Foreign companies doing business in China are abuzz with news and rumors regarding China’s plans to set up what will essentially be a social credit system for companies that do business in China. In China is building a ‘comprehensive system’ for tracking companies’ activities, CNBC does a great job explaining what this new system will mean for companies operating in China. The article starts by discussing how “Chinese authorities want to collate information from businesses operating in China — domestic and foreign firms alike — and integrate them into a centralized digital database.” It then notes how this will “vastly increase the amount of data companies must share with the central government.” Though Beijing claims this system is intended to create a “fair, transparent and predictable”, many are concerned with how the Chinese government will use this data, “especially in light of escalating trade tensions with the U.S.” This new system will bring China “significantly closer to its goal of tracking the actions of people and businesses so that it can reward behaviors it likes and punish behaviors it doesn’t — the so-called “social credit” system.” Trust me when I say that it undoubtedly will. This new database will allow the Chinese government to better “track and monitor the activities of all businesses in China” and to better monitor “how companies comply with the law.” A test version of “this new database — called the National “Internet+Monitoring” System — will likely be released this month with a final version due by the end of the year. When completed, this new system will target individual citizens and businesses and it will consist of three parts: a master database, a blacklisting system and a structure for punishments and rewards.” It will allow the Chinese government to see whether a company has complied with regulations “or engaged in the potentially vague definition of ‘good behavior.'” The plan is to give scores to every company based on their behavior, with higher scores leading to “lower tax rates, better credit conditions, easier market access and more public procurement opportunities” and lower scores leading “to the opposite. . . . even blacklisting.” Each company will “bear the burden of tracking whether their business partners, such as suppliers, are adhering to government rules.” It is “no exaggeration to say that the Corporate SCS [Social Credit System] will be the most comprehensive system created by any government to impose a self-regulating marketplace, nor is it inconceivable that the Corporate SCS could mean life or death for individual companies.” The data “companies will need to provide could be ten times more than the current requirement.” Companies that have been “content to drift around in grey areas . . . . can’t do that anymore,” especially since “a simple violation could have significant consequences.” Once the system goes live, foreign companies doing business in China will need to collect and submit their data to the government. Chinese government authorities will also conduct their own inspections to gather data. My firm’s China lawyers meet weekly, during which time we talk about (drumroll please) China. At yesterday’s meeting we discussed what is happening to foreign companies in China with their WFOE or Joint Venture subsidiaries and we noted the following two things:

1. We are not aware of a single instance where a foreign company in China has been shut down or fined or even hassled all that much when it had done nothing wrong. Despite the harsh rhetoric stemming from the US-China trade war, the Chinese government does not want good, compliant foreign companies to leave China.

2. China has greatly stepped up its efforts to make sure all foreigners and foreign companies in China are operating 100% legally. As one of our China attorneys put it, “This is nothing new. We’ve been dealing with this and warning about this for at least ten years. The only difference today is that the Chinese government is more committed than ever before to making 100% compliance a reality and more effective at making sure that happens. Overall policies have not really changed.”

This discussion was engendered because earlier in the day, a couple of us were discussing how our law firm has set up a record number of China WFOEs in the past year, which is great indicator that foreign companies are not shying away from going into China. Our joint venture numbers are on the rise as well (see Why NOW Is a Good Time to Double Down on Doing Business in China), all this while the compliance noose just keeps tightening.

We explain to those companies looking to set up in China the tough requirements in doing so, along with the tough requirements and the risks of doing business in China in general. We stress the need to “dot every i and cross every t“, and we explain how there are costs involved with that. I sometimes mention that the legal fees for setting up and operating a company (correctly) in China are at least double today what they were five years ago because China has more laws and rules and regulations than five years ago and because China now takes those laws and rules and regulations so seriously.

In Want to Keep Your Business in China? Do These Things NOW, we talked about how China has a long history of cracking down on foreign businesses when tensions rise between China and the West and when China is going through tough economic times. With China’s relations with the West currently strained right now and with its economy slowing, its crackdown on foreigners and foreign businesses is no surprise.

But what does all of this mean for your China business? What can and should you do to avoid China legal problems and stay on the right side of greatly stepped up Chinese government business monitoring? What can you do to ensure a high score in China’s soon to be operational corporate credit system? You should review/audit your current situation to make sure you are in full compliance with China’s legal requirements and you should remedy any instance where you are not.

In particular, we recommend you do the following:

Make sure your WFOE or your Joint Venture or your Representative Office actually exists. See Doing Business in China Without a WFOE: Will the Defendant Please Rise. It is not uncommon for foreign companies to pay to set up a China WFOE, only to learn much later that whomever they paid (be it a crooked WFOE formation company or a crooked employee) pocketed the money and never formed the WFOE. Our law firm has also had plenty of companies come to us to get out of a China Joint Venture that never existed. In these cases, the Chinese JV partner that was to have formed the JV gave the foreign company fake documents showing that it had, when in fact it had not. Make sure your China WFOE or JV is licensed to do the business it is actually doing in China as it is quite common for this not to be the case. Examples for why this happens abound. You went into China fifteen years ago as a one person consulting WFOE and you are now a 40 person e-commerce company and you never changed the scope of your WFOE. In See How to Form a WFOE in China: Why Business Scope is so Important, we wrote how WFOEs that get approved “can and do get shut down all the time when subsequently audited” by the Chinese authorities:

These audits are common because the Chinese government makes a lot of money from them. Here is the typical scenario. US or European company uses a third rate entity formation company for its China WFOE formation because third rate company has the lowest prices by far. Third rate entity formation company then quickly forms a China WFOE for the American or European company. Five times out of ten this WFOE will be a consulting WFOE (because those are the quickest and easiest). Nine times out of ten (yes I am guessing here) the third rate entity formation company will assure the American or European company that “this is China and this is how we do things here, so do not worry about your company not really being a consulting company.” One time out of ten, the third rate entity formation company will just lie, claiming it formed a such and such WFOE to match the American or European company’s actual business, when it really went off and formed a Consulting WFOE. About 70 percent of the time, the third rate entity formation company will rely on the American or European company being unable to read Chinese and about 30 percent of the time it will create fake documents showing the formation of some other type of WFOE. Make sure that what your China Representative Office is doing in China now is proper for a Rep Office. Rep Offices are extremely limited in what they can do in China. Two things Rep Offices cannot do in China is make money or directly hire employees. If your Rep Office is doing either of these things it is not operating legally. See The Slow Death Of The China Rep Office. Make sure your China WFOE or Joint Venture is current on its capital obligations. Make sure your WFOE or Joint Venture or Representative Office is properly licensed to do business in every city in which it is doing business. It is shocking how often this is not the case. A typical scenario is a company that started out in one city and then expanded to one or two more cities without going through all the required company and employment law hoops to do so. We often come across this when conducting employer audits because each city in China has different employment and benefit requirements. Speaking of which…. Make sure your company is doing everything correctly with its employees. Note that our China employment lawyers have never once conducted an employer audit (and we do 2-3 of these pretty much every month) without finding multiple problems needing remedying. Note also that employment problems is THE favored way to go after foreign companies operating in China. Few things make a Communist government look better to its citizens than making sure foreign companies treat their workers properly or are easier than finding foreign companies not fully complying with China’s complicated and localized employment laws. See China Employment Law: Local and Not So Simple. Make sure your company is current with its taxes. If you think it may not be, it almost certainly is not. China’s government loves collecting taxes and interest and penalties. Review your lease agreement and the relevant zoning rules. Are you renting from a real landlord? Is it really legal for your business to do what it is doing where it is doing it? Make sure all your contracts related to your China operations are legal and effective. Getting sued is a great way for your company to stick out in China, and that is not what you want at all. Conduct due diligence on your suppliers, manufacturers, distributors, retailers, and e-commerce platforms. The company you keep impacts your risks. China’s new company monitoring system makes this perfectly clear. Make sure your IP has been properly registered and that your company is not violating a China company’s IP rights. It is the rare company that stays current with its IP registrations.

Nothing we suggest above regarding compliance is new, but with all that has been happening and will happen with China, their importance has increased exponentially. To put it simply, now is the time for you to comprehensively self-audit (if you have people in-house truly capable of doing this) or do a third party audit of your company to make sure you are not doing anything wrong in China. Your company score and your China future depend on it.