Tag:corporate-mergers-and-acquisitions-foreign-direct-investment-fdi
On 29 December 2023, the Standing Committee of the National People's Congress of the PRC adopted amendments to the PRC Company Law (2023 Revision) (the "New Company Law").
The New Company Law makes substantial changes to the current Company Law in a number of regards, including time limits on capital contribution, overhauling of corporate governance structures, expanded powers for the board of directors, increased director liability, new rules in relation to equity transfer, a simplified route to reducing the registered capital, to name a few of the main issues.
The New Company Law is the second comprehensive revision to the PRC Company Law since its first promulgation in 1993 and will come into force on July 1st, 2024.
Most foreign-invested enterprises ("FIEs") in China are limited liability companies. This article will summarize the key impact the New Company Law will have on FIEs as well as our suggestions as to next steps to be taken.
I. Key Changes in the New Company Law
1. Capital Contribution
The New Company Law pays more attention to the protection of the company and its creditors and imposes higher requirements on shareholders to fulfill their obligation in respect of capital contribution.
- Time limit for capital contribution
The time limit for capital contribution was removed in the 2018 revision to the PRC Company Law. At the time this change was designed to encourage entrepreneurs to make the leap and start businesses. However, in the last 5 years there has been an explosion in financial frauds in which shell companies with high but unfortunately not paid in registered capital were used.
In order to combat this the New Company Law has put back a time limit as to when shareholders must make their capital contributions. The purpose is to add credibility to the registered capital and provide creditors with a truer picture of the actual capital and solvency of the companies they are dealing with.
To be more specific, the New Company Law requires shareholders of a company to fully pay in their subscribed registered capital within five years of establishment of the company.
Crucially, the time limit for capital contribution applies retroactively. Accordingly, companies established before the New Company Law comes into force (i.e. before July 1st, 2024) will also need to gradually adjust their capital contribution to meet the new requirements. It is not clear how this "gradually adjusting" will unfold but we expect the State Council to issue clarifying implementing measures.
The capital contribution time limit also applies to capital increases. The law is unclear when the starting point of the 5-year time limit for capital contribution of such capital increases starts but assumedly it will be from the date of subscription, e.g., the date when the capital increase agreement becomes effective.
- New form of capital contribution
The New Company Law recognizes that equity or creditor's rights can be a new form of capital contribution. Accordingly a shareholder can use equity in another company or use its creditor rights (i.e. debt to equity swap) as its capital contribution.
- Liabilities for defective capital contribution
Shareholders that fail to make their full capital contribution on time will be directly liable to indemnify the company for any losses arising therefrom.
To add insult to injury, the New Company Law also states that if any shareholder fails to make full capital contribution according to the articles of association of the company ("AoA"), then the other shareholders at the time of the incorporation shall bear joint and several liability to the extent the capital contributions are insufficient.
- Shareholder's forfeiture of equity
If a shareholder fails to make capital contribution in time as specified in the AoA, the company may call upon such shareholder in writing to make such capital contribution; if the capital contribution remains unpaid despite a grace period (no less than 60 days), then the company may send a written notice of forfeiture of equity to such shareholder upon a resolution of the board of directors. The shareholder will forfeit its unpaid equity upon issuance of such notice by the company.
Any such forfeited equity will be transferred or the registered capital will be reduced. If no transfer or registered capital reduction occurs within six months, then the other shareholders will be required to make up the outstanding contribution in full according to their contribution ratio. Shareholders who dissent from the forfeiture of equity are entitled to file a lawsuit in a court within thirty days upon receipt of a notice of equity forfeiture.
- Acceleration of capital contribution
Where a company is unable to pay off its due debts, the company itself or creditors with mature claims may demand shareholders to accelerate their unpaid capital contributions.
Currently, it is unclear how "unable to pay off its due debts" will be interpreted - whether any unpaid due debts or whether the company must be trading insolvently.
2. Corporate Governance
The New Company Law makes significant changes to corporate governance rules. This includes a reconstruction of organizational structures and adjustment of governance powers within the company.
- Legal representative
Currently, the Company Law stipulates the legal representative of a company must be the chairman of the board, executive director or general manager. The New Company Law expands the potential pool of legal representatives to include any director or general manager who represents the company to execute corporate affairs. This will give the company greater flexibility when designating its legal representative.
If the legal representative causes damage to others in the performance of his/her duties as legal representative, then the company shall bear corresponding civil liability. The company can in turn hold the legal representative liable if the legal representative was at fault.
- Shareholders' meeting
The New Company Law slightly narrows down the authority of the shareholders' meeting by removing its authority in respect of the following: (1) determining operational policy and investment plans; and (2) reviewing and approving annual financial budgets and final accounts of the company. This relieves the shareholders from bearing the burden of company operational matters which should more reasonably be the responsibility of the board of directors.
- Board of directors
The New Company Law delegates expanded authority to the board of directors. In particular, (i) the expression "the board of directors is responsible to the shareholders' meeting" has been deleted; (ii) "other authorities granted by the shareholders' meeting" has been added as an authority of the board of directors; and (iii) the minimum number of directors of a board remains three but there is no longer any limit as to the maximum number of directors (previously this was capped at thirteen).
The New Company Law further allows a board to set up an audit committee composed of directors rather than a separate board of supervisors. Such single-layer governance structure is like some European countries and the U.S and may enhance efficiency. However, there may be concerns of conflict of interests as the audit committee will be composed by directors who will be exercising a supervisory function over the board of directors. This conflict will need to be addressed in future implementing measures.
In addition, any company with more than 300 employees will need to have employee representation on the board unless the existing board of supervisors already has employee representation.
- Board of supervisors
Relatively small-scale companies or those with a small number of shareholders may appoint a single supervisor rather than a board of supervisors. If all shareholders consent, then the company can even choose not to have a supervisor. FIEs may select to continue to have a supervisor just in order to have some counterweight to the board and management.
- General manager
The New Company Law deletes all statutory authority of the general manager. The authority of the general manager will need to be specified in the AoA or delegated by board of directors.
3. Equity Transfer
- Procedural changes of equity transfer
The New Company Law simplifies equity transfer procedures. Equity transfer to third parties no longer requires consent from other shareholders except as otherwise stated in the AoA but shareholders still enjoy a right of first refusal. A shareholder intending to transfer all or part of its equity in the company will need to issue a notice of such proposed equity transfer to other shareholders. The other shareholders will be deemed as having waived their right of first refusal if no reply is given within 30 days of receipt of such notice.
- Capital contribution liabilities related to the equity transfer
If a shareholder transfers non-contributed equity then the transferee shall bear the obligation to make the capital contribution. In case the transferee fails to make full capital contribution for the non-contributed equity, the transferor shall bear a supplementary liability for such overdue capital contribution.
If a shareholder transfers defective equity (i.e. no capital contribution made or the actual value of the non-cash assets is substantially lower than the value of the subscribed equity), the transferor and the transferee shall assume joint and several liability to the extent the contribution is insufficient. If the transferee was not aware (and had no reason to be aware the equity was defective) then liability shall be assumed by the transferor.
The above requirements highlight the importance of due diligence in an equity transaction and the parties should be careful to ensure equity contributions are fully paid in.
- Minority shareholder's right to request for repurchase
If a controlling shareholder seriously damages the interests of the company or other shareholders by abusing shareholder's rights then the other shareholders have the right to require the company to repurchase their equity at a reasonable price.
4. Rights and Obligations of Directors, Supervisors and Senior Management
The New Company Law creates more rights and obligations as well as greater liability exposure for directors, supervisors and senior management of companies in China.
- Directors' obligation to call for contribution
To ensure full capital contribution, the New Company Law requires directors to call for capital contribution. The board is obliged to verify the status of shareholders' capital contributions. If the board uncovers that a shareholder has failed to make its capital contribution in full within the required time limit, then the company shall notify such shareholder in writing to make the capital contribution in full.
Losses caused to the company due to failure by the board to check the shareholders' capital contribution status will result in the responsible directors being liable to compensate the company. Accordingly, this is a serious liability for directors to bear.
- Compensation for removal of directors without justified reason
The New Company Law offers directors the right to compensation from the company if unjustifiably removed prior to expiration of his/her office term. This may prove challenging to MNCs when managing directors are appointed to entities in China. Traditionally such directors served at the pleasure of their overseas parent corporation. This may also complicate dismissals. Another concern is that it is unclear what "legitimate reasons" are. This will need to be further clarified by judicial practice and future legislation.
- Compensation liability for directors and senior management
The company is liable to compensate parties that incurred losses arising from a director's or senior management's performance of duties. However, if damage is due to intentional misconduct or gross negligence, then the director or senior management will also be liable. As a result, FIEs may consider expanding the scope of coverage of the director and senior management liability insurance policies to cover the increased risk to such officers.
- Reporting requirement for director liability insurance
The New Company Law officially recognizes director liability insurance. The board is required to report to the shareholders' meeting as to the amount of liability insurance coverage, scope and the premium.
5. Rights and Obligations of Shareholders
- Obligations and liabilities for controlling shareholders and actual controller
The New Company Law has adopted changes to prevent the controlling shareholders or actual controllers of the company from improperly using their power to harm the interests of the company and its shareholders.
The controlling shareholder or actual controller who does not serve as a director but actually directs the affairs of a company also bears a duty of loyalty and an obligation of diligence. Moreover, any controlling shareholder or actual controller of a company who instructs any director or senior management to carry out acts damaging the interests of the company or the shareholders, shall bear joint and several liability with the directors or senior management.
This may complicate employee disputes where the parent company intervenes in the operations of its subsidiary. Dealing with management issues in a failing FIE was always fraught in joint ventures but this change may also complicate matters when parent companies decide to restructure their WFOEs.
- Enhanced rules of piercing the corporate veil
The current Company Law establishes rules for piercing the corporate veil vertically (i.e. the sole shareholder of a company is liable for the liabilities of such company if such sole shareholder cannot prove that its assets are independent from the assets of the company).
Under the New Company Law, the rules have also been expanded to pierce the corporate veil horizontally (i.e., when a shareholder abuses the independent status of the company and its limited liability to evade debts and seriously damage the interests of the creditors of the companies by using two or more companies under its control, then in such cases each company shall bear joint and several liability for such debts).
- Expanded shareholders' information rights
Shareholders' information rights have been expanded to access and copy the shareholders' register and to access the accounting vouchers of a company. Shareholders are also allowed to access and/or copy relevant materials relating to 100% subsidiaries of the company. This change will be beneficial to MNCs that are minority shareholders in Sino-foreign joint ventures.
6. Company's Profits and Capital
- Six months' time limit for profit distribution
The New Company Law clearly requires the board of directors to distribute profits within six months from the date of the shareholders' meeting resolution.
- More choices for loss recovery
The scope of funds to be used for making up losses will include capital reserve. In case the reserve of a company is used to make up losses, the discretionary reserve and statutory reserve shall be firstly used; if the losses still cannot be fully recovered, then the capital reserve will also be used.
- Liability of illegal profit distribution
Profit distributions to shareholders in violation of the New Company Law will result in directors, supervisors and senior management liability.
7. Capital Reduction, Liquidation, and De-registration
- Optimized capital reduction rules
The New Company Law provides that a company shall reduce the amount of capital contribution in proportion to the capital contribution held by the shareholders, except as otherwise provided by law or otherwise agreed upon by all the shareholders of a limited liability company. Accordingly, the New Company Law confirms that capital reductions can be made disproportionally amongst shareholders.
The New Company Law also provides a simplified procedure for capital reductions. If the losses of a company cannot be made up after using the statutory reserve, the discretionary reserve and the capital reserve, then the company can further make up such losses through capital reduction. In this case, the company is not required to notify its creditors but the company is not permitted to make any distribution to shareholders, nor are shareholders exempted from their obligation to make their capital contributions. After completing such simplified capital reduction procedure, the company shall not distribute profits until the accumulated amount of statutory reserve and discretionary reserve reaches 50% of the company's registered capital.
If a company reduces its registered capital in violation of the New Company Law, the shareholders shall refund funds received, and the capital contributions shall be restored to their original status. Shareholders, relevant directors, supervisors and senior management shall all bear liability for any losses suffered by the company.
- Optimized liquidation rules
Under the current Company law, shareholders are responsible for the liquidation and the liquidation committee is composed of shareholders. The New Company Law, however, specifies that the directors are responsible for the liquidation and the liquidation committee of a limited liability company shall consist of directors unless otherwise provided in the AoA or by shareholders' resolutions. Such changes are consistent with the changes to expand the authorities of the board of directors under the corporate governance structure.
The directors shall be held liable if they fail to fulfill the liquidation obligations in a timely manner and if any loss is caused to the company or its creditors. The members of the liquidation committee bear a duty of loyalty and diligence; any liquidation committee member who neglects to fulfill their liquidation duties and causes loss to the company shall be held liable, and any liquidation committee member who causes loss to any creditor either intentionally or by gross negligence shall also be held accountable.
- Simplified de-registration rules
Currently, liquidation is complicated and time-consuming. The New Company Law simplifies this by allowing a company with no outstanding debts to be de-registered through a simplified procedure; any shareholder making a false commitment bears joint and several liability for debts incurred before de-registration.
II. What's Next?
- The New Company Law will have a major impact on the operation and corporate governance structure of FIEs in China. MNCs must be well prepared for what's next as it comes into force on July 1st, 2024:
- Currently, some FIEs have subscribed a relatively high registered capital but never planned to contribute capital in full much less within five years. Such companies will need to consider whether they will need to reduce their registered capital as stricter requirements on capital contribution are coming.
- FIEs will need to consider how wide ranging changes in corporate governance structure, capital contribution requirements, equity transfer rules, will impact their individual circumstances.
- FIEs will need to update the relevant corporate documents (such as AoA and joint-venture agreements) to reflect the changes in the New Company Law earlier rather than later. For example, (i) the methods for the appointment and change of the legal representative shall be specified in the AoA; (ii) the authorities of the shareholders' meeting and the authorities of the board of directors shall be adjusted; and (iii) equity transfer to third parties no longer needs consent from more than half of the other shareholders. Shareholders still enjoy a right of first refusal.
- In addition, it is also worth noting the 5-year interim period provided under the Foreign Investment Law is due to expire on December 31, 2024. FIEs which have not updated their corporate governance structure as required by the Foreign Investment Law should also consider a consolidated approach which also takes into account the New Company Law's impact.
- FIEs may need to update their actual controllers, directors, supervisors, and senior management as to how the changes under the New Company Law will impact them.
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