Buddha Steel, VIEs and Legal Ethics: Part II, Man Discovers the WFOE

(Beijing Today website’s blog section does not represent any view of Beijing Today or its reporter. Anyone interested about the story can find the original text from the link above the article. The site’s blog section aims to introducing expat blogs in China to more Chinese readers as 50 percent of Beijing Today readership remain young Chinese who have experience of living abroad, white colors or school students. Blogger who does not want his or her story linked at Beijing Today’s website, please email to info@beijingtoday.com.cn to take down the stories. )

http://www.chinahearsay.com/buddha-steel-vies-and-legal-ethics-part-ii-man-discovers-the-wfoe/

Last time I talked about how some canny lawyers and their venture capital overlords came up with a sneaky way to get around China’s foreign investment restrictions during the Internet boom years. The structure involved an offshore company and a series of dubious contracts between that foreign company and the Chinese entity that held various Internet-related licenses.

But time marches on, and wily attorneys adapt to changing circumstances. Let’s rejoin our heroes, Everyman Wang and Generic Zhang. When last we saw our intrepid entrepreneurs, they were busy pissing away 12 million dollars of investment on the dubious venture ‘EZ Cheez,’ a PRC-based cheese straightening company. It’s now 2006, and the boys have called up CEO Capital with a new pitch:

Wang & Zhang: Hi, Mr. CEO. We feel really bad that EZ Cheez went under, but that’s how the cookie crumbles.

CEO: Yeah, that’s life. We lost a ton of money on shitty deals, but lucky for us, we were bought out of some others and even managed to ride a couple to public listings.

Wang & Zhang: Congrats. We have a new company that needs investment.

CEO: Great. We invested once, so you guys must be OK. Gimme the pitch.

Wang & Zhang: Through our government contacts, we’ve once again secured a monopoly position in a highly restricted industry in China: sneeze insurance.

CEO: Come again?

Wang & Zhang: You know, when you sneeze, you involuntarily close your eyes and several different muscles can contract. This leads to a lot of accidents. Consider what happens if you’re operating heavy machinery and you sneeze at just the wrong time.

CEO: Never worried about it before.

Wang & Zhang: And with sneeze insurance, you won’t have to.

CEO: You guys never cease to amaze me in your ability to create new markets.

Wang & Zhang: Our new company, iSneeze, has been promised the only license to underwrite sneeze insurance policies in the PRC, but we need 50 million dollars to capitalize.

CEO: Consider it done, but let me talk to my lawyer first.

Since the EZ Cheez deal, CEO has fired its previous lawyer, Merc, for being too old (32). This is a young man’s game, and they now get their advice from Tyro, a 28-year-old VC lawyer with several years experience “in the Valley.”

CEO: Well, young Tyro, what can you tell me about iSneeze?

Tyro: Yep, it’s in a restricted area, but don’t worry, I’ve got you covered.

CEO: You’re not going to set me up with one of those offshore company/service contract setups, are you?

Tyro: Well, yes, what’s wrong with that?

CEO: It’s just so six years ago. Can’t you give me something a bit more fresh?

Tyro: Sure, I have a fresh option for you that will make it even easier for you to get profits offshore.

CEO (laughing): ‘Profits.’ You lawyers, always with the strange jargon. Just tell me what the structure looks like.

Tyro: OK, well, as usual, we set up an offshore company somewhere like the Cayman Islands or BVI – the shareholders will be Wang, Zhang and CEO Capital.

CEO: Sounds familiar.

Tyro: Here’s where it’s different. Instead of all those contracts between the offshore company and Wang & Zhang’s Chinese company, iSneeze Insurance PRC Ltd., we do something else. The Cayman company sets up its own PRC entity, a wholly-foreign owned entity, or WFOE–

CEO: Gesundheit.

Tyro: –which provides services to iSneeze Insurance PRC Ltd.

CEO: But iSneeze Insurance is the one that has the insurance license and makes all the money, right?

Tyro: Yes.

CEO: And we don’t own any of that company?

Tyro: No. You own a WFOE, iSneeze Services Ltd., the exclusive service provider to iSneeze Insurance Ltd. The insurance company collects premiums but the WFOE will suck up all the profits and send them offshore to the parent company. The great part is that since the service agreements are between two PRC-based companies, we won’t have to get an approval from the foreign exchange authority!

CEO: Wow, that’s clever! But if it doesn’t really own anything, will that affect the listing of the Cayman company?

Tyro: Not at all. It will own the WFOE, which will have an exclusive deal with the insurance company. Moreover, in addition to service agreements between these two onshore companies, other contracts will bind Wang & Zhang, and iSneeze PRC to the Cayman company.

CEO: Such as?

Tyro: Such as: a Power of Attorney, giving the Cayman company the ability to control certain actions of the founders; an Option Agreement, which allows the Cayman Company to buy equity in iSneeze PRC; a Loan Agreement, whereby the founders state that they have borrowed money from the Cayman company to establish iSneeze PRC.

CEO: Wow, that sounds very technical. What does all that get us?

Tyro: If something goes wrong, you’ll be able to exert control over the PRC company and even purchase shares if need be.

CEO: And these agreements are enforceable?

Tyro: I’ve never had a judge strike them down, not once!

CEO: Great! Let’s do it!

Editorial Note: You probably recognize this as the so-called ‘Sina structure’ after the Net portal Sina. They were one of the first to use it, and the name stuck (I still use that name, as opposed to VIE structure).

What’s the problem with a Sina structure? Basically, it’s a fiction. When you list, you’re telling folks that you have a solid legal foundation, when in reality you don’t. The Sina structure gives you the benefits of that restricted China business while hiding the regulatory risk from everyone. Much like wearing dark pants and pissing down your leg, you get a nice warm feeling, but nobody notices.

What’s the risk? The problem here is that that offshore company, despite these contracts, doesn’t really exert control over the PRC entity. Sure, they have these loan agreements and option agreements and so on, but try going into a court in China and enforcing them. Ain’t gonna happen.

My fictional lawyer Tyro claimed that he never had a judge strike down these contracts. Probably true. I once asked a very famous China-based VC lawyer, who had done hundreds of deals, if he had ever tried to enforce any of these agreements in a PRC court. He actually laughed, then paused, then admitted that it had never happened.

The Sina structure is even more sneaky than the one I talked about last time because there is an actual PRC-based company, the WFOE, that exists. When a company lists, there it is for folks to look at. “Hey, look there, that’s what we’re getting, a Chinese company. Let’s toss in a lot of money.” Unless they read all the disclosure docs carefully AND get an expert opinion, they probably have no idea that the WFOE is probably only legally allowed to provide “consulting services” or “software development,” a far cry from the kinds of things the listed company is all about.

Ten years ago, I used to wonder what on earth people were thinking when they bought shares in these companies. Eventually I realized that they were relying on prospectuses and disclosure docs that were far from transparent. Lawyers and accounting firms, and their legislative partners in crime, have gamed the system so that the language given to prospective investors is downright misleading.

Think about it this way. Many of the China-based lawyers I know don’t even understand this stuff, much less know whether a Chinese judge would enforce these agreements. Your average investor/fund/legal counsel (whatever) knows much, much less, and yet they are expected to take that language and make an educated investment decision. This is what the “rigorous” U.S. securities laws give us. It’s kind of a joke, and it makes me wonder (since I’m not a securities lawyer) how often investors get screwed over like this.

Minimum Capital Requirements. Good News For Small Companies Looking At Shanghai.

http://www.chinalawblog.com/2011/01/minimum_capital_requirements_good_news_for_small_companies_looking_at_shanghai.html

Shanghai has recently loosened its minimum capital requirements for WFOEs (Wholly Foreign Owned Enterprises), making location of service businesses in Shanghai far more attractive. Chinese company law mandates all one shareholder corporations have a minimum registered capital of at least RMB100,000. The WFOE formation regulations provide for no specific amount for registered capital. Instead, the rules provide that the amount of registered capital must be sufficient for the proposed operations of the WFOE.

Most jurisdictions require the registered capital be equal to the first full year of expenses of the WFOE. As a practical matter, it is rare for a big city jurisdiction like Shanghai to require less than USD$150,000 in registered capital. What many investors do not realize is that the registered capital does not need to be contributed in a single lump sum. The rule is that 15% of the registered capital amount must be contributed within 90 days of WFOE formation, with the remainder payable over a period of two years. It is a rare WFOE that will not need to pay capital in the amount of $150,000 over its first two years of operations for rent, salaries and supplies. In accordance with these rules, if the registered capital is set at $150,000, the initial payment due in 90 days is $22,500 with the remaining amount payable within two years. This is not usually a burden for a normal WFOE operation.

In the past, Shanghai had imposed a different rule. Shanghai required minimum capital of $150,000 and required that the entire amount be paid within 90 days. Though this requirement was not usually a problem for manufacturing WFOEs, it often posed a substantial barrier to small service companies that do not have high initial capital costs. In fact, this requirement forced many service WFOEs to form their companies outside of Shanghai. I discussed this issue a number of times with local Shanghai officials over the years and they would told me that they fully understood the effect of their 90 day payment requirement and that they had no problem with forcing small service and retail businesses out of Shanghai.

Based on my recent discussions, however, it appears that all of the local districts with the exception of Jingan have modified their requirements. The minimum registered capital is still set at $150,000, however, these districts now follow the general rule whereby 15% of the total must be paid within 90 days of formation, with the remainder paid over two years. Jingan still maintains a more restrictive approach, requiring minimum capital of $150,000, 15% payment within 90 days, with the remainder payable within six months of company formation.

The result of these changes is that Shanghai is now an acceptable alternative for formation of low capitalization consulting, service and retail WFOEs. This is major change that should be welcomed by service companies considering formation of a WFOE in China.

SME Legal Bills In China. I’m So Glad You Asked.

http://www.chinalawblog.com/

I was talking with a client today for whom we are doing what I consider to be our standard China start-up “package.”  We are helping them form a WFOE, helping with the legal side of their lease, registering and protecting their IP in China, and drafting their China employee manuals and employee contracts.

I mapped out generally what the client could expect during its first year in China in terms of legal fees and then I very briefly talked about some non-legal accounting and wage issues with which it should be prepared to deal. The client then asked a great question and one that, surprisingly enough, I had never been previously asked. “How much should we set aside for China legal matters after the first year? 

I thought for a moment and then noted how unless there is a major corporate change, there usually is surprisingly little need for legal help after one’s first year in China. I then said our clients might call us after the first year with a labor law issue, but that those are usually very quickly and cheaply resolved.

I got off the phone and five minutes later a client called. He had just been told by one of his female Chinese employees that she was entitled to 13 days leave for her marriage (as opposed to the standard three days) because she is 25 years old. The client thought his employee was making this up, but he wanted to be sure. Sure enough, brides over 22 years old are entitled to an extra ten days of leave time. They are entitled to thirteen days leave, but this leave shall include weekends (but not legal holidays). It took us all of ten minutes and we did not even bother to charge.

Cracking Down On Illegal Land Use In China. Do You Really Still Feel Lucky, Foreign Punk?

The following is an amalgamation of a number (maybe 5 or 6) of conversations I have had over the years with people wanting to register a WFOE (Wholly Foreign Owned Entity) in China fast:

Potential Client: Can you help me register a WFOE in China.

Me: Yes. Not a problem. Do you have a lease yet? Do you know that a legitimate lease is required for the approval of a WFOE?

Potential Client: I know that but we are in a real hurry here.

Me:  Okay. But do you have a lease.

Potential Client: We have a lease but I don’t think it technically will qualify.

Me: What do you mean?

Potential Client: The land is zoned agricultural but my Chinese partner has secured all the okays to allow us to use it for our factory.

Me: Not a good idea. Trust me on that.

Potential Client: The factory has been there for two years without a problem and my Chinese partner assures me that the local government is fine with it.

Me: Don’t do it. Right now, the local government is okay with it. But what if the current mayor is pushed out next week on corruption grounds. Do you really want to be in a situation where you have spent a large amount of money on a space that gets shut down?

Potential Client: I am in a hurry and this is the only space that works.

Me: Are you sure? You are in a hurry, but is it really going to be worth the few months if you get shut down?

Potential Client: I am not going to get shut down. My Chinese partner is incredibly connected.

Me: Incredibly connected to the current local administration, MAYBE, but as I said, that administration could be out the door next week. Beijing checks on these things too and if they see that your facility is illegal, Beijing could see to its shut-down. I just don’t think it a good idea to go into a WFOE illegally and my firm cannot be a part of that.

Potential Client: That’s ridiculous. This is how business is done in China. Are you really saying you won’t take us.

Me: Yes. We won’t take you because we do not want our reputation damaged when you get shut down and we won’t take you because we do not want to be blamed when you get shut down. On top of that, I know that the Chinese law firm in _________ with which we work on these matters will not do it either because they don’t want to be viewed badly by Beijing. 

Potential Client: Well I am sure I will have no trouble finding someone to help me on this. Good-by.

I know that at least one of these companies did end up getting shut down (within about a year) because someone at the company who had sided with me on the company not going forward emailed me to tell me of this. 

I thought of the above today after reading “Cracking Down On Illegal Land Use: The BYD Case” over at the consistently excellent China Bystander blog. The post is on BYD, “the fast-growing compact automaker in which American investor Warren Buffett has a 10% stake.” Seems BYD has seven factories on land zoned for agriculture and China’s Ministry of Land and Resources is going to be ruling by September 30 on what to do about that: 

China Bystander nails it in describing these situations:

It is not unknown for local officials to turn a blind eye to such zoning violations in the drive for economic growth. Companies want to bring new production capacity on stream without waiting for all the red tape to be dealt with, while officials themselves are judged on their promotion of local economic growth and local governments have become hooked on land sales for their revenue.

The ministry has said that 7,800 hectares of land had been used illegally in the first half of this year, a 14% increase over the same period last year. That reversed the trend of the figures of the past three years. They had shown the issue was shrinking, but that may just have reflected lax enforcement and reporting. The country’s farmland has continued to be eaten up by industrialization and urbanization. It has shrunk by 6% over the past decade to 122 million hectares, barely above the minimum arable land the ministry reckons China needs to be self-sufficient in food. The summer’s floods and the drought earlier in the year in some parts of the country have reduced that margin further.

China has been cracking down hard on facilities operating outside China’s zoning laws:

The ministry has hit five companies so far this year for illegal land use, following a tougher inspection regime launched in February that found examples of illegal land use in more than half the 13 cities examined in an initial spot check and officials cooking the books in four. In those cases buildings were ordered to be demolished, land taken back, executives imprisoned and official reprimanded.

China Bystander ends its post by noting that none of the companies previously sanctioned were as high profile as BYD and then wonders” how tough the ministry will be this time” and what sort of signal will it want its ruling to send? 

Bottom Line:  If China is going after Chinese companies for putting manufacturing facilities on agricultural land, what in the world makes you as a foreign company think you will be able to get away with doing the same thing? And it is not just agricultural land. I am aware of a big China city office building that was shut down because it was zoned for a hospital. 

What are you seeing out there?

http://www.chinalawblog.com/