We recently did a couple of posts on what is required to form a Wholly Foreign Owned Entity (WFOE) in China. In the first of these posts, "How To Start A Business In China -- WFOE," we we set out the four main steps in forming a WFOE. In our second post, "How To Start A Business In China -- The Minimum Capital Requirements For A WFOE," we discussed the minimum capital requirements for such entities. I tagged both of these posts with our newly created "Basics of China Business Law" category.
Micah Schwalb, an attorney and blogger at Boulder2Beijing then wrote me with the following:
One item it might be interesting for you to touch upon is when you DON’T need to do any sort of formation, as in the case of a foreign business contracting with a Chinese business for certain services, or when companies pay (foreign) employees on the basis of service contracts. I’m not saying that these are particularly, well, legal, but it might make for an interesting post, as it happens quite often.
Unfortunately, Micah is right. I say unfortunately, because there is no right or wrong answer on when it is necessary to form a company, which means writing a blog post on it is not an easy task and which means this post will NOT be going into the "Basics of China Business Law" category.
It is necessary to form a business in China is that it is legally necessary if you will be doing business in China on anything other than a temporary basis. But what exactly does that mean?
This post is not intended to give a definitive answer as to when it is necessary to form a Chinese company. Rather, it is meant to raise some of the issues and expose some of the analysis that goes on about those issues.
We face this issue all the time with companies that want to hire independent contractors in China. There is no legal way to do this under Chinese law, yet it goes on all the time. Some companies that do this run very little risk, while some run huge risks. What fascinates me about the companies with which I discuss this is how many of them have not even considered the risks, which include the following:
1. The independent contractors take physical or IP assets and the foreign company cannot sue because it is not even supposed to be in the country at all. We had a software company contact us about its independent contractors in China who had taken their software codes and were now selling their product both inside and outside China. Not a good situation.
2. The independent contractors sue the foreign company on an employment claim. These happen all the time and the foreign company essentially has two options. One, pay the entire claim in an effort to minimize (but not eliminate the risk of being thrown out of China) or just simply pack up (really quickly) and leave.
3. Getting shut down.
The other thing I find people fail to consider is their ability to secure investors or to sell the company later. We have a very savvy client who has started and sold dozens of companies around the world and one of the things he is always telling us is that his expertise in forming companies is one of the things he makes money from on the sale. He has formed and sold around a half dozen China WFOES (he sells them from one American company to another) and he says much of what he makes is relieving the buying company from having to take the time and money to form its own company.
My firm will not write investment contracts for companies that do not exist. Those are never worth it.
Let me give you some real life examples and the advice we gave and why.
1. US services company that sends five highly skilled people to a remote region in China once or twice a year for one or two months at a time to provide services to US companies with WFOEs in China. Because it would not be that big a deal if these people were blocked from entering China or forced to leave on short notice, we jointly determined that the risks involved with not forming a WFOE were not all that high and the client has chose not to do so.
2. US company that had five people whom it called "employees" doing R&D work for it in China. This sort of arrangements are disasters waiting to happen as these are the exact sort of arrangement the Chinese government is stepping up its efforts to shut down. See our post "China: First Let's Clear Out The Long Time Foreigners," for more on that. See also "Fake China Joint Ventures. Why You Calling Me, I'm Not The Guy!" In that post, I laid out what has become an all too typical phone call:
Caller: I've got this great website and it is exactly what China wants/needs. And I've been working on developing it with some Chinese tech friends of mine and we want to take it legal so we can start getting VC (venture capital) funding for it. Here's our plan. Now I know that the old/truly legal/expected/usual way to do this is for me to form my own company and then form a joint venture with my Chinese partners, but I also know that will cost a lot of money. So our plan is for the Chinese company to own the website and then we will have an oral agreement (or a written agreement) that I really own half of it.
Me: Listen, my firm has been contacted at least twenty times after these situations have gone bad and I am aware of at least another twenty times where the same thing has happened, and let me tell you, these arrangements (it is NOT proper to call these joint ventures) virtually always end the same way. They end with the Chinese company booting you out completely and leaving you with no recourse. Protecting foreign companies in legitimate joint ventures is difficult enough, but it is pretty much impossible under the scenario you are describing. We had a guy who paid us a lot of money once for us to do everything we could to try to get "his" multi-million dollar business back. Guess what, we could not even come close to getting it back. Every Chinese lawyer we talked to about suing to get it back told us we had no chance of winning at all. I mean, just listen to the argument we would need to make to the judge:
Your honor, my client knew that China's laws are very clear on what foreign companies must do to operate legally in China, but he thought these very clear laws should not apply to him because, well because he is an American tech company and he was just too smart/too poor to bother to comply with the very clear laws. So instead, he had this great method for completely circumventing China's very clear laws. His idea was to not form a company, but rather, have his Chinese friends form the company and he would have a little side deal with that company. Well, that side deal has now gone bad and my client wants you to go against China's very clear public policy on how foreign business is to be done in China and enforce this unwritten side deal.
What do you think of that argument? Oh, and I should also tell you that since these contracts you have will almost certainly be found to violate Chinese law, the judge will almost certainly find them void them ab initio, which means they will be deemed to have never existed.
Caller: (long pause) I understand things could go wrong with that kind of arrangement, but would you be willing to draft the contract between me and the Chinese company?
Me: No. I can't do that. I can't draft a contract that I know will never work. I just can't. Give me a call if you ever want to do this legally, in a way where you actually have a chance of profiting from your work down the road.
To be crystal clear here, these arrangements are not legal and they do not work.Yes, they might work for a year or so, or even a few years, but our experience and the experience of every single person I know who really knows China is that eventually these arrangements will fall apart and when they do, it will be you as the foreigner who will pay the price. And the interesting thing about these arrangements is that they not so coincidentally fall apart right when the great foundation has been laid and they are really starting to bring in money. No surprise there.
There are really only two ways to handle the situation where you want to have people in China working for your company. One, you form a Chinese entity, either a WFOE a Joint Venture (JV), or a Representative Office (RO) and you hire them as employees (of your company or of a staffing company if you are going in as a Rep Office). Or two, you enter into a business to business (B2B) contract with a Chinese company that itself employs the people in China you would like to see working for your company. It really comes down to a question of costs and control. It will almost certainly cost you more up front (though you may actually save money in the long term) to form your own company and hire your own employees, but you will have more control over them that way. So form your own company and hire people or contract with a legitimate Chinese company with its own employee, but just don't "hire them" yourself without a company in place.
But there are always exceptions. We are "aware" of a company that is operating illegally in China because there is absolutely no way for it to operate legally because its type of business cannot be owned by foreigners. This company knows exactly what it is doing and it has considered the risks and rewards and chosen to go forward. It assumes it will eventually get shut down and it operates accordingly in that it seeks to make as much money in the short term as possible, while spending as little as possible. Its goal is to hang on in China until its type of business becomes legal, and then it plans to do so itself. It has been there for nearly two years now.
3. US service company that every once in a while gets highly lucrative contracts from one particular US company that has it send about twenty people to China for three to six months. It would be a complete disaster (maybe to the point of losing this one giant client) if more than a couple of these employees were not allowed into China right away or if any of them were to be kicked out. So even though the risk of having a problem were actually fairly low, the cost to the company if that were to happen were high enough that we decided it should form a Chinese company and secure employment visas (Z visas) for a sufficient number of key employees. It did that and it has operated without a hitch ever since.
4. US manufacturing company with two salespeople in China. These two salespeople had been with the company for around five years and their relationship with the company had been uniformly excellent. These two wanted to become legal employees themselves and they asked our client to form a China WFOE so that would be possible. Our client was rightfully reluctant to do so because of the formation costs. We talked with them about how they could form a Rep Office and "re-hire" these two people through a Chinese agency. But the whole issue of using commission salespeople in China is a mess and since salespeople are subject to the same employment contract rules as everyone else. So most foreign companies would prefer to treat these Chinese salesmen as 'independent contractors", raising all the issues discussed above. There is no great solution here.
The same is true for the foreign company that wants to hire one or two people to repair their sold product in China. The foreign company has essentially only two legal choices. Form a WFOE and hire these people as employees, or convince them to form their own Chinese domestic company and enter into a contract with that company.
What do you think?