Contract validity: Beware of ministerial-level regulations

By Pan Bo, Grandway Law Offices

For the longest time, judicial and theoretical circles have held a common belief that, pursuant to the Contract Law and its judicial interpretations, a contract is invalid only if it violates laws formulated by the National People’s Congress or its standing committee, or administrative regulations formulated by the State Council.

However, under certain specific circumstances, the ministerial-level rules and regulations may have a bearing on the public interest or order in a certain field, in which case they may ascend to a position where it affects the validity of a contract, e.g., the Administrative Measures for the Equity of Insurance Companies formulated by the former China Insurance Regulatory Commission (CIRC) and the Administrative Provisions for the Equity of Securities Companies formulated by the China Securities Regulatory Commission (CSRC).

Pan Bo
Grandway Law Offices

For example, in the Fujian Weijie Investment v Fuzhou Tiance Industry business trust dispute, the parties executed a trust shareholding agreement under which the settlor entrusted the trustee to hold equity of an insurance company in a trust. The Supreme People’s Court (SPC) determined that an agreement for the holding of equity on behalf of another party that violates article 8 of the above-mentioned measures – which specifies that “no entity or individual may entrust a third party or accept the entrustment of a third party to hold the equity of an insurance company” – is invalid, mainly based on the following three points:

(1) Expressly authorized by laws and regulations. The CIRC formulated the measures pursuant to the express authorization by article 134 of the Insurance Law, which states that, “The insurance regulator of the State Council shall formulate and issue rules and regulations for the regulation of the insurance industry in accordance with laws and administrative regulations” in order to maintain the stable operation of insurance companies, protect the investors and the insured, and strengthen oversight of the equity of insurance companies. This provides the grounds at the level of “law” for the “ascension” of the measures.

(2) No conflict with higher-level legislation, such as laws and administrative regulations. From the provisions of the measures prohibiting the holding of the equity of an insurance company on the behalf of another party it can be seen that such provisions fall within the CIRC’s purview and do not conflict with the relevant laws and administrative regulations at a higher level.

(3) Harmful to the public interest. If such type of holding is allowed, this will permit the true investors of insurance companies to escape from the oversight of the relevant functional authorities of the state, and, under certain circumstances, will jeopardize the financial order and social stability, thereby directly harming the public interest.

These points analyze several conditions that lead to the invalidity of a contract due to the violation of ministerial-level rules and regulations, with the ultimate point being “harming the public interest” as specified in item (4) of article 52 of the Contract Law.

The above mentioned case is essentially an echo of the statement “validity of a contract in the event of a violation of rules and regulations” in the Minutes of the National Work Conference on Civil and Commercial Adjudication by Courts: “generally, a violation of rules or regulations does not affect the validity of a contract. However, if the provisions of such a rule or regulation has a bearing on public order or good customs, such as those that have bearing on financial security, market order, state macro policies, etc., the contract shall be found to be invalid. When determining whether a rule or regulation has a bearing on public order or good customs, the People’s Court is required, on the basis of an examination of the target of the rule or regulation, to carefully consider such factors as its regulatory force, protection of the security of the transaction as well as the social impact, and fully lay out its reasoning in its decision document.”

Second paragraph of Article 18 of the Administrative Provisions for the Equity of Securities Companies. These provisions fall within the category of ministerial-level rules and regulations, and the second paragraph of article 18 specifies that, “Where a relevant matter is subject to the approval of the CSRC, it shall be specified that the agreement enters into effect only after such approval.”

If there is a change in a shareholder that holds at least 5% of the equity of a securities company, could a court determine whether a contract relating to the change in question is valid on the basis of the above-mentioned provisions? The author believes the answer is no, and the reasons are set out below.

First, this provision is not directed at the equity transfer act itself, but rather at how the parties to the equity transfer form the transfer contract, making it a mandatory provision of an administrative nature, not a mandatory provision addressing validity.

Second, the provisions deny the approval of the CSRC as being a statutory condition for the entry into effect of an agreement, but rather require the parties to an agreement to specify in a provision to that effect that the approval of the CSRC is a condition for the entry into effect of the agreement.

Third, what the CSRC approves is a “change in a shareholder holding at least 5% of the equity”, namely the change in shareholder and the shareholder qualifications, not the change in equity. Accordingly, inserting “the agreement shall enter into effect only after the approval of the CSRC” into the contract does not have the express authorization of laws or administrative regulations.

Finally, if the parties to the agreement fail to specify the approval of the CSRC as a condition for the entry into effect of the agreement, this does not signify the existence of a situation where “any entity or individual holds or actually controls at least 5% of the equity of a securities company without approval”. As long as the parties carry out the registration of the change in title to the equity after carrying out the CSRC approval procedure, there is no violation of a mandatory provision of laws or administration regulations and this will not result in a breach of public order.

Pan Bo is an associate at Grandway Law Offices

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