In recently released interpretations, the Supreme People’s Court of China clarified a number of uncertainties often faced by foreign-invested enterprises (FIEs) and their shareholders in order to streamline ways of handling FIE-related disputes across the country and help ensure equal rights for domestic and foreign investors.

In recent years, China has become the most popular destination for international investments; as a result, foreign-invested enterprises (FIEs) have played a significant role in the national economy of China. Naturally, the rapid development of FIEs in China has also led to the quick increment of commercial disputes related to foreign-invested enterprises, which account for about 20 per cent of the total foreign-related civil and commercial cases handled by local courts in the past two years. These disputes generate from various stages of the establishment, operation and termination of FIEs, including complicated controversies and issues in connection with the trusted investment arrangement, equity transfer, assets acquisition and liquidation of foreign-invested enterprises.

In order to set forth a unified guidance for handling these types of disputes in the local courts, after extensive solicitation of public opinions, the Supreme People’s Court of China released the Interpretations of the Supreme People’s Court on Several Issues concerning the Trial of Disputes Involving Foreign-Invested Enterprises (I) on 5 August 2010. which went into effect 16 August 2010. It is the first judicial interpretation focusing on commonly disputed issues related to FIEs, including a validity test of certain FIE-related agreements, trusted investment by foreign investors, the pre-emptive rights of non-transferring shareholders and more.

Validity Test of FIE Contracts

According to China’s laws and regulations on foreign investment, contracts related to FIEs, such as joint-venture contracts and equity transfer contracts (FIE Contracts), shall only become valid and effective upon the administrative approval of competent authorities, i.e., the Ministry of Commerce and its local branches (MOFCOM). Hence, the failure to obtain the above statutory approvals will render such FIE contracts invalid. But the law is far from clear as to how to allocate the risks and liabilities related to the failure of obtaining administrative approval under an invalid FIE Contract.

The interpretations restate the traditional validity test that effectiveness of FIE Contracts shall be subject to administrative approval if laws and regulations request so. However, the interpretations also recognize two exceptions to the above validity test to safeguard the legitimate interests of innocent parties under such FIE Contracts.

First, the interpretations provide that terms specifying or relating to the fulfillment of the obligation to obtain administrative approvals shall survive where the failure to obtain the statutory approval renders an FIE Contract invalid. Further, the interpretations also support claims that an innocent buyer may raise at the court against the seller of an equity transfer contract who fails to fulfill his or her contractual obligations to obtain the administrative approval for such equity-transfer contract. Specifically the innocent buyers may ask the court to order the seller or the FIE to fulfill their obligations to obtain statutory approval within a given time period, and they may even ask for an authorization from the court to obtain the statutory approval by the buyer itself if the seller and the FIE fail to do so in the given time. Alternatively the innocent buyer may claim actual losses for monetary damages, which may cover the loss of difference between equity prices, the equity proceeds and other reasonable losses.

Second, the interpretations point out that supplementary agreement(s) to an FIE Contract shall not be deemed invalid for the lack of statutory approval if such supplementary agreements do not significantly or materially change terms of the FIE Contracts. According to the interpretations, significant or material changes include changes of registered capital, corporate form, business scope, business term, equity contribution and form of contribution, and corporate merger, division, equity transfer, etc..

The interpretations further clarify that the equity pledge contract signed by the shareholders of an FIE to pledge their equity interest in the FIE for the benefit of a third-party creditor shall not be deemed invalid if such equity pledge agreement has not been approved by MOFCOM, even though it confirms the general principles under the Security Law and the Property Law that such pledge will only become effective upon its due registration at the competent registration authority.

Dormant Shareholder

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 arrangement. Under such a structure, foreign investors make the actual investment but are not shown as shareholders in the articles of association and registered documents of the FIE (known as the “actual investors” or “dormant shareholders”); meanwhile certain local Chinese individuals or entities are entrusted by the foreign investors to hold the equity on their behalf and act as the registered shareholders of the FIE (or “nominal shareholders”). 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 side agreements has been a controversial issue under China laws and practice. In the absence of clear guidance under the existing laws, court decisions on this issue vary from place to place. The interpretations attempt to clarify this critical issue by addressing two fundamental questions: whether side agreements are binding and whether the actual investors can be admitted as the shareholders.

According to the interpretations, the binding effect of a side agreement between the actual investor and the nominal shareholder is not subject to the administrative approval of MOFCOM. It shall bind the parties provided that it can stand the general validity test under the Contract Law. For example, the following will be deemed invalid under the Contract Law:

  • Contracts formed by means of fraud and duress, and such contracts that impair the interests of the state
  • Contracts concluded on malicious conspiracy of the parties, which are detrimental to interests of third parties, collective units or the state
  • Contracts designed to conceal illegal goals under the disguise of legitimate forms
  • Contracts detrimental to the public interest
  • Contracts in contradiction of mandatory interpretations of the laws or administrative regulations

Hence, if a side agreement stands the general validity test under the Contract Law, the actual investor may claim proceeds obtained by the nominal shareholder from the FIE and other damages caused by the nominal shareholder’s breach of the contract. Moreover, the actual investor may be admitted as the shareholder of the FIE if the following conditions are all met: the actual investor has actually made the investment; shareholders other than the nominal shareholder recognize the actual investor as the shareholder of the FIE; and change of shareholder from the nominal shareholder to the actual investor is approved by MOFCOM during the lawsuit.

Pre-Emptive Rights of Non-Transferring Shareholders

According to China’s laws and regulations on foreign investments, a shareholder of an FIE shall obtain the unanimous consent of all other shareholders when transferring all or some of its equity in the FIE to a third party, and the non-transferring shareholders will also have pre-emptive rights to purchase such equity at sale under the same terms and conditions. However, non-transferring shareholders are not required to exercise their pre-emptive rights if they disapprove the proposed equity transfer. As a result, such unconditional veto power once exercised by non-transferring shareholders will certainly lead to deadlock in the proposed equity transfer of an FIE.

The interpretations reinforce the pre-emptive rights of non-transferring shareholders of an FIE by confirming that an equity transfer agreement may be nullified by the court at the request of non-transferring shareholders if their pre-emptive rights have been prejudiced. Moreover, the interpretations also specify remedies for infringement of such pre-emptive rights of non-transferring shareholders, including claim to revoke the equity transfer contract or claim for damages, which must be brought within one year of the non-transferring shareholders becoming aware of, or when they ought to have been aware of, the execution of the equity transfer agreement.

However, the interpretations also adopt and further develop the flexibility in the equity transfer systems under the Company Law, whereby non-transferring shareholders are required to exercise their pre-emptive rights if they dissent to the proposed sale of such equity.

According to the interpretations, the veto power of the non-transferring shareholders of an FIE may be disqualified upon the occurrence of any of the following events:

  • There is evidence to prove that the non-transferring shareholders have agreed upon the transfer
  • The transferring shareholder has sent a written notice on the proposed equity transfer, and the non-transferring shareholder(s) have failed to respond within 30 days upon receipt of the written notice
  • The non-transferring shareholder(s) neither agree to the transfer nor purchase the transferred equity

Conclusion

By clarifying a number of uncertainties often faced by FIEs and their shareholders in China, the interpretations of the Supreme People’s Court should assist in streamlining different local practices and interpretations in handling these FIEs related disputes—and thus play a positive role in ensuring equal rights for domestic and foreign investors.