On 12 April 2016, China’s Supreme People’s Court (SPC) issued a draft judicial interpretation (Draft Interpretation)1 on the PRC Company Law (Company Law) for public consultation. Once finalised, this will be the fourth judicial interpretation on the Company Law. The deadline to submit comments is 13 May 2016.
The Draft Interpretation focuses on five subject areas, namely validity of board and shareholders’ resolutions, shareholders’ inspection rights, profits distribution, pre-emptive rights in equity transfer and derivative litigation. While the Draft Interpretation provides much needed clarification on a range of issues that are often the subject of disputes in China, especially since the Company Law was revised in 2014, it may also have generated new questions.
Validity of Resolutions
Article 22 of the Company Law provides very general rules on the validity of shareholders’ resolution or a board resolution – basically a resolution is invalid if its content, or the procedures for passing the resolution, violate any law or regulation. The Draft Interpretation supplements these rules from a number of aspects, including, among others:
- In addition to shareholders, directors and supervisors who are eligible to file a lawsuit to nullify a resolution, the Draft Interpretation enables senior management, employees or creditors that have any direct interest in such resolution to seek a court order to nullify a resolution under Article 22 of the Company Law.
- As to the grounds for invalidation of a resolution, the Draft Interpretation provides two additional specific circumstances which are developed from Article 20 of the Company Law: » Any shareholder who abuses its power through a resolution that harm the interests of the company or other shareholders; or
- Any resolution that excessively distributes profits or approves any improper material related to party transaction that harms the interests of creditors.
- As a new type of relief, the Draft Interpretation provides that the plaintiff may apply to the court for an injunction to prevent an invalid resolution from being implemented.
While the Draft Interpretation provides certain clarification for implementing Article 22 of the Company Law, it appears to have expanded the application of Article 22 beyond what is provided in the Company Law. For instance, by allowing employees to apply for invalidation of a board or shareholders’ resolution in which they have “direct interest”, the Draft Interpretation could have fettered the right of the directors and shareholders to determine the business of a company. Similarly, it is not clear why creditors should be entitled to challenge the validity of a board or shareholders’ resolution in cases other than insolvency (or likely insolvency) of the company, in which case creditors already have recourse under the Company Law and the Enterprise Bankruptcy Law.
Shareholders’ Inspection Rights
The Draft Interpretation defines further, and provides, detailed rules to the framework under Article 33 and Article 97 of the Company Law on shareholders’ access to meeting minutes, books and records.
The Draft Interpretation expands the scope of accounting records that a shareholder may access to cover vouchers and source documents. This will greatly facilitate shareholders (especially minority shareholders who do not participate in the operation of the company) in verifying the accuracy and authenticity of the accounting records.
Under the Company Law, a company may reject its shareholders’ inspection request “if the request is for unjustified purpose”. Local courts’ interpretation as to what constitutes an “unjustified purpose” tends to vary. The Draft Interpretation provides some guidance by citing the following circumstances as examples of “unjustified purposes” - if the requesting shareholder is running a business that competes with the company, or if the requesting shareholder is to sell the information to others for profits. Further, the Draft Interpretation clarifies that any defects in a shareholder’s capital contribution will not justify a company’s rejection to the shareholder’s inspection request.
According to the Draft Interpretation, the court may uphold a plaintiff’s request to distribute profit if:
- There is a validly passed resolution on the profit distribution; or
- There is no valid resolution on such distribution but the plaintiff can prove that the lack of such resolution is due to the abuse of power by other shareholders or fraud by the senior management.
Moreover, a court’s decision to support distribution of profit is enforceable by shareholders who have not participated in the relevant lawsuit. This means these shareholders do not need to lodge a separate claim, thus largely saving parties’ costs and enhancing judicial efficiency.
Pre-emptive Rights in Equity Transfer
Under Article 71 of the Company Law, shareholders of a limited liability company have pre-emptive rights to purchase the equity of another shareholder who intends to transfer all, or part, of its equity to a third party, under the same conditions.
As the Company Law only contains general principles, the Draft Interpretation aims to provide more guidance to courts on how the pre-emptive rights should be enforced. These provisions, as set out below, are generally in line with commercial practice:
- Unless the company’s articles of association (AoA) provides otherwise, pre-emptive rights do not apply under the following circumstances:
- Equity transfer by inheritance or bequeath;
- Equity transfer among existing shareholders;or
- Non-transferring shareholder exercising pre-emptive rights to buy only part (but not all) of the sale equity.
- To effectively enforce the mechanism, major terms of the proposed transfer must be notified to the non-transferring shareholders, such as name of the proposed buyer, type, amount and price of the sale equity, how the transfer will be performed and by when.
- “Under the same conditions” as used in Article 71 of the Company Law is defined to include the price, payment method, timeline for payment, and other factors.
- The court will uphold the non-transferring shareholder’s claim to nullify an equity transfer to a third party, if:
- entering into the equity transfer agreement does not comply with statutory procedures;
- the actual terms and conditions of the equity transfer substantially differ from those originally offered to the non-transferring shareholders; or
- the transferring shareholder, in collusion with the proposed buyer, proposes substantially less favourable terms (e.g., excessively high price) which cause the non-transferring shareholders to waive their pre-emptive right.
If an equity transfer is declared void by the court, the non-transferring shareholder is entitled to buy the equity on the same (which is more favourable) terms as the transaction that has been nullified.
However, the Draft Interpretation adds that if the AoA contains excessively stringent restrictions on equity transfer which make it impossible in practice for a shareholder to transfer its equity, the court will uphold the affected shareholder’s claim to nullify such restrictions. It is not clear from the Draft Interpretation what kind of restrictions may be considered as “excessively stringent” and hence, the parties’ agreed arrangements in the AoA may risk being challenged in court. In addition, in respect of Chinese-foreign joint ventures, since any equity transfer remains subject to approval by the original approval and examination authority, a shareholder of a Chinese-foreign joint venture will have to go through additional hurdles even if it has obtained a court order to enforce its pre-emptive right.
The Draft Interpretation clarifies a number of procedural issues relating to shareholders bringing claims on behalf of the company against a third party. In particular, shareholders of a parent company are entitled to bring derivative litigation on behalf of its wholly-owned subsidiaries.