China: New Rules On Nominee Shareholding Arrangements To Impact Foreign Investors

In a typical case of nominee shareholder arrangements, in 2001, a foreigner provided capital for an investment in the name of a Chinese individual, but on behalf of the foreigner. The final purpose of this specific investment was to acquire a second domestic company in an industry restricted to foreign investment. When in 2009 the parties came into conflict on the company's operations, the foreigner filed two litigations in court to confirm his rights as a shareholder of the first company, and for the payment of benefits from the second company.

Defending the Chinese individual, we argued successfully that:

(1)      The foreigner's investment was not approved by the competent department under the Ministry of Commerce, as is required under PRC laws and regulations on foreign investment;

(2)      The foreigner neither managed that company as shareholder, nor had ever received dividends;

(3)      As the second company operated in an industry closed to foreign investment, the confirmation that the first company was foreign-invested company would have consequences for the legality of the second company.

The focus of this case was the nominee shareholding arrangement between a domestic party and a foreign investor. Many such arrangements have been concluded over the years to avoid restrictions to foreign investment in certain industrial sectors, to avoid the high minimum registered capital or other special requirements on foreign investors, or to take advantage of simplified establishment procedures that apply to domestic investment. However, many of these arrangements have also led to disputes, in which the position of the foreign investor has often been precarious.

In future cases, however, foreigners may have stronger legal arguments to protect their nominal investments. On 6 December 2011, the Supreme People's Court passed the Interpretations on Several Issues concerning the Application of the Company Law of the People's Republic of China (III). On nominee shareholding arrangements, Article 25 provides that where a foreign investor enters into an agreement with a nominal shareholder of a limited liability company, the former's claim to be included in the company's registration documents should be ascertained only if more than half of the company's other shareholders agree. However, the article also stipulates that an agreement confirming the actual (foreign) investor's capital contribution in return for investment rights and interests, shall be valid and recognized by a People's Court.

The only – and very important – exception is made for a situation where the agreement between the actual investor and the nominee shareholder is invalid under Chinese law. Article 52 of the PRC Contract Law provides the circumstances for an agreement to be regarded invalid, including the "violation of mandatory provisions of laws and administrative regulations". Thus while a nominee shareholder can no longer defend against claims simply by referring to a company's registration, if the agreement was signed in violation of mandatory provisions such as restrictions on foreign investment in a certain industry, then a People's Court shall not recognize the agreement. In that case, the investor will not have a claim on the company or subsequent interests, though he may still be able to claim for a return of his investment.

The interpretations of the Supreme People's Court thus mark the first time that formal recognition is granted to nominee shareholding arrangements. However the pre-conditions – that the contract is valid under the PRC Contract Law, and that inclusion in the company's registration can only be enforced with the support of other shareholders, are strict preconditions. If they cannot be met, then the foreign investor's claims will be rejected.

Article 26 of the interpretations deals with another aspect of nominee shareholding. Where a nominee shareholder transfers, pledges or disposes of equity registered under his name, and the actual contributor tries to halt this disposal on the ground that he enjoys the actual right to the equity, the people's court should handle the case according to Article 106 of the PRC Real Rights Law: the nominee shareholder shall assume liability for compensation where he has causes losses to the actual contributor, but as long as the third-party acquirer acted in good faith, then it shall legally obtain relevant rights to the equity according to the bona fide acquisition system. Thus if the actual investor cannot prove that the third party acted in bad faith, then his only option is to claim for compensation from the nominee shareholder.

Comments

Nominee shareholding arrangements are a special kind of investment that has been adopted by many investors due for flexibility and confidentiality reasons. Before promulgation of the interpretations, judicial institutions have expressed conflicting views towards the confirmation and recognition of these structures because of a lack of due laws. As a result, many (foreign) investors have lost their interests in enterprises that were built with their capital. Under the interpretations however, nominee shareholder investments and the rights of anonymous shareholders should be recognized and protected by China's judicial institutions, provided that the investments do not violate the law.

This makes it important – more than ever – that investors clarify the rights and obligations between the nominee shareholder and the actual investor in a well-drafted, effective agreement that sets restrictions on the nominee shareholder and increases its liabilities in case he breaches his obligations. Moreover, the actual contributor should consider whether it is feasible to actively participate in the management of the company and hold the company stamps, the capital contribution certificate and other relevant documents. This would enable it not only to control and supervise operations, but also to prevent any malicious disposition of the investment by the nominee shareholder to a third party.

Relevant laws:

Article 52 of the Contract Law: A contract shall be null and void under any of the following circumstances:

(1)    A contract is concluded through the use of fraud or coercion by one party to damage the interests of the State;

(2)    Malicious collusion is conducted to damage the interests of the State, a collective group or a third party;

(3)    An illegitimate purpose is concealed under the guise of legitimate acts;

(4)    Damaging the public interests;

(5)    Violating the mandatory provisions of laws and administrative regulations.

Article 106 of the Real Right Law: Where a person untitled to dispose a real property or movable property transfers the real property or movable property to an assignee, the owner has the right to recover the real property or movable property. Except it is otherwise prescribed by law, once it is under any of the following circumstances, the assignee shall obtain the ownership of the real property or movable property:

(1)    The assignee accepted the real property or movable property in good faith;

(2)    The real property or movable property is transferred at a reasonable price; or

(3)    The transferred real property or movable property shall have been registered in case registration is required by law, and shall have been delivered to the assignee in case registration is not required.

 Where an assignee obtains the ownership of a real property or movable property in accordance with the preceding paragraph, the original owner may ask the person untitled to dispose of the real property or movable property to make compensation for his losses.

Where a party concerned obtains any other real right in good faith, he shall be governed by the preceding two paragraphs by analogy.

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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