China: The Supreme People's Court and the Company Law: Presumptions and Gap-filling Round Three

Last Updated: 7 June 2011
Article by Zhang Baosheng

In 2005, China amended its Company Law(1)and made substantial adjustments to the State's company law system and strengthened the justiciability of company related disputes. However, some provisions of the amended Company Law are overly general, conceptual and declaratory, and as a result it is not uncommon to find disparate outcomes in similarly situated cases. In order to ensure uniform understanding and application of the Company Law and provide guidance for judicial practice and commercial activities, the Supreme People's Court (the "Supreme Court") issued two judicial interpretations of the Company Law(2), mainly clarifying certain fundamental principles of applying the Company Law and specific matters like dissolution and liquidation of companies.

On February 16, 2011, the Supreme Court further issued Provisions of the Supreme People's Court Regarding Certain Issues Concerning the Application of the Company Law of the People's Republic of China (III) (the "Supreme Court Interpretation"). The Supreme Court Interpretation provides clarification of various widely disputed issues in practice, including assumption of liability at the pre-incorporation stage, equity contribution and verification of equity interests and so on. This article aims to share our view on the Supreme Court Interpretation from a practice point of view.

I. Who shall assume liability arising during the incorporation phase of the company?

During the incorporation process of a company, it is usual for promoters of the company to enter into contracts in their name or the company's name. However, the Company Law has no provision on who shall assume liability caused by promoters' actions. For the purpose of reducing transaction costs and protecting the interests of the counterparties, the Supreme Court Interpretation adopts the Rechtsschein(3)as the rule for determining assumption of liability, which holds that the individuals initially named as parties to the contract shall assume the respective liability. The foregoing rule, however, is subject to two exceptions: (i) if a contract was originally formed in the name of the promoters, but the company, after its establishment, ratified that contract or has become the actual party to that contract, the counterparty can require that the company assume liability; or (ii) if the promoters enter into a contract in the name of the company for their interest, the promoters shall assume liability. theory (or theory of appearance)

II. Defining the validity of making contributions using property owned by another.

The Supreme Court Interpretation does not deny the validity of all acts of making contributions using property owned by another. Instead, it adopts the good faith acquisition principle(4)under the Property Law. If contribution is made using money gained through criminal activities such as corruption or misappropriation, auction or forced sale of equity interest can be conducted to compensate the non-breaching party's loss. This approach is favorable to maintain the company's capital, safeguard the interest of the counterparty and protect the interest of the company's creditors.

III. Setting the criteria for determining whether a non-cash contribution is fulfilled and the respective remedies

The Company Law allows shareholders to make equity contributions with non-cash property, but it fails to provide the respective standards and procedures for non-cash contribution. According to the Supreme Court Interpretation:

When it is uncertain whether the value of non-cash property that has not been evaluated is consistent with the payable contribution amount, such non-cash property shall be evaluated by an evaluation institution designated by the court.

Regarding certain kinds of non-cash property which are subject to registration requirement for transfer of ownership, the completion of ownership change registration and actual delivery of such property are both required for equity contribution.

Investors may make contributions using equity of other companies which have no defects in rights and are not subject to any claim or lien, provided that the required evaluation and equity transfer procedures are duly performed.

IV. Refining the civil liabilities of defective contribution(5)

Making equity contribution is the shareholder's basic obligation to the company. The shareholder's failure to perform its obligation of making equity contribution would injure both the interest of the company and the interest of the company's creditors. The Supreme Court Interpretation provides in detail the civil liabilities of defective equity contribution. The provisions are conducive to supervise and urge the shareholder to fully perform its obligation of making equity contribution, which also provides a clear legal basis for the creditors to claim recourse.

A. Expanding who shall be liable for defective equity contribution. Where promoters of a limited liability company fail to make equity contribution, the other promoters shall bear joint liabilities. Where a shareholder fails to make equity contribution at the time of capital increase, the directors and senior officers who breach their duty of care shall bear corresponding liabilities. The other shareholders, directors, senior officers and persons in actual control who assisted a shareholder in wrongfully withdrawing an equity contribution shall bear joint liabilities. Where a third party advances funds to a promoter to assist the promoter in establishing a company and the promoter wrongfully withdraws the contribution, the third party shall bear joint liabilities. Where the shareholder who made defective equity contribution transfers its shares to an assignee, if the assignee is aware of or should have been aware of the defects of equity contribution, the assignee shall bear joint liabilities.

B. Clarifying the scope of the parties who have the right to request the shareholder to perform his obligation of making equity contribution and bear the liabilities of equity contribution. Parties with such rights shall include the company, the other shareholders of the company and the creditors of the company.

C. Clarifying the scope of the liabilities of the shareholder failing to make equity contribution or wrongfully withdrawing an equity contribution, which includes the principal and interest of the contribution, and it limits the shareholder who has defects in equity contribution to raise a defence on the ground of the statute of limitations.

V. Limiting and disqualifying the rights of shareholders who have defects on equity contribution for the first time

The Company Law does not clearly stipulate whether the rights of shareholders who refuse to make equity contribution should be limited or even if such shareholders should be disqualified. Thus, the Supreme Court Interpretation provides a breakthrough: the company can reasonably limit the rights of shareholders who have defects on equity contribution to claim for profit distribution, their preferential subscription rights of new shares and their rights to claim for residual property distribution based on the Articles of Association of the company or the shareholders resolution; if the shareholders of a limited liability company refuse to make equity contribution or withdraw their capital, and do not contribute or return the capital upon request by the company, the company can disqualify these shareholders through shareholders' resolution.

VI. Balancing the rights and obligations of nominal shareholders, actual investors, creditors and equity assignees

In commercial practice, the situation in which nominee shareholders and actual investors are different individuals or entities is not uncommon and sometimes causes disputes. The Supreme Court Interpretation confirms the validity of the agreement between nominee shareholders and actual investors is based on the spirit of freedom of contract and clarifies the allocation of equity profits and liabilities as follows:

A. Nominee shareholders shall not challenge the actual investors based on their registered status; actual investors are entitled to claim for investment profits against nominee shareholders according to the agreement, but if actual investors require the company to change nominee shareholders, such request must be approved by a vote representing more than half of the other shareholders of the company, not counting the nominee shareholders.

B. If the creditors request the shareholders who do not make equity contribution to undertake liability, nominee shareholders can not challenge the creditors on the grounds that they are not actual investors.

C. The good faith acquisition system of Property Law is adopted to permit the bona fide third party to acquire the equity shares transferred by the nominee shareholders' without the consent of the actual investors. The Supreme Court in principle recognizes that the third party can rely on the public registration information, unless such third party does not act in good faith. Actual investors can claim damages against nominee shareholders. This principle is applicable to the situation when the original shareholders have transferred their shares and the registration of such transfer has not been completed by the registration authority.

The new Supreme Court Interpretation reflects Chinese judicial authority's most current position on the regulations and legal principles of the Company Law. Not only do the provisions provide practical refinements for the regulation of investments and shares, but the provisions fill important legislative gaps. The provisions also provide a clearer basis for a range of relative rights holders to exercise their rights.

This article was originally written in Chinese, the English version is a translation. This article was first published in the firm's periodical China Bulletin March Issue, 2011, Vol. 47)

Notes:

1、Company Law of the People's Republic of China was promulgated on December 29, 1993 and has been amended three times. The current version was issued on October 27, 2005 and effective as of January 1, 2006.

2、These two judicial interpretations include Provisions of the Supreme People's Court about Several Issues Concerning the Application of the Company Law of the People's Republic of China (I) issued on April 28, 2006 and Provisions of the Supreme People's Court about Several Issues Concerning the Application of the Company Law of the People's Republic of China (II) issued on May 12, 2008.

3、The Rechtsschein theory was created by the German private law scholars in the beginning of the last century. It requires determining the effect of commercial activities based on the appearance of the parties' act. Appearance may be inconsistent with the true intention. Pursuant to the Rechtsschein theory, for the purpose of protecting transaction security, transaction activities cannot be revoked once they are conducted. That is to say, when a party argues that his true intention differs from the manifestation of intention, the latter shall prevail and shall be effective once it is conducted.

4、Article 106 of the Property Law of the People's Republic of China (promulgated on March 16, 2007) provides the rule of acquisition in good faith: "In case a person unauthorized to dispose realty or chattel alienates the realty or chattel to an assignee, the owner is entitled to recover the realty or chattel. The assignee shall obtain the ownership of the realty or chattel if meeting all of the following conditions, unless it is otherwise prescribed by law: (1) to accept the realty or chattel in good faith; (2) to purchase the realty or chattel at a reasonable price; (3) in case registration is required by law, the alienated realty or chattel shall have been registered, while in case registration is not required, the delivery thereof shall have been accomplished. In case, according to the preceding paragraph, an assignee obtains the ownership of a realty or chattel, the original owner may require the person unauthorized to dispose of the realty or chattel to compensate for his losses. In case a related party obtains any other form of real right in good faith, the preceding two paragraphs shall apply by reference."

5、Defective contribution generally includes failing to make contribution, failing to make full contribution and illegally taking away the contribution by shareholders.

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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