Potential Exposure of WFOE Insiders for Failed China Operations

China Update

In the wake of the financial crisis, some international investors of wholly foreign owned enterprises (WFOEs) have found themselves short of cash to fulfill their funding commitments. A WFOE’s business license may be revoked for such failure to fund while significant taxes, debts and employee salaries may remain unpaid. In this China update, we highlight the potential liabilities and risks under such circumstances for WFOE insiders such as investors, senior managers and directors.

WFOEs are limited liability companies; as such, with the exception of cases involving intentional fraud or underpayment of registered capital, insiders are generally shielded from direct or personal exposure. The issue of “piercing the corporate veil” may, however, arise when proper liquidation procedures are not followed. This, in turn, may expose insiders to potential civil, administrative or even criminal, liabilities.

What happens after revocation of a WFOE’s business license?

A WFOE’s business license may be revoked, among other reasons, for failure to pay registered capital or to complete annual review by government authorities. However, revocation of a business license, in and of itself, does not necessarily result in the termination of a WFOE or relieve it from its legal liabilities. Therefore, completion of the liquidation procedures is essential to prevent piercing of the corporate veil.

If a WFOE’s business license is revoked for gross violations of Chinese laws or regulations, the legal representative—often the chairman of the board, managing director or general manager as stipulated in the articles of association—may be placed on a nation-wide blacklist. This, effectively, would prevent such a person from registering as a director, manager or supervisor of another company for a period of three years.

What is an insider’s potential exposure if a WFOE is not duly liquidated?

If a WFOE is not duly liquidated, its investors could be liable for paying any of its unpaid taxes, debts, employee salaries or social insurance contributions. Its senior managers or directors could also be exposed to criminal liabilities. The thresholds that trigger criminal liabilities are relatively low. For example, the threshold for tax evasion through illegal transfer of assets is RMB10,000 (US$1,581) and the threshold for contract fraud is RMB20,000 (US$3,162). Further, investors could be held liable, beyond their capital contributions under civil or administrative statutes, for paying thousands of dollars in fines and back payments.

In addition, investors of a WFOE not duly liquidated may also encounter barriers to making future investments in China. This issue has been addressed more recently at the local and municipal levels. For example, in 2011, Nantong and Yangzhou, two cities in Jiangsu Province, implemented measures to specifically prevent investors of internationally-invested companies (including WFOEs) that were not properly liquidated from making investments in other companies.

Could a travel restriction be placed on foreign insiders?

The Chinese authorities have been mindful of the increasing losses to domestic creditors and employees from improperly liquidated WFOEs. As a measure of relief to local stakeholders, the government has issued, and is more likely to enforce, a more aggressive legislation recently promulgated to ban international insiders that pose a flight risk from leaving China. Such individuals facing civil lawsuits or criminal charges or having unfulfilled employee payment obligations, could be subject to a no-departure restraining order in China until such matters are settled. Their personal assets may also be frozen and subject to seizure.

Chinese authorities have also issued certain guidelines addressing the improper departure of foreign investors and their appointed foreign directors/managers from China. The guidelines encourage Chinese parties to seek overseas enforcement of civil judgments against foreign parties based on civil and commercial judicial assistance treaties. Chinese authorities may also be able to exercise extradition rights against foreign insiders suspected of tax evasion based on criminal judicial assistance treaties and extradition treaties.

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Sidley was among the first U.S. law firms to recognize the importance of having a presence in China. Our Hong Kong office opened in 1994, followed by one in Beijing in 1996 and one in Shanghai in 1999. Our professionals advise clients on U.S., Hong Kong and English law and speak fluent English as well as fluent and native Mandarin and Cantonese.

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This article is adapted by the authors from one first published in the June 2012 issue of China Law & Practice. This version is published here with the kind permission of the editor.

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