New Judicial Interpretation Introduces Stricter Shareholder Liability
On 6 December 2010 the Supreme People’s Court of the People’s Republic of China (the “PRC”) promulgated Interpretation (III) of Several Issues relating to the Application of the PRC Company Law (“Interpretation III”), which came into force on 16 February 2011.
Interpretation III specifies the application of the PRC Company Law in disputes arising from company establishment, capital contributions and transfer of equity interests. Although procedural in nature, Interpretation III modifies the corporate legal framework in the PRC. Foreign investors should also consider it when drafting or amending corporate documents of foreign invested enterprises (“FIEs”).
The main relevance of Interpretation III is likely to be the direct liability of a shareholder to its subsidiary’s creditors for its own failure and that of other shareholders to provide capital contributions (see item 3 below for details).
Interpretation III covers the following main issues:
- The parties’ liabilities prior to the establishment of a company;
- Validity of capital contributed in the form of property not owned by the contributor;
- Stricter rules to support timely and complete capital contributions;
- Unlawful capital withdrawal; and
- Acknowledgement of the concept of nominal shareholder.
1. The parties’ liabilities prior to the establishment of a company
It is common practice for investors in a company to conclude contracts (either in their own name or in the name of the company to be established) prior to the forming of the company. In practice, leases for premises are often signed before the company is established. In certain cases, supply contracts are also signed before the company has acquired its business licence. Legally speaking, a company is not established as a legal entity until its business licence has been issued, and only then does it have the civil capacity to conclude contracts in its own name.
In order to protect the other contract partner, according to Interpretation III investors must bear the related liability arising in connection with a contract concluded in their own name if the other party makes a corresponding claim. However, if the company approves or has actually performed such a contract, the company bears the related liability after its establishment in the event of a claim by the contract partner. As a consequence, if a lease is signed between landlord and investor in the name of the investor for the benefit of an FIE before its establishment, it is advisable to clearly stipulate in the lease that the landlord forfeits any claims against the investor once the rights and obligations under the contract have been assigned to the FIE. This will prevent the landlord from using Interpretation III to try to hold the investor liable for the lease of the FIE originally signed in the investor’s name but later assigned to the FIE.
If the company fails to be established, the court may order all or some of the investors to bear joint liability towards the creditors if they make a corresponding claim.
2. Validity of capital contributed in the form of property not owned by the contributor
Contributions in kind to the registered capital of a company via property which the contributor concerned (the “Contributor”) does not own and is not entitled to dispose of will not be automatically regarded as invalid. Contributions are deemed to be valid if:
(i) the other shareholders and the company are bona fide when the Contributor makes such contribution;
(ii) the appraisal value of the property was reasonable; and
(iii) the property has been actually delivered to the company and such ownership change has been properly registered if registration is required by law.
The actual owner of the contributed property may claim for damages against the Contributor. This means that it is possible for a company to acquire ownership of property contributed in kind which was not previously owned by the Contributor. In this respect, Interpretation III constitutes a significant improvement of a company’s legal standing after receipt of such contribution in kind.
3. Stricter rules to support timely and complete contributions by investors
Interpretation III provides for stricter rules to encourage investors to duly perform their basic capital contribution obligations. Particular attention needs to be drawn to the following aspects:
(i) Who can be sued?
a) Promoters of a limited liability company bear joint liability with a shareholder who fails to duly perform its capital contribution obligation at the time of establishment of the company. The concept of promoter as defined in the PRC Company Law was originally intended for companies limited by shares only and has been extended by Interpretation III to include the shareholders of a limited liability company. Before Interpretation III, only shareholders who failed to duly perform their capital contribution obligations were liable to the company and to other shareholders who had duly performed their capital contribution obligations. The circumstances under which non-defaulting shareholders can be held jointly liable for another shareholder’s failure to contribute capital are strictly limited to dissolution of the company or cases where the actual value of the capital contributions in non-monetary properties is found to be significantly lower than set out in the company’s Articles of Association.
The new rule has expanded the scenarios in which non-defaulting shareholders may be held liable. It also poses a considerable risk for foreign investors involved in Sino-foreign joint venture companies, should their Chinese joint venture partners refuse to fulfil their capital contribution obligation. In such cases, the foreign investors may be liable to the company’s creditors for performance within the scope of the defaulting Chinese joint venture partner’s unpaid capital contribution and the relevant accrued interest. They may only subsequently claim for compensation from their Chinese partners.
b) Directors and/or senior management personnel who breach their duty of loyalty and/or duty of diligence bear liability if a shareholder fails to perform its capital contribution obligation during a capital increase.
(ii) Who can sue?
The company, shareholders who have properly fulfilled their contribution obligations and the company’s creditors are all entitled to sue. This is an important change to the legal concept of the limited liability company under Chinese law. Essentially, shareholders are only liable to the company for their capital contributions and not to a creditor of the company, apart from the few exceptions set out above. Before Interpretation III, creditors had to sue the company and could not sue the shareholders directly unless the company was dissolved. This change means that there is now a considerable potential risk involved in establishing joint venture companies.
(iii) What is the scope of liability?
The scope of liability due to failure to properly contribute capital includes both the outstanding capital amount and the related accrued interest.
(iv) Besides payment claims, what other rights does the company have vis-à-vis defaulting shareholders?
The company is allowed by way of shareholders’ resolution to exclude the defaulting shareholder or to limit its rights, such as the right to profits, pre-emptive rights to new issuance, rights to distribution of assets after liquidation, etc.
(v) Shareholders who fail to duly perform their capital contribution obligation cannot use limitation of action as a defence in a lawsuit.
4. Unlawful capital withdrawal
Interpretation III specifies certain circumstances that constitute fraudulent withdrawal of contributed capital. They include:
(i) transferring funds out of the company by creating false debts and credit relationships or through related party transactions;
(ii) increasing profits via fraudulent financial reporting and distributing said profits;
(iii) transferring company funds after capital contribution verification; and
(iv) withdrawing capital in other ways without following legitimate procedures.
As to the consequences, the withdrawing shareholder must compensate the company and the company’s creditors for all losses and damages incurred due to the capital withdrawal. Further, any shareholders, directors, senior management personnel or actual controlling persons who assist a shareholder in withdrawing its capital contribution are jointly liable. Lenders of capital to a shareholder are also jointly liable if they have agreed that the capital will be withdrawn after being verified to compensate such lender and the shareholder cannot make up the difference created by the withdrawal.
5. Acknowledgement of the concept of nominal shareholder
Interpretation III clarifies the legal interests of nominal shareholders and actual contributors. In general, a contract between a nominal shareholder and an actual contributor will be respected by the court when clarifying their respective legal interests.
If the actual contributor requests a change to the registered shareholder, the issue of a capital contribution certificate, to be recorded as a shareholder of the company, to be recorded in the Articles of Association and filed with the competent Administration for Industry and Commerce, he must obtain the consent of more than half the shareholders excluding the nominal shareholder.
If the nominal shareholder directly disposes of equity interests to a bona fide third party, the court will usually support the validity of said disposal. The actual contributor may claim damages against the nominal shareholder.
With regard to FIEs, however, the Provisions on Several Issues concerning the Trial of Disputes involving Foreign-invested Enterprises of 16 August 2010 need to be considered. Any acknowledgement of nominal shareholders in FIEs is subject to the approval of the competent Authority of Commerce. It is by no means clear whether the Authority of Commerce will allow their approval system to be bypassed in favour of any nominal shareholders. Approval and registration are the basis of the FIE regime in China. Therefore, the practical relevance of Interpretation III is likely to be minor in this regard.
6. Other issues
Interpretation III also contains regulations on the consequences of failure to properly fulfil contributions in kind, improper transfer of identical equity interests to multiple parties, etc.