China: Foreign Investors And Foreign Invested Companies: Overview Of The Impacts From The New Company Law

On December 29, 2023, the Standing Committee of the National People's Congress of the People's Republic of China ("the PRC") adopted an amendment to the Company Law ("New Company Law"), which will come into effect on July 1, 2024. This new amendment makes substantial changes to the current Company Law in the areas of corporate governance, executive qualification and liabilities, equity/share transfer mechanism and registered capital handling, etc.

This newsletter highlights the potential impacts the New Company Law will make on the foreign invested limited liability companies in China, including wholly foreign owned enterprise ("WFOE"). Understanding such potential impacts will be crucial for foreign invested limited liability companies to develop proper plans in advance for compliance with the New Company Law.

1. IMPLICATIONS FOR SENIOR MANAGEMENT

Employee Representation in the Corporate Management

The New Company Law for the first time requires that a company with 300 or more employees must have an employee director appointed in its Board of Directors. The employee director should be appointed by the Congress of the Employees or the All-Employees Meeting or elected through other form of democratic voting. Before the New Company Law, the employee representation in Board of Directors is only a statutory requirement for the state-owned companies.

However, the requirement to impose the employee director seems not clear and certain. The New Company Law also allows a company to appoint an employee representative in the Board of Corporate Supervisors. In the event that a company chooses to have a Board of Corporate Supervisors, the company is further required to have an employee director in its Board of Directors, the employee representation in the company management seems stronger than, or, at least, equal to, the shareholder of the company. That does not seem reasonable as a proper way, as the employees enjoys stronger protection but bears less risk than the shareholder in the success or failure of the company. Moreover, based on the previous legislative drafts of this provision and the Legislative Technical Specifications, it is more likely that the company with more than 300 employees can choose to have an employee director in the Board of Directors or an employee representative in the Board of Corporate Supervisors if the company choose to have the latter.

Legal Representative

The New Company Law provides that, subject to the Articles of Association, a director or the general manager who handles company matters on behalf of the company should be appointed as the legal representative of a company. The current Company Law provides that the legal representative can only be served by either the chairman of the Board of Directors (or the executive director if a company does not have a Board of Directors) or the general manager.

The New Company Law further provides that a company should be liable for civil activities conducted in the name of the company or duty performance by its legal representative. Restrictions on the powers of the legal representative imposed by the Articles of Association or the Board of Shareholders is not a compelling defense against claims by a bona fide counterparty. Subject to the Articles of Association and the relevant law, the legal representative should be personally liable to the company if the legal representative is found fault with its duty performance which causes losses of a third party.

Therefore, it seems that the shareholder of a company has more options for the position of the legal representative. However, the shareholder should exercise extra caution on the appointment of the legal representative and take more efforts to design the Articles of Association to limit the potential risk exposure and maximize the potential compensation claims associated with the legal representative.

Duty of Loyalty and Duty of Care

The New Company Law imposes the duty of loyalty and the duty of care on the directors, corporate supervisors, other senior management members of a company, as well as the controlling shareholder and de facto controller of a company even if they do not take the aforesaid positions. The current Company Law only imposes the duty of loyalty and the duty of care on the directors, corporate supervisors, and other senior management members.

The New Company Law also, for the first time, clarifies the legal definitions of the duty of loyalty and the duty of care in the law. The duty of loyalty requires avoidance of the conflict between self-interest and the company interest, as well as forbearance from seeking improper interest by leveraging the duty of the position. The duty of care requires reasonable care exercised by a normal professional manager acting for the best interest of the company. The New Company Law further defines actionable examples of breaching the duty of loyalty and lays out the proper rules that should be followed by the Board of Directors or the Board of Shareholders to vote on the conflicts.

2. POWERFUL BOARD OF DIRECTORS

Audit Committee

Under the New Company Law, the Board of Corporate Supervisors or the corporate supervisor is no longer mandatory. Instead, the New Company Law provides for an Audit Committee as an alternative, and the Audit Committee should be established within the Board of Directors. Such an alternative consolidates the power of corporate operation and the power of compliance oversight of the directors, and makes the governance structure more efficient and effective. Although the Audit Committee is voluntary and is subject to whether there is a Board of Corporate Supervisors, the New Company Law's intent to centralize the power of compliance supervision to the Board of Directors is clear.

Power Shifting from Board of Shareholders

Under the New Company Law, some powers that was statutorily delegated to the Board of Shareholders are now transferred to the Board of Directors (e.g. the new statutory liquidation team shall be composed of the directors instead of the shareholders). Moreover, matters that may not previously be authorized by the Board of Shareholder are now allowed to be approved by the Board of Directors in accordance with the New Company Law.

In addition to the above, the New Company Law also grants more other decision-making powers to the Board of Directors, such as the power to decide on forfeiture of shareholders' equity interests in company liquidation process. Foreign shareholders need to pay attention to the stronger Board of Directors under the New Company Law, so that they can make wise decision on the appointment of directors.

3. TRANSFER OF EQUITY INTEREST

Simplified Rule on the Right of First Refusal

The New Company Law removes the previous requirement that the transfer of equity interest by a shareholder to a person other than a shareholder of the company should firstly be approved by the majority of the other shareholders. The New Company Law stipulates that a selling shareholder should now notify the other shareholders in writing of the quantity, price, method of payment and period of time for the intended transfer, and the other shareholders should have the right of first refusal under the same conditions. The shareholders who fail to respond within thirty days from the date upon receipt of the written notice will be deemed to have waived their right of first refusal.

While the effort to make easier to sell company shares to a non-shareholder third party is plausible, the caveat is that the non-selling shareholders may be left with an unexpected business partner. WFOE with two or more foreign investors, or Sino-foreign joint venture companies may consider creating a proper mechanism to prevent the caveat in the Shareholder Agreement, the Joint Venture Contract, and the Articles of Association.

Capital Contribution Liabilities

According to the New Company Law, if at the time of the transfer, the outstanding capital contribution has not become due under the company's Articles of Association, the transferee should be liable for the outstanding capital contribution; and, if the transferee fails to fulfill such an obligation of capital contribution, the transferor is the secondary obligor to make the contribution of the outstanding capital.

If at the time of the transfer, the outstanding capital contribution is already overdue, or the actual value of the in-kind contribution made by the transferor is determined significantly below the subscribed capital amount, the transferor will be liable for the outstanding capital contribution. In such an event, the transferee will be held jointly and severally liable, unless it is a bona fide transferee, i.e. it is not aware and should not have otherwise become aware of the status of the outstanding (or defective) capital contribution.

Therefore, a foreign investor who is planning to purchase the equity of a limited liability company should conduct thorough due diligent about the status of the capital contribution; and an existing foreign shareholder of a limited liability company, who is selling its shares, should properly inform the actual status of its capital contribution and carefully assess the buyer's financial strength if there is outstanding capital contribution.

4. CAPITAL CONTRIBUTION

Shortened Capital Contribution Period

The New Company Law requires shareholders of a limited liability company to pay the subscribed capital contribution within five years from the date of establishment of the company, unless otherwise provided in other laws and regulations. Existing companies not conforming to such a requirement will be required to amend their schedule of capital contribution, although the implementation rules are yet to be issued. Foreign investors of the existing companies should assess their financial strength and be prepared for a potential statutory "acceleration".

Board of Directors' Responsibility

The New Company Law further provides that, after incorporation of a limited liability company, the Board of Directors must verify the contribution status of the company's registered capital, and, in case that there is delay in contribution by a shareholder, must issue in the name of the company a written demand letter to the shareholder in default, calling for prompt contribution. If any director fails or refuses to fulfill the above verification and demand obligations in a timely manner, and, where losses are suffered therefrom by the company, such a director will be held personally liable to compensate the company for such losses. Foreign investors should consider buying additional coverage for such a potential liability for the directors they appoint.

Shareholders' Joint Liability

Pursuant to the New Company Law, if, at the time of the incorporation of a limited liability company, a shareholder fails to pay the capital contribution pursuant to the Articles of Association of the company, or if the actual value of the shareholder's in-kind capital contribution is significantly lower than the amount of the capital contribution it subscribed to, the other shareholders at the time of the incorporation of the company will be jointly and severally liable for the shortfall in capital contribution. Foreign investors should ensure on-time contributions to avoid such an unfavorable consequence.

Acceleration Rights

The New Company Law allows a limited liability company or its creditors to accelerate the capital contribution by the shareholders even if the contribution obligation has not become due, if the company is unable to pay off its debts that become due before the due date of the capital contribution. To avoid such acceleration, foreign investors need to ensure the operation of the company sticks to its budget and business plan.

Forfeiture of Shareholders' Equity Interests

Under the New Company Law, if a company issues a demand letter to its shareholder to pay the due outstanding capital contribution, the shareholder will have a minimum sixty-day grace period to fulfil such an obligation. If the shareholder fails to fulfill such an obligation, the company may, upon a duly made resolution by its Board of Directors, forfeit the shareholder' equity interests corresponding to the outstanding capital contribution.

In addition, the Board of Directors of the company can decide whether the forfeited equity interests should be transferred to other shareholders who are willing to make the contribution or cancelled by capital reduction. If the forfeited equity interests are not transferred or canceled within six months, the other shareholders of the company will be responsible to contribute the outstanding capital contribution corresponding to their respective equity holding ratio in the company. Foreign investors should carefully evaluate their finance status and exercise due diligence regarding shareholders' capital contribution, and take quick action to transfer or cancel the capital in default.

5. PIERCING THE CORPORATE VEIL

The New Company Law explicitly allows authorities to put aside limited liability of a limited liability company and hold a corporation's shareholders personally liable for the corporation's actions or debts if the shareholder trying to escape debt by using two or more companies under its control, and, companies involved in such a scheme will be held jointly and severally liable for the debts of each other.

The New Company Law further provides that if the shareholder of a one-shareholder company is unable to prove that the property of the company is independent from its own property, this shareholder shall be jointly and severally liable for the debts of the company. Thus, the New Company Law officially reverse the burden of proof rule for piercing one-shareholder company's veil. Foreign investors shall carefully maintain their status of independence in the limited liability companies, especially when it refers to internal transactions between subsidiaries.

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The New Company Law has a pervasive impact on foreign investors and the limited liability companies they established in China. The above article only serves a quick snapshot of some major changes in the New Company Law, that are worth of your attention. We hope that they are informative and helpful.

We will prepare a serial of advisory alerts to provide more detailed coverage of each major change. Please follow us for those useful follow-up alerts.

In the meantime, should you have concern about any of the above issues, you are welcome to reach out to us for a more detailed analysis of the relevant provisions of the New Company Law and a solution to address such concerns in advance.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.