Corporate Control of Foreign Invested Enterprises

March 2013

Stories of foreign investors in China falling victim to strategic rent-seekers are not uncommon, and often arise because the investors did not adequately employ corporate controls, thereby creating a lax environment that escalated into chaos.

With proper understanding, preparation, and maintenance, foreign investors in China can establish a robust and healthy corporate control environment, allowing for focus on commercial objectives while mitigating risk. This alert identifies some key areas of focus for corporate control in China.

Board Powers
A foreign invested enterprise (“FIE”) board of directors, and by extension investors, should remain aware of and involved in the governance of the FIE. The board’s powers are established via the articles of association, which set out the FIE’s internal rules of operation. The articles of association may establish board powers such as approving contracts exceeding a certain value, appointing management, selecting auditors, establishing internal audits, and determining other corporate control measures. Board powers may also be established through board resolutions that are directed to FIE managers, such as instructing managers to comply with company seal use protocols, bank account access protocols, or contract approval protocols. Regular board meetings and proactive execution of board powers establishes a culture of transparency and accountability, and conveys such culture to the FIE’s management.

Transparent Accounting
An accounting control strategy should target points of weakness in accounting cycles (e.g. the purchase order to payment cycle, or the sales to cash cycle), typically where handoffs occur between people or departments. Increasing transparency at such points of weakness strengthens the integrity of the underlying accounting data.

Day-to-day accounting control strategies are based on the establishment of standard protocols for accounting cycles, which may include sign-offs on each stage from multiple employees, verification of any information obtained externally (e.g. supplier pricing), template contracts, and controlled access to petty cash.

A thorough accounting control strategy should also include periodic large scale measures to confirm accounting data, such as a well-considered monthly closing procedure, random audits, and detailed contract reviews.

Bank Account Protocol
Access to bank accounts is most often granted to those in possession of the relevant company seal, or to the FIE’s legal representative (A legal representative is a person authorized to bind the company, and historically has been the chairman of the board). However, it is possible to establish additional measures to control access and to provide the investors with transparency, including the requirement of several approvers for all transactions, special approvals for large transactions, Chinese and English language bank statements issued to several parties, and online account access.

Company Seal Protocol
Various company seals, or chops, are typically used (rather than signatures) to legally bind a company. Therefore, seals wield significant power, and ensuring the transparent and controlled use of seals should be an area of focus for any corporate control strategy in China. Protocols for the use of company seals may mandate specific storage requirements, a defined chain of approvals, a requisite witness, a written record of each seal’s use, and scans of sealed documents. The seal protocol can be reinforced through a corresponding board resolution, acknowledgements signed by employees, and tying the responsibility for seals to the employee’s duties set out in his or her employment contract. For FIEs where seal control is deemed particularly imperative, the investors may even contract a third party to store and apply the seals.

Robust Employment Contracts
Robust employment contracts and employment handbooks ensure clear communication of what is expected from employees and serve as the first line of defense against rent-seeking employees.

Employment contracts may include confidentiality obligations, non-compete restrictions, a well-written job description that includes broad professional duties and concepts (e.g., timely completion of assignments) and a clearly-defined notion of fiduciary duty. For employees with significant responsibilities, employment contracts may expressly hold employees personally liable for actions that violate the terms of the employment contract and harm the FIE (e.g. a manager exceeding his authority), and may even define damages for gross violations of obligations.

Conclusion
Investors of FIEs in China face unique challenges ranging from China-specific regulations to language, distance, and culture. Corporate control helps to bridge these challenges by creating a system of transparency, accountability, and control.

©2013 All content of this article is the property and copyright of China Solutions Inc and may not be reproduced in any format without prior express written permission. The content of this article is intended to provide a general guide to the subject matter and should not be treated as a substitute for specific advice concerning individual situations. Readers should seek legal advice before taking any action with respect to the matters discussed herein.

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