Insights into Good Corporate Governance for Chinese WFOEs
By Winnie Yang & Maarten Roos
With decades of experience providing high-quality legal services to foreign investors doing business in China, and in particular greenfield investments, foreign investors often ask us about officer assignments to their Chinese subsidiary and officer liabilities under Chinese laws. Taking the WFOE – the wholly foreign-owned enterprises, a limited company wholly-owned by foreign investors and the predominant vehicle for foreign investment into China – as an example, we look at the topic of good corporate governance from both a legal and a practical perspective.
Under Chinese company laws and relevant regulations, the investor (recognized as the shareholder) is a WFOE’s highest authority and has to decide which natural positions will be appointed to the below positions of the WFOE and duly registered with the Chinese authorities. In China, all corporate officer appointees must be natural persons, though there is no requirement on nationality or residence.
Directors are appointed by the investor. The investor may issue a shareholder decision to appoint one executive director (for small-scale WFOEs) or a board consisting of between 3 and 13 directors including one chairman. The role of the board (or executive director) is to manage the company’s business operation with responsibility to the investor.
If there is a board of directors, then directors can only make decisions as part of the board. This means that in China, directors do not have direct individual authority (except in the case of the executive director).
- General Manager
The general manager is appointed by the board or executive director through a resolution or decision. The general manager shall be in charge of the company’s business operation with responsibility towards the board / executive director. The same person can be appointed as both executive director / board chairman and general manager.
- Legal Representative
The legal representative must be either the executive director / board chairman (whichever applies) or the general manager, and so this role must be confirmed by the investor prior to the WFOE registration. The legal representative acts in the name of the WFOE both in the corporate set-up (i.e. opening bank accounts) and in operations, as the only person who is directly authorized to represent and sign for the WFOE. It is important to emphasize that every Chinese company has only one legal representative, who is recognized as the company’s official representative with full authority to act on its behalf.
The board or shareholder can still set limits to the authority of the legal representative, but these are internal limits only.
Through a shareholder decision, the investor must appoint one or two supervisors, or even a board consisting of at least 3 supervisors including one chairman. The supervisor is a relatively independent position that does not involve the company’s business operation. The role of the supervisor is to supervise the performance of duties by the company’s directors and management, and has the right to inspect the company’s finances. The supervisor cannot simultaneously be appointed in another position (of director or manager) of the Chinese entity, and is responsible to the investor. In practice, the investor often appoints one of its own directors or managers in this position, or a legal / financial professional.
- Financial Administrator
The financial administrator has the responsibility to deal with daily tax issues, i.e. this is usually the contact person of the local tax office. In the past this role was not a formal appointment, but in Beijing for example the financial administrator is now formally registered as a company officer, visible in the public database of the company registry.
The PRC Company Law explicitly stipulates that the officers of the company shall abide by laws, regulations and the company’s Articles of Association (AoA, the company’s internal constitution), and bear fiduciary duties towards the company. Both, deliberate misconduct and negligence of duties may trigger officer liabilities towards the company.
Key examples of an officer’s misconduct and negligence are listed in the law:
- embezzlement of company funds;
- opening a bank account in one’s own or another’s name to deposit funds of the company;
- use of company funds to make loans to others or provide collateral for others in violation of the company’s AoA, and without the consent of the shareholder or board of directors;
- conclusion of contracts or transactions with the company as a contracting party in violation of the company’s AoA or without the consent of the shareholder;
- abuse of duties to seize the company’s commercial opportunities for himself/herself or others or engage in business similar to that of the company for himself/herself or for others without the consent of the shareholder;
- misappropriation of transaction commissions between the company and other parties;
- unauthorized disclosure of company secrets; and
- any other acts that are against his/her fiduciary duties towards the company.
In practice, the categories of liabilities for officers in violation of their fiduciary duties are the following:
- Civil Liabilities
In principle, officers shall compensate the company for losses/damages suffered as a result of his/her violation of laws, regulations or the company’s AoA.
In judicial practice, courts will specifically take into account if the said officer was at fault and if their act was reasonable and in the interest of the company.
- Administrative Liabilities
Officers can in certain circumstances bear administrative liabilities; for example, they can be fined if company assets are intentionally concealed during liquidation, or a major accident occurs due to failure of performance of duties over safety control during business operation. Also in some circumstances, a court or tax office could put consumption restrictions on the legal representative – for example if the company fails to pay its (enforceable) debts.
- Criminal Liabilities
Officers can be pursued for criminal liabilities if they commit crimes. Examples of crimes that have led to imprisonment include the misappropriation of funds, embezzlement, and the false issuance of VAT invoice – all examples of deliberate misconduct or gross negligence. Moreover, the company’s officers may bear criminal liability not only for their own act, but also if they were “in charge of” or “responsible for” a crime – for example of a bribe paid by another employee on behalf of the company.
Officers of a company in China have the authority to manage, involve or influence business operations, but this automatically combines with potential liabilities.
The first step is to understand the rights and obligations of company officers under Chinese law, The second step is to appoint the right persons in these positions. For many companies, an optimal balance needs to be found between maximizing compliance and maintaining control on the one hand (e.g. by appointing HQ managers as the company’s officers), and minimizing liabilities for such officers on the other. Two “tricks” that can be of help:
- Outsource certain administrative functions (e.g. accounting, treasury, company stamps) to a reliable third party, to minimize risks of non-compliance by the local team.
- Develop documentation to specify the authority of the local team, and to show who is actually in control of day-to-day operations (and therefore should take liability for any compliance issues).
On the other hand, China’s legal framework for corporate governance continues to develop and new developments should be taken into account as well. Published in December 2021, the Draft Revision to the PRC Company Law propose a strengthening of the responsibilities of the company’s officers: a director, manager or supervisor that is aware (or should have been aware) that the shareholder fails to contribute the required registered capital or unlawfully withdraws the registered capital, and fails to take the necessary actions, may be held personally liable for the consequences. Once again, this exemplifies the need to consider the best way to organize corporate governance in China.
R&P supports international clients on investments into China through WFOE’s and Joint Ventures, by way of greenfield and M&A. As part of this work, the team advises businesses on corporate governance structures. The corporate team also works closely with R&P’s specialists in compliance, employment law and tax, and with Acclime China (www.acclime.com) – which provides accounting, tax and payroll outsourcing services to the subsidiaries of international companies in China. For more information, please reach out to Maarten Roos at [email protected], or your usual contact at R&P.