The amendment to the Ｃhina Company Law in 2005 has led to an upsurge of corporate dispute litigations in the Chinese courts, in connection with the establishment, capital contribution, dissolution and shareholder rights of Chinese companies. However, the relevant provisions of the Company Law on these issues have often proved to be too general to provide any unified and practical guidance for the Chinese local courts to adjudicate these cases. As a result, it is not uncommon that the decisions rendered by the local Chinese courts on these issues may vary a lot case by case.

Ever since the Company Law took effect in 2006, the Supreme People’s Court of China (Supreme Ｃourt ) has been trying to clarify various legal issues involved in the trial of company disputes. In April 2006, the Supreme Ｃourt issued its first interpretation to the Company Law, which mainly addressed certain statutory limitations for filing shareholder claims. The second interpretation to the Company Law was published by the Supreme Ｃourt in May 2008 to address a variety of issues related to the dissolution and liquidation of Chinese companies.

In order to further set forth a unified guidance for handling the common corporate disputes in connection with the establishment, capital contribution and shareholder rights of Chinese companies by the local Chinese courts, on January 27 2011, the Supreme Ｃourt  released the Provisions on Several Issues Concerning the Application of the Company Law  (Interpretation 3) after extensive solicitation of public opinions, Interpretation 3 attempts to clarify, among other things, the following issues:

1) how to allocate liabilities for contracts executed in preparation for incorporating a company;
2) how to assess the non-cash capital contribution by the shareholders and related legal remedies;
3) how to make a claim against the shareholders and other relevant parties who are involved in the insufficient capital contribution or improper capital withdrawal ; and
4) how to confirm the equity ownership and how to allocate the liabilities between the nominal shareholders and actual investors.
As the Company Law and its related judicial interpretations issued by Supreme Ｃourt are equally applicable to Chinese domestic-funded companies and foreign-invested enterprises, foreign investors doing business in China should be aware of these recent developments brought about by Interpretation 3.
Pre-incorporation contracts
In preparation for establishing a foreign-invested enterprise in China, investors will normally need to sign various contracts, such as investment agreements with the local government, joint venture agreements with local Chinese partners, office lease or land use right purchase agreements, financial or legal service agreements, etc. These contracts may be signed in the name of the investors or the companies to be incorporated.
According to Interpretation 3, contracts signed for the purposes of establishing a company will generally be enforceable against the party who actually signed the contract, for example, the investor or the company. However, where such a contract was signed by the investor in his own name, but it was later ratified by the company, or the company has actually enjoyed the contractual rights or performed the contractual obligations after the company was established, the company may be held liable for such a contract. Moreover, in the event that the investor is found to have signed the contract in the name of a company to-be-established for the investor’s own personal interest, the company, after its due incorporation, may refuse to bear the liabilities under such a contract unless the other party to such contract was a bona fide third party.
Interpretation 3 further provides that in the event a new company fails to be established, the creditors may hold some or all of the investors jointly and severally liable for the costs and damages arising from the incorporation of such a company. After compensating the creditors all the relevant costs or damages, the paying investor(s) may ask other investors to share such compensation according to the pre-fixed cost-sharing ratio or the proposed equity percentage as per the investment agreement. In the case of a failure of such pre-fixed figures, the court may equally split the above compensation among all investors. However, if the failure of incorporation was due to some investors’ fault, the court may determine the scope of liability for such default shareholders accordingly.
Apparently, to mitigate the above risks, it is advisable for the investors to add certain protection clauses in these pre-incorporation contracts to clearly allocate the costs and liabilities related to the preparation for the establishment of a new company.
Non-cash capital contribution
According to the Company Law, shareholders of Chinese companies may make capital contributions in the form of cash, industrial assets, land use rights, intellectual property, equities or debts, such as shareholder loans (in certain areas on a pilot basis). Even though the Chinese laws request that a non-cash contribution must be duly appraised and verified, and the title of such non-cash properties must be transferred to the company, there has remained a controversial issue in the Chinese law and practice as to how to determine whether a non-cash capital contribution obligation has been properly performed.
To tackle the above long-standing issue commonly faced by the disputing shareholders of Chinese companies, Interpretation 3 sets out the following guidance:
With respect to the statutory evaluation request for a non-cash contribution, Article 9 of Interpretation 3 provides, in the event a contributor of capital makes a non-cash capital contribution without a due evaluation as requested by the law, if the company, any other shareholder, or any creditor of the company claims that the contributor of such non-cash capital has failed to fulfill the capital contribution obligation, the people’s court should instruct a legally qualified evaluation institution to evaluate the contribution. If the results of the evaluation are significantly lower than the value of the capital contribution stated in the company’s articles of association, the court will determine that the capital contributor has failed to fully perform its obligation according to the law.
Regarding the statutory title transfer provisions for a non-cash contribution with properties such as land use rights, real estate or intellectual property, Articles 8 and 10 of Interpretation 3 further clarify that if such properties have been delivered to the company for use but the formalities of title transfer have not been completed, the court should order the capital contributor to transfer the titles of such properties to the company within a specified reasonable period. If the titles are transferred within the aforesaid period, the capital contributor will be deemed by the court to have fulfilled its capital contribution obligation from the time when such properties were actually delivered to the company for use.
However, where a capital contributor makes a non-cash capital contribution and has transferred titles but failed to actually deliver it to the company for use, if the company or any other shareholder claims the capital contributor should deliver the property to the company and should not enjoy the corresponding shareholders’ rights prior to the actual delivery, the people’s court should support such a claim.
With regards to making the capital contribution by using the equity interest of an existing company, Interpretation 3 sets out the following testing conditions:
1) the equity interest shall be lawfully owned by the capital contributor and may be transferred according to the law;
2) the equity interest shall be free of ownership disputes or other encumbrances;
3) the capital contributor has fulfilled the legal formalities required for the transfer of such equity interest; and
4) the equity interest has been duly evaluated.
In the event of a failure to meet any of the above testing conditions, the validity of the capital contribution may be challenged. However, the court will give the capital contributor a reasonable time to rectify the defects in any of the first three testing conditions listed above. Only when such defects are not duly corrected within the given time will the court deem the capital contributor to have breached its obligations of capital contribution. As for the absence of the statutory evaluation in the above fourth testing condition, the court will instruct a qualified evaluation firm to conduct the appraisal and make its decision based on the results of the evaluation.
Improper withdrawal of capital
According to the Company Law, shareholders of a limited liability company are liable to the company and its creditors to the extent of the registered capital of the company they have subscribed for. The shareholders of a Chinese company are also requested by the Company Law to pay in their subscribed registered capital within statutory time limits. Once the registered capital is paid into a company, the shareholders are prohibited by the Company Law from withdrawing such capital out of the company without going through statutory procedures such as capital reduction or liquidation. Any improper withdrawal of capital from the company may subject the shareholder to civil, administrative and even criminal liabilities under Chinese laws.
Despite the strict statutory prohibitions, it is not uncommon for shareholders of Chinese companies (including foreign-invested enterprises) to dilute or withdraw their paid-in registered capital by various disguised transactions. In practice, it is very difficult for the victims of such improper capital withdrawal to identify and prove such misconduct.
To address this practical difficulty, Article 12 of Interpretation 3 provides that the Chinese court may identify the following activities as improper capital withdrawals if such activities are found to be detrimental to the interest of a company:
1) Remit the cash capital out of the capital verification account of a company right after the completion of the capital verification;
2) Transfer of the capital contribution out of the company via fictitious debts;
3) Distribution of fictitious profits based on doctored financial statements;
4) Transfer of the capital contribution out of the company via related translations; or
5) Other withdrawals of the capital without the following statutory proceedings.
Notwithstanding the above provisions, it remains to be seen how effectively the local Chinese courts may use such provisions to pin down various improper capital withdrawals. Particularly, given the fact that the related transactions between affiliated companies are often justified by various commercial considerations, it would be difficult to draw a clear line between legitimate related transactions and the disguised improper capital withdrawal.
Enhanced default liabilities for defective capital contribution and maintenance
As discussed above, the Company Law imposes strict liability for shareholders of a company to make and maintain their capital contribution to a company, but the claims against such defaulting shareholders are often thwarted by the lack of detailed implementation procedures for granting relevant legal remedies. For this reason, Interpretation 3 introduces various detailed procedures to clarify certain issues related to claims against the defaulting shareholders and other relevant parties in connection with the insufficient capital contribution or improper capital withdrawal.
In addition to the conventional liability imposed on the default shareholders, Interpretation 3 for the first time expressly provides that the relevant parties (including the company, the innocent shareholders or creditors of the company) who are victims of the improper capital withdrawal may also sue the directors or senior management on a joint and several liability basis if the directors or senior management are found to have facilitated or assisted in such misconduct. Moreover, if the insufficient capital contribution was fully or partly attributable to the breach of the fiduciary duty by the directors or senior management, then such directors or senior management will be held liable accordingly.
More importantly, Interpretation 3 also confirms the validity of certain self-remedies in lieu of court proceedings that might be adopted by a company against its shareholders who default in their capital contribution or maintenance obligations. For example, according to Article 17 of Interpretation 3, a company may impose reasonable limitations on the rights of the defaulting shareholder according to the relevant existing provisions of its articles of association or a resolution made by the shareholders’ meeting of the company. Such reasonable limitations might be imposed on the defaulting shareholders’ right to dividends, right to subscribe to new shares and right to participate in the distribution of the residual assets of the company.
It is not clear under the above provisions whether such restrictions may also extend to other statutory shareholder rights such as information rights or voting rights, but according to Article 18 of Interpretation 3, the shareholders’ meeting of a company will have the right to strip the defaulting shareholder of all of its shareholder rights if it fails to make any capital contributions or improperly withdraws its entire capital contribution. Given the possibility that the defaulting shareholder may spare no effort to block the passing of any shareholders’ resolution that limits or removes its rights, it will become a vital issue whether the existing articles of associations of a company have already incorporated such restrictions on shareholder rights.
It should also be pointed out that according to Interpretation 3, the defaulting shareholders may not rely on statutory limitations to defend their liabilities in connection with the insufficient capital contribution or improper capital withdrawal. It is also for the first time clarified under Chinese law that the transferee shareholders who purchased the equity interest of a default shareholder who fails to fully discharge its capital contribution obligation shall also be held jointly liable for the insufficient capital contribution provided the transferee shareholders know or should have known the existence of such insufficient capital contribution.
Confirmation of shareholding rights
In addition to various legal remedies against the default shareholders, Interpretation 3 also provides specific guidelines to affirm certain shareholding rights regarding the equity ownership and related registration.
According to the Company Law, a company shall issue a certification of capital contribution to its shareholders upon the incorporation of the company. The Company Law further requires that the information of shareholders of a company shall be properly registered at the shareholder registry of the company and filed at the corporate registration authority accordingly. In an equity transfer transaction, a company is required to update the original shareholder registration with the information of the new shareholders at the corporate registration authority. However, for various reasons, the capital contribution certificate and the shareholder information registration are often found to be missing or problematic, which will have severe implications for the shareholders’ ownership of such equity interest.
To address these common problems, Article 23 of Interpretation 3 provides that a court shall confirm a shareholder’s ownership of the equity interest of a company as long as it can prove that it has duly subscribed for or paid the registered capital of the company or has duly acquired the equity interest of the company without violating any mandatory prohibitions under Chinese laws and regulations. If shareholders of a company have duly performed their capital contribution obligations or duly acquired such equity interest of the company, but the company fails to issue capital contribution certificates for such shareholders or does not properly register such shareholders at its own shareholder registry and at the corporate registration authority, such shareholders may sue the company at the court and ask the company to issue the above certificates and make proper registrations accordingly.
Article 27 of Interpretation 3 further provides that, in the event where, prior to the completion of the required change of shareholder registration in an equity transfer transaction, the original shareholder transfers, pledges, or otherwise disposes of the equity still registered under his name to a third party, the new transferee shareholder may make a claim to challenge the validity of the above disposal of equity by the original shareholder. However, the third party who acquired such disputed equity interest from the original shareholder may survive such challenge proceedings if it can prove that it is a bona fide purchaser. In this case, the above unregistered new shareholder may claim damages from the original shareholder and even the directors, senior managers, or actual controllers of the company who are found responsible for the failure to update the shareholder registration. If the unregistered new shareholder also partly contributed to the failure of the above registration, the liabilities of the aforesaid directors, senior managers, or actual controllers may be proportionately reduced.
It is also worth noting that Article 7 of Interpretation 3 recognises the equity ownership of a shareholder even though such shareholder uses the properties of others to make the capital contributions, as long as the company can prove itself to be a bona fide third party who has received such capital contribution in good faith and has also properly registered such capital contribution. Moreover, in the event where a person uses cash revenues generated from criminal activities to make capital contributions to a company and thus owns an equity interest of the company, the validity of such equity ownership will not be tainted by such criminal activities and the court may dispose of such equity by way of auction or sale if such person is prosecuted for said criminal offences.
Nominal shareholders versus actual investors
The Company Law does not recognise the division between a nominal shareholder and an actual investor, but as a matter of commercial reality, some registered shareholders (the “nominal shareholders”) of certain Chinese companies are actually holding equity interests on behalf of third parties (the “actual investors”) who make the actual capital investment into such companies. Particularly, as certain industry areas in China are still restrictive to foreign investment, it is not uncommon for some foreign investors to enter into such restricted areas through trusted investment arrangements. Under such an arrangement, foreign investors will be the actual investors, as they make the actual investment but are not shown as shareholders in the articles of association and registered documents of the foreign-invested enterprises. Meanwhile, certain local Chinese individuals or entities will serve as the nominal shareholders, as they are entrusted by the foreign investors to hold the equity on their behalf and act as the registered shareholders of the foreign- invested enterprises. As a general practice, actual investors control nominal shareholders by signing various carefully-crafted side agreements for the entrusted investment, whereby the nominal shareholders are required to transfer the profits of the investment to the actual investors and return the equity to the actual investors under their own names when the restriction in such areas is removed.
The validity of such side agreements has long been a controversial issue under China’s laws and practice. In May 2010, the SUPREME COURT published certain judicial interpretations on several issues concerning the hearing of cases in disputes involving foreign-invested enterprises and attempted to clarify this critical issue by addressing two fundamental questions: whether side agreements are valid and whether the actual investors can be admitted as shareholders.
Remaining consistent with the SUPREME COURT’s earlier judicial interpretations, Interpretation No. 3 also announces that the validity of such side agreements shall be tested according to the Contract Law. For example, the following will be deemed invalid under the Contract Law:
1) Contracts formed by means of fraud and duress, and such contracts that impair the interests of the State;
2) Contracts concluded on malicious conspiracy of the parties, which are detrimental to the interests of third parties, collective units or the State
3) Contracts designed to conceal illegal goals under the disguise of legitimate forms;
4) Contracts detrimental to the public interest, or
5) Contracts in contradiction of mandatory provisions of the laws or administrative regulations.
Interpretation 3 further provides that if a side agreement passes the general validity test under the Contract Law, the actual investor may claim from the nominal shareholders proceeds obtained by the nominal shareholder from the company and other damages caused by the default of the nominal shareholders. However, the actual investors may not ask the company to register themselves as the real shareholders in replacement of the nominal shareholders in the capital contribution certificate, shareholder registration and statutory registration at the corporate registration authority, unless the actual investors have obtained consent from more than half of the other shareholders of the company.
In the event a nominal shareholder transfers, pledges, or otherwise disposes of the equity registered under his name to a third party, the actual investor may makes a claim to challenge the validity of the above disposal of equity by the nominal shareholder. However, the third party who acquired such disputed equity interest from the nominal shareholder may survive such challenge if it can prove that it is a bona fide purchaser. In this case, the actual investor may hold the nominal shareholder liable for the losses it may suffer as result of such unauthorised disposal of the equity interest according to the entrusted investment agreement.
Final thoughts
By clarifying a number of uncertainties often faced by Chinese companies and their shareholders and creditors in China, the interpretations of the SUPREME COURT should assist in streamlining different local practices and interpretations in handling these common disputes. As these interpretations are equally applicable to both domestic and foreign investors, they will thus play a positive role in ensuring equal rights and protection for both domestic and foreign investors doing business in China.