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Business> Legal-Ease
UPDATED: September 15, 2009 NO. 37 SEPTEMBER 17, 2009
Are You in Control of Your China Operations?

Since the global financial crisis began, we have seen two new trends develop in the management of foreign enterprises in China. First, as expected, the flow of foreign direct investment into China has decreased. Second, there has been an increase in oversight from overseas headquarters. This article will focus on the latter trend, exposing several common difficulties that undermine the real control foreign managers should have when running their China operations.

Managing a legal entity in a country with a language not easily understood by foreigners, a young legal system, a complicated and quickly evolving tax regime and a strict foreign exchange control is often full of challenges for foreign managers. Moreover, the financial crisis is pressuring many companies to clear up old structural inaccuracies, adopt efficient financial control systems, lay off under-performing personnel and reduce overall costs.

Ensuring full control over an investment from both the legal and financial side of a business requires a thorough understanding of the laws and regulations and a clear perception of local practices.

We first look at some of the common legal issues that managers should ensure to have been properly carried out, as they can have a long-term impact on the success of their China business.

Business scope

The concept of a company's business scope is easy to understand and basically refers to a detailed explanation of what the company is entitled to do, the sector it will be involved with (manufacturing, service, trading) and the products it will handle.

In China, an enterprise can only engage in operations within its business scope as approved in its registration with the enterprise registration authority. Because of this, the drafting of the business scope deserves particular attention, as the company will need to register it with a wide range of authorities that will validate it before authorizing business operations.

A typical well-drafted business scope for a foreign company involved in trading (also known as a foreign-invested commercial enterprise or FICE) can be divided in three parts. It should state that the company is "engaged in wholesale, commission (excluding auction) and import and export of products, relevant commercial consulting, technical support and customer service (following the national and local regulations on license management goods and special regulated goods)."

There are two very common types of mistakes made by foreign investors when drafting their business scope:

1) Mistakes related to lack of local knowledge and understanding of how foreign-invested companies operate in China. These usually include the omission of services such as "commission-based services" and relevant other services such as after sales, quality control and so on.

2) Mistakes related to negligence, for example, when describing the treated product.

Some of the "omissions" may not initially seem important or relevant to the investor, nevertheless these may impact operations later in ways that would have been useful and, furthermore, could have been included without further capital injection, time or paperwork.

From an operational point of view, an erroneously registered business scope may bring problems and serious limits to a business. Many FICEs in China often start operations by assisting their headquarters on a commission basis, providing services such as quality control and supplier or client searches, avoiding (at least at the beginning) being involved in actual buying and selling of products, the extensive paperwork and handling of customs. However, if these business operations have not been accounted for from the beginning, a newly established trading company might not be able to operate without revising or enlarging their business scope, costing both time and money.

From a strict legal point of view, punishment for operating outside the stated business scope can induce fines ranging from 10,000 yuan ($1,460) to 100,000 yuan ($14,600), and more importantly, in cases that involve items requiring special approval like chemicals or food and beverages, the revocation of the business license. Companies therefore need to ensure that their business scope is an accurate description of the actual business and if not, to find the chance—during a capital increase—to review and update it.

(We will continue this article in Issue 41)

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