Other Author Elfie Wang of Meng Bo Law Office, a PRC law firm based in Shanghai, with which Mayer Brown has a close working relationship.
Long term investors in the People’s Republic of China (PRC) are well aware that the legal and business environment is constantly evolving and changing. The PRC Company Law dates back to 1993 when China started opening up with a view to developing a market economy. It has changed several times since then and the process is continuing.
Investors have long been familiar with the way in which contributions of equity (referred to in the PRC as Registered Capital) have been made by shareholders. The risks associated with the contributions of capital and duties owed by directors and senior management have long been of concern, particularly the risks of personal liability. Investors have also been well aware of the rules of senior company officers, particularly regarding the legal representative, and have been familiar with registration requirements.
China recently published the 2nd Consultation Draft of the amendment of the Company Law (the “Draft Law”) which proposes significant changes to shareholder responsibilities and the way companies will need to be structured going forward. This has been issued for public consultation and contains some significant proposals, some of which are discussed below.
Commitments on Capital Contribution – a Change in Direction
In 2014 China lifted minimum registered capital requirements and the time period within which shareholders are required to make contributions. This reform was intended to stimulate investment (and perhaps bring China in line with international norms). There does however seem to be a change in policy and there are concerns that some companies have been established with a high registered capital with the intention of making them appear larger than they actually are. Although intended to allow shareholders more flexibility as to their investment timetable, there have been concerns that some shareholders may be artificially inflating registered capital levels and postponing actual contributions indefinitely by stipulating a lengthy contribution period in the articles of association. It appears that the relaxations introduced over the last decade might now be under review.
The Draft Law indicates a reversal of some of the recent changes so as to strengthen shareholders’ commitments on capital contribution.
- Article 46 originally stated that articles of association should specify the “contribution period”, but it has been replaced with “contribution date” (implying a return to traditional deadlines) in the latest draft.
- The Draft Law proposes that the company’s board of directors (Board) be obligated to check the capital contribution of shareholders and demand payment if any shareholder fails to make contributions on schedule.
- A 60-day grace period will be granted after the company issues a demand; and if the shareholder fails to make contribution within the grace period, the company may issue a written notice to such shareholder to forfeit its equity interest with respect to the unpaid registered capital contribution.
- Significantly, if the forfeited registered capital is not transferred or deregistered through capital reduction within six months, the other shareholders will be required to make the corresponding capital contribution, in proportion to their capital contributions.
- Under current practice, shareholders may be required to make immediate contribution if the company is liquidated or made bankrupt. Article 53 of the Draft Law now states that the company or the relevant creditor may request shareholders to make capital contribution if the company is unable to discharge the debts when they become due.
Equity Transfer and Potential Liability
Under the existing Company Law, any equity transfer (i) is subject to the consent of more than half of the other shareholders, and (ii) subject to a right of first refusal in favour of the other shareholders. It is now proposed that shareholders consent will no longer be needed. Rather, a transferring shareholder need only notify the others in writing, so that the other shareholders may decide whether or not to exercise their right of first refusal; and they will be deemed to have waived such right if they do not reply within 30 days.
There is also a change in how to allocate liability between the seller and buyer with respect to any unpaid registered capital.
Under the current law, the seller remains liable for any unpaid but transferred Registered Capital, while the buyer will only be jointly and severally liable if it can be demonstrated that the buyer was aware, or ought to have been aware, of the underpayment. Obviously, in most well documented transactions, this would be taken in the negotiation of price and obligations recorded accordingly.
It is now proposed that the buyer assumes the contribution obligation for such unpaid Registered Capital, but if the buyer fails to do so, the seller can be held responsible! This does seem a rather odd reform to introduce – and there is obviously the risk of transactions being structured taking into account the contribution of Registered Capital already paid up by a seller, only for the seller to face additional and unexpected liability to the company in the event that the buyer fails to pay up the registered capital as required. This is something that will need to be considered carefully in the event that the final law contains the amendment as currently drafted.
Furthermore, the buyer will be jointly and severally liable if the seller fails to make the contribution on schedule, or the value of the non-monetary contribution (for example, where assets on Intellectual Property are contributed rather than cash) made by the seller is significantly lower than the subscribed capital, and the buyer is aware or ought to be aware of such circumstances. Careful drafting and appropriate due diligence will be necessary to limit these risks.
The current Company Law requires that directors, supervisors and senior management bear the duty of loyalty and diligence towards the company, but it fails to provide a clear definition of such duties.
The Draft Law seeks to provide some clarification and requires that directors, supervisors and senior management bear a duty of loyalty to the Company and take measures to avoid any conflict of interest – and in particular, shall not use their powers to seek "improper interests". They shall also bear the duty of diligence to exercise reasonable care to ensure that management personnel exercise authority in the best interests of the company.
The Draft Law expressly sets out certain circumstances where directors, supervisors and senior management may be personally liable for losses of a company where:
- the actual value of non-monetary contributions made by shareholders are significantly lower than its subscribed contribution;
- a shareholder withdraws its contributed capital;
- the company distributes profits in violation of the Company Law; or
- the company conducts capital reduction in violation of the Company Law.
Further, as a general rule, damage to third parties will result in a company being liable. However, the Draft Law suggests that if the directors or senior management show "intent" or are "grossly negligent", they may be personally liable. There is obviously scope for allegation and more complex disputes.
Given such new risks, the Draft Law proposes that a company may take out liability insurance for directors; in which case, the insured amount, coverage and premium rates would need to be reported by the Board to the shareholders’ meeting.
There are a number of new developments in respect to corporate governance of companies.
The legal representative of a company is viewed as having ostensible authority to represent the company vis-a-vis the outside world. The current Company Law requires that the role of legal representative should be taken by the company’s chairman, executive director or general manager. Since there is no requirement that the legal representative should be actually involved in the company’s affairs, in practice it is not uncommon for there to be a gap between the responsibilities of a legal representative and the actual role he or she plays in the company. This may be due to wealthy shareholders controlling companies through family members. It may also be relevant where a foreign investor appoints a local person as legal representative, but directs such person from offshore.
The Draft Law proposes that the legal representative must be taken up by a director or the general manager who represents the company in attending to company affairs, thus encouraging active involvement in the conduct of a company's business. The intention is to encourage legal representatives to act responsibly and remove the excuse that such person was not actually involved in the conduct of the business of a company. Individuals may therefore need to exercise caution when taking up such a position.
Supervisory Organ and Audit Committee
Under the current Company Law, companies are required to establish a supervisory board – or for small-size limited liability companies, either one to two supervisors in lieu of a supervisory board – to supervise the company’s directors and senior management. In practice, such roles are non-active and the supervisors are not usually expected to be involved in company affairs.
The Draft Law proposes the following amendments to the supervisory body:
- For small size companies, no supervisory organ needs to be established upon unanimous consent of all shareholders.
- Limited liability companies may establish an audit committee under the Board to exercise the functions and duties of the supervisory board; and in such case, there is no need to establish a supervisory board or appoint supervisor(s).
- However, if a limited liability company with more than 300 employees has not established a supervisory board that includes an employee representative, then the Board of such company must have at least one employee representative.
Effect of Registration
For many years, China has used a registration regime, which means that many corporate changes only take effect upon completion of formalities with the authorities.
However, Article 34 of the Draft Law indicates that the effect of registration is to become a mere confirmation mechanism, rather than something to be used to determine the effectiveness a change.
This will to a certain extent ease the company’s burdens to complete the registration to effect a change. However as a result, companies will need to ensure they are well organised when preparing, executing and archiving their internal documentation, such as the relevant resolutions, as these will be the documents to determine the effectiveness date – and probably how liability should be allocated.
Other Proposed Amendments:
- Article 71 indicates that a director of a limited liability company may claim compensation against the company if removed by the shareholders’ meeting without justification.
- In state-funded companies (including companies in which the state holds a controlling share), the Chinese Communist Party is required to play a leading role, study and discuss business management matters, and "support" the company exercise its functions in accordance with the law.
- The detailed functions and duties of the general manager have been removed from the Draft Law, so it is now completely subject to joint venture contractual arrangements and the company’s articles of association.
- Meetings can be convened, and resolutions may be adopted, by electronic communication.
The above is a general discussion of some of the more interesting features of the Draft Law. There are many other suggested amendments – and it remains to be seen exactly what changes will survive when the final text of the new Company Law emerges. Many other details as to how the new law will be implemented will take time to be worked out; and no doubt additional regulations will be required in order to provide such guidance. However, it does appear that significant change is on the way!
It is important that foreign investors are aware of the changes and ready to adapt accordingly.