Foreign Companies in China: What We are Seeing and Hearing NOW, Part 2

In yesterday’s post, Foreign Companies in China: What We are Seeing and Hearing NOW, we provided updates on what is happening in China relevant to foreign companies doing business in China or with China. The gist of that post was that many foreign companies that manufacture in China are leaving China, reducing their footprint in China, or looking to leave China or reduce their footprint there. Yet at the same time, foreign companies that sell products or services in China are forming WFOEs to go into China or if they are already there, they are growing their presence there, while at the same time, making sure they are operating legally.

We got a very interesting comment to that post, worthy of a full response:

If you actually have an increase in WOFE requests I have an FICE that I would be willing to sell cheap. My guess is all of my other friends who are leaving China with their businesses would be happy to sell theirs too. Most of them are just walking away though and not actually closing the business.

There are and will always be WFOEs in China looking to shut down and the number of these typically increases when times get difficult in China. The number of WFOEs closing during tough times is usually for a combination of two reasons: decreased economic opportunities and increasing compliance enforcement. In yesterday’s post I talked about how many of our clients are coming to us for what we call WFOE audits, which typically consist of our China lawyers doing some or all of the following:

  • Make sure their WFOE actually exists and is licensed to do what it is actually doing.
  • Make sure they have the proper entities and licenses to do business in every city in which it is doing business.
  • Make sure its trademarks and other IP have been filed in China.
  • Have us conduct an employer audit to make sure it is doing everything right on the employee side.
  • Make sure it is current with its taxes.
  • Review lease agreements.
  • Review contracts signed by the WFOE or by the parent company relating to China operations.
  • Due diligence on suppliers/manufacturers and distributors, retailers, and e-commerce platforms to make sure that those relationships do not violate home country (US or EU or Australian) laws and to make sure that those companies are financially sound.

If China is getting economically difficult for you and you are contemporaneously being hit with increasing regulations and increasing regulation enforcement, leaving is a logical choice and we are seeing that happening as well, but I forgot to mention that yesterday. Why did I forget to mention that? Because WFOEs leaving China is nothing new and we have not seen a massive uptick in that, with the possible exception of 1-2 person consulting WFOEs that had essentially stopped doing much if any business in China years ago. For the 101 on how to close a China WFOE, check out Shutting Down a China WFOE: Don’t Go There.

What about selling your WFOE rather than shutting it down? On the surface, this makes complete sense in that it allows you to make money by leaving China, rather than having to pay money to leave China. Unfortunately, for a whole host of reasons, it is extremely difficult to sell a WFOE, as we explained in Selling Your China WFOE: Yeah, That’s the Ticket:

The problem is that to buy a WFOE requires the buyer essentially want to do exactly what the seller has been approved to do. So for example, if I want to do a consulting business in Qingdao, I must buy a consulting business in Qingdao. And then I also have to make sure that the costs of my doing due diligence on the WFOE and the risks of buying into the liabilities and problems of the WFOE, do not outweigh the advantages of taking over a WFOE, as opposed to forming a new one.

It is indeed possible to sell a WFOE and our China M&A lawyers have been involved with a couple such sales and they are not difficult from a legal perspective, but they are usually difficult to justify from a business perspective. We sometimes see WFOE sales to employees (either expats or Chinese citizens or even combinations thereof) who want to see the WFOE keep going so they can hold onto their jobs. It is possible to sell a WFOE to a Chinese company or a Chinese citizen (and this would include to an employee) and then it converts to a Chinese domestic company. This too is not difficult legally, but such sales are rare because usually the employee knows exactly why the WFOE is closing and chooses to essentially take over the WFOE after the foreign company has left, and do so “informally” and without any payment.

You can sell your WFOE to a foreign company looking to do business in China, but that too has many inherent difficulties, which we detailed in Buying And Selling China WFOE Shell Companies.

Those trying to sell their WFOEs usually tout them as liability free and therefore ready to go much faster and at a much lower price than forming a brand new WFOE For what it takes to form a WFOE in China, check out the following:

The above posts show that forming and registering a WFOE in China is a difficult and time consuming process but buying an existing WFOE is in most cases not much easier, if at all.

The thing about off the shelf WFOEs is exactly that: they are off the shelf and not customized. And that is where the problems arise. Let’s take as an example a WFOE that someone tried to interest me in many months ago. That company was in the IT outsourcing business in a second tier city. So right there, its only real potential buyer is someone who is interested in doing IT outsourcing in that second tier city.  Because if the buyer of that WFOE is interested in doing anything other than IT outsourcing, it will need to petition the government to expand or change its business scope. Similarly, if the buyer is interested in doing IT outsourcing in some other city, it will need to petition the government to move its WFOE or it will need to set up a branch in that other city, and thereby have to maintain two offices. When you throw in the fact that anyone buying a WFOE will need to conduct due diligence on it to make sure it truly does not have liabilities of any kind (including, tax, employee, environmental, tort, etc.) you can quickly see why forming a WFOE is going to be safer and probably equally as fast and cheap as buying one. The biggest benefit in buying a shell WFOE would be speed, but it is going to be the rare instance where saving a few months will warrant the extra risk.

But if you under or overreach on the description of your business scope, you might find yourself in big trouble.  We are getting an increasing number of calls from American companies in trouble with the Chinese government for doing things in their business that they did not mention in the business scope section of their initial WFOE.

In some cases, the companies have admitted to us that they were never “really comfortable” with the business scope mentioned in their applications, but that the company they had used to form their WFOE had “pushed” them into it as it would “make things much easier.” In some cases, the scope of the business changed after the application was submitted and the company had failed to secure approval in advance for the change. And in some cases, the company probably would never have been approved at all had it been upfront and honest in its application. In nearly all instances, the companies had managed to secure local approval but were now in trouble with Beijing, which constantly is auditing these applications. In one instance, the local government went back and changed its mind, probably after conducting an audit of its own.

I cannot go into any more detail on these matters, but I can give this advice: applying for a WFOE in China involves a heck of a lot more than just filling out a form and getting approval. It does matter for what you get approved and you (or whomever you are using for your WFOE application) need to know China’s foreign investment catalog inside and out before applying. You then must tailor your application to meet both the requirements of the foreign investment catalog AND the reality of what you will be doing in China. A failure to comply on both fronts will lead to, at best, a rejection of your application and, at worst, being shut down months or years later.

The odds of a shell WFOE’s city and scope lining up perfectly with what is needed by potential WFOE buyers are low and we are not aware of any website that tries to match up WFOE sellers with potential WFOE buyers.

Steve Barru, a former China business blogger, wrote many years ago about trying to “get out of his China WFOE” [his blog is no more but because we previously quoted him here, his words on selling a China WFOE live on]:

Selling the company, even for next to nothing, quickly moved to the head of the line. But transferring the business license and my legal person status to the wannabe new owner involved far more than filling out a couple of forms.

It was the buyer who had to jump through the bureaucratic hoops. For all intents and purposes he went through the same process one goes through to establish a WFOE. With one key difference – he did not have to invest new capital in the company. The original US $70,000 in registered capital (that I had put in and had later managed, for the most part, to take out) was all that was required. Since registered capital for a WFOE had increased to US $200k by 2005, there were demands for additional investment, but rather convoluted negotiations eventually got around this obstacle. Fortunately, the buyer was located in Nanjing. The need to move the WFOE to a new locale would have been a deal breaker.

Eventually, after several months of discussions and chopping forms, all the questions about registered capital, business scope of the company, the good character of the new owner, and the license transfer had been answered and the sale was complete. The price probably covered my express mailing costs and bought me a couple of dinners. But I was out from under what had become an enormous, very time consuming headache.

The same is true today.