Whenever China’s economy starts to decline, our China lawyers start to see problems with foreign company formations.
One of the things my law firm’s China lawyers are always saying and seeing is how China is constantly getting more legalistic, especially with foreign companies doing business in China. And yet, too many foreign companies — for all sorts of different reasons — fail to take action to stay ahead of China’s increasing legalization.
Forming a China company is a prime example of this, both with WFOEs and Joint Ventures. What usually causes the problem to bubble to the surface is different as between a WFOE and a Joint Venture, but what caused the problem in the first place is nearly always the same: the foreign company trusted what was happening with its China company formation, without doing any verifying.
1. The WFOE Problem
The WFOE problem is a somewhat simple one. The foreign company believes it has formed a WFOE in China (oftentimes a long time ago) and so it thinks it is operating completely legally in China now. The foreign company typically then has a problem with its most important China “employee” and it wants to terminate that employee. The first thing our China employment lawyers do in this sort of situation is look at the official records on the China WFOE to get a better handle on the employee’s authority at the company.
Sometimes we discover that the WFOE that was formed has nothing in common with the WFOE that exists. My favorite example of this was a company that had a sock production WFOE in Wuxi and it was a baking business in Shenzhen. Don’t even ask how this happened but it did and it meant that it was not operating legally. Sometimes we discover there is no WFOE at all. My favorite story on this is a company that learned its $100,000 a year China director (this was a long time ago) owned an $8 million condo in Hong Kong. Further investigation revealed that this company with about 3,000 China employees did not even exist in China and had never paid any taxes. It was by cutting out such things that the China director had managed to embezzle millions without anyone noticing.
When we see issues like those mentioned above, the primary legal issue ceases being about terminating the employee; it becomes about determining what makes sense in light of a messed-up China situation and the company’s present-day China goals. You cannot terminate an employee from a company that does not exist and it is ill-advised to terminate an employee from a company that is operating completely illegally.
2. How do companies get to this point?
What leads a company to believe it had a China WFOE when it didn’t? Most of the time, the fatal mistake was trusting the person the company now wishes to terminate. That person claimed to have formed a WFOE for the foreign company but never did. Maybe he or she formed a Chinese domestic corporation he or she owns. Or maybe this person never formed any Chinese entity at all. In any event, the foreign company paid this person believing the money would go to form a WFOE. Virtually always, the company then paid more money to this person believing that money would go to pay rent, personnel, taxes and other business expenses. Probably some of the money went to these things, but it is likely a good chunk of it went straight into the pockets of the person who lied about having formed the WFOE.
3. The Joint Venture Problem. Same but different.
This is really two different problems. One, the non-existent Joint Venture, which is very similar to the WFOE problem, but usually more complicated. The putative JV partner was put in charge of forming a China Joint Venture and it either never formed any company at all or it formed a company in Hong Kong or even the United States that the foreign company believed to be a China Joint Venture but it wasn’t.
The foreign company thinks the Hong Kong or US company owns a company in China and that this corporate structure is itself a China Joint Venture. It isn’t and the China entity into which the foreign company ends up pouring time and money and technology has no ownership by the foreign company. The foreign company usually reaches out to our China lawyers when it becomes concerned about never having received any money from its Joint Venture or when the Joint Venture has gone completely silent. See China Scam Week, Part 6: The Fake Joint Venture. We then look for the registration of the China joint venture and there is none.
We also often see instances where the foreign company trusted its Chinese Joint Venture partner to prepare the necessary Joint Venture documents and now that there is a problem, we as their lawyers discover that thos documents were written to favor the Chinese side so completely there is nothing the foreign company can do but leave the joint venture. See China Joint Ventures: The Tide is Out.
4. How do a companies get to this point?
Foreign companies get to this point with China joint ventures by never verifying the terms of the Joint Venture. Some wrongly believed the Chinese lawyer who drafted the Joint Venture agreements was acting on their behalf or as neutral, but this is almost never the case. See China Joint Ventures: A Warning.
Do you have a Chinese company? Are you sure? With China starting to crack down again on foreign companies, now is the time for you to double-check on this.