China: Contract validity in the Transfer of Mining Rights through Equity Transfers

Last Updated: 18 March 2015

To acquire mining rights through equity transfers is a common investment scheme in the mining industry. However, its legal effect is not without problems. This article provides a brief analysis of this scheme and the related legal issues.

Transfer of Mining Rights through Equity Transfers: the Mechanism and Its Potential Problems

To summarize, the typical scheme to transfer mining rights through equity transfers is as follows: the seller transfers all or a majority of shares of a mining company to the buyer, who subsequently becomes the sole or majority shareholder of the mining company. Through its ownership of shares in the mining company, the buyer can exercise the mining company's mining rights indirectly.

On the face of it, this scheme only changes the ownership structure of the mining company, while the mining company remains the registered mining rights holder on the Mineral Resource Exploration Permit or Mining Permit. Therefore, the nature of the transaction is an equity transfer instead of a mining rights transfer, and it will not trigger approval procedures required for the transfer of mining rights.

However, under the circumstances where the seller sold all or a majority of shares of the mining company, although the buyer has not become the registered mining rights holder, it has de facto control over the mining rights registered in the name of the mining company. In practice, many mining companies' only asset is the mining rights, or the mining companies are established for the purposes of transferring mining rights. Such practices further illustrate that the actual transaction purpose is to "transfer mining rights in the name of equity transfers."

There are two main reasons for the popularity of this scheme. First, it simplifies transaction procedures in that an equity transfer normally only requires the lawful performance of the agreement and the registration of the equity transfer at the local office of Administration of Industry and Commerce. It does not require regulatory approval. In contrast, the transfer of mining rights requires approval and registration. The approval process is time-consuming and complex. In addition, there are risks that the approval may not be granted.

Second, it reduces transaction costs. Compared to the taxes and fees involved in the transfer of mining rights, equity transfers can save business tax and surcharges for the seller, and the deed tax and transaction fees for the buyer. As a result, equity transfers can significantly lower the total cost for both parties.

However, under current laws, administrative regulations or judicial interpretations, there is no specific regulation on the issue of contract validity in transferring mining rights through equity transfers. As a result, this issue is disputed in judicial practice. Upon reviewing relevant cases and judicial opinions, we found two main views: the "invalid contract" view and the "valid contract" view. Different regional courts may take different positions in trial practice, which results in uncertainties in the effect of this type of transaction and the outcome of disputes arising therein.

The Main Arguments of the "Invalid Contract" View and the "Valid Contract" View

  1. Invalid Contract View

The "invalid contract" view can be summarized as follows: the equity transfer agreement entered by the parties provides for the transfer of all or a majority of the shares, and specifies the transfer of the mining company's assets and relevant right certificates. The original mining rights holder withdraws from the operation of the mining company. The contract should be deemed as a transfer of mining rights in disguised form and should be invalid. Its main arguments include:

First, this scheme seeks to avoid administrative approval and the payment of relevant taxes and fees. It can also result in multiple "transfers" of the mining rights prior to the expiration of the period during which the mining rights holder is not permitted to transfer its mining rights. Accordingly, the scheme seeks to conceal an illegal purpose with legal forms. Pursuant to Article 52 (3) of Contract Law of the PRC, the contract should therefore be null and void.

Second, Article 6, paragraph 3 of the Mineral Resources Law of the PRC provides that "profiteering in exploration rights or mining rights shall be prohibited." In the process of the equity transfer scheme mentioned above, however, most shareholders (of the mining company, which is the seller) receive high profit margins through the transfer, and therefore profiteer through selling corporate shares. As a result, such equity transfer agreements violate the mandatory provisions of the law. Pursuant to Article 52(5) of the Contract Law of the PRC, the contract should therefore be null and void.

Third, such equity transfer agreements will cause the loss of government tax income, which will also harm the public interest. Pursuant to Article 52(4) of the Contract Law of the PRC, the contract should therefore be null and void.

The above arguments are also supported by some regional High People's Court opinions. For instance, the High People's Court of Heilongjiang Province held that "the act that transfers mining rights by way of contracting or equity transfer, and begin production without obtaining administrative approval shall be deemed concealing an illegal purpose with legal acts. Pursuant to Article 52 of the Contract Law of the PRC, such transfer of mining rights is null and void."

In addition, the High People's Court of Yunnan Province held that "where the contract provides for the transfer of all or most shares or partnership ownership, and a new business entity will take over the operation, and it can be confirmed at trial that it serves as de facto transfer of exploration right and mining right, such contract shall be deemed null and void."

  1. Valid Contract View

The "valid contract" view can be summarized as follows: the equity transfer agreement described above does not violate any mandatory laws and regulations, therefore such agreement should be considered valid. The main arguments include:

First, the subject matter of an equity transfer is the equity, not the substantive rights and benefits of the mining company. Any change in equity may cause the change in control over the substantive rights and benefits of the company. Whether an equity transfer agreement is valid or not should be assessed based upon the Contract Law and other mandatory provisions under relevant laws and administrative regulations. It should not be judged by the change in the company's ownership of proprietary right.

Second, in terms of mining rights, an equity transfer or a change of shareholder may not necessarily disrupt administrative management of the mining rights. In principle, the change of the shareholder of a mining rights holder does not cause the change of management and technical personnel (e.g. mine director). Hence, it is not necessary to deny the validity of such equity transfer agreement.

Third, because partial equity transfers are also employed in practice, despites strict regulations, the parties are able to circumvent such regulations by setting up multi-layer share structures. Hence, it is impracticable to regulate this type of agreement.

In judicial practice, many cases have held that such equity transfer agreements are valid. And the validity of such agreements is not expressly denied in the judicial documents issued by many regional High People's Courts. Some of the judges of the Supreme People's Court also consider such agreements valid. However, the Supreme People's Court has not reach a consensus in the process of drafting the judicial interpretation for cases involving mining rights disputes.

Our Understanding and Suggestions

It is our understanding that one cannot draw a simple conclusion regarding the issue of contract validity in the transfer of mining rights through equity transfers. In fact, disputes over validity of such contracts often involve much more complicated factual issues than anticipated in theoretical discussions. Thus it is necessary to analyze the issue on a case-by-case basis, in order to reach a conclusion that is most consistent with the laws and legal principles.

Before unified rules on this matter are promulgated, when the parties design a specific transaction, they should neither alter the entire transaction for the fear of the contract being found invalid, nor simply conclude that the equity transfer scheme can artfully circumvent laws and regulations governing the transfer of mining rights. Rather, in order to guarantee the legality and efficiency of the transaction, all aspects of the transaction (e.g. share ratio, transfer of licenses and permits, change of management and operation, etc.) should be considered comprehensively. Prior decisions of the local court and local taxation policies (e.g. in some regions, special taxes may be imposed on such transactions) need also be taken into consideration. If any dispute arises from the transaction, a comprehensive consideration is needed when reviewing the terms and conditions of the contract, and searching for evidence that supports the client's position and protect its lawful interest.

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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