Legal Risks in ‘Walking Away’ From China

February 18, 2011 Posted by China Briefing Reading Time: 6 minutes

Choosing to liquidate versus running away from debt

Op-Ed Commentary: Chris Devonshire-Ellis and Richard Hoffmann

Feb. 18 – Although most foreign investments in China are successful and generate considerable profits for their investors, some investors do wish to close down their businesses either because of poor profitability, global restructuring, or for some other reasons such as M&A making a site redundant. This is pertinent especially at present, and increasingly so in South China’s export processing business, coming under pressure to adapt to new trading conditions as margins deteriorate and operating costs rise.

Can a foreign investor choose to just “walk away” if there are no substantial assets left in their business? Will the investor who does so incur any liability that can be enforced against him or his other assets in China or elsewhere? Can a foreign investor make a strategic retreat from their Chinese investment without being chased by the creditors? The short answer, not surprisingly and quite properly, is “no.” This is a critical issue that must be considered not only during the closing down of a business, but also in the process of running an enterprise.

Limited liability of FIEs and potential liabilities for foreign investors
Foreign invested enterprises such as WFOEs and JVs are independent legal persons and own their own assets and properties. The foreign investors, in principle, only bear the limited liability for their investment to the extent of their registered capital originally brought into China. However, under certain circumstances, foreign investors may be held personally liable for their investment activities beyond the capital contribution obligation. The potential liabilities applying to those foreign investors who “walk away” differ from those who face bankruptcy or voluntary liquidation.

Penalties for “walking away”
According to business registration regulations in China, it is the investor’s obligation to register properly when the business is created and update the registration authority in the event of any significant changes of circumstances. If a foreign invested company is being wound up, the foreign investor is required to deregister the company before they may take back any remaining assets of the company. In other words, you must tell the authorities.

Deregistration can only take place after the company has gone through a liquidation procedure, including a liquidation audit, and the payment of any liabilities to the tax authorities, customs, employees, and creditors.

If a foreign investor fails to meet this obligation, and instead “walks away” without going through a proper liquidation, the registration authorities are entitled to impose a fine of between RMB10,000 and RMB100,000 on the company and to revoke its business license. In addition, the legal representative of the FIE whose business license is revoked, and who is personally liable for such revocation, shall be banned from being appointed to director, supervisor, or other senior management positions for three years in any other business entity in China as from the date of revocation of the business license. The names of the “walk away” investors are blacklisted in the official archives of the registration authorities and they may be barred from the China market in the future.

In many cases of this kind there are remaining assets or property in a failed FIE. In this situation, as well as the legal representative being sanctioned as discussed above, under Chinese Law it is held that a foreign investor who did not go through a liquidation proceeding but took back the assets of the FIE should be held liable for all of the company’s remaining debts and liabilities.

Liabilities for foreign investors in bankruptcy
The Enterprise Bankruptcy Law of the People’s Republic of China stipulates in Article 5, “(the) validity of any bankruptcy proceedings commenced in accordance with this law shall extend to the properties of the debtor outside of China.” For the first time, a claim can be made over the assets of foreign investors in a bankruptcy case in an exterritorial jurisdiction outside of Chinese territory. The bankruptcy administrator is responsible for bringing actions against any debtors on behalf of the company during bankruptcy proceedings. According to the bankruptcy law, any foreign shareholder who had not fully paid up their registered capital shall be held liable for this inadequate capitalization.

Enforcement of judgment or arbitration award against foreign investors
If a Chinese court makes a ruling to hold a foreign investor liable for their Chinese entity debts, the petition for enforcement against the investor may be made either by the Chinese creditors or the bankruptcy administrators in one of two different ways.

Firstly, in the event that the foreign investor has assets or other investment in China, the Chinese creditors or the bankruptcy administrator may make a petition to the court to freeze these properties. The foreign investor shall either settle the debt with their Chinese creditors to release the frozen property, or their properties shall be auctioned and used to pay to the creditors. It should be noted that according to the mutual arrangements on recognition and enforcement of civil judgments between Mainland China and Hong Kong and Macau, the assets and properties of the foreign investor located in Hong Kong and Macau may also be subject to enforcement by their creditors in Mainland China.

Secondly, even if the foreign investor does not have any assets or investment in China, and there is no mutual agreement on recognition and enforcement of civil judgments between China and the investor’s country of origin, he is still not safe from the claims of the Chinese creditors in China. In this case, the Chinese creditors may file a petition to a court in the foreign investor’s home jurisdiction for the recognition and enforcement of a court judgment against the foreign investors according to the applicable law in that jurisdiction.

In addition, if there is an arbitration agreement between the foreign investor and its Chinese creditors, and the Chinese creditors file for arbitration in an established arbitration commission instead of civil litigation in a Chinese court, the application made by the Chinese creditors for recognition and enforcement of the arbitration award obtained from the arbitration institution shall be upheld pursuant to the so-called New York Convention of 1958, the United Nations Convention on Recognition and Enforcement of Foreign Arbitration Awards, with 142 signatory countries.

China increases monitoring of downsizing by foreign investors
In the wake of the global financial crisis, the Chinese government has reacted by instituting several new guidelines for investors in the country. These range from how mass layoffs are to be handled to how the government will treat investors who attempt to flee the country without properly tidying up their business requirements. Companies based in several provinces are now required to apply for approval from their local human resources and social security authorities prior to a layoff of 40 or more workers. These regulations amend the national Labor Contract Law implemented in 2009. According to the national labor contract law, companies that want to lay off more than 20 employees must first apply for approval from labor unions and report their plan to labor authorities. These provincial regulations are in response to China’s Ministry of Human Resources and Social Security which advised local governments to ensure stable employment levels and monitoring labor-intensive factories that are susceptible to layoffs.

In addition to changes to the labor law on the provincial level, foreign investors should also be aware that Beijing recently began seeking help from foreign governments to pursue overseas investors who flee the country without properly liquidating their assets. China’s ministries of commerce, foreign affairs, justice and public security jointly issued guidelines for cross-border investigation and litigation of fugitive foreign investors. The government laid out in the guideline how they would follow both international rules and domestic regulations to address such cases and seek assistance from foreign countries. China will request extradition or case transfer when “large amounts of money” are involved the guidelines have stated. Investors who “walk away” from their China operation now face will not only face problems in China, but in their home country as well.

It is therefore clear that, whatever the circumstances and whatever may have happened in the past, foreign investors cannot, and should not, simply “walk away” from a failed business in China. With the growing confidence of the Chinese people, and the proper protection of both local and international laws, the interests of Chinese creditors, employees and the community at large are now defensible.

Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates, a foreign direct investment practice with 10 offices and 19 years of experience in the China market. Richard Hoffmann is a senior legal associate with Dezan Shira & Associates and may advise on matters of liquidation in China. The firm is also able to provide liquidation audits. Please contact the firm at legal@dezshira.com for assistance with liquidation or related matters. The firm’s brochure may be downloaded here.