China’s Company Chop System And Risks To Foreign Investors.

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China’s Company Chop System And Risks To Foreign Investors.

 

2 September 2020

 

Asia Pacific Legal Updates

 

Since June 2020, a fight over the control of the China subsidiary of ARM, a leading semiconductor company, has centered around the possession of the company chop. ARM was reported to have fired its head of China, Allen Wu, who is still registered as the legal representative of ARM China. With control over the company chop and business licenses, Wu would seem to have a powerful weapon to use as a bargaining chip with ARM’s shareholders outside of China, even though there is no doubt he will eventually be removed from his position. How can physical possession of the company chop cause so much trouble for ARM’s shareholders? This article will:
 

  • introduce China’s company chop system;

  • provide context for foreign companies and individuals doing business in China; and

  • make recommendations on best practices for the management of company chops. 
     

The History of Official Chops
 

The company chop system in China has a long history. As early as the Zhou Dynasty (1046-256 BCE), chops were used on official vendor qualifications for the trading of goods. From the Han Dynasty, emperors used chops made of jade on various decree documents to represent their authority. The cultural affinity towards the use of chops is thus deeply rooted in China as in some other Asian countries.
 

The Use of Company Chops
 

As a practical matter, company chops are needed for all kinds of corporate activities in China. For example, authorities require application materials to be chopped to confirm the real intention of the company as the “applicant” when making a change in its business registration. In commercial activities, a company will execute contracts with its company chop, turning such contracts into binding legal obligations with just the use of the chop (no signature is needed).
 

Every company in China has an official company chop which can be used on almost any occasion. There are also chops with special purposes or chops exclusively used to represent branches or departments of a company. These chops can only be used in specific circumstances, such as the contract chop for contracts, the financial chop for bank issues and the invoice chop for chopping invoices; or they may give limited authorization to represent a department or a branch of the company. 
 

Why the Company Chops Matter
 

Chops have a long history of use in commercial practice. Over the years, China maintained a “legal representative” system, where a sole legal representative has inherent authority to act on behalf of the company with no need to show specific authorization on a particular matter or scope. The legal representative is either the Chairman of the Board, a company’s Executive Director (if no Board), or the General Manager of the company. In order to facilitate the business activities of the company, the company chop is used as another way of expressing the company’s approval without having to constantly obtain the signature of the sole legal representative. Generally, either the signature of the legal representative or application of the company chop has the legal effect to bind the company in various commercial transactions. For convenience, the company chop is used more often than signatures in commercial practice.
 

However, the company chop is usually mandatory for government filings. Government authorities also require documents to be chopped when the company changes the legal representative. Therefore, the legal representative if also an employee of the company may take advantage of this opportunity. However, while judicial practice has changed recently to weaken the importance of the chop, prevailing practice will not change overnight. 
 

Misuse of Company Chops
 

A company should formulate internal controls to prevent misuse of company chops as well as placing explicit limitations on the power of the legal representative. But when the counterparty to a contract acts in good faith in assuming the chop was used with proper authority and in fact it was not, a company can find itself in a difficult situation trying to disavow such contract and its legal obligations.
 

While the shareholders of the company have full discretion on who to appoint and replace as legal representative, it cannot formally complete the replacement of an outgoing legal representative without the company chop. If the outgoing legal representative holds the company chop and refuses cooperation, then the shareholders usually have two options. Neither is easy to implement, and until finalized the company should be worried that the outgoing legal representative will be a continuing disruption and distraction to company operations.
 

  • The shareholders can go through the time-consuming procedure of cancelling the old company chop and carving a new company chop, but for this they will usually require the original business license; 

  • The shareholders can decide to file a lawsuit against the former legal representative to claim return of the company chop as well as damages, but this is a process that can take many months. 
     

A final point: the company generally must bear the legal consequences of any misuse of the company chop, because the company has the primary burden and responsibility to properly manage its company chops in the first place, and prevent it from being misused or stolen. If any company chop is missing, relevant counterparties should be notified in a timely manner.
 

Recommendations
 

Given the importance of the chop, a company should pay careful attention to internal controls on chop management. This is especially true for foreign-invested companies with management outside of China, and/or managers who cannot understand Chinese. Based on our many years of assisting clients on chop management and resolving disputes, we strongly recommend that every company follows these practical recommendations:
 

  1. Carve only one company chop. Inform counterparties in a timely manner and report to the police if fake chops are discovered. If the company allows a second company chop to exist, even if it has not been recorded with the authorities, the use of that chop could still be considered binding. Furthermore, limit the number of chops for special purpose – the more chops there are, the more difficult it becomes to control them.
     

  2. Combine the use of the company chop and signature by the legal / authorized representative as the only way to execute documents. This measure can help prevent abuse. For example, a counterparty which has a long-term cooperative relationship with your company and knows your habit of combining the signature and the company chop, will be put on constructive notice when the legal representative or the person who possesses the company chop acts beyond their authority. Also, it means that employees cannot simply stamp their own employment contracts.
     

  3. Limit access to the company chop. The company chop should be kept by the legal representative or another trusted person in the company; or if this is not feasible (e.g. where the legal representative is someone at the headquarters and not located in China, and/or there is no senior local management) then the foreign shareholder could designate a trusted law firm or accounting firm to safe-keep the company chop instead. This will also help prevent situations where the legal representative uses the company chop as a bargaining chip in case of disputes. 
     

  4. Establish details rules for chop use. Details rules should be drafted and formally implemented (e.g. through a Board resolution of Shareholder resolution) to establish who is keeping the company chop and special purpose chops, how they may be used, how use should be recorded etc. These rules should be formulated as a legal document, so that they can also establish liabilities for misuse.
     

Gradually the electronic company chop is making an entrance in China. Compared with the physical company chop, an electronic company chop has the advantage of higher security, due to encryption and authentication techniques. With the development and promotion of technology, this electronic company chop may gain more traction and if so, it may become a viable alternative to the physical company chop that continues to prevail for now. Until then, companies should have a clear strategy in place to keep their chops safe and available for the business.
 

 

For further information, please contact:

 

Maarten Roos, Managing Director, R&P China Lawyers

[email protected]