Jianwei (Jerry) Fang and Jie Gao
The Chinese market, however too big to ignore, is full of risks. Multinational companies (MNCs) have been investing in China in various forms over the past three decades, ranging from the earlier joint ventures (JVs) to the more recent wholly-owned subsidiaries. This evolution of foreign investment vehicles has called for a key awareness of the risks associated with each structure, most notably shareholder disputes and corporate liability.
In a JV, the foreign investor has a Chinese partner that monitors the local management and employees. This arrangement can lead to corporate governance issues with local shareholders in the long run.
Meanwhile, a wholly foreign-owned enterprise (WFOE) offers greater simplicity in governance and eliminates the possibility of conflict with Chinese partners. But its ultimate shareholders and decision-makers are overseas and forced to rely on reports to monitor local operations. Notwithstanding the compliance and internal controls placed on the subsidiaries, the reduced on-the-ground supervision by the ultimate shareholders can result in its own set of problems.
The PRC Company Law provides that a company’s articles of association should designate a legal representative to act on its behalf. The absence of the parent’s ultimate controllers means that a legal representative essentially takes de facto control of the WFOE. If he becomes uncooperative, foreign investors may lose control of the WFOE. Legal representatives can also be difficult to replace, so choosing a reliable individual is critical.
Without a local shareholder who understands Chinese customs to supervise, employees are more likely to get away with misconduct and avoid detection. Fraud may be committed by employees seeking personal gain through deceitful activities such as stealing company property, accepting bribes, abusing powers, embezzling company funds or fudging financial reports. And fraud committed by higher-level employees can not only cause financial losses, but can also harm a company’s culture and reputation.
Chinese law provides several avenues for companies to counter employee fraud and recover losses. One approach is to initiate civil proceedings against the offending employee. For instance, a complaint can be filed for infringement of property rights or for return of unjust gains. Complaints against directors or senior management can also be based on negligence or breach of fiduciary duties. And in some cases, the company can also sue the employee’s aider and abettor, such as a vendor or customer who agreed to help the employee personally profit from a transaction at the cost of the business.
Another approach is to report the fraud to authorities for criminal prosecution, which is appropriate when the misconduct reaches the criminal threshold. Two common examples are embezzling and accepting bribes. In recent years, the number of criminal cases involving embezzlement and bribe-taking by non-state actors have increased substantially, reflecting a new focus on combating financial crimes in the private sector.
Chinese laws have long criminalized embezzlement and bribe-taking. The Interpretation on Several Issues Concerning the Application of the Law in the Handling of Criminal Embezzlement and Bribery Cases, issued by the Supreme People’s Court and the Supreme People’s Procuratorate on April 18, 2016, set new sentence thresholds. Employees can be imprisoned for embezzling or accepting bribes worth more than Rmb60,000, and if the amount reaches Rmb1 million, employees can face imprisonment of more than five years, as well as have their personal properties confiscated.
A successful criminal report can be highly effective in punishing offending employees and recovering losses, especially as prosecution places greater pressure on offenders to cooperate. Also, authorities can exercise investigative powers and other means not available in civil proceedings.
One particular case we handled on behalf of a multinational client involving its WFOE and a Shanghai employee exhausted the entire criminal trial process, including an internal investigation, a criminal report filing, prosecution and charges and, eventually, trial and sentencing. The People’s Court in Jin’an District, after an open trial, held that the employee embezzled approximately Rmb600,000 by conspiring with a third-party vendor, sentenced the employee to two and a half years in prison, and ordered the seizure and return of the total embezzled amount to the company.
This case sets several valuable takeaways for MNCs:
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