Equity governance is the key to corporate governance. According to the Company Law, except for one-person limited liability companies and wholly state-owned companies, the shareholders of other companies all participate in major decision making, choose managers and enjoy asset returns in accordance with the existing law and autonomy agreements permitted by law.
The distribution of power or interests is bound to involve competition between shareholders. The most straightforward case is that a powerful principal shareholder always has the final word, which minority shareholders either accept silently or fight for greater power. At that point, minority shareholders, despite owning only a tiny stake, may set off widespread conflict in the company.
Due to factors such as follow-up financing and obstacles to the filing of equity changes, the company and its principal shareholders may be plagued by lawsuits. Therefore, equity governance is particularly essential for companies seeking to go public. Drawing on practical experience in providing guidance for companies preparing for listing, the following equity governance recommendations are presented for reference.
Eligibility verification
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The China Securities Regulatory Commission (CSRC) requires shareholders of companies filing for IPO to disclose their information to prevent “nominee shareholders” and to comply with the provisions of relevant laws and regulations of China. Such provisions, prohibitive or restrictive, are mainly embodied in the Company Law, the Securities Law, the Civil Servant Law, the negative lists for foreign investment and the regulatory rules issued by regulatory authorities.
In addition to checking shareholders’ eligibility pursuant to laws and regulations, background checks on the capital contribution and integrity of prospective shareholders also contribute to subsequent corporate governance and reduce the trial-and-error cost of selecting partners.
Sign with prudence
At first, when shareholders invest in a company, all parties are full of confidence and expectations for the future. However, with financial, business and personnel problems continually emerging during operation, relations between shareholders may become increasingly delicate. In the end, they may confront each other in court, lamenting: “If only time stopped at the moment when we first met”. The investment contracts, articles of association, various agreements and memorandums that they have signed will serve as evidence.
Signing each legal document with prudence helps reduce disputes between shareholders and improves the efficiency of corporate governance. For example: gathering originally dispersed ownership to a single platform; lacking comparable market capitalisations, the future market capitalisation is forecast at a more reasonable level to avoid valuation compensation; consistent wording should be used for different rounds of share capital increases, and special terms and conditions signed by different shareholders or, alternatively, the written approval of other shareholders should be obtained; no ambiguous expressions should be used, and professional securities lawyers should be in place to control the quality of legal documents.
Restore nominee holding
There are certain legal prerequisites for the authenticity and legality of a nominee shareholding. Not only should there be compelling evidence of a nominee holding, which generally includes a nominee holding agreement, and proof of capital contribution and other shareholders’ awareness of a nominee holding, but the shareholders should also meet the eligibility requirements as per laws and regulations.
A nominee holding involves issues such as whether the issuer’s ownership structure is clear, whether there is any dispute over ownership, and whether the nominee holding will lead to changes in control. Therefore, any nominee holding in a company to be listed is one of the key regulatory concerns. Prior to filing for an IPO, it is necessary to turn the nominee holding back to a direct holding.
Either the market regulator or the taxation authority will regard turning the nominee holding back to a direct holding as an equity transfer. Therefore, the process will likely entail a tax payment on the equity transfer. It is a risk that should be considered in the initial stage of an equity setup because neither the nominee holder nor the beneficial owner would be happy with a large amount of tax.
Debt offset
According to the author’s experience in legal due diligence, some shareholders offset their debt claims over the company against unpaid registered capital and make direct adjustments to accounts.
Such circumstances will likely trigger disputes between the company and its shareholders, or among shareholders themselves. In judicial practice, offsetting actions may not be recognised due to a lack of consent from other shareholders, or failure to register changes in the form of capital contributions through business registration. This could potentially harm the legitimate interests of other creditors.
Similarly, shareholders may contribute capital through debt-for-equity swaps. Although no law explicitly requires any valuation process for such capital contribution, it is generally suggested to have a debt valuation report issued by an agency qualified for securities valuation.
Marxist philosophy tells us that there are primary and secondary contradictions in a thing. The primary contradiction is the one that dominates the system of contradictions and plays a decisive role in the development of the thing.
When it comes to a company, the primary contradiction is the company’s development, while conflicts between shareholders serve as the secondary contradiction.
If a company develops well and successfully becomes eligible for an IPO filing, the internal friction between shareholders will be minimised, and the contradictions between them, if any, will not be so prominent. In that sense, straightening out the internal logic of corporate equity governance is vital to driving the company’s development and addressing conflicts among shareholders.
Zhao Xun is a partner at Grandway Law Offices
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