Many small to medium-sized companies come to China with the idea that establishing their Representative Office, Wholly Foreign Owned Enterprise or even Joint Venture will be an easy and quick process. However, after going through the establishment process, hiring local employees, whether it is managerial staff or lower levels and during the startup period, foreign investors are finding that in China "everything takes much longer than expected and nothing ever turns out the way one imagines."

Problems in Foreign Invested Enterprises (FIEs) can vary from outright criminal activity to serious non-compliance issues. Many of these problems are foreseeable but due to a lack of poor management and lack of control from the foreign investors, these issues are frequent and can cause not only monetary punishments but also jail time.

Factors that Contribute to Fraud and Corporate Governance

Lack of control and communication

Many foreign companies feel they only need to send a company representative from overseas to China once or twice a year. The majority of clients let this happen. They rarely conduct visits and the majority of the time they let the office run freely, giving complete control to the General Managers. Due to the language barriers, emails or phone calls are rarely made to check on the office. At the same time, financial reports are usually only provided for in Chinese making it impossible for the foreign investor to understand the figures being presented to him.

Recommended Action: Many companies look to outsource their administrative functions, such as accounting, tax filing, payroll and other corporate governance functions to external consultants. This benefits the investor in two ways:

1. Professional advisors often provide a "new set of eyes" or they can predict what problems may arise and they offer a greater level of understanding of the corporate environment; bringing experience and best practice across all business functions - from finance, accounting, legal and IT
2. They can act as independent "Administrative Managers" making sure that the Limited Company is in compliance in all aspects of operations. This can be an asset for investors who want to only focus on the company's day-to-day activities and alleviate any financial and business risks.

Turning a blind eye

Many companies before deciding to establish an entity will hire a local manager to take care of this for them. Many companies end up realizing after three or four years that in fact their company had never been established legally in the first place and they had been hiring local employees illegally. Many foreign companies fail to make an investigation as to what the Chinese legal requirements are or how to implement some form of corporate governance into their Chinese entities so as to prevent this.

In many cases, China is still considered too far away and a "different world" and as a result the China entity is not treated as a part of the parent company's group where corporate governance has been implemented and is being followed.

Recommended Action: Every case of incompetence, fraud or deliberate non-compliance is known by someone within the company who is willing to tell. It is important for the investor to maintain contact with all staff, particularly if it is a small operation. Naturally the authority of the General Manager should not be undermined but it is also reasonable for the investing company / individual to be exposed to skeptical or critical voices within its subsidiaries. Naturally, not all rumors or critical statements can be accepted at face value. However, such information will provide headquarters with guidance as to which areas should be investigated in particular during the internal audits.

Many of the problems companies meet with is due to a lack of clarity in what is authorized and what procedures are to be followed. It is recommended to prepare internal operational guidelines and management directives (typically known as management by-laws) so that all employees, whether they be administrative staff or technical staff are familiar with the companies protocol. More importantly foreign managers need to make sure that the company policies are compatible with the relevant PRC laws in order for proper implementation.

Additionally the employment contract is important for the overall security of the company. As is typical in China one cannot always rely on contracts alone. Contracts should include confidentiality and non-competition clauses and it is recommended that they be drafted by professionals who are familiar with the laws and regulations.

Ethical Situations

Many foreign companies feel that it is appropriate to promote business activities that they themselves would never conduct in their home country, but because it's China they believe they can get away with it. This is a wrong perception of China. There are numerous foreign investors who employ local staff illegally or they do not declare their staff to the government agencies under which local staff must be employed. They pay employees in cash so that the staff does not have to pay Individual Income Taxes. This may save costs but if at any point the investor dismisses a staff member or a staff member resigns, the local employee (more often than not) will report the investor to the authorities and ask for more compensation than is required by law. The costs will be more than if the investor had followed the law.

Recommended Action: It is important that foreign investors stay within their prescribed business scope and conduct all business according to PRC Law. It is advisable to become familiar with the regulations and laws associated for your business scope.

Inexperienced Foreign Staff

It is very common in China to find young foreign professionals, straight out of university being assigned to move to China and start up the business due to their lower salary compensation wishes compared to the more experienced managers, who complain that China is a hardship living experience. There is no doubt; China is not an easy assignment. Complications arise in every business deal, and although the young professional may learn by hands on experience it is a good opportunity for him rather than the investor who is looking to expand quickly. Negotiating contracts for expatriates can also be time consuming and can deter from training and explaining the responsibilities of the China entity.

Recommended Action: In any company it is important to hire proper "experts in their field". It is of up most importance in China to check the background of each staff member as it is common for employees to embellish their resumes. Virtually everyone working in China appears to be an expert of some sort, whether it is General Manager, Division Manager or Department Manager. It is important to not only check the resume and references but also to contact the previous employer (who are normally more forthcoming by phone) for more details. This should particularly be done for any Managerial positions.

Recommended Action to Prevent Fraud and Non-Compliance Issues

Health Checks and Internal Audits

Although companies in China are not required by law to perform internal audits, more and more FIEs are becoming aware of the importance of it as an effective tool to ensure the companies are operating in an effective and efficient way, the financial reports submitted to the government authorities and public are reflecting the true position and performance of the companies and most importantly that the companies are in compliance with the relevant laws and regulations.

It is also advisable for foreign investors to conduct internal through an external company (outside perspective) regularly in a year, for example on a quarterly basis before tax filing occurs. It is a good tool to keep updated on the company's standing. Additionally, background checks on staff in management positions can be conducted. Internal audits often assist in discovering anomalies which lead to further discoveries. However, it is impossible to guarantee that all secrets will be found through an audit.

Appointment of Directors and Senior Management Personnel

There are several precautions that can be implemented to protect investors, their investment in China as well as the individual appointees, such as the following:

• A Legal Representative of an FIE should be selected carefully. Additionally, the appointed person should sign and chop undated termination-related documents before being appointed.
• The Legal Representative and other directors and managers can be provided with individual liability insurance, as the individuals invited to fill these positions may demand that investors give them a broad indemnity.
  
  
• The shareholder(s) should define clear limits on the authority of the company's Legal Representative and other officers along with procedures for approving actions that exceed those limits, observe and monitor these procedures, and should consider using the company's website and other channels to give notice to potential counterparties of the limits on these individuals.
  
  
• When establishing the entity in China, the parent company should not rely on the published and standard form of articles which is preferred by the local governments. The best compromise is to adopt the basic style and sequence of that form and add detailed provisions on the authority of the Legal Representative as well as other senior officers within the entity and any other points that are important to the shareholders.
  
  
• Additionally the company should have a chop control mechanism in place to record all usage and restrict access to the chops. If there is a clear policy as well as strict record keeping of possession and usage of the chop, the risk of misuse is reduced dramatically.

If a chop is used for emergency purposes while the usual keeper is out of town, it is recommendable to leave it with your accountant or law firm.

Obtain Advice

The biggest mistake a FIE can make when handling any government or law issue in China, for example taxes, is trying to do it by itself. For all matters concerning the entity it usually does pay to seek professional advice in advance. In China, the law and regulatory environment changes very rapidly. Virtually every week you see new circulars, regulations and laws coming out. On top of all this, because of China's vastness, there are regional variations, so the interpretations of laws and regulations tend to vary from location to location by the different bureaus. In addition, the practices of the authorities may differ, which adds to the complexity of the system. It is therefore important to seek professional advice and be kept updated on all the recent developments and changes.

Protection of the Parent Company by having a Holding Entity

Many foreign companies feel it is a risk to establish an entity in China. The establishment may not require a high capital investment but there can be a risk factor. Due to these aspects, more and more investors are establishing offshore companies to act as a holding entity for their China investment and thereby creating a buffer layer to take over the full liability for the Chinese operation from the parent company. The establishment of many of these offshore companies is an easy process and due to an uncomplicated tax system and accounting requirements, simple to operate. Double taxation agreements have been drafted and implemented between China and many of these offshore jurisdictions, which adds an additional benefit.

Conclusion

There is no reason for foreign investors to be nervous or hesitant about establishing a China operation. The key for many investors is to make sure they do not become excessively complacent and to avoid any fraud or non-compliance issues. It is advisable to obtain advice and assistance through a consulting company or law firm in relation to the requirements, regulations and related activities.

Many problems in Foreign Invested Enterprises (FIEs) can be traced back to their initial establishment and the project's structure. The main reason for this is that many foreign companies come into this new country and this new culture with high expectations and their western style of doing business, which may not always work in China. It is very good to come into a new market with high expectations and with these great opportunities being offered, however one should be prepared for unexpected occurrences and obstacles. It is wrong to expect everything in China to operate as in the home country. However, it is equally wrong to place blind trust in the system and accept any problem which arises and saying "That's China". Supervising and paying attention to one's China entity can prevent many problems from arising and can alleviate any worries and fears.

If you require assistance with the above subject, please contact us at This e-mail address is being protected from spambots. You need JavaScript enabled to view it with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.