How will amendments to China’s Company Law impact investor strategies and risks in investment and financing?
China’s newly revised Company Law will take effect on 1 July 2024. It brings profound changes to the establishment, operation and governance of Chinese corporate entities. This article analyses the key revisions regarding the company capital system. It highlights the changes, risks and response measures for investors in investment and financing practices.
Capital contributions
Partner
Brightstone Lawyers
The new Company Law mandates that shareholders of limited liability companies must fully pay the subscribed capital within five years of the company’s establishment. They must strictly adhere to the capital contribution regulations for establishing a limited liability company and specifying the time for payment of additional registered capital.
This amendment will significantly impact founding shareholders of technology startups. They risk loss of rights, administrative penalties and compensation liabilities if they are unable to meet full capital contribution requirements.
Given that founding shareholders are often key management or controlling individuals, such unresolved issues could jeopardise a company’s IPO plans – the primary exit route for investors. Parties may explore options such as raising funds through dividends, selling shares, or granting founders the opportunity to subscribe to new shares to tackle these challenges.
Capital acceleration
The new Company Law states that, if a company cannot settle maturing debts, it or its creditors may request shareholders make early contributions of unpaid capital.
To address this, investors should consider establishing mechanisms in investment agreements where other, existing shareholders make contributions in advance. This helps prevent the acceleration of capital contribution obligations during phased deliveries and disruptions in investors’ capital arrangements.
Forfeiture and compensation
Associate
Brightstone Lawyers
The new Company Law allows companies to issue forfeiture notices if shareholders fail to pay capital on time, resulting in the loss of their rights to unpaid shares since the date of the notice. Shareholders who fail to contribute capital are also liable for compensating the company’s losses.
To mitigate risks stemming from investors’ temporary inability to fulfil capital obligations other than of their own will, parties can negotiate the longest statutory contribution period in the company’s articles of association and specify circumstances in investment agreements where default on contributions will not be constituted, or forfeiture will not be applied. However, to avoid conflicts with legal provisions, investors should also consider risk-hedging arrangements.
Defective share transfers
The new Company Law clarifies that founders bear joint and several liability with other founders for inadequate capital contributions during a company’s establishment. Therefore, investors should consider how founders’ defective capital contribution affects a company’s capital adequacy and future IPO prospects, and ensure the company’s compliance with IPO review requirements in investment agreements.
The new Company Law also specifies transferors’ responsibilities in share transfers:
- The transferor bears supplementary contribution responsibility for shares transferred before the contribution deadline if the transferee fails to pay on time;
- The transferor bears joint and several liabilities for overdue or insufficiently contributed shares (within the shortfall) with the transferee; and
- The transferor bears full responsibility if the transferee is unaware or should not be aware of the situation.
Therefore, as transferors, investors can make the fulfilment of contribution obligations by the transferee (regardless of maturity) a prerequisite for share transfers.
As transferees, investors can use the transferor’s disclosure of contribution obligation fulfilment, including capital adequacy, completion or supplementation, as a prerequisite for the share transfer or a trigger event for the investor’s right to terminate the transaction.
Authorised capital
The law allows boards to issue new shares not exceeding 50% of existing shares within three years. This regime significantly impacts investors’ rights in capital increases, anti-dilution and pre-emptive rights. Investors can demand specific authorisation details in a company’s articles of association, including duration, the upper limit of the percentage of issuance, share types and price ranges.
Setting appropriate shareholder voting mechanisms ensures effective investor participation. Additionally, granting investor directors balancing rights at board meetings is advisable.
Loss recovery
The new Company Law permits companies to use capital reserves to compensate for losses that cannot be covered after using discretionary reserves and statutory reserves.
If losses are still not offset, a company can further reduce its registered capital to compensate for the losses without distributing profits to shareholders during this process, and shareholders’ capital contribution obligations remain unaffected.
This revision benefits both financing companies and investors, facilitating rapid improvement of financial conditions and creating conditions for future dividends. In practice, investors often specify the use of investment funds in investment agreements, allowing capital reserves generated from investment premiums to be used for loss compensation.
Takeaway
In the face of regulatory changes, investors should promptly and proactively plan and adjust investment strategies and legal practices, avoiding investment risks and losses due to neglect or lack of response.
Grace Zhao is a partner at Brightstone Lawyers. She can be contacted by +86 189 1760 5461 or by e-mail at glzhao@brightstonelawyers.com
Wendy Wang is an associate at Brightstone Lawyers. She can be contacted by +86 159 0163 9509 or by e-mail at luyao.wang@brightstonelawyers.com
Suite T61, 15/F, Shanghai World Financial Centre
100 Century Avenue, Pudong New District
Shanghai 200120, China
Tel: +86 21 6881 5499
