Anatomy of a Corporate Hijacking: How Your Chinese Company Can Be Hijacked and How to Prevent It

April 10, 2014 Posted by China Briefing Reading Time: 7 minutes

By Chet Scheltema, Director, Dezan Shira & Associates

BEIJING – The American executive was bewildered and somewhat panicked. Calling late in the evening from the U.S. Midwest, he was trying to understand where his Chinese company’s corporate financials were being held and why he couldn’t access them. Local management had become uncooperative and refused to answer questions or provide information. The executive wondered why he couldn’t immediately terminate and replace the local managers and retake control of his company.

The hijacking of foreign invested enterprises by local employees in China is not uncommon. Recent high-profile examples include the publicly traded company ChinaCast Education Corporation, as reported in a New York Times article entitled, Battle Over a Chinese Company Turns Physical. However, most incidents go unreported and unnoticed by the public.

The key to understanding how a company can be so easily hijacked by local employees – and the key to understanding how to prevent it – is to understand the administrative details of how a Chinese corporation is managed, including how authority and power are dispersed and the company’s points of managerial vulnerability, and also to understand the leverage that local employees have under Chinese labor law.

Corporate Seals

The authority to manage and direct the resources of a Chinese enterprise is dispersed very differently than in a western enterprise. Authority in western corporations resides in individuals appointed by and acting with the apparent authorization of the board of directors and ultimately the shareholders. Much to the surprise of foreign investors – and sometimes consternation — authority in a Chinese company resides in fact primarily in the hands of the person who currently holds the company’s corporate seals or “chops.”

Everything from accessing the company’s bank accounts to entering into commercial contracts to making regulatory filings requires the use of the corporate seal or “chop.” Yet there is no legal or practical restriction on who may physical control or use these chops; in practice, these seals are commonly passed from hand to hand of all manner of employee or service provider throughout the course of a business day.

Further complicating the situation is the fact that the corporate seals are not easily canceled or replaced when lost. Such cancelation or replacement requires a time-consuming and bureaucratic process involving the petitioning of the Chinese Public Security Bureau.

Legal Representative or Chief Representative

Besides whoever happens to be holding the “chop” at the moment, authority in a Chinese enterprise also rests with the person who is officially registered with the Administration of Industry and Commerce (AIC) as the Legal Representative of the enterprise, or in some cases a Chief Representative.

Unlike senior managers of Chinese companies, Legal Representatives carry almost unlimited authority and decision-making power. Yet unlike the situation in western corporations where a decision of the board of directors to dismiss an executive (or “legal representative”) is effective immediately, it may take months to update the records of the AIC and thereby replace a Legal Representative. Meanwhile, the individual currently registered with the AIC as the Legal Representative will continue to act with the apparent, full authority of the company and board of directors and shareholders.

Of course, a terminated Legal Representative acting without the actual authorization of the board or shareholders may face personal liability for his or her actions, but in the meanwhile he or she still acts with all apparent authority of the company until the AIC records are updated.

Terminating an Employee in China

Besides the fact that a Chinese entity is, practically speaking, controlled by whoever currently wields the chops and whoever is registered at the AIC as the Legal Representative (or Chief Representative in some cases), there is another factor that may increase the challenge of retaking control of a Chinese enterprise from rogue employees. It is the difficulty of terminating an employee under Chinese labor law.

Chinese law does not allow an employer to freely fire an employee. The employer must have good cause to terminate an employee or otherwise must pay potentially significant severance salary (roughly two times a capped monthly salary for each year of employment) and may even be required to reinstate the employee. And where the employee pursues arbitration or legal action to enforce his or her rights, the expense of a legal defense may be high and usually the employer will fail to successfully defend itself. As a result, Chinese labor law affords employees significant leverage to negotiate their severance terms and wise employers are hesitant to take rash action in terminating even the most derelict of employees.

Other Vulnerabilities

The control and sustainability of corporate operations in China is also vulnerable to employee abuse in other ways. Access to and control of the company’s financial records and bank “tokens” is one obvious example. Access to and control of key assets is another.

One less obvious example relates to China’s VAT system and the administrative details of how it works. China’s newly implemented Value-added Tax system is intricate and challenging to navigate, and it needs to be skillfully managed in order to avoid a potentially sizeable tax burden: Potentially a full 17 percent on every transaction of the company or its vendors involving the purchase or sale of goods, if general VAT taxpayer status is not obtained and leveraged.

One of the many links in the chain needed to successfully manage this VAT system is the use and accurate printing of physical VAT invoices. The VAT invoices must be printed on specially purchased and prepared invoice paper from special printers associated in official records specifically with the relevant corporation. If the printers or VAT invoice paper become unavailable for whatever reason, business partners or vendors may refuse to do business, lest they incur an outsized tax bill on each commercial transaction. And this is not a hypothetical or theoretical concern, as the author has observed several such cases where the unavailability of VAT invoices led to a delayed or canceled transactions.

‘Don’t put all your eggs in one basket”

So the practical, proverbial advice to not “put all your eggs in one basket” is highly apropos at this moment. Designing a hijack-proof Chinese company involves dispersing the points of power and authority and also dispersing responsibility for the points of vulnerability of a company in such a way as to prevent their abuse by any one person or group of persons. And for those points of authority or vulnerability that remain, albeit dispersed, it involves creating accountability mechanisms, such as regular reporting and monitoring. A healthy corporate management structure in China would not concentrate all authority in one general manager who is also the Legal Representative, who has minimal reporting requirements, and whose activities are lightly supervised or monitored.

An example of a healthy structure would include appointing separate individuals with independent interests to the positions of general manager and Legal Representative. It would create a mechanism to track, record, and monitor the use of the corporate seals. And it would also obviously entail regular, detailed reporting by the general manager and Legal Representative to supervisors at corporate headquarters. Furthermore, the responsibility for points of vulnerability, like the VAT invoice printers and invoice paper, would be entrusted to several managers with independent interests who could be accessed at any time and who would regularly report on their activities to senior supervisors.

Vigilance

As a wise man once wrote, “A little sleep, a little slumber, a little folding of the hands to rest — and poverty will come on you like a thief.” Designing a hijack-proof corporate management structure means implementing vigilance by dispersing authority and power in your Chinese company and implementing practices of accountability and healthy oversight.

Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam in addition to alliances in Indonesia, Malaysia, Philippines and Thailand as well as liaison offices in Italy and the United States.

For further details or to contact the firm, please email china@dezshira.com, visit www.dezshira.com, or download our brochure.

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