China: Full Of Eastern Promise?

Last Updated: 14 March 2006
Article by Dale Fisher and Derek Roth-Biester

It has been four years since China became a member of the World Trade Organisation. During that time it has implemented a number of changes to its formerly command-based economy to open up its markets to foreign investment and competition. The latest move to "westernise" itself and improve the legal and business environment for foreign investors came at the start of 2006 when wholesale revisions to the Company Law of the People's Republic of China (PRC) came into force.

The revised Company Law has incorporated wholesale revisions to the regulation of Chinese corporate entities – the most significant of these include changes to registered capital requirements, corporate governance and the increased protection of minority shareholders. The revisions to the Company Law affect primarily the regulation of the two most common forms of domestic enterprise namely limited liability companies ("LLCs") and companies limited by shares, but will also have an incremental impact on the way foreign investors do business in China.

Foreign investment options

Foreign investment in the PRC is restricted by law to a limited number of corporate vehicles known generally as foreign-invested enterprises ("FIEs"). These FIEs most commonly take the form of wholly foreign-owned enterprises ("WFOE") or joint ventures (of which there are two types, namely equity and co-operative). Each type of FIE is subject to its own specific regulatory regime, which in each case contains restrictions on, for example, the minimum investment required from the foreign party, expatriation of profits and in the case of JVs the maximum percentage of equity which the foreign party may take .

FIEs are not only required to comply with the Chinese laws and regulations specific to the relevant form of FIE, but they will also be subject to the Company Law to the extent that there is no clear stipulation in the regulations specific to the type of FIE in question. Furthermore, FIEs themselves are permitted in certain circumstances to acquire interests in domestic PRC companies (such "reinvestments" being themselves subject to a specific regulatory regime). It is here where the revisions to the Company Law will have the greatest impact upon foreign investors.

Registered capital

The Company Law adopts a "true capital principle" which differs from the authorised capital provisions commonly seen in the west. This means that there is no gap between the registered capital and the capital actually contributed by investors. The revised Company Law lowers the minimum registered capital requirement for both limited liability companies (to RMB 30,000 (ca. GBP 2,100) and for companies limited by shares (to RMB 5,000,000 (ca. GBP 350,000), and broadens the methods by which registered capital may be contributed. Whilst the lowering of registered capital requirements may appear spectacular on paper, the amounts stated in the revised Company Law are indicative at best. In practice, authorities often require investors to contribute much higher amounts to registered capital in order to ensure that a company owns funds sufficient to carry on its intended business. In addition, regulations specific to foreign investment in certain industries may require higher amounts of minimum registered capital.

Instead of the previous rule that capital contribution in the form of intangible assets may not exceed 20% of the total registered capital, the revised Company Law stipulates simply that the cash contribution may not be less than 30% of the total registered capital, which means investors will be allowed to contribute as much as 70% of the total registered capital by such intangible assets as intellectual property rights (although any non-cash assets which can be monetarily valued and legally transferred can now be contributed). Regrettably, the revised Company Law does not clearly state whether shares can be contributed to the registered capital of companies.

Furthermore, in lieu of the previous provisions for the full payment of registered capital at the inception, the revised Company Law allows the registered capital of a company to be contributed in certain cases as much as two years after its establishment. These changes are expected to make it easier, and perhaps cheaper, for foreign parties to invest in or set up a company in the PRC.

Removal of the "50% rule"

Prior to the recent revisions, the Company Law provided that where a company invests in other companies, the aggregate amount of such investment is not allowed to exceed 50% of the net assets of the company. This cap on outward investment has been a significant barrier to many M&A activities, including those driven by foreign investors, as it meant that companies were unable to fully employ all of their assets and thus were seen as ineffective investment vehicles. This limitation has now been completely removed under the revised Company Law, leaving outward investment to the discretion of the shareholders of the company. It is anticipated that this will have the effect of simplifying the M&A market and facilitating acquisitions involving smaller companies (particularly the private LLCs) who need to inject most if not all of their assets into a proposed joint venture. Unfortunately, due to a similar restriction on inter-company investments by FIEs found in the Tentative Measures on Investments in China by Foreign-invested Enterprises (effective since 1st September 2000), FIEs will not be able to benefit from this relaxation until such restriction is repealed.

Corporate governance

The changes to corporate governance include restrictions on the authority of the Chairman of the Board (who is under Chinese law the legal representative of the company) and, at the same time, delegation of more authority to the board of supervisors, such as the right to call a shareholders meeting and the right to file lawsuits against directors or senior management who are in default. The revised Company Law also introduces the rules of conflict of interests where a controlling shareholder, effective controller, director or senior manager of a company incurs personal liability when taking advantage of a relationship with a third party which damages the interests of the company. Directors of listed companies are ineligible to vote on matters in which they have an interest. Notably, the revised Company Law imposes a stricter duty of care on the directors, supervisors, and senior management. This will give foreign investors, traditionally wary of granting too much power to appointees of their JV partners, some comfort that these senior staff can be held accountable for their actions.

Protection of minority shareholders

For the first time the revised Company Law enhances shareholder control over the company in that those holding 3% or more of a company’s shares may put forward proposals to the board of directors. Shareholders also now have a right to petition the court to revoke resolutions which were made in breach of the law, to sell their shares to the company at reasonable prices and to petition the court to liquidate the company under certain circumstances. Those holding 10% or more of a company’s shares have the right to petition to the People’s Court to liquidate the company when the company’s managerial problems threaten to damage shareholders’ interests. A certain percentage of shareholders are also now entitled to bring actions against directors, supervisors and/or senior management for breaches of the law or the company’s articles of association. This will be particularly important in the case of an FIE JV where the foreign party is a minority shareholder, which is common where the industry in which the JV is operating is deemed restricted by the Ministry of Commerce.

Other issues

The revised Company Law also brings in a variety of noteworthy changes such as introducing one-person companies, introducing the principle of "piercing the corporate veil", regulating transactions between affiliated companies, enhancing employees’ participation in the management of the company and amending the conditions for public listing and bond issue. However, it is by no means a complete panacea – it contains sufficient contradictions, omissions and ambiguities to cause headaches for lawyers advising clients looking to invest in the PRC. The legal community will therefore be looking to the Chinese government to promulgate further implementing regulations with the aim of clarifying the regulatory procedures - it may be that the full impact of these revisions can be fully assessed only after such clarification is provided. Besides, foreign investors should note that, in many respects, FIEs and domestically-invested companies are subject to different regimes and rules. Article 218 of the revised Company Law states that, where the laws governing foreign investment differ from the provisions of the revised Company Law, the former shall prevail. Consequently, the revised Company Law applies to foreign investors and FIEs only in circumstances where legislation on FIEs is silent. For this reason, few of the benefits of the revised Company Law will actually flow through to foreign investors and FIEs.

The authors are based in Pinsent Masons Hong Kong office

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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