Dealing with disputes over equity transfers

Article 44 of the PRC Contract Law specifies that “if laws or administrative regulations require approval, registration or other such procedures before a contract enters into effect, such provisions shall govern”. Article 20 of the Sino-Foreign Equity Joint Venture Law Implementing Regulations (the Implementing Regulations) specifies that any equity transfer involving foreign investment must “be submitted to the approval authority for approval”, otherwise the transfer will be invalid.

Article 3 of the Changes in Equity Interests of Investors in Foreign Investment Enterprises Several Provisions (the Equity Change Provisions) specifies that “changes in equity that have not been approved by the approval authority shall be invalid”.

Thus it has long been accepted that an equity transfer contract that has not yet gained approval is invalid.

However, article 44 of the Contract Law states only that a contract “enters into effect upon approval”. Article 9 of the judicial interpretations of the Contract Law (1), issued by the Supreme People’s Court, specifies that if required approval and registration procedures are not completed, a court should find that the contract has not entered into effect. This introduces the concept of “not having entered into effect”. Paragraph 88 of the minutes of the second national conference on foreign-related commercial and maritime trials specifies that if an equity transfer contract involving a foreign investment enterprise (FIE) has not been approved, it has not entered into effect.

Article 1 of the Several Issues Concerning the Trial of Disputes Involving Foreign-Invested Enterprises Provisions (1) (the Disputes Provisions) issued by the Supreme People’s Court in 2010, again specifies that if an equity transfer contract “has not been approved, the People’s Court shall find that it has not entered into effect. If a party requests that such a contract be ruled invalid, the People’s Court shall reject such request”.

As to the conflict between the Contract Law and the Implementing Regulations, on the one hand, and the Equity Change Provisions, on the other, the author believes that as legislation of a higher order, article 44 of the Contract Law should take precedence.

Legal consequences

Where a contract has entered into effect and a party fails to perform its obligations under the contract, the other party may demand that it do so; in contrast, where a contract has not entered into effect, no such demand may be made.

An invalid contract is not binding on the parties. In contrast, a contract that has not entered into effect is formally binding on the parties in that neither party may terminate it unilaterally, and has substantive binding force in that the parties are subject to subordinate obligations.

For example, if an equity transfer contract has been concluded and approval is pending, neither party may terminate it and the party which is required to submit it for approval must do so.

Rights of the transferee

If the transferor refuses to perform its obligation to submit the contract for approval, the transferee may take legal action, demanding that the transferor perform its obligation, or terminate the contract.

Pursuant to the Equity Change Provisions, it is the FIE that applies for approval to the foreign investment authority, not the parties to the equity transfer contract.

Accordingly, if the transferee brings a suit against the transferor without also bringing a suit against the FIE, the court will be unable to order that approval be applied for. Instead, under article 6 of the Disputes Provisions, “the transferee may institute legal action naming the transferor as the defendant and the FIE as a third party, and request that the transferor and the FIE jointly perform their approval obligation within a fixed period of time”.

If the transferor fails to submit the contract for approval despite a court order to do so, then, under article 8 of the Supreme People’s Court’s judicial interpretations of the PRC Contract Law (2), the transferee may carry out the approval procedures in its place.

Alternatively, the transferee may opt to terminate the contract under article 94 of the Contract Law and seek compensation for its losses. According to the second paragraph of article 6 of the Disputes Provisions, compensation “may include loss due to the price disparity of the equity, the returns on the equity and other reasonable losses”.

As a contract that has not been submitted for approval does not enter into effect and judicial authority may not arbitrarily interfere with administrative authority, a transferee may not directly petition a court for a ruling ordering a transfer of equity. The court can only order the party with the obligation to carry out approval procedures to perform such obligation within a period of time.

If, after review of the equity transfer contract, the foreign investment authority does not grant approval, the contract becomes void. The transferee may institute separate legal action requesting that the transferor refund it the transfer moneys that it has already paid and demanding that the transferor compensate it for its losses.

Rights of the transferor

Once an equity transfer contract has been executed, if the transferee has derived benefits from the FIE, but fails to perform both its approval obligation and its obligation to pay the equity transfer moneys, the transferor may terminate the contract and demand payment.

However, because the contract has not been approved, the transferor has no right directly to demand that the transferee perform its contractual obligations.

The people’s court will then, pursuant to article 9 of the Disputes Provisions, adjourn the case and instruct the transferor to carry out the approval procedures within a certain time. The court will uphold the transferor’s request that the transferee pay the equity transfer moneys only if the equity transfer contract is approved. If it is not approved, the transferor’s only option is to institute a separate legal action in accordance with article 10 of the Disputes Provisions.

Hansen Zhao is a partner at Martin Hu & Partners (MHP Law Firm)