Defective establishment of WFOE: Legal validity and risks involved

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When establishing a wholly foreign-owned enterprise (WFOE) in the PRC, the examination and approval procedures usually require several months. Naturally, investors from Europe and the US would like to shorten the required time so that they can establish their PRC entities and commence operations as soon as possible.

Kenneth Kong, Partner, MHP Law Firm
Kenneth Kong
Partner
Martin Hu & Partners (MHP Law Firm)

In our experience, when a client elects to invest in a local industrial park or economic development zone, the competent authority will often promise that it will procure the obtaining of the business licence for the new WFOE within a short period of time.

In one case with our American client investing in and establishing a plant in a certain development zone, as approval of the proposal for the project happened to fall in December, the investment bureau and the local administration for industry and commerce issued the business licence after the client had merely signed a simple form, in order to have the total foreign investment amount of that project counted toward the foreign investment attracted by the development zone’s investment bureau for the year. However, the British Vergin Islands company, being the holding company for the proposed WFOE, had not yet been fully established. The “special attention” given by the local development zone resulted in a situation where the subsidiary was established before the parent company.

When such a situation arises, the foreign client will often worry about the validity of the establishment of the company and the related legal risks.

Legal risks

Ada Zhang, Assoicate, Martin Hu & Partners (MHP Law Firm)
Ada Zhang
Associate
Martin Hu & Partners (MHP Law Firm)

Pursuant to the Company Law and the Administration of Company Registration Regulations, the establishment of a company is required to satisfy a series of substantive requirements, e.g. the number of shareholders, minimum registered capital amount, having articles of association and an organizational structure that is legally compliant. Furthermore, a newly established company is additionally required to satisfy numerous procedural requirements, including the payment and verification of its registered capital, examination and approval of the application documents for establishment and completion of business registration. Any instance in which a company that does not satisfy or has not carried out all of the substantive conditions or procedural conditions but nevertheless obtains its business licence can be deemed a case of “defective establishment of a company”.

Common instances of defective establishment of companies include: the articles of association not having been reviewed and approved by all of the shareholders; the articles of association or other application documents containing provisions that violate mandatory provisions of laws; the internal organizational structure not complying with the law; and fraudulent reporting of the company’s registered capital. In the foreign investment sector, the securing of registration without having gone through the normal examination and approval procedures is also a common form of defective establishment.

At present, the Company Law does not expressly distinguish defective establishments that involve the violation of substantive provisions from those that violate procedural provisions and does not expressly address whether the substantive qualifications of the corporate legal person are affected by a defective establishment. Notwithstanding the lack of clarity in legal principles and regulations, the most serious administrative penalty that a company during whose establishment a violation of the law was committed can experience is an order revoking its business licence. The question of what level of defective establishment constitutes a serious violation of the law is one that is considered in a judicial ruling/judgment or by an administrative authority. In our opinion, a simple delay in submitting some application and registration documents should not be deemed a serious violation of the law and the company should be given the opportunity to remedy the defect.

However, if the company did not carry out any of the substantive examination and approval procedures nor provide substantive approval documents, yet was granted permission to establish, or in the course of the establishment of the company, establishment of its parent was not yet completed or if another such non-remediable defect existed, it should be deemed a serious violation of the law and the substantive qualifications of the corporate legal person should be revoked in accordance with the law.

Operating risks and burdens

A WFOE that was established without the review of its application documents will, when it is providing all of the missing documents, generally be required to backdate the documents to a time before the company establishment date indicated on its business licence. For certain foreign investors with rigorous corporate governance, the backdating of legal documents often runs counter to local laws or the company’s rules and regulations and could give rise to legal liability for the investor. If such a circumstance as the establishment date of the WFOE being earlier than the date of establishment of its investor should arise, a non-remediable defect will be left in the WFOE’s company registration file.

If, in future, the WFOE seeks to make a public offering of shares and list or the company is to be sold, it is very likely that the lawyer doing the due diligence will discover this problem and issue an unfavourable legal opinion.

Even if a WFOE obtains its business licence earlier, it will usually be required to carry out anew the approval procedures that it did not carry out initially, the most typical being the advance permission procedures in special industries, such as environmental impact assessments. As these procedures are not the responsibility of the initial government authorities, it is rare for an enterprise to obtain similar “special consideration”, and it is even possible that because it does not satisfy the approval conditions it will be required to revise its scope of business and other documents. There have been a number of WFOEs that, although they obtained their business licences, were unable to actually operate due to similar reasons.

After it has obtained its business licence, a WFOE still needs to continue to complete a series of subsequent registrations before it can operate. These procedures include the opening of bank accounts, payment and verification of its registered capital, and foreign-invested enterprise foreign exchange, tax and customs registrations. An enterprise could continuously run up against a variety of difficulties in the course of such subsequent registrations due to the earlier defect. Again taking the above mentioned case where the subsidiary was established before the parent as an example, in the course of the verification of the parent’s registered capital, the capital verification institution that issues the report is likely to raise doubts. Similarly, the company could in future encounter difficulties in financial accounting and tax treatment.

Kenneth Kong is a partner and Ada Zhang is an associate of Martin Hu & Partners (MHP Law Firm)

Martin Hu & Partners (MHP Law Firm)8/ Floor, Kerry Parkside Office
1155 Fangdian Road, Pudong
Shanghai, China
Postal code: 201204
Fax: +86 21 5010 1222
www.mhplawyer.com

Martin Hu
Tel: +86 21 5010 1666*966
E-mail: martin.hu@mhplawyer.com

Kenneth Kong
Tel.: +86 21 5010-1666*922
Email: kenneth.kong@mhplawyer.com

Ada Zhang
Tel.: +86 21 5010-1666*918
Email: ada.zhang@mhplawyer.com

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