Select Corporate Concepts for China-Focused Transactions

August 2013

Companies established in different countries share many common characteristics; nevertheless, every jurisdiction has concepts that carry unique meaning. This CS alert explores the role of the business scope, registered capital, legal representative, and company seals in the China context; these concepts should be understood by any China-focused investor or manager.

Business Scope
A key building block of a China-established company is its business scope, which describes the economic activities that the company has been approved to engage in.

The business scope matters because it defines and limits activity, and determines special grants and prohibitions that may be relevant to activity. Operating outside of a business scope can result in the imposition of fines and/or revocation of business license, and contracting with a partner on activities that the partner is not approved to engage in may lead to the ineffectiveness of a contract with that partner.

Application
The business scope of a company is determined upon company formation. It is included in the application materials, and may be rejected, revised, or approved by the authorities. A company may apply to revise its business scope after the company is established, but this requires resources and entails risk of rejection.

Sectors
If the company is a non-Chinese company, the government reviews the proposed business scope in light of the Foreign Investment Guidance Catalogue, which reflects current foreign investment priorities by categorizing sectors as permitted, encouraged, restricted, or prohibited. Foreign investment in a restricted activity typically requires the foreign entity to be in a joint venture with a Chinese entity, where the foreign investor’s shares may be limited. Foreign investment in encouraged sectors can enjoy preferential policies such as tax cuts and fiscal subsidies.

The catalogue is periodically revised as the government’s priorities change; the most recent version, released in 2012, indicates a trend towards placing more sectors in the encouraged and permitted categories, and fewer items in restricted or prohibited categories.

Takeaways
• Ensure your draft business scope is accurate, and is sufficiently forward-thinking to anticipate all activities that your company may engage in across its lifetime
• Consult the Catalogue with respect to your foreign investment plan.
• Know your commercial counterpart’s business scope.

Registered Capital
Registered capital is the investment amount that is required in order to establish your company in China. The most common form of registered capital is cash, but it can also include land use rights, intellectual property, and other forms.

Registered Capital - A Necessary Evil?
Many foreign investors look at registered capital (“RC”) as a necessary evil and, accordingly, seek approval for the lowest RC possible. However, the RC covers your company’s operating costs until it becomes self-sufficient. Therefore, consider identifying and then injecting the amount of capital that will be needed until your company is self-sufficient. Failure to do so may result in the need for any number of more complex alternatives, e.g., apply for an RC increase which consumes resources and carries risk of rejection; invoice the parent company for services rendered and incur corresponding tax liability; obtain a shareholder loan which requires resources and repayment is exposed to forex restrictions and accounting complications.

Legal Minimum, Approved Minimum
China’s Company Law sets out the minimum capital requirements, which vary depending on the type of company being established. For example, a limited liability company has a minimum requirement of RMB30,000, a company limited by shares requires RMB5,000,000, and a one-person limited liability company requires RMB100,000.

However, the legal minimum is rarely (if ever) approved; approval authorities will look at other factors to set the approved minimum, including the scale of the business (e.g., a 100 square meter store versus a 10,000 square meter store), the business scope, the authorities’ quota for foreign direct investment in their district, and other factors. At best, the legal minimum is a starting point for approval authorities to determine how much will ultimately be required.

Timing of Injections, Capital Verification
At the time of your company’s establishment approval, the approval authorities will review and consider approval of the injection schedule of your RC. The most common schedule requires that an injection of 20 percent be made within 90 days of the business license being issued and that the balance be injected within two years of license issuance.

Note that each cash injection must come from the investor’s bank account, and it must go to the capital account of your company, where the RC must be verified by an accountant and can only then be made available for daily operating needs (but will still be subject to forex conversion limitations). The capital verification process typically requires four to eight weeks.

Takeaways
• Consider your RC needs from a break-even perspective, not just a minimum legal or approved perspective.
• Once injected, RC is not immediately available.

Legal Representative
All businesses established in China are required to have a legal representative. Not to be confused with a lawyer, the legal representative is a natural person who has the authority to legally bind the company, and can bear significant responsibility for the company’s acts and omissions, such as outstanding tax liabilities or failure to timely complete a mandatory annual inspection.

The legal representative is given very broad powers by law and custom; he or she is authorized to perform all acts that relate to the general administration of your company and are consistent with the corporate purpose. Examples of this broad authority include acting to conserve assets, executing powers of attorney on your company’s behalf, and executing legal transactions falling within company business.

Checks and Balances - Cumbersome Prevention
Given the depth and breadth of the legal representative’s powers, best practice calls for checks and balances on the legal representative’s authority. Important tools for creating these include: terms and conditions in the employment contract; provisions in the employee handbook; additional pledges; rigorous protocols for accessing company seals, corporate documents, and bank accounts; and limitations set out in the articles of association and board resolutions. These measures are costly and cumbersome in the short term because the legal representative needs to spend time and energy to comply with the various protocols. And, critically, success in these measures cannot be known since success is defined by the non-occurrence of bad events.

Supervisor - A Paper Tiger
Another means of limiting the legal representative’s power is the role of the supervisor. This person (or board, depending on your company’s size) is charged with protecting minority shareholder interests and corporate interests against officers, board members, or shareholders who seek profit at the expense of your company. Examples of the supervisor’s powers include attending board meetings, initiating lawsuits against shareholders, board members, and officers who have harmed corporate interests, and requesting access to documents.

Legal Representative Perspective
The legal representative’s position is a powerful position, but potentially an unattractive one because it can incur civil, criminal, or administrative liability as a result of the company’s actions. Consequences of this liability can include being unable to leave the country (but free to travel within) or even detention (in a confined space). Often, in the event of disputes or regulatory anomalies, the legal representative becomes a person of interest to creditors and authorities.

Takeaways
• The legal representative must be trustworthy.
• Consider a system of checks and balances on the legal representative’s power, which, though cumbersome, can stave off massive problems in the long term.

Company Seal
Company seals (or chops) are the standard mechanism for your company to show its agreement or approval; they are important because they serve as the effective signature of your company and make documents binding against it.

Registration
Seal registration is required during the company establishment process. An impression of each, along with the legal representative’s signature, is often kept on file with the company registration authorities.

Type of Seals
A company may hold a wide range of seals, each with a different purpose. The Company Seal is the most frequently used; it is used for contracts, applications to the regulatory or approval authorities, bank account openings, and more. Each company may only have one Company chop and it must be approved by the Public Security Bureau.

Other types of chops have specialized purposes and allow individual departments to bind the company without using the Company chop. The Financial chop, for example, can be used by your company’s finance division for issuing checks, processing transactions with a bank, and other financial paperwork. Common types of specialized chops include:

• Financial
• HR
• Legal Representative
• Contract
• Customs
• Invoice

Common scenarios include the use of forged chops, disgruntled employees holding chops hostage until certain terms are met, and unauthorized use of chops. Therefore, it is important to consider having a robust and secure chop maintenance and use protocol to reduce

Takeaways
• Have a healthy respect for seals and avoid a blasé approach.
• Develop a robust protocol for seal use.

©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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