Over the past years, the number of foreign investment disputes increased steadily. In the past two years, they constituted 20% of all foreign related civil and commercial disputes heard by People’s Courts. Many of these disputes involved controversial corporate legal issues. In order to further unify the judicial practice, on August 5, 2010, the PRC Supreme People’s Court issued the Provisions on Several Issues Concerning the Hearing of Cases about Disputes Involving Foreign-invested Enterprises (I). Please find enclosed an overview on the Provisions.

On August 5, 2010, the PRC Supreme People’s Court issued the Provisions on Several Issues Concerning the Hearing of Cases about Disputes Involving Foreign-invested Enterprises (I) (the “Provisions”). The Provisions entered into force on August 16, 2010, and provide authoritative guidance for certain important, but previously controversial issues arising from the establishment of and corporate changes to foreign-invested enterprises (“FIEs”). The following are some key issues addressed by the Provisions.

1. Validity of Contracts

According to PRC law, certain contracts concluded for the establishment of or for making corporate changes to an FIE (“FIE Contracts”) become effective only after being approved by the competent authority. Examples include joint venture agreements, articles of association and equity transfer agreements. If these contracts were not approved, the contract parties found themselves in a legal dilemma: since the contract was invalid, neither party could enforce any part of the agreement against the other party, nor could they force the other party to apply for the necessary approval to render the contract valid. The Provisions solve this problem by confirming that these contracts are not invalid, but have just not come into effect. In this phase, the contractual clauses regarding the obligation to apply for approval are binding on the parties.

If a supplementary agreement to an approved FIE contract (“Supplementary Agreement”) is executed and is yet to be approved, according to the Provisions, the Supplementary Agreement will be valid as long as it does not constitute a material change to the approved FIE Contract. Material change is defined in the Provisions as any change in respect of registered capital, company form, business scope, business term, subscribed capital amount, means of capital contribution, merger, division and equity transfer.

The Provisions also state that the People’s Court retains the final say over the validity of an FIE Contract. Even if an FIE Contract has been approved by an administrative approval authority, the People’s Court can still hold that the contract is void or voidable.  

2. Equity Transfer of an FIE

According to PRC law, an equity transfer agreement comes into effect upon approval by the competent authority. The equity is effectively transferred upon approval and registration of the transfer agreement. In practice, due to various motivations, the seller may delay or even refuse to submit the equity transfer agreement to the approval authority for approval after it has been executed. Equally, the purchaser may also delay or refuse to pay the purchase price. The Provisions clarify the obligations imposed and legal remedies available in such situations.

a) Obligation of Submission for Approval

According to the Provisions, both the seller and the FIE are obliged to submit the equity transfer agreement to the competent approval authority for its approval. If, upon demand for performance by the purchaser, the seller and the FIE fail to do so, the purchaser may:

terminate the equity transfer agreement, claim for a refund of any part of the purchase price which has been paid, and request indemnification for any actual loss arising; or claim for performance of the obligation to submit the equity transfer agreement to the competent approval authority within a certain time period.  

If following a court judgment, the seller and the FIE still fail to submit the equity transfer agreement within the given time period, the purchaser can instead directly submit the equity transfer agreement to the competent authority. Alternatively, the purchaser is entitled to bring another claim for termination of the equity transfer agreement and indemnification for losses, including the difference of the purchase prices, equity proceeds and other reasonable losses.

b) Payment Obligations

In cases where the equity transfer agreement has not been submitted for approval and the purchase price has not been paid, the Provisions state that the legal consequences will be according to the terms of the agreement.

For example, if the equity transfer agreement stipulates that the seller will not be obliged to submit the agreement to the competent authority for approval until the purchaser has paid the purchase price, and the purchaser fails to pay the purchase price, the seller is entitled to terminate the agreement and claim for the actual losses caused by the delayed performance.

If however, payment of the purchase price is not stipulated to be a pre-condition for the transfer of the equity and the equity transfer agreement has not yet been approved by the approval authority, the seller is entitled to claim for the payment only after the Agreement has been approved by the approval authority, within a time limit specified by the court. In practice, equity transfer agreements usually stipulate that the purchase price shall only become due after approval and registration of the transfer. Purchasers are well advised to insist on such kind of clauses. Any payment before the actual transfer of the equity should not be made to the seller, but only to an escrow account.

c) Shareholder’s Pre-emption Rights

According to PRC law, the shareholders of a company have a statutory pre-emption right over any proposed equity transfer. The Provisions confirm that if a shareholder’s pre-emption rights are infringed by the proposed equity transfer, the aggrieved shareholder is entitled to claim for revocation of the relevant equity transfer agreement. In order to exercise this claim, a one-year limitation period applies, which commences from the date the shareholder knew or should have known about such transfer.  

3. Equity Pledge

The Provisions clarify the rules on the validity of an equity pledge contract and the validity of the equity pledge itself. While the equity pledge comes into effect upon registration of the agreement creating it, an equity pledge contract shall come into effect upon execution, unless the contract, laws or administrative regulations stipulate otherwise. The Provisions explicitly stipulate that the validity of an equity pledge contract is not subject to approval by the competent authority. This reverses the stipulation of the Several Provisions on Change of Investor’s Equities in Foreign-invested Enterprise dated May 28, 1997.  

4. Dormant Shareholder’s Equity Interest in the FIE

In some instances a shareholder of an FIE may act on behalf of an anonymous investor (a “dormant shareholder”) through an entrustment structure. In the past, such holding structure created certain risks for the dormant shareholder, because only the registered shareholder could enjoy the rights arising from a shareholder position. For the first time the Provisions now address the legal issues and disputes arising from such an arrangement on a national level.

a) According to the Provisions, a dormant shareholder can be acknowledged by the People’s Court as a shareholder if the following requirements are fulfilled:

  • the dormant shareholder has actually paid the capital contribution to the FIE;
  • the other shareholders of the FIE, except the nominal shareholder, unanimously acknowledge that the dormant shareholder is a shareholder of the FIE; and
  • either the People’s Court or the dormant shareholder has obtained the consent of the competent approval authority for the change of the dormant shareholder into a registered shareholder of the FIE during the litigation process.

b) According to the Provisions, a shareholding entrustment agreement between the nominal shareholder and the dormant shareholder is valid upon execution and requires no examination and approval by the authority.

However, as with other contracts governed by PRC law, a shareholding entrustment agreement can be invalidated by the stipulations of laws and regulations if used for illegal purposes, such as the avoidance of investment restrictions.

c) Where a valid shareholding entrustment agreement exists, the dormant shareholder has the following rights:

  • to request that the nominal shareholder performs the contractual obligations agreed by both parties; and
  • to request that the nominal shareholder (not the FIE) hand over any proceeds obtained from the FIE, even in the absence of any explicit agreement between both parties.

However, the dormant shareholder has no right to directly request that the FIE pay dividends to it or to exercise other shareholder rights.

d) The Provisions also clarify the legal consequences when an agreement between a dormant shareholder and a nominal shareholder are held invalid. In this case, the dormant shareholder may request the nominal shareholder to return his paid-in capital and a reasonable share of the investment proceeds, if the current value of its actual shares in the FIE is no less than the paid-in capital. If the current value of the dormant shareholder’s shares is less than the original paid-in capital, he may request payment of an amount equivalent to the current value of his actual shares in the FIE.

If the nominal shareholder expressly gives up the nominal equity interest or refuses to continue to hold the shares on behalf of the dormant shareholder, such equity interest shall be sold by the court and the consideration received shall be returned to the dormant shareholder. Any profit on the initial investment shall be reasonably divided between the nominal shareholder and the dormant shareholder.  

5. Capital Contribution in Kind or Terms of Cooperation

In some cases, making of capital contribution or provision of the terms of cooperation of a shareholder in an FIE requires registration with the competent authority. According to the Provisions, the shareholder shall be regarded as having made the capital contribution or provided the terms of cooperation if

  • the relevant property has already been delivered to the FIE for actual use, and
  • the relevant registration formalities of the title transfer have been completed within a reasonable period, as determined by the People’s Court.

This stipulation in practice can be to the advantage of Chinese partners who contribute non-cash assets such as land use rights or buildings to a Sino-foreign joint venture. Parties must take this into consideration when negotiating a joint venture contract.

Finally, FIE contracts usually provide that disputes be dealt with through arbitration rather than litigation procedures. Since the Provisions were issued by the Supreme People’s Court and are enforced by the local People’s Courts, in theory they do not bind Chinese or international arbitration tribunals. However, in practice, the Provisions play an important role in assisting arbitrators with their interpretation of PRC law, especially when an arbitration award is to be enforced in the PRC. Also when PRC law is not clear on any of the matters discussed above, the applicable Provision may offer guidance.