Personal Liability for Failed China WFOEs: The Law and the Reality

China problem solving

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 answers 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 and answers.

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?

7 responses to “Personal Liability for Failed China WFOEs: The Law and the Reality”

  1. Yeah, you Yankee lawyers tell your Yankee clients they can just leave China with debts and there’s no consequences for any of the Yankee managers. Great advice and saves a bunch of cash. Nice to see you on the ball again.   

  2. That’s not what he said.  He’s citing the letter of the law, and then describing the consequences of the law as it is applied locally.  Getting the hell out of the area before local authorities take liberty with the application part is probably not a bad idea.  He’s not advocating that anybody do a runner.

  3. Is this any different for a rep office? I thought (perhaps mistakenly) that the regional director was personally held liable if the rep office didn’t unwind according to p.r.c. law. I realize this was written about a WFOE but what about rep offices?

  4. The standard method for dealing with a corporate insolvency in China is to leave town and let the local government handle the situation.  There is usually some equipment and facilities that can be sold, and if you leave town and abandon the equipment, then the local government will figure out what to do.
    There is a catch-22 here.  If you weren’t personally liable for the debts of the company before, by being unavailable and not participating in a liquidation process, you are can become personally liable.
    The other thing is that there are economic reasons why insolvency is different in the US than in China.  Most US companies are debt based, which means that if you come up with some arrangement with the bank, you can keep the company running, and the bank is interested in keeping the company running so that they can salvage what they can.  Bankruptcy is a process by which you hold off paying the bank so that you can pay the workers and creditors and keep the company in business.  In the types of Chinese companies we are talking about, there is very little debt, but because there is little debt, if the company is insolvent then there is nothing to salvage.
    Also, most US companies are “knowledge/network based” which means that the value of the company is in intangibles, so the value of the physical plant is pretty negligible.  The types of Chinese companies that we are talking about have very large pools of physical plant.  So what happens is that the owners skip town, the workers start demonstrating, the local government chips in something to keep the workers happy, and then recovers the cost by reselling the land use right.  The local government is putting a lot of pressure on the companies, because they more money they can squeeze out of the company, the less money they have to put up to keep the workers from rioting.

  5. Also you have to worry as much about the bad things that could happen in the US….
    One other bit of practical advice is that you really need to contact the bankruptcy lawyers of the parent company.  If you have a foreign subsidiary of an insolvent parent company that is incurring post-filing liabilities this is going to have a big, big impact on the bankruptcy of the parent company.
    Assuming the parent company is a US company, then there are some pretty big land mines here.
    If the Chinese WFOE is not properly wound up, then it’s possible for a Chinese judge to find that the liabilities of the WFOE are those of the parent company (and again I have to emphasize that to pierce the corporate veil the judge needs to find that there is merely negligence and not intentional fraud).  At that point you are going to have a bankruptcy judge in the US and a creditor committee that is going to be seriously, seriously upset.  If those liabilities happen after the date of the filing of the US bankruptcy, they are going to be superior to those of any other pre-filing creditors.
    Finally, considering resigning and going home…..  One legal reason for doing that is that if the situation is a total mess, then you have to look out for yourself.

  6. One other important piece of legal advice is when you are talking with a lawyer, it needs to be made clear to both you and the lawyer who the lawyer is representing.  Is the lawyer representing your personal interests, the interests of the WFOE, or the interests of the parent company?  This is important because these interests may conflict.  It may be in the interests of the parent company to keep the plant in China running for as long as possible, but it may be in your personal interest to resign and leave town tomorrow.
    The other important piece of advice is to realize that seemingly minor details can change the legal situation.  For example, if the owner of the WFOE is “Trans-Giant Worldwide Corporation” then as a general manager it is very unlikely that you will have any personal liability. 
    On the other hand if the owner of the WFOE is “Mom and Pop Limited” and “pop” is the general manager, and the board of directors “pop’s” relatives, then he may be personally liable not withstanding the fact that he is not a shareholder or holds no formal position.  The reason *that* matters is that Chinese companies are often family-owned companies in which the formal titles do not reflect at all the actual control structure so the law is set up so that courts can ignore the formal structure in order to get at the actual control structure.
    One final point is that there is a lot of “informal” stuff that happens with Chinese insolvency that the written law will only be of limited help in, but there is also a lot of “informal” stuff that is happening on the corporate side.  These situations invariably have a ton of corporate politics and sometimes family politics, and managing the home office can be as tricky and as trencherous as managing the Chinese street.  Because the decisions are being made half way around the world, it’s easy to be left hanging.

  7. Good summary – second part should not be taken lightly – HQ should realize its duties to its legal reps and directors, and legal reps and directors should understand their legal duty to know what is going on in the company.

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