Author: Li Yu
The concept of Legal Representative under Chinese laws does not distinguish between domestic enterprises and Foreign Invested Enterprises (FIEs). Accordingly, the provisions referred to in this legal opinion providing the liabilities for legal representative shall apply to the legal representative of all companies registered in China including WFOE.
I. Obligations and Qualification of the Legal Rep
Under PRC law, each company in the PRC must have one "legal representative" (法定代表人 fa ding dai biao ren) – an individual with broad powers and potential liabilities. Under Article 38 of General Principles of the Civil Law of the PRC, a Legal Representative (hereinafter referred as “Legal Rep”) is the legally responsible person acting on behalf of each company in exercising its functions and powers in accordance with the law or the Articles of Association of the company.
Externally, the Legal Rep has wide-ranging authority to act on behalf of any matters in accordance with laws and Articles of Association. In theory, Legal Rep represents the company itself, any actions taken by the Legal Rep are binding on the company without specific authorization. In other words, the Legal Rep will not undertake any personal liability arising out of performing his/her professional duties. For example, a Legal Rep can enter into negotiations and sign commercial contracts on behalf of a company without any need to present evidence of his corporate authority. Additionally, as the company’s signatory, Legal Rep can use the legal representative's chop (a carved stamp bearing the Legal Rep's own name) to enter into agreements on behalf of the company and take other actions to implement the decisions of the board such as appointing and dismissing staff, signing and issuing documents submitted to the authorities, representing the company to participate in litigation or legal procedures.
Internally, the responsibility and authorization of a Legal Rep can be stipulated and limited by the Articles of Association. However, such internal agreements cannot bide on any third parties who reasonably and genuinely relied on the promises or decisions made by the Legal Rep. To illustrate the reasonableness factor, examples like previous knowledge of the excess of authorization by the Legal Rep, or any illegal acts or transactions proposed by the Legal Rep shall be deemed as unreasonable and maliciousness of the third party. Under those circumstances, the company shall not assume any liabilities arising out of the Legal Rep’s conducts. .
According to the PRC Company Law ("Company Law") in 2014, the position of Legal Rep shall be assumed by either the chairman of the board, executive director or manager of the company as stipulated in the Articles of Association. The owners of the company have some discretion in choosing the Legal Rep, but the pool of nominees cannot exceed the scope of the above mandatory requirement. As to other qualifications, there are no residence or citizenship requirements, but the Legal Rep must be a natural person and cannot be a corporation, partnership, or other form of "legal person." In addition, the Company Law also specified the following individuals cannot serve as Legal Reps:
1. An individual with no civil capacity or with limited civil capacity – for example, a minor, a person who is mentally incapacitated, or a person who is legally incompetent;
2. Individual being wanted by the police or state security departments;
3. An individual who has been convicted and sentenced for corruption, bribery, misappropriation of property, embezzlement of property or disruption of economic order, and less than five years have passed since the end of any term of imprisonment or payment of a fine;
4. An individual who has served as a director or general manager of a company which has declared bankruptcy or has been adjudged insolvent, and is personally liable for the bankruptcy, and less than three years have passed since the completion of the bankruptcy liquidation;
5. An individual who has served as the Legal Rep of a company whose business license was revoked or that has been ordered to close down for violation of law, and less than three years have passed since the revocation or close-down;
6. An individual who has a large amount of due and unpaid personal debt.
II. Appointment/Removal of a Legal Representative
The appointment and removal of a Legal Rep shall subject to approvals of industrial authorities if the company is of financial services industry (i.e. banking, security or insurance). Otherwise, a company shall only undertake certain formalities with the registration authority in order to appoint or remove its Legal Rep. Since there is no requirement to explicitly name the Legal Rep in the Articles of Association, we recommend to provide only the title of the Legal Rep (chairman of the board, executive director or manager) instead of individual names to make subsequent changes of Legal Rep easier.
In the context of WFOE, the appointment of Legal Rep shall comply with the procedures specified in the Articles of Association. An appointment letter and shareholders' resolution naming the first Legal Rep for the company will be submitted to the approving authority as part of the incorporation process.
To replace company’s existing Legal Rep, an application for the changes of company registration will have to file with the registration authority. The list of documents needed to complete the change in registration includes:
1. “Application form for change of registration of Foreign Invested Enterprises”
2. Resolution or decisions made in accordance with laws
3. The removal document of the former Legal Rep and appointment document of the successor
4. Registration form of the new Legal Rep
5. Photocopy of the duplicate of business license
6. Additional documents required by the registration authority.
This process of amending company registration can take 10-20 working days depending on where the company is located. The procedure to file such change of registration is normally straightforward, but there are some practical issues to be aware of:
1. After the registration authority completes its review, the company must submit the same amendment application to various other government entities, such as the Administration of Foreign Exchange, the local statistics bureau, and the local taxation bureau, because the licenses or certificates issued by those government entities to the company bear the name of the Legal Rep.
2. Since the name of the Legal Rep is indicated on the company’s business license, a new Legal Rep is needed to dismiss the predecessor. Legally speaking, a company cannot operate without a Legal Rep, however, in practice there is a gap period between removal of an existing Legal Rep and formal recognition by the registration authority of the new Legal Rep (who until then cannot legally act as the Legal Rep of the company). We recommend the company to have the existing Legal Rep execute a power of attorney authorizing another person (or the new Legal Rep) to act as the Legal Rep of the company during the transitional period. The power of attorney should be carefully drafted to cover all daily operational issues.
3. On the issue of selecting and appointing the Legal Rep, a company shall have to strike a balance between power distribution and risk control. Under the abovementioned requirement, the Legal Rep shall be appointed among chairman of the board, executive director and manager. The Legal Rep does not have to be a shareholder, and in order to prevent potential risks, the investor/owner of the company may appoint a nominal Legal Rep who holds the title as manager or director but are not really involved in the company’s management. Nonetheless, considering the wide-ranging power the Legal Rep is granted, we suggest the company to carefully weight the advantages and disadvantages of pointing a nominal Legal Rep.
4. The replacement of an uncooperative or hostile Legal Rep requires the company to take protective measures such as notification of major business partners, confiscation of company seals and chops that are in the custody of the existing Legal Reps, and, in some cases, change of bank signatures and authorization codes of online banking systems. In an extreme case, an uncooperative Legal Rep can cause significant interruptions in a company's operations. If this situation is anticipated, careful steps should be taken well in advance to forestall the exiting Legal Rep's ability to cause problems during the transition period, such as pre-executing resignation documents and the power of attorney mentioned immediately above.
III. Applicable Laws and Regulations
Below are the effective laws and regulations we refer to in this legal:
1. General Principles of the Civil Law of PRC《中华人民共和国民法通则》
2. Company Law of PRC《中华人民共和国公司法》
3. Criminal Law of PRC《中华人民共和国刑法》
4. Administrative Regulations of PRC Governing the Registration of Legal Corporations《中华人民共和国企业法人登记管理条例》
5. Administrative Regulation of PRC on Registration of Companies《公司登记管理条例》
6. Administration on the Registration of Legal Representatives of Business Enterprises《企业法人法定代表人登记管理规定》
7. Rules for the Implementation of the Law of the People’s Republic of China on Foreign-funded Enterprises《中华人民共和国外资企业法实施细则》
8. PRC Procedure Law《中华人民共和国民事诉讼法》
9. Interpretation of the Supreme People's Court on Issues regarding the Application of the Enforcement Procedure in the Civil Procedure Law《最高人民法院关于适用〈中华人民共和国民事诉讼法〉执行程序若干问题的解释》
10. PRC Law on the Administration of Tax Collection《中华人民共和国税收征收管理法》
IV. Liabilities of Legal Rep
Generally, when a Legal Rep acts in accordance with the laws, administrative regulations and Articles of Association of a company, such acts shall be deemed as acts of the company and any consequences and liabilities arising out of such activities are assumed by the company. Therefore, a Legal Rep does not take any personal liabilities for such acts. However, in case the Legal Rep violated the above normative documents, he/she is potentially liable to civil, administrative, criminal penalties and compulsory measures for the full range of company activities.
The standard of prudence and competence expected from a Legal Rep is generally higher than that expected from other company personnel, although this is not clearly defined.
1. Civil liabilities.
Under Article 149 of the Company Law, a Legal Rep of a company is liable to compensate the company if he/she violates laws or administrative regulations or acts beyond the scope of the company's articles of association in the execution of company duties, and thereby causing losses to the company. It is therefore important for every Legal Rep of a company to familiarize himself with the articles of association and the legal environment within which the company is operating.
A Legal Rep may also incur civil liability to the company if he/she violates the provisions of the Company Law relating to the duties of senior officers. These duties are as follows:
(1) to abide by the articles of association of the company, and faithfully perform their duties (Article 147, Company Law);
(2) to not use their functions and powers to accept bribes or other illegal income, nor can they seize company property (Article 147, Company Law);
(3) to not misappropriate company funds or lend company funds to others without the prior approval of the shareholders' meeting or the board of directors (Article 148, Company Law);
(4) to not open accounts in their own or another individual's name for deposit of company assets (Article 148, Company Law);
(5) not without the prior approval of the shareholders' meeting or the board of directors, use company assets as security for the debts of company shareholders or other individuals (Article 148, Company Law);
(6) not without the prior approval of the shareholders' meeting, engage in the same type of business as their company, whether for their own account or that of others(Article 148, Company Law);
(7) to not enter into contracts or trade with the company, except as provided for in the company's articles of association or approved by the shareholders' meeting (Article 148, Company Law); and
(8) to not disclose company secrets except in accordance with the law or as approved by the shareholders' meeting (Article 148, Company Law).
The Legal Rep may also incur civil liabilities to the creditors of a company he/she serves if, for example, during the liquidation of the company the Legal Rep also acts as a member of the liquidation committee and creditors consequently suffer losses as a result of the wilful act or omission or serious fault of the Legal Rep (Article 189, Company Law).
2. Administrative Liabilities
In addition to civil penalties, a Legal Rep may be liable to administrative penalties (usually payment of fines or confiscation of any illegal income) if the Legal Rep or the company violates any PRC laws or administrative regulations which attract administrative penalties.
The concept of separation of powers, as understood in constitutional democracies, has not been adopted in China. Accordingly, in practice there is no separation between the judicial/interpretive branch and the executive branch of government in China. Administrative penalties may therefore be imposed by an administrative agency without going through any judicial proceeding, subject to the aggrieved party's right to seek an administrative review by a superior administrative agency or commence administrative litigation against the administrative agency before a judicial tribunal. For example, if in the course of liquidation, a company conceals its assets, the local bureau of the State Administration for Industry and Commerce ("AIC") may impose a fine of between RMB10,000 and RMB100,000 on any or all supervisory personnel of the company who are deemed to have direct responsibility for the act, including the Legal Rep and directors who approve such act (Article 204, Company Law).
As per General Principles of the Civil Law of PRC, in following circumstances, administrative fine or sanction, or even criminal liabilities in case of committing a crime may be imposed not only on the company but also the Legal Rep.
(1) conducting illegal operations beyond the range approved and registered by the registration authority( Article 49, General Principals of the Civil Law of PRC);
(2) concealing facts from the registration and tax authorities and practising fraud ( Article 49, General Principals of the Civil Law of PRC);
(3) secretly withdrawing funds or hiding property to evade repayment of debts( Article 49, General Principals of the Civil Law of PRC);
(4) disposing of property without authorization after the enterprise is dissolved, disbanded or declared bankrupt( Article 49, General Principals of the Civil Law of PRC);
(5) failing to apply for registration and make a public announcement promptly when the enterprise undergoes a change or terminates, thus causing interested persons to suffer heavy losses( Article 49, General Principals of the Civil Law of PRC);
(6) engaging in other activities prohibited by law, damaging the interests of the state or the public interest( Article 49, General Principals of the Civil Law of PRC).
In addition, according to Administrative Regulations of PRC Governing the Registration of Legal Corporations, in the following circumstance, the administrative liability and economic liability of the Legal Rep could be investigated in accordance with the circumstances of the illegal act.
(1) withholding the truth or practicing fraud as regards a registration application or unlawfully commencing business before completing examination, approval and registration procedures(Article 30);
(2) amending any of the main items of registration without authorization or engaging in business activities beyond the approved and registered scope of business(Article 30);
(3) failing to cancel registration in accordance with regulations or failing to submit an annual review report or to carry out annual review procedures in accordance with the regulations(Article 30);
(4) forging, altering, leasing, lending, transferring, selling or reproducing without authorization a Corporate Business Licence or duplicate copy(Article 30);
(5) withdrawing or transferring capital or concealing assets in order to evade payment of debts(Article 30);
(6) engaging in other illegal business activities(Article 30).
In fact, such liabilities are stipulated under many PRC laws and regulations, hence it is necessary for the companies and their supervisory personnel to ensure that the company remains in compliance with the law at all times. However, in most circumstances the Legal Rep was among the "supervisory personnel with direct responsibility" or "persons with direct responsibility" when such administrative penalties are imposed on it.
3. Criminal Liabilities.
Naturally, in addition to civil and administrative liabilities, Legal Reps may also face criminal charges if he/she or the company commits any offence as proscribed under the Criminal Law of the PRC ("Criminal Law"), as amended. Every Legal Rep must be registered at a local bureau of the AIC within 30 days from the date of his/her appointment. Failure to do so can result in a fine of between RMB10,000 - 100,000 for the company or the Legal Rep. Obviously, failure to properly fulfill the Legal Rep's statutory duties and responsibilities (outlined above under "Civil Liabilities") (e.g. misappropriation of company funds) may attract criminal prosecution as well as litigation.
Furthermore, as a general principle, Article 31 of the Criminal Law provides that if a "unit" (including a company) commits an offence under the Criminal Law, the unit shall be fined and its "supervisory personnel with direct responsibility" and "other person with direct responsibility" shall be punished for the same offence which, depending on the offence in question, may include a fine and imprisonment. In this regard, the key offences relating to company affairs which are listed in the Criminal Law and which may result in the Legal Rep being sent to prison include:
(1) False registrations of capital (Article 158)
(2) False contributions to registered capital of a company or illegally withdrawing registered capital (Article159)
(3) Providing false financial and accounting statements (Article 161)
(4) Concealing accounting vouchers, statements and false insolvency (Article 162)
(5) Accepting kickbacks or bribery (Article 163)
(6) Obtaining any loans by fraudulent means (Article 175)
(7) Evading taxes (Article 201);
(8) Defrauding state export tax refunds (Article 204);
(9) Falsely issuing exclusive value-added tax invoices or other invoices to defraud export tax refunds or to off set taxes (Article 205)
4. Compulsory measures
Under certain circumstances, when a company has entered into bankruptcy proceedings, or a person or entity has applied to the court to impose compulsory enforcement measures upon the company, or the company has defaulted on tax payments, the judicial and administrative authorities shall have the authority to impose compulsory measures on the Legal Rep of the company.
(1) If a company has unsettled civil cases or fails to perform its duties imposed by legal documentation, judicial authorities may impose compulsory measures on its Legal Rep, including restrictions on him or her leaving the country. (Article 231 of the PRC Civil Procedure Law, Article 37 of the Interpretation of the Supreme People's Court on Issues regarding the Application of the Enforcement Procedure in the Civil Procedure Law)
(2) If a company has entered bankruptcy proceedings, its Legal Rep shall not leave his/her place of domicile without permission of the court.
In addition, during bankruptcy proceedings, a company's Legal Rep is required to undertake responsibilities including the safekeeping of all assets, property, seal, accounting books, documents, and other items that are occupied, used and managed by the Legal Rep; fulfilling his/her duties as required by the court and the administrator and answering their inquiries truthfully; attending creditors' meeting as a nonvoting delegate and answering creditors' inquiries truthfully; and not accepting a position as a director, supervisor or senior officer of another company.
(3) If a company defaults on its tax payment, late payment interest or fails to provide a guarantee to the tax authorities, the tax authorities may restrict its Legal Rep from leaving the country (Article 44 of PRC Law on the Administration of Tax Collection)
5. Tax Liabilities
A Legal Rep's criminal and administrative liability for the acts and omissions of his/her company extends to tax matters and a Legal Rep may of course be liable to prosecution in China for any instances of tax evasion or other improper acts carried out by or on behalf of the company.
In the part of criminal liabilities, we listed some major crimes which the company may commit. A Legal Rep has an obligation to properly supervise his company to ensure that it duly contributes enterprise income tax ("EIT") and other taxes required by law and properly withholds individual income tax contributions on behalf of all employees. A Legal Rep who fails to properly discharge such duties could be liable to a fine, and in egregious circumstances, the Legal Rep may be fined and prohibited from leaving the PRC until such fines are paid.
In addition to the above liabilities, which arise from failure to properly discharge official duties, a Legal Rep may also become personally liable to PRC Individual Income Tax ("IIT"). The PRC's revenue model subjects resident individuals and enterprises to PRC tax on any income derived from PRC sources as well as potentially on their worldwide income.
A Legal Rep may therefore be subject IIT under the following circumstances (simplified for clarity):
(1) Where he/she has:
(i) a residence in China or;
(ii) does not have a PRC residence but has accumulated a period of stay of over one year in the PRC, and is receiving income from either the PRC or from an overseas source which is subject to a legal obligation to pay IIT;
(2) Where he/she has no residence and no accrued period of stay exceeding one year in PRC but obtaining income from the PRC.
V. Ways to minimize the risks of Legal Rep
1. Indemnification Agreement
An Indemnification Agreement is an agreement by the company to indemnify and hold harmless the Legal Rep from certain claims or losses suffered from performing his/her delegated duties. Depending on the needs of the company, the indemnification agreement can include restrictions on the types of damages, total amount of damages, and the situations that will enable the Legal Rep to enjoy indemnification from the company. An Indemnification Agreement can be a part of the employment agreement with the Legal Rep or an independent contract.
2. Liability Insurance
Directors' and officers' liability insurance (D&O insurance) is increasingly available for directors and officers of Chinese companies. Typically, D&O insurance is provided to directors and senior managers of a public company to cover losses or damages arising from certain types of alleged wrongful conduct.
3. Incorporating exemption clauses into the Articles of Association
China does not have a "business judgment rule" similar to the concept which is widely recognized in the U.S. Nevertheless, a company can adopt such a concept in its charter and internal rules. Such clause shall ensure the Legal Rep not be liable for any act, where such act is provided under the company's articles of association or stipulated by the board of directors, conducted in their respective capacity unless such act constitutes malpractice, gross negligence, wanton misconduct, or intentional damage to the company's interests. Incorporating a "business judgment rule" in corporate documents can also work with any indemnification agreements to provide thorough yet not unreasonable protection for a Legal Rep.
On the whole, the potential scope of liability faced by any Legal Rep seems extensive and daunting. As mentioned above, Legal Reps are held to a standard of prudence and competence that is generally higher than that expected from other company personnel. Given the ambiguity of many PRC laws and regulations, the predominant non-compliant business culture and the wide-ranging discretionary powers wielded by regulators, it seems remarkable that any rational person would willingly assume the role of Legal Rep for any PRC company.
In practice, if there are no allegations of individual errors or omissions which are illegal or negligent, the Legal Reps of foreign-invested enterprises are generally not held personally liable. However, this practice has not found any support from an express legal standard.