Limiting Your Legal Risks

Legal risk is a pretty broad category in China, as it is anywhere. It can encompass everything from noncompliance with the law to losing control of your company or assets.

Chinese laws are often fairly vague and broadly worded. They can seem more like statements of principles than anything else. Lawyers in China are particularly fond of saying that the devil’s in the details. That’s because you often can’t see the real impact of a law until implementing rules and interpretations come out.

Minimum suggestions: We know what the law says, but . . . According to Winston Zhao, the partner in charge of Jones Day’s Shanghai office, one of the most frustrating parts of doing business in China is how unpredictable the legal environment can be. And by “legal environment,” he doesn’t just mean the laws; although laws and regulations themselves lead to unintended consequences, the more common issue is in implementation of laws and regulations. Zhao tells a story from the early 1990s that illustrates how officials’ varying priorities can affect their interpretations of the law. At the time, Zhao was assisting a client in setting up a pharmaceutical company in a southern Chinese city. After reviewing the application, some officials called Zhao to tell him that the social benefits the client projected paying were too low. Zhao double-checked the figures and confirmed that they complied with the amount set by law. When Zhao made this point to the officials, they responded that they view the law as only establishing the minimum level. After some discussion, the officials made it clear that the client faced a choice: Either pay a higher level of benefits or go elsewhere. (Incidentally, the client chose to pay the greater benefits.)

Thinking locally

You may frequently encounter situations in which local officials have a good deal of latitude in how to interpret the law. The different priorities and goals of different areas can affect how officials interpret laws. Officials’ sophistication varies, too. Some areas have well-educated officials who deal with foreign investors all the time. Other places may have officials for whom your business venture is a completely new concept.

Making matters worse is that an official can sometimes tell you that your application is fine, but when you go for approval, you’re rejected. That rejection isn’t out of bad faith. It’s just that the official you’re speaking with doesn’t know how his superiors will come out on something. Unfortunately, asking such an official whether the boss agrees with his or her interpretation would be rude. For this reason, you’re rarely going to get an official to give you a written interpretation.

Much of the variation depends on location, so you can limit your risk by setting up in places used to dealing with foreign investors. If you’re setting up in places like Shanghai, which has thousands of foreign investors, you’re going to get a process that’s more consistent. However, Shanghai isn’t going to go out of its way to get your investment, so you have to balance the eagerness of the local government against its experience with foreign investment. (By the way, don’t assume that just because one bureau is really interested in attracting your company, the approval agencies will fall in line. They may or may not. For more on government relations, see Chapter 8.)

Taboo relations Even a good corporate governance system can become corrupted by unforeseeable events, so do frequent inspections and audits. One of the worst corporate governance situations we’re aware of involved a Western wholly foreign-owned enterprise with an expatriate GM. The GM was married with a wife and kids who moved out to China with him, and he lived in a cozy expat compound. The GM began having “relations” with not one, but two — yes, two — female subordinates. One of the subordinates happened to be the financial controller. After a while, the controller realized that she could steal from the company without worry because the only person who could catch her was the GM. So the GM stood by and watched her rip off the company, knowing that if he did something about it, his career and marriage would be over. Eventually, he found another job.

Implementing corporate governance

Corporate governance, or ensuring that company managers have the company’s interests at heart, has been a hot topic in the West for the better part of a decade now, and the term may seem overused. As important as good governance is in your home market, it’s critical when headquarters is thousands of miles away from the operation.

What can go wrong if you have weak governance? In a word, everything. Money and property can be siphoned off; the FIE can be violating labor, environmental, or numerous other laws; or the China branch can be competing with headquarters for customers. This section gives some tips for beefing up your corporate governance.

Wholly foreign-owned enterprises (WFOEs) may have even more problems with compliance and embezzlement than JVs do. In JVs, the mutual feeling of slight distrust between the partners acts as somewhat of a restraint. In many poorly supervised WFOEs, the management (usually the general manager) has virtually unfettered power because nobody else is minding the store.

Putting a strong finance person in place

Your general manager (GM) and controller have to work well together. (But you don’t want them to work too well with each other, either — see the “Taboo relations” sidebar.) Ideally, both come from your home operations, and you know them well.

To ensure proper checks and balances, the finance person, not the GM, should keep the official company seals (the chops). See Chapter 7 for details on chops.

Having an adequately involved board

An active board should do the following:

✓	Hold regular meetings. Most FIE boards in China meet only once per year, which is too seldom. FIE boards should receive and review regular written reports from the general manager (GM).
✓	Separate management from the board. Especially make sure that a manager doesn’t serve as chairman of the board. The chairman’s role is important in certain crisis situations because some documents require his or her signature. Because bad management usually precipitates such crises, having a manager/chairman can make matters worse.
✓	Enact a clear set of management bylaws that the GM and all managers must abide by. These bylaws should specify what decisions each manager may make unilaterally, which ones require joint management actions, and which ones require board approval. Having various management controls in the bylaws rather than in the Articles of Association (AOA) is preferable because changes to the AOA require official approval.

As we discuss in Chapter 5, the minority shareholder in JVs must have at least one board seat. In addition, JV decisions are all made at the board (rather than shareholder) level. By law, certain board decisions must be unanimous.

Limiting the powers of the general manager and chairman

Place limits on the GM and the chairman of the board. Your China operation should have management bylaws that limit the GM’s power. For instance, you may make a provision that the GM can’t make certain decisions without board approval. This idea is even more important in JVs because Chinese JV structures typically make the GM the sole decision maker in the organization.

By law, the chairman of the board is the legal representative of the company. Although chairman is rarely a full-time position, the authorities give a lot of deference to the chairman. The chairman is responsible for signing the minutes of board meetings and various important documents. When negotiating JV terms, don’t be too quick to cede the ability to appoint the chairman.

In JVs, having controls on the chairman’s powers is important if your partner appoints the chairman. You may want to give another board member the ability to convene board meetings if the chairman can’t do so. More to the point, though, the JV contract should restrict the chairman’s ability to act without written board authorization. Failure to get authorization should result in the chairman’s removal and the chairman being personally liable for his or her actions.

Trusting — but not too much

Headquarters should send somebody senior to check out the China operations regularly — at least once each quarter. This person should be able to spend significant time in the office and factory on his or her trips.

One of this representative’s goals should be to develop relationships with employees other than senior managers. Employees can then feel that they have a contact at headquarters in case they want to report something. This person should also monitor whether the corporate culture has taken hold. If not, he or she should work with the management to instill it.

If the China side seems to be scheduling an inordinate amount of time out of the office for visitors from headquarters, they may be covering something up.

Conduct legal audits every so often — particularly if you smell something fishy. In such an audit, you engage outside counsel, which works in conjunction with your in-house counsel (if any). The auditors sift through reams of contracts and other documents, looking to see whether the company has undertaken any transactions that don’t comply with procedures.