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Supreme People's Court issues important new interpretation of Chinese company Law

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Ho Victor
Victor Ho

Registered Foreign Lawyer, Cal

Hong Kong

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09 March 2011

On 27 January 2011, the Supreme People's Court (the SPC) issued a new “Interpretation on Several Issues Concerning the Application of the PRC Company Law” (the Interpretation), the third such interpretation issued by the SPC in respect of the 2005 PRC Company Law (the Company Law).

The Interpretation is a welcome development, providing much-needed clarity on a range of issues that are often the subject of disputes in China, including:

  • the allocation of liability for contracts executed in preparation for the establishment of a company;

  • the performance and maintenance by shareholders of their capital contribution obligations; and

  • the consequences of a shareholder's failure to fully contribute or maintain its capital contribution.

This e-Bulletin highlights some of the key provisions of the Interpretation, with a focus on those provisions most likely to be of interest to foreign investors in China.

Liability for contracts signed during the course of establishing a company

Article 1 of the Interpretation clarifies that the ’founder’ of a company includes the shareholders which established a limited liability company. The Interpretation further provides that contracts signed for the purposes of establishing a company will generally be enforceable against the party signing the contract, be it the founder or the company, unless there is evidence to the contrary.

Therefore, to avoid liability, we recommend that foreign investors sign contracts either in the name of the subsidiaries they intend to establish in the PRC or have those subsidiaries ratify the contracts as soon as they are established.

Capital contributions ’in kind’

Prior to the Interpretation, there was limited guidance under PRC law as to the standards applicable for determining whether an in-kind capital contribution obligation (ie property in forms other than cash) had been properly performed, or the consequences of failure to perform such obligation. In practice, this has given rise to a significant number of disputes between Chinese and foreign investors, notably Danone's dispute with its JV partner Wahaha over Wahaha's obligation to complete the transfer of the Wahaha trademark to the parties' Chinese joint venture company.

In an effort to ensure that the registered capital of a company is fully contributed and maintained, the Interpretation sets out the following principles:

  • Valuation: Article 9 of the Interpretation provides that where the parties dispute the actual value of the in-kind capital contribution, the court shall entrust a qualified valuation institution to conduct a valuation.

  • Capital contributions in the form of property rights requiring registration of title: it is common in China for the formal transfer of ownership of certain property rights (eg, housing and land usage rights and intellectual property rights) to be conditional upon formal registration with the relevant government authorities. Disputes often arise between shareholders when one of the shareholders has failed to complete the relevant registration procedures for the transfer, even though the relevant property has already been delivered for use by the company.

    Article 10 of the Interpretation specifies that if shareholders fail to complete the registration procedures, they will be subject to a court order to do so within a certain period of time. Further, if the shareholder complies with the court order, it will become entitled to its rights as a shareholder of the company from the time that the property was delivered for use by the company. As a result, Chinese investors will find it difficult to frustrate or prevent the completion of title transfer procedures.

  • Capital contributions in the form of property which the shareholder is not entitled to dispose of: Article 7 of the Interpretation clarifies that the “bona fide purchaser” under Article 106 of the Property Law will apply to capital contributions to a company, which will enable a company to enjoy its rights to a capital contribution even if title to the contributed property is in any way defective.

Capital withdrawal

Chinese JV parties have sometimes attempted to dilute or withdraw their contribution to the company's registered capital. This is often disguised as a legitimate transaction, which presents difficulties of proof for the foreign party. Article 12 of the Interpretation expressly identifies five circumstances in which shareholders will be deemed to have withdrawn their capital contribution to a company. In particular, transactions between affiliated companies may amount to capital withdrawal. The practical implications of this provision are uncertain, and there is some concern that it could be used abusively to invalidate legitimate related-party transactions.

Enhanced procedures to ensure completion of capital contribution

The Interpretation introduces various measures to protect the right to sue in disputes over insufficient capital contribution or capital withdrawal.

  • Joint and several liability among the defaulting shareholder, founders, directors, senior management, third parties and transferee shareholder: the Interpretation (Articles 13, 14, 15 and 19) for the first time provides a clear legal basis for extending the liability of defaulting shareholders to other parties involved in the shareholder's default.

  • Scope of plaintiff extended: the Interpretation expressly extends the pool of potential plaintiffs from the company to other shareholders and, in specified circumstances, to creditors.

  • Time limitation no longer a defence: Article 20 prohibits defaulting shareholders from using time-limitation arguments to avoid liability.

‘Self-help’ remedies as a result of insufficient capital contribution or capital withdrawal

Importantly, the Interpretation recognises the validity of certain remedies that might be adopted by the parties in lieu of court proceedings. Article 17 allows the parties to impose reasonable limitations on the rights of the defaulting shareholder either pre-emptively in the company's Articles of Association or subsequently by a resolution of the shareholders' meeting. Shareholder rights subject to limitations might include rights to dividends, rights to subscribe to new shares and rights to participate in the distribution of the residual assets of the company. It remains open to question whether such restrictions also extend to voting rights. Article 18 further affords the shareholders' meeting the right to strip the defaulting shareholder of all of its shareholder rights if it fails to make any capital contribution or withdraws its entire capital contribution.

Notwithstanding these provisions, it is possible that the defaulting shareholder will be able to block the passing of any shareholders' resolution limiting or stripping away its rights. Further, it is not clear whether these self-help remedies apply to a foreign-invested joint venture, the highest authority of which is the board of directors (rather than the shareholders' meeting). Therefore, companies in the PRC are advised to incorporate these restrictions on shareholder rights in their Articles of Associations to the extent possible.

Finally, the Interpretation also affirms the validity of de facto/nominee shareholding arrangeme