Illustrating The Impact of Non-Compliance with Chinese Authorities - The Challenge of The Foreign Company

By: Alex Wu, Donia Joevion Fuller-Barrett     On: 2016-11-01

The Background

Anecdotal evidence suggests that subsidiaries of foreign companies are finding it challenging to remain compliant with relevant Chinese authorities. It is being posited that whilst the reasons for this state of affairs is manifold, one primary reason is the absence of the use of effective compliance systems. Furthermore, Companies continue to neglect the implementation of effective compliance systems because until affected the relevant personnel fails to realize just how costly non-compliance can be. The following cases illustrate the range of matters where a company could find itself in a non-compliant state and the potential effects this may have on the company and its key officials.

1. The Case of the Unregistered Loan

In jurisdictions outside of China, there is often no need to register loans provided to a subsidiary by the parent Company, however it is standard that this loan must be reflected on accounting and audit records. In China, a loan from the foreign parent company of a local subsidiary must be registered with the State Administration of Foreign Exchange (‘SAFE’) as an “external debt” within a prescribed time limit. Furthermore, permission from SAFE is also required in order for the loan to be repaid. 

In one instance, a larger Danish company in the electronics industry failed to register such a loan, which resulted in the SAFE refusing to permit its repayment. Understandably, this caused severe financial issues for the parent company. The solution which was devised was not completely successful, therefore it would not be inaccurate to say that this was a clear illustration of the saying, “prevention is better than cure”. In other words, it was necessary to have a compliance maintenance system in place akin to the comprehensive compliance guard system offered by Asia Base Law & Projects. It is designed in such a way that it helps to, maintain and monitor compliance where the company is already in a state of compliance and devise strategies to attain compliance where red flag areas are discovered and viable solutions are found before the red flag areas become an issue and compliance authorities become involved.

2. The Case of Exceeding the “Approved Business Scope”

In most Western jurisdictions, once a company is registered, regardless of whether it expands its product offerings or even revamps its business offerings altogether, it would not generally have an issue with company compliance. This is especially the case where a company undertakes additional business activity which is merely incidental to its existing functions, or a natural progression from the services or products it sought to offer when it was set up initially. This is not the case in China, rather the notion of the “approved business scope” on the business license is interpreted in a very strict sense and a literal approach is taken when authorities consider what a business is licensed to do. This approach is so stringent that, if the approved business scope is for example, to manufacture products with rubber parts, manufacturing the same product by using a different material because of durability or business efficacy without modifying the scope of business, could find a company running afoul of compliance standards.

An illustration of what a failure to ensure that the approved scope of business of one’s company is not exceeded can mean for a business is seen in the example of a well-known European corporation in the furnishings industry. Sometime after acquiring its business license as a production company, the company engaged in certain activities which are arguable on its production/trading classification. Noteworthy is that these activities could easily be considered accessorial to the production activities with which the business was concerned. Nonetheless, the “approved business scope” as encapsulated in the singular sentence and which is printed on the official business license did not include the trading activities. Initially, this issue of non-compliance went unnoticed; there was no compliance system in place so no one even considered the possibility that expansion in the way undertaken by the company would see it running afoul of its compliance requirements. However, during the course of business a supplier which had a dispute with the company took the “opportunity” to report the company to the Administration of Industry and Commerce (‘AIC’). The AIC immediately stopped all activity at the factory, therefore, several days of production time were lost.

What saved the company was the fact that it had submitted a detailed, well-written feasibility study report in support of its application for its business license a few years earlier. The document had explicitly mentioned such activity, thus the authority had a chance to object to this facet of the company but did not. Therefore, during several meetings with high ranking Chinese authority officials Asia Base Law & Projects was able to use this information to establish a case for why the limited business scope should not be used to establish a case against the company. Fortuitously, the case was settled with no fine being levied, however it can be easily seen that the matter could have had a completely different result, had the feasibility study report not included such element.

The fact however, is that this could have been avoided if a compliance system had been in place from the outset. For instance, Asia Base Law & Projects as part of its compliance attainment mechanism always seeks to ascertain from clients how their actual, day to day activities compare to the “approved scope of business”. The best time for this assessment is admittedly before the relevant applications are submitted for a business license. Nonetheless, in a situation such as this one, even a belated compliance check could have permitted the issue to be discovered and thereafter a solution devised, hence avoiding all the inconvenience which was associated with the experience.

3. The Case of Being Unable to Capitalize on Insurance Protection

In some jurisdictions, a company’s interactions with other businesses may be inhibited if the relevant regulatory approvals or licenses in respect of certain activities are not in order. Some States do not compensate companies for losses sustained consequent upon the actions of a state agent if it occurred whilst the company was not compliant with company registration or other guidelines. In view of the rigid manner in which Chinese authority compliance is administered, it is hardly surprising that a similar situation could be experienced in China. 

This is exactly what happened to one Northern European multi-national corporation in Shandong Province in China. Having had the unfortunate experience of a massive fire which destroyed a great percentage of its warehouse, the company sought to claim from its insurers for the losses. The insurance company was willing to honor its contract of insurance, however it required a copy of the building’s fire approval. This building however, did not belong to the company, rather it was leased by the company. Their landlord did not have the fire approval, nor were they aware that this was required. In an effort to help the company, the Local Fire Fighting Bureau offered to grant the document with retroactive effect but required a building certificate.

After tremendous effort, the building authorities offered to issue same with retroactive effect, but required a Land Use Right Certificate. In continuation of what may seem to some to be a comedy of errors, the landlord again had failed to get the relevant certificate. Furthermore, enquiries made of the planning authorities and land bureau, revealed that the land had retained its “agricultural land” status and had not attained” industrial land” status. The reason for this is that there was a quota system in place for such conversion in that city and this quota was exceeded. Therefore, even before the company had negotiated its lease, compliance systems were required to ascertain whether or not the site was appropriate for the industrial activities which the business had contemplated. Eventually, the company received some compensation, but not nearly as much as would have been provided if the relevant matters of compliance had been in order. Thus, whilst suffering major losses from the fire, significant expense had to be incurred in order to try to receive insurance compensation and in the end, the total compensation was not received.

Again, the recurrent theme of the presence of a compliance check system being able to prevent these losses which has been running through this article appears. One of the critical services performed by Asia Base Law & Projects is ascertaining whether building and facility documentation are in order. This is preferably done before buildings are leased, bought or built so as to prevent issues associated with non-compliance from arising in the first place. Nonetheless, if the service is utilized after acquiring the operations space, this service could readily discover areas of non-compliance so as to find a solution which is as cost effective as possible.

Dealing With the Challenge of Authority Compliance in China

It is patently clear, that complying with authority rules and regulations can be difficult in China. Moreover issues are usually discovered after extended periods of time have passed and the matter becomes problematic often times involving a third party. Yet, compliance is not optional and a failure to comply could result in tremendous losses for a company. To that end, we submit that the case is made out for proponents of the use of compliance check systems from the start when the subsidiary is in its establishment phase. Each illustration above clearly makes the point that the issues faced could have been avoided along with the losses which were experienced. Therefore, in dealing with the challenge of authority compliance in China, the solution is to implement compliance checks and maintenance systems, a beneficial strategy in the long and short haul of the business.