Controls on legal reps can help businesses manage legal risk in China

They need to identify the key internal and external risks that could affect their operations in China, quantify these risks and their impact, and have a plan they can implement if those risks materialise.

Understanding the role of legal representatives in undertaking China operations – and putting in place sensible controls on their activity – is an important first step in this process.

Where risks can arise

Examples of where risks arise include:

• corporate governance model and processes including different corporate roles and powers;
• material third party contracts, implementation, and potential disputes;
• major transactions, investments, or divestments;
• the legal relationship with employees and employee disputes;
• compliance and data management;
• obligations and liabilities as a shareholder.

Having sound awareness and proactive systems in place can help business avoid future difficulties – or disasters – if substantive risks materialise. There are endless examples of where greater awareness and proactively dealing with foreseeable risk could have saved a business time and money, and sometimes internal embarrassment.

The role of a business’ legal representative

Senior executives and general counsels (GCs) should understand who sits in what position and with what powers in their China operations, and there should be levers of control in place. A critical position in PRC entities is the legal representative.

The legal representative can significantly impact commercial operations. They are the legal authority representing the company in China. Businesses will typically need the legal representative’s consent and sign-off for all strategic decisions, including acquisitions, divestments, joint ventures, and dissolutions. They have broad powers. These include:

• legally binding the company – they can contract on behalf of the company with third parties. Agreements executed with bona fide third parties will bind the company;
• signing off on internal documents for regulatory compliance – they sign the audit reports and other key documents required for regulatory filing;
• opening, managing, and closing bank accounts – banks in China will require the legal representative’s authority to open and manage bank accounts on behalf of a business and to authorise certain financial transactions. In practice, these include approving large transfers, applying for loans, credit lines, and transactions involving foreign currency;
• entering legal proceedings – legal representatives have the power to initiate legal proceedings and represent the company in such proceedings including arbitration.

The legal representative usually plays an important management role, which makes sense given their consent is required to effectively operate the business in China.

The importance of trust

The most important risk mitigation for shareholders is having a trusted person occupy the role of legal representative. The ideal candidate would be a person selected internally with a deep and long-standing relationship with the parent entity. Someone loyal with long term interests aligned with the business. Legal representatives do not need to be based in China by law, but given the depth and importance of the role, they should be – or at least spend considerable time in the country.

Offshore levers of control

Trusted candidates of the kind described above often have a contractual and commercial relationship with the parent company offshore. This allows for some control to be built in at the parent level. Contractual arrangements offshore can be put in place to map out the individual’s obligations around how they perform the role of legal representative in China. These would need to be enforceable in that offshore jurisdiction. Shareholders would then have some recourse against the legal representative offshore, which could be leveraged if there is wrongdoing or their actions give rise to other potential claims.

Onshore corporate controls

Some control over the legal representative can be exerted onshore through shareholder’s meetings, the board of directors, and the company’s articles of association. The shareholder’s meeting or the board of directors can set internal policies which the legal representative must follow. The board also monitors and supervises the legal representative and can implement reporting requirements to ensure policy compliance. The board can terminate the legal representative’s contract, but this is an involved process including amendments to the articles of association, shareholder resolutions, notification to relevant authorities and banks, and new applications to register the replacement. It is a tedious and time-consuming process.

Control over the legal representative can also be exerted by specifically defining the role and its limitations in the articles of association, and any shareholders agreement. These controls, however, will not prevent the legal representative from binding the company to contracts with bona fide third parties.

Splitting control

Although the legal representative is often required to sign documents, there are transactions and situations that in practice will require the company chop. The company chop is separate to the signing authority of the legal representative; it is the legal seal of the company. Situations which in practice often require both the legal representatives’ signature and the company chop include obtaining bank loans, land use rights-related contracts, and other substantive transactions. Regulatory bodies may also insist on seeing both the legal representative’s authority and the company chop. By having a separate and trusted person control the company chop, the powers of the legal representative will be limited where the company chop is also required.

A combination of controls

A combination of measures can help international businesses maximise the control they can exert over the activities of their legal representatives in China.

The combination of: selecting a trusted individual with long standing ties to the business to sit as the legal representative; appropriate offshore contractual arrangements with the legal representative, enforceable offshore; clearly defined limitations in the articles of association of the PRC entity; a clearly defined relationship and protocols between the legal representative and the board to which they report; and separate control over the company chop, will help mitigate risk associated with the broad powers of the legal representative in China.