China question: What are the liabilities for a failed WFOE?
June 01, 2012 | BY
clpstaff &clp articles &The economic slowdown has caused many WFOEs to shut down leaving bad debt. Under Chinese law, what are the liabilities for managers, directors and the shareholders?
The domestic perspective
Under PRC law, if a wholly foreign-owned enterprise (WFOE) is unable to repay its debts, and the WFOE's assets are insufficient to settle all its debts, bankruptcy proceedings may be initiated. The WFOE may file for bankruptcy by itself, or a creditor of the WFOE may file for bankruptcy. The directors, senior managers and shareholders may assume liabilities.
Directors and senior managers
Under the PRC Enterprise Bankruptcy Law (中华人民共和国企业破产法), if a WFOE is bankrupted because the directors, supervisors or senior managers violate loyalty or diligence duties, they assume civil liabilities and cannot work in that capacity at any other enterprises for three years from the date bankruptcy procedures are completed.
The PRC Company Law (中华人民共和国公司法) sets out detailed provisions over loyalty and diligence duties of directors and senior managers. According to the Law, directors, supervisors and senior managers shall observe laws, administrative regulations and the company's articles of association (AOA), and bear the loyalty and diligence duties. Directors, supervisors and senior managers cannot take advantage of their functions and powers to accept bribes or collect other illegal earnings, or illegally take possession of the enterprise's property. In addition, if a WFOE suffers losses because its director, supervisor or senior manager violates laws, they are legally obliged to compensate the enterprise.
The Company Law also lists activities of directors and senior managers that constitute violation of loyalty. Some of these activities include misappropriating funds, opening an account in the name of the director or senior manager or in the name of another person to deposit the funds of the enterprise, or loans using the enterprise's property as a guarantee. If a director or a senior manager conducts any of the activities in the Company Law, which leads to bankruptcy, they shall assume the liabilities, in addition to returning the earnings derived from such illegal activities.
Shareholders
In general, if a WFOE has limited liability, shareholders assume liability of the capital contributions subscribed by shareholders. If shares limit the WFOE, shareholders assume liability to the extent of the shares they hold.
There are restrictions on company shareholder's liability. According to the Company Law, shareholders of a WFOE are prohibited from abusing their independent legal status or limited liability to damage creditor's interests. If a shareholder abuses its independent legal status or limited liability to evade debts, which seriously damage creditor's interests, the shareholder assumes joint and several liabilities. For example, if shareholders shut down the WFOE in bad faith to evade debts due to the creditor, the policy of limited liability will not apply and shareholders shall assume joint and several liabilities to the creditor.
He Fan
Haiwen & Partners, Shanghai
The international perspective
Since the financial crisis many wholly foreign-owned enterprises (WFOEs), have found themselves short of cash. Often, in the shadows of closure, huge amounts of taxes, debts and unpaid employee salaries remain. Foreign and local creditors don't like the idea of leveraging any more bad debts. Foreign investors also lose all optimism and halt any further capital contributions to the dying operation. Under these circumstances, what are the liabilities for investors, senior managers or directors?WFOEs are limited liability companies and therefore, with the exception of cases involving intentional fraud or underpayment of registered capital, insiders like investors, senior managers and directors are generally shielded from direct or personal exposure. The issue of rights and duties or piercing the corporate veil may arise when proper liquidation procedures are not followed, which exposes insiders to potential civil, administrative or even criminal liabilities.
A WFOE's business licence may be revoked, among other reasons, for failure to pay registered capital or complete the annual review by government authorities. However, revocation of a business licence does not equal termination of a WFOE or relieve it from legal liabilities. Respecting the liquidation procedures is essential to prevent piercing the corporate veil.
Non-liquidated WFOE
If a WFOE is not properly liquidated, investors could be liable for paying any unpaid taxes, debts, employee salaries or social insurance contributions. Criminal liabilities are also a possibility for senior managers or directors. Compared with other jurisdictions, thresholds that trigger criminal liability are low. For example, the threshold for tax evasion through illegal transfer of assets is Rmb10,000 ($1,581) and the threshold for contract fraud is Rmb20,000 ($3,162). Furthermore, investors can be held liable beyond their capital contributions under civil or administrative statutes, which could result in thousands of dollars in fines and back payments.
Business licence revocation
If a WFOE's business licence is revoked for gross violations of Chinese laws or regulations, the legal representative (often the chair of the board, managing director or general manager as stipulated in the articles of association), may be placed on a nationwide blacklist. This effectively prevents this person from registering as a director, manager or supervisor of another company for a period of three years. In addition, the WFOE's investors may also encounter barriers in making future investments in China. Investors of a company that is not properly liquidated cannot make future investments in China. This issue has been addressed recently at the local and municipal levels. For example, in 2011 two cities in Jiangsu Province – Nantong and Yangzhou – implemented measures to prevent investors of foreign-invested companies, including WFOEs which were not properly liquidated, from making investments in other companies.
Travel restrictions
The Chinese authorities have been aware of the increasing losses to domestic creditors and employees from improperly liquidated WFOEs. As a relief measure to local stakeholders, the government has issued, and is more likely to enforce, legislation restricting foreign insiders who pose a flight risk. Foreign insiders facing civil lawsuits or criminal charges could be subject to a no-departure restraining order until matters are settled and their personal assets may be frozen and subject to seizure.
Chinese judgments abroad
In 2008, Chinese authorities also issued certain guidelines addressing the improper departure of foreign investors and their appointed foreign directors or 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. To a certain extent, Chinese authorities may also be able to exercise extradition rights on persons suspected of tax evasion based on criminal judicial assistance treaties and extradition treaties.
Tang Zhengyu
Sidley Austin, Shanghai
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