict with the laws and norms of Europe and North America is simply not relevant. What is relevant is that if you are not willing to comply with China’s ownership disclosure laws, you will not be permitted to set up and operate a WFOE in China.
As I wrote in my previous post, the “actual controlling person” requirement does not make legal sense under modern corporation structures, but the PRC government simply ignores this fundamental point. Thus, even after we do a full disclosure of all shareholders and thereby PROVE there is no single actually controlling person, the response of MOFCOM is to say: “You must identify the actual controlling person or we will not approve the investment.” Most local MOFCOM offices accept the name of the Chairman/CEO of the first level shareholder as the “actual controlling person.” Even that result though is not certain and there are two other possibilities:
  • The CEO/Chairman/Managing Director of the majority owning private equity fund or SICAR, no matter how far up the chain of ownership.
  • Endless requests for the name of the actual controlling person, when in fact there is no such person, making a response to the request impossible.
Our China attorneys have encountered all three of the above in our work on WFOEs during the period after the actual controlling person requirement was imposed. To date, there has been no consistency in the requirements.
In part 2 of this post, to come out tomorrow, I will discuss some of the specific situations we have encountered regarding ownership disclosure requirements when trying to register a China WFOE.
China lawyers and attorneys
China’s legal system has changed. Get used to it.

BREAKING NEWS: The China of today is different from the China of  1999. Okay, so you knew that, right? Are you sure? Just like you know your 22-year-old kid is now an adult but in your mind is still 14 or 15 years old? Have you really caught up with today’s China or do you at some level still view it as it was one or two decades ago? I ask these questions after reading a China Skinny article, entitled, Why is it Popular? Dolce & Gabbana’s Fail Uncovers Restored Chinese Pride? This article talks about a “recent Dolce & Gabbana ad campaign” that was not taken well by China’s netizens:

China’s netizens took to social media, condemning D&G for its apparent espousal of backward and racist associations with China. The overwhelming sentiment was that the China photographed perpetuated Western viewpoints of an underdeveloped, dirty and inferior land. The people wanted to know: why was their country still represented by tuk-tuk drivers and pudgy, awkward tourists? The photos had gone global, posted on D&G’s western media like Instagram and Facebook, and the people were mad.

The article goes on to explain why China’s citizens were justified in their views regarding the ads, by citing the following:

A short drive from the scene of the Beijing photos could take you to the site of a $2.1b A.I. research park to host 400 businesses and churn out $7.6b in annual output by 2023. The chair of the US Defense Innovation Advisory Board recently spoke plainly on the subject of the rise in China’s A.I. capabilities; “By 2020, they will have caught up. By 2025, they will be better than us. By 2030, they will dominate the industries of A.I.”

Or you could pop down to the Beihang University and its School of Astronautics and discuss China’s plans to have nuclear-powered space shuttles by 2040 which will “colonise the solar system.” These feats are just a drop in the ocean of advances which have driven China’s rise on the world stage and a fiercely proud population that no longer sees a reason to back down.

Good points.

The legal front is no different. Hardly a week goes by where one of my firm’s China lawyers does not have to explain to someone how much China has changed, usually involving one (sometimes more) of the following, along with my own typical quick response.

1. “I’ve heard that it’s fine to operate in China without having a China business [typically a WFOE or a Joint Venture] because they will never catch you or if they do you can usually get off just by paying the person $500.” My Response: Twenty years ago, maybe. Now, if you get caught doing business in China without you and your company (and even those who work for you in China) will be in big trouble. See Doing Business in China with Deportation or Worse Hanging Over Your Head. And note that going into China via Hong Kong hasn’t really worked in most situations for a decade. See A Hong Kong Company Is NOT a Mainland China Company and a Hong Kong Trademark is NOT a Mainland China Trademark. And paying bribes has always been a really bad idea for a whole host of reasons. See China Bribery. Not Smart and Not Necessary.

China AttorneysBecause of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that may provide some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

Companies frequently reach out to our Chinese lawyers regarding their desire to do a China joint venture and we often find ourselves suggesting they first do more to make sure there is a sufficient meeting of the minds with the Chinese company before paying lawyers to start drafting the necessary joint venture documents. Our clients then usually ask what they need to know to gain greater certainty. We also get similar questions based on our blog posts.

There is a Chinese saying that is often applied to joint ventures is “same bed, different dreams.” This Chinese saying (同床异梦) actually far predates joint ventures — it applies to any sort of partnership without a meeting of the minds. But it most certainly makes sense for joint ventures as we far too often see Western companies and Chinese companies rush into joint ventures without ever discussing their respective dreams.

Many years ago, a client about to fly to China to meet with a potential Chinese joint venture partner asked for our help in formulating questions to ask of the Chinese company to help determine whether to enter into the joint venture deal. We provided a list of issues to raise at that meeting, and have provided a similar list (honed a bit more each time) to subsequent clients facing the same situation. The goal of raising these issues is to determine whether the two companies share the same dreams, and whether the Chinese company is JV worthy. This list includes the following questions and it is what I send clients who ask me either what they should be discussing with their putative joint venture partner or even when they ask what makes a joint venture work or fail. The below are questions to which the answers will give you a good idea regarding whether your joint venture will work.

  • Why are you seeking to form a joint venture with us and what will be the goals of the joint venture?
  • What will you do for, and with, the joint venture?
  • What exactly do you plan for your company to be doing to advance the business of the joint venture and what exactly do you expect our company will be doing to advance the business of the joint venture?
  • Who will make business decisions for the joint venture, and what will mechanisms will we use for reaching a decision?
  • What will each of us be contributing to the joint venture? For instance: property, technology, intellectual property, money, know-how, and employees. If the joint venture loses money, who will be responsible for putting more money in?
  • How will we resolve disputes? China lawyers like to include provisions saying that we will work out any issues among ourselves and if that fails, we will arbitrate. The tougher question is: how will we deal with day to day disputes in a way so that the joint venture does not collapse?
  • Can either of us use confidential JV information for our own business? Can our own businesses compete with the JV? Can our own businesses do business with the JV?
  • How and when will the joint venture end? What if one of us wants to buy the other out?

Posing these questions puts China  joint venture dreams to the test.

For more on China joint ventures, check out Joint Venture Jeopardy and Avoiding Mistakes in China Joint Ventures

China Contracts That Work

Your enemy won’t do you no harm, ’cause you’ll know where he’s comin’ from; don’t let the handshake and the smile fool ya. Take my advice I’m only tryin’ to school ya. Smiling faces, Smiling Faces, Sometimes they don’t tell the truth.

             Smiling Faces Sometimes, by The Undisputed Truth

Not a month goes by without some company telling one of our China lawyers how great their relationship is with their Chinese counter-party, be it the Chinese company with which they are contemplating a joint venture or the Chinese company that manufactures their widgets.

As lawyers, our thoughts upon hearing this sort of thing tend to be as follows:

1. Great. Truly great. It is always better to have a good relationship with the companies with which you do business, be that company be in China or in Peoria. I am always saying that “we can draft the world’s best contract, but if it is with a crook, it won’t be worth the paper on which it is printed.” So yes, the character of those with whom you do business does matter. A lot.

2. But to us as lawyers, that you are friends with your Chinese counter-party or that you have a great relationship is legally irrelevant. We have been trained to ask the what ifs and the what ifs here are easy-peasy (sorry, but I just wrapped up season two of Stranger Things, which BTW, is every bit as good as season one).

The what ifs here are easy for us because we deal with them pretty much every day, usually in one of the following two situations:

  • The foreign company was wrong about its Chinese counter-party and their relationship with it. Or maybe they were right but the situation changed enough so that the relationship soured.
  • The existing ownership or management structure changed and the relationship changes with it.

Either way, we as lawyers can help a company having to deal with one of the above situations if they have written documents to protect them. And if they don’t, we typically can’t help them.

Contracts are generally written when the relationship among the contracting parties is good. There are three reasons why it makes sense to have a contract with your Chinese counter-party — even if your relationship with it is great:

1.  Clarity. The first is to achieve clarity. To make sure you and the Chinese company are on the same page. For example, if you ask your Chinese supplier if it can get you your product in 20 days, it will say “yes” pretty much every time. But if you put in your contract that the product needs to ship in 20 days AND for every day it is late, the Chinese company must pay you 10% of the value of the order, there is a great chance the Chinese company will get honest with you and tell you that 20 days is impossible. At that point, you and the Chinese company can figure out what is realistic and then you know what to expect, realistically, going forward. Needless to say, I can give countless examples of this sort of thing, but this is yet another reason why we advocate putting your contract in Chinese (and not just translated). Clarity before you start the relationship. It is more important than you think and it totally makes sense no matter how good your relationship may be.

2.  Stricture The second benefit of having a contract with your Chinese counter-party is that it will likely bring that company to heel. By this I mean that just having a well written contract that is at least potentially enforceable means that the Chinese company knows exactly what it must do to comply. And, in most cases, it might as well. Let’s use the 20 day example as the example here as well. If your Chinese manufacturer makes widgets for 25 foreign companies and 5 of those have very clear time deadlines with a very clear liquidated damages provision, and the Chinese company starts falling behind on production, to which companies will the Chinese manufacturer give production priority? Of course it will put the five companies with a good contract at the front of the line and that is relevant even if you have a good relationship. Or are you willing to go to the back of the line because your Chinese counter-party believes you are the safe one to delay because of your good relationship?

3.  Enforceability. You may at some point need to sue your “friend” and if you do it will help to have a China contract that works. And for those who do not  believe China is good with contracts, note that the World Bank ranks China 5th (yes 5) among 183  countries in terms of enforcing contracts.