China: China Finalises New Court Guidelines On Disputes Involving Foreign Investment

Last Updated: 27 August 2010
Article by Nicolas Groffman

China has issued, in final form, new regulations on cases involving foreign enterprises. This follows the release of draft rules which Mallesons noted in a client alert in November 2009. The new rules, called "Regulations on Issues in Adjudicating Cases Involving Foreign Invested Enterprise Disputes" could have a wide impact on the drafting of joint venture contracts and foreign investment in general, however their scope might be limited by the widespread use of arbitration clauses.

The Rules have the following advantages:

  • they try to find ways to stop defaulters from making use of administrative complexity and weaknesses in the court system to avoid liability;
  • they provide ways for investors to create more sophisticated investment arrangements without needing to go through approval.

Arbitrators may well want to follow these rules, but might argue that they are not obliged to do so as the Rules are for courts only.

Below, we discuss the Rules in more detail. Differences between last year's draft and the final version are highlighted, so if you are familiar with the draft version you need only read the parts flagged with the words "New Provision".

Not everything needs to go in the joint venture contract

Any contract that affects the establishment or amendment of foreign invested enterprises (FIEs) only takes effect when approved. However, if supplemental agreements do not constitute any "material or substantial" changes to the approved joint venture contract, the court may consider that the supplemental contract is effective.

For years there has been a question mark over the effectiveness of "side agreements" that investors often sign to cover issues that they deliberately omit from the joint venture contract. Side agreements are signed because the main joint venture contract is subject to examination and approval. The more complex the contract, the longer the examination process takes, because the authorities debate the content among themselves and with the investors. To avoid delays, investors insert much of the detail into a side agreement which they do not submit for approval. The new rule seems to allow such side agreements, as long as the change does not constitute a material change to the approved contract.

"Material change" includes changes in registered capital, company type, scope of operations, term, contributions by shareholders, methods of contribution, mergers and divisions, and share transfer.

New Provision

Failure to contribute

This concept was already in the 2009 draft but has been tweaked. If a party to a joint venture is to contribute "in kind" (rather than in cash), transferred the relevant assets (e.g. land and buildings) but failed to change the title registration in respect of such assets, and if the title registration can be updated within a time period prescribed by the court, then the court should not treat this as a failure to make its capital contribution.

If the FIE or any other shareholder can prove that the FIE has suffered losses as a result of this party's delay in updating title registration, the court should order such party to compensate such losses.

Failure to register a transfer

Sometimes a shareholder sells its interest in an FIE to a third party, but the FIE's staff fail to register the change. The new rules provide that the court may order the seller and the FIE to apply for approval jointly within a specific period of time.

If they still fail to do so, the draft (and the new rules) give the buyer the option to get his money back, along with damages amounting to (among other things) the difference in price, as well as "other reasonable loss" incurred by the buyer.

New Provision

In addition to the option for damages set out above, the final form Rules lay out two more options for the buyer:

  • if the seller and the FIE fail to apply for approval within reasonable time period after being requested by the buyer, the court should, upon the request of the buyer, order a termination of the underlying contract, ask the seller to pay back the transfer price, and to compensate actual losses so sustained by the buyer; and
  • the court should allow the buyer to effect the approval procedures by himself, if the seller and the FIE fail to do so within the time period prescribed in the court verdict.

Dealing with default by the Transferee under the Equity Transfer Contract

Occasionally, a sale goes ahead and the buyer comes into the FIE as a new shareholder, exercising all associated rights before the government authority has approved the sale. In such a case, if the seller sues the buyer for unpaid purchase price, then the court must simply order the seller to complete the approval procedure. Only if the approval is actually issued should the court support the lawsuit of the seller.

As mentioned last year, this is a step away from contract freedom and confirms that pre-approval payments will not be upheld by the courts, e.g. if the seller has negotiated for a portion of the purchase price to be paid on the day of signing. This confirms current practice in contract drafting, but does not rule out such pre-approval payment obligations as consideration for performance of other obligations, such as cooperation bonus payments under separate contracts.

New Provision

If approval cannot be secured, the court should order the buyer to give up any rights to operate and manage the FIE and repay to the seller its proceeds from exercising its shareholders' rights (after deduction of relevant costs), if so requested by the seller.

Pre-emptive rights

The parties to a joint venture have statutory pre-emptive rights when one party wishes to sell equity to a third party. Even if the transfer has been approved by the government, the other shareholders of the company can cause the sale to be declared void if they were not given the opportunity to exercise their statutory pre-emptive rights.

New Provision

The above is subject to the condition that they raise such claim within one year from the date when the other shareholders become aware or should become aware of the execution of the equity transfer agreement.

Neither the buyer nor the seller may use this as an excuse to back out of a transaction they have come to regret. The right to undo the sale is granted only to the other shareholders of the joint venture.

New Provision

Shareholders cannot always block equity transfer just by failing to consent

The Rules treat the lack of the other shareholders' consent as a trigger to revoke such equity transfer agreement, except where:

  • there is evidence showing other shareholders' consents being secured;
  • the other shareholders fail to respond with thirty days after receipt of written notice issued by the transferring shareholder; or
  • the other shareholders object to the transfer or refuse to purchase the transferred equity.

Share Pledge Contracts

If the shareholder of an FIE enters into a Share Pledge Contract with a creditor, the contract is valid whether or not it is registered. However, only when the pledge is registered are the "pledge rights" over the equity established.

This separation of pledge rights and contract rights might seem odd to common law lawyers, but not to those familiar with civil law. The Property Law of 2007 provided for this separation (which follows German law), and as a result a pledge agreement becomes effective when formed, but the pledge right itself is only valid when delivered or registered. The creditor would be able to sue for damages under contract, but not be able to exercise its pledge rights until the pledge is properly registered.

Entrustment investment can be effective

If the parties have agreed that one party will make the actual investment and enjoy the shareholder's rights and interests, while the other party acts as nominal shareholder, this trust agreement is effective.

New Provision

The above is conditional on the trust not constituting a void contract under applicable laws and administrative regulations. A reference to "social public interests" in the draft has been removed in the final form of the Rules.

When should the court support claims of a de facto shareholder?

The de facto investor, being the principal under the trust, needs to be astute about how it enforces its rights if the nominee investor later decides not to cooperate. If the investor directly requests the court to acknowledge his shareholder identity in the FIE, or to change the shareholder of the FIE, the court should generally not support his claims.

New Provision

The requirement above that the court should not support the investor's claims is negated, and the court should support the de fact investor, if the following three circumstances exist:

  • the de facto investor has actually made the investment;
  • the other shareholders other than the nominal shareholder have recognized the de facto investor as a shareholder; and
  • the courts or the parties have obtained, during the litigation period, the consent from approval authorities of the underlying FIE to register the de facto investor as the FIE's shareholder.

If the investor sues the FIE itself for dividends rather than suing the nominee shareholder, the court should not support his claim.

If the investor requests the court to cause the nominee to perform the relevant obligations as agreed by the parties in the trust agreement, the people's court should support him.

New Provision

If the trust agreement is declared null and void, and if the value of equity held by the nominal shareholder is not sufficient to cover investment of the de facto shareholder, the Rules provide that the court should order the nominal shareholder to repay the current value of the equity to the de facto shareholder.

In addition, the Rules also offer a new remedy to the de facto investor if the nominal shareholder expressly waives his equity right or refuses to hold the equity. Under such situation, the court can rule to auction or sell the FIE's equity held by the nominal shareholder and have the proceeds paid back to the de facto shareholder.

Chinese citizens living overseas are treated as foreigners

It is common for foreign investment rules to be extended to cover Hong Kong and Macao (and Taiwan), in recognition of the different legal systems in place in those regions. However, rather oddly, the rules also provide that Chinese citizens with foreign domicile are covered by the rules. It is not clear how this will be carried out, if implemented. Only in exceptional circumstances and in a few locations in China can Chinese citizens be treated like foreigners for investment purposes, so it seems unlikely that this ostensibly nationwide provision will work in practice.

New Provision

This is not really a new provision, but it is a significant amendment to the draft. The draft provided that even WFOE contracts, between two or more foreign parties, need to be governed by Chinese law. This requirement has been deleted.

Retroactive effect

The rules are to have retroactive effect on all cases that have not yet reached a final verdict, whether at first instance or on appeal. However, some cases reach final judgment but are then subject to "review," which is effectively a second appeal. Cases that are subject to review will not be covered by the new rules.

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.

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