China: Practical Review On The 4th Interpretation On The Company Law

Last Updated: 20 March 2017
Article by Broad & Bright

Highlights of Key Articles

On April 12, 2016, the Supreme People's Court announced The Supreme People's Court's Provision on Several Issues Relating to Application of the Company Law of the People's Republic of China (IV) (Draft for Comments) (hereinafter referred to as the "4th Interpretation"), for public comments. This Draft for Comments was reviewed and passed in principal by the Judicial Committee of the Supreme People's Court on December 5, 2016. There are a total of 36 Articles in the 4th Interpretation, covering five categories of cases. This article intends to present a brief illustration on the key Articles of the 4th Interpretation and provide brief analysis with reference to the present judicial practice.

Since at the time of this article, the official full text of the 4th Interpretation has not been announced yet, the introduction and analysis hereunder are based on the Draft for Comments published by the Supreme People's Court on April 12, 2016.

(1)Cases regarding validity of the company resolution

With regard to the validity of the company resolution, there are only general rules set forth in the Company Law stipulating that the shareholder has the right to request the court to affirm certain resolutions being invalid or revocable. The 4th Interpretation largely focuses on this issue to refine and expand the existing provisions.

First of all, the 4th Interpretation refined the relevant regulations about suits for affirming invalidation of the resolution. The scope of valid plaintiff was expanded. In addition to those widely accepted plaintiffs in practice, such as shareholders, directors and supervisors, the 4th Interpretation expressly expands the scope to include the senior managements, employees, creditors and others who have a direct interest in the company resolution. It seems that the word "others" here implies that listed above is not exhaustive. The 4th Interpretation also specified the circumstances which would invalidate the resolutions. In addition to the provided circumstance, i.e. "violation of the provisions of laws and administrative regulations", the 4th Interpretation specifies another two typical circumstances: 1) abuse of the shareholders' rights which jeopardizes the interests of the company or other shareholders; and 2) over-allocation of profits, engage in material improper related party transactions which jeopardizes the interests of creditors of the company. It is obvious that the 4th Interpretation leans to protect the interests of minority shareholders and creditors of the company. Unlike the rigid stipulation of "violation of the provisions of laws and administrative regulations", "abuse of rights", "over-allocation of profits" and "material improper" are to some extent discretionary, which leave ample room for the judges to exercise their discretion.

Secondly, the 4th Interpretation refined regulations regarding the suits for revoking the resolution. Unlike the suit for invalidating the resolutions, the plaintiff for the suit to revoke the resolution remains to be the shareholders of the company, and shall remain his/her shareholder identity throughout the litigation process. As to the cause for revoking the resolution, in addition to the existing cause, i.e. "the convening procedures or voting method of a meeting violates the provisions of laws and administrative regulations or the articles of association of the company", the 4th Interpretation further clarifies the content of "convening procedures" and "voting method". Compared to the suit for invalidating the resolutions, revocation of a resolution is mainly focused on the procedure issue, which makes the differentiation between the qualified plaintiffs for the suit for invalidating the resolution reasonable. Thirdly, the 4th Interpretation introduces the suits for affirming "the non-existence of a resolution" and "failure to form a valid resolution". This provision improves the current regime of defective resolutions in China. By adding non-existence of a resolution apart from the revocable and invalid resolution, the judicial practice methodology is broadened. Furthermore, the scope of qualified plaintiff of these two types of suits is same as the suit for invalidating the resolution. However, since the manifestation of the suit for affirming "the non-existence of a resolution" and "failure to form a valid resolution" is highly similar, and their legal consequences are basically the same, it remains debatable whether it is necessary to differentiate these two situations in the judicial interpretation. By comparison and reference to the Contract Law, which stipulates the validity of a contract as established contract, valid contract and revocable contract, but does not provide for the non-existence of a contract. Therefore, the necessity of differentiating "non-existence of a resolution" and "failure to form a valid resolution" remains debatable.

Lastly, the 4th Interpretation allows the plaintiff to apply for behavior preservation over certain resolutions. This provision could become an effective method for minority shareholders and interested parties to protect their own interests. However, we notice that in this provision the subject to apply for behavior preservation is described as "the plaintiff". Normally, a party can be called as "the plaintiff" only after a suit has been filed. Considering that the Civil Procedures Law regulates the pre-litigation preservation and preservation during the litigation process separately, does this imply that the "plaintiff" in the suit regarding validity of resolutions could only apply for preservation during the litigation process, and pre-litigation preservation could not be applied? Meanwhile, since the court adopts a rather preservative attitude toward behavior preservation, to what extend such preservation would be granted is still pending further reference to more real cases in practice

(2)Cases regarding the right-to-know of shareholders

The 4th Interpretation emphasizes that the right-to-know is an inherent right of the shareholder and provides protection to such right from the practical level. First of all, the 4th Interpretation stipulates that the shareholder's right-to-know shall not be impacted by the flaw in the capital contribution by the shareholder, or be restricted by articles of association of the company or agreements between the shareholders.

Secondly, the Company Law stipulates that the shareholders of a limited liability company shall have the right to check the books and records of the company; the company may reject such request if the company has reasonable grounds to believe that the shareholder who makes the request has an improper motive and may cause damage to the interests of the company. In addition to the books and records of the company, the 4th Interpretation further allows the shareholder to check the original accounting vouchers of the company, which are undoubtedly of vital importance to the financial right-to-know, and are even more important than the books and records to some extent. Thus, this provision has obvious significance in protecting the right-to-know of minority shareholders. Meanwhile, the 4th Interpretation listed four types of improper motive that the company could use to defend the shareholder's request, among which, the third type (i.e. "the shareholder has benefited from notifying a third party of the information it has learned about from accessing or duplicating the company's documents in the past two years") is noteworthy. This provision means if a shareholder has a record of selling the company's information by exercising his/her right-to-know, the shareholder's request to check or copy the company's documents will not be supported by the court. However, the start date of this two-year period is not specified in this provision. The start date could be the day on which the shareholder exercising the right-to-know, the day on which the shareholder leaked the information, or the day on which relevant verdict came into effect. This question needs to be further specified.

Lastly, the 4th Interpretation requires the verdict of the court shall specify the time and place for checking/ duplicating relevant documents. The 4th Interpretation also affirms that the shareholder has the right to entrust a proxy to access or duplicate the company's documents. Judging from our past experience, the enforcement of dispute regarding shareholder's right-to-know is rather difficult, which makes it hard for the shareholders to exercise their right-to-know even with a valid verdict in favor of them. On the other hand, there are always controversies regarding whether the shareholder is allowed to entrust proxy (usually accountants or legal professionals) to exercise the right-to-know. Judging from this perspective, it is likely that the 4th Interpretation may solve the issues of the difficulties in enforcing the right-to-know enforcement to some extent. Meanwhile, the 4th Interpretation also stipulates the directors and senior management's compensation liability when the company fails to prepare or keep the company documents according to the law, which provides another guarantee for the shareholder's right-to-know from the subsequent punishment aspect.

(3)Cases regarding the right to request for profit distribution

Before the announcement of the 4th Interpretation, if the company does not make profit distribution, the shareholders could only request for a buy-back of their equity interests, while acquiring minority shareholders' equity interest is exactly what preferred by the majority shareholders. Regarding whether shareholder has the right to file a lawsuit requesting the company to make profit distribution, there is no clear and specific stipulation in the Company Law and the judicial interpretations thereto. In judicial practice, the courts usually request for a profit distribution resolution of the company, the absence of which will lead to the overruling of such claim for profit distribution.

By summarizing the previous judicial practice experience, the 4th Interpretation specifies for the first time that the shareholder shall have the right to file a lawsuit requesting profit distribution. The suing shareholder shall submit a valid resolution of a shareholders' (general) meeting, setting forth the detailed profit distribution plan. Otherwise the court will not support such request unless the suing shareholder is able to prove that the other shareholders abuse their shareholders' rights, or directors or senior managements commit fraud, resulting in company's failure to distribute profits. In practice, the shareholders' meeting of a limited liability company does not generally pass a specific resolution for not making any profit distribution. It will be regrettable to exclude the justiciability of such cases as a whole. And whether the above scenario could be considered as the shareholders' abuse of shareholders' rights specified in the 4th Interpretation is pending further observations. Similarly, we will keep close attention to the level of the burden of proof in proving the other shareholders' abuse of shareholders' rights and directors or senior managements' commitment of fraud. Lastly, a valid judgment issued by the court to order profit distribution shall be also valid for all the other shareholders of the company. The 4th Interpretation on one hand increases shareholder's approach for remedy by specifying shareholder's right to request profit distribution through litigation, which is a breakthrough in protecting minority shareholder's interests. On the other hand, the 4th Interpretation also shows certain restraint by respecting the autonomy of company.

(4)Cases about pre-emptive rights

Regarding the shareholder's transfer of the equity interest in a limited liability company to a third party, the Company Law only stipulates in principle that the other shareholders shall have pre-emptive right to acquire such equity interests pursuant to equal terms; where there are separate provisions in the articles of association of the company, such provisions shall prevail. The 4th Interpretation makes specifications and additions based on the above principal.

With respect to the application of law, the 4th Interpretation lists specific situations under which pre-emptive right cannot be claimed for: 1) inheritance or bequest; 2) transferring equity among shareholders; 3) exercise the pre-emptive right only for part of the equity; 4) the transferring shareholder gives up the transfer after the other shareholders exercises their preemptive right, unless an equity transfer agreement has already been concluded. However, the articles of association of the company can agree otherwise.

With respect to the conditions for exercising the preemptive right, the 4th Interpretation specifies that "equal terms and conditions" shall be determined in light of transfer price of the equity, payment method and term, etc. The 4th Interpretation also specifies the required contents of the written notice as well as the method to determine the term for exercising the pre-emptive right. In a transaction involving state-owned equity and requiring a bidding process, the "equal terms and conditions" and "written notice" shall also refer to the trading rules of the relevant assets and equity exchange. With respect to the remedies for infringing the preemptive rights, there is no specified stipulation in the Company Law regarding the validity of the contracts that infringe the preemptive rights. Earlier judicial practice mainly ruled such contracts as valid, validity-pending, revocable or void. The 4th Interpretation stipulates that under the following circumstances, the relevant contracts shall be void:

  1. Failing to enter into equity transfer agreement in compliance with the procedures under the Company Law and its judicial interpretations;
  2. After the other shareholders waive their preemptive right, the transferring shareholder substantially change the equal conditions specified under Company Law and its judicial interpretations by transferring the equity interest to a third party at a reduced price;
  3. The transferring shareholders induces the other shareholders to waive their preemptive right by malicious collusion with the third party in violation of the equal conditions specified under Company Law and its judicial interpretations by means of false declaration of high price and etc., while the actual transaction terms is lower than the terms specified in the written notice.

After the above contract is affirmed to be invalid, the other shareholders may request to purchase such equity interest pursuant to the terms and conditions of the actual transaction. The transferring shareholder shall indemnify the irreproachable transferee with goodwill.

The above provision is simple and practicable from the aspect of the plaintiff (usually minority shareholders) and it is well-reasoned if the court supports the plaintiff to exercise the preemptive right in the same case; meanwhile, the transferee with goodwill can get certain relief. In the short term, it helps protect the interests of every party (especially minority shareholders), and saves litigation costs and judicial resources. However, we worry that such provision may cause more uncertainty and costs from a comparatively long term perspective. At the moment, there is neither prescribed period for litigation nor corresponding scheduled period for requesting for affirming contracts as invalid in PRC, and thus it seems that there is no time limit in exercising such rights. However, affirming contracts as invalid arbitrarily may lead to even more unfairness and inefficiency to the parties concerned. Suppose that one shareholder claims invalidity of the original equity transfer agreement and requests for affirmation on invalidity of such agreement in a comparatively long time after the transferee entered into the company, under such situation, in principal all relevant actions of the target companies after the entrance of the transferee will also be deemed as invalid due to the transferee's defect of right. In this case, the company may fall into managerial chaos, juristic uncertainty and economic losses. The interest of the other shareholders will also be impacted due to the losses suffered by the company. Furthermore, the transferee with goodwill cannot continue to hold the equity interest on one hand; and on the other hand, they will face the problem of not being able to determine its actual losses when claiming against the transferring shareholder for losses. Therefore, it is an issue worth study whether it is necessary to limit (in term of time) the right for claiming for invalidity of contract under the abovementioned provision.

Lastly, the 4th Interpretation also provides that where a provision of the articles of association of a limited liability company excessively restricts shareholder from transferring equity interest, making it substantially impossible to transfer the equity interest, and the shareholders request to affirm such provision as invalid, the claim shall be supported. That is to say there should not be provisions substantially restricting equity transfer of shareholders in the articles of association of the company, otherwise such provisions would be deemed as invalid. To our understanding, the purpose of such provision is to protect the shareholders' right to dispose their equity interest. However, the absoluteness of such provision may trigger further issues. For example, in the area of private equity, investors usually request the founding members not to transfer their equities in an agreed period through various mechanisms. After the effectiveness of the 4th Interpretation, the above practices may conflict with such provision. How to bridge such provision with common practice in the private equity area may be one of the problems that need to be solved in the future.

(5) Cases regarding direct actions and shareholder derivative actions

The Company Law only provides for principle provisions regarding shareholder direct actions and shareholder derivative actions. The 4th Interpretation further clarifies the parties concerned in such actions and their Locus Standi; and makes it clear that the company may replace the shareholders to continue the derivative actions with the consent of the shareholders; and the mediation agreement in the shareholders derivative action shall be approved by the shareholders' (general) meeting or agreed by all shareholders of the limited liability company in writing. Lastly, the 4th Interpretation specifies the principle on the disposal of interests after winning the litigation, which provides legal basis for the allocation of litigation interests and costs. A series of provisions regarding shareholders derivative action in the 4th Interpretation greatly reinforced the operability of shareholders action.

Overall speaking, the 4th Interpretation provides inclined protection to the creditors of the company and minority shareholders; meanwhile, further improved procedural provisions in the 4th Interpretation obviously enhanced the operability of lawsuits relating to the Company Law. Many provisions in the 4th Interpretation provide unified regulations regarding certain urgent issues to be solved in the current practice, and thus provide solid basis for the future company operation and judicial practice. However, certain provisions in the 4th Interpretation also made breakthroughs to the current Company Law legal regime and it is pending whether such breakthroughs can bridge with the other laws and regulations and judicial interpretations and whether it can meet its original purpose.

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