China WFOE Closures Are Increasing
China WFOE closures/shutdowns are rising due to China’s economic slowdown, its deteriorating relations with the rest of the world, and the difficulty and risks of sending people to China.
There is an old saying about how lawyers do well in good times and in bad times, just not in times when not much is changing. What is happening in China bears this out for our law firm. In the last few years our law firm has seen a massive uptick in work related to shutting down China businesses, litigating disputes against (and even sometimes for) Chinese companies, and helping companies move their manufacturing from China to other countries, especially Mexico.
On the flip side, our China WFOE formation business is way down, as is our drafting of China employment contracts. Few foreign companies want to go deep into China right now and few are hiring new employees. At the same time, our China employment lawyers are doing a bang-up business helping foreign companies reduce their China employment rolls, which as you might imagine, is not terribly popular with Chinese government officials right now.
With respect to WFOE closures, we are also seeing a big increase in closures of China WFOEs that have insufficient funds (in China) to continue their business activities. These WFOEs often have to shut down suddenly, leaving numerous unpaid debts. We have received a number of calls from worried general managers and directors concerning their personal liability in these situations. Just as a quick aside, these calls create all sorts of potential conflict of interest issues in that the interests of the foreign company looking to shut down its China WFOE often diverge from those of its general managers and directors, particularly those general managers and directors based in China and wanting to remain in China.
I will describe the normal China WFOE closure scenario below, followed by the usual questions we get and the answers we give, based on Chinese law as well as the realities on the ground in China.
1. The Typical China WFOE Closure 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 five 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’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 China 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 in salary to workers, plus severance to workers if their employment is terminated.
- Debt to suppliers and rent to landlord.
- China taxes, which nearly always mysteriously seem to greatly increase for foreign companies looking to leave China.
The WFOE will never be able to repay these amounts because it is operating at a substantial loss and its foreign shareholder is no longer willing to fund it.
2. The FAQs on China WFOE Closure Laws and Personal Liabilities
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 not legally liable for the debts of the WFOE.
Question: What personal liabilities might the representative director face stemming from the WFOE closure?
Answer: The representative director is also not liable for the debts of the WFOE. 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 not 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 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 China WFOE closure? 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 another organization in China because, as discussed above, personal liability is not 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 after having been associated with a China WFOE closure?
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 intentionally 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 after having been associated with a China WFOE closure? 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 employee salaries in China and that the general manager and legal representative can be found guilty of this crime. Is this true?
Answer: It is a crime for the “responsible persons” in a company to fail to pay employees when funds for such payment are available. It is generally not a crime to fail to pay workers due to insolvency, as described in the scenario we are discussing.
3. The Realities on the Ground are Not So Sanguine
The above analysis is based on China’s written law. With respect to future employment and future investment, we have heard a few stories of general managers and directors not being able to find future employment in China that they attribute to their prior work with the failed WFOE. We also have heard stories of investors having had subsequent WFOE applications rejected. But we have never been able to conclusively say that the general managers and directors became unemployable due to their previous time with a failed WFOE. Because our law firm has never had a WFOE application rejected for any reason, we have also never seen a WFOE application be rejected because of an investor’s prior WFOE shutdown.
On the issue of payments to employees and creditors of the WFOE, the situation on the ground is more complex. China is a rough place and in the real world, you must consider the following :
1. Many local CHINESE governments do not care about the written law. They are far more concerned about payment of employees and taxes. When WFOEs fail and leave these debts unpaid, the local government oftentimes will apply strong pressure on any locally based foreign staff to try to force payment. This can involve threats of sanctions against the locally based foreign staff, regardless of their status in the WFOE.
Though not legally based, you should take these threats seriously and your locally based foreign staff should 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 Chinese cities. I urge you to read Meng Wenzhou, the Two Michaels and China Hostage Taking: What YOU Need to Know.
2. The more serious threat is that your Chinese creditors will take matters into their own hands and threaten to or commit violent acts against your company staff and company property in an attempt to force payment. This usually involves taking staff hostage or wholesale destruction of company property. See Commercial Hostages in International Business Disputes. For this reason, we often recommend foreign staff leave China (or at least the local area) as soon as possible if payments to employees or local vendors will not be made.
Though Chinese law provides certain protections for WFOE directors and legal representatives against liabilities to shareholders and the company, it’s crucial to be aware of the heightened risks associated with third-party liabilities. This includes responsibilities towards employees, public safety, and environmental regulations. The distinct legal framework in China, especially in comparison to that in the West, necessitates a thorough understanding and careful navigation to mitigate potential legal pitfalls. It’s important for potential legal representatives to be fully informed and seek comprehensive legal counsel before assuming such roles. It’s even more important that they have legal counsel when their WFOE is being shut down.
