Equity design from a corporate control perspective

Shenzhen Special Economic Zone´s Regulations on Commercial Registration came into effect on 1 March 2021. Article 4 of the regulations added the provision that “arrangements for differences in voting rights shall be specified in the articles of association if the company sets up a special equity structure according to the law”. This term was misunderstood by the mass media to mean that the “same shares with different voting rights” – or dual-class – structure can be applied by all types of company in Shenzhen, arousing great concern and lively discussion among market players.

The Shenzhen Administration for Market Regulation clarifies that this new revision is to dovetail with the previously released Regulations of Shenzhen Special Economic Zone on Science and Technology Innovation, and the enterprises that can set up these dual-class structures are still limited to science and technology innovation companies.

The reason why the regulations aroused broad discussion is that market players continue to look for more flexible, economic and practical ways to control a company through equity.

Basic control through equity

Under the Company Law, major decisions need to be approved by a vote of shareholders representing at least two-thirds of the voting rights. If the articles of association do not specify special arrangement on voting rights, shareholders of a limited company generally exercise their voting rights in proportion to their capital contribution. A shareholder with 67% or more has absolute control over the company, and a shareholder with 34% or more has a one-vote veto right over major issues. This is the basic way for shareholders to control a company.

This method has high capital requirements for shareholders, especially in the case where a company has a large number of subsidiaries.

Dual-class shares

The dual-class shares structure is a means to exercise effective control over the company by separating capital contribution from voting rights. Under the existing judicial framework in China, enterprises that can set up dual-class structures mainly include limited liability companies, companies limited by shares listed on the GEM and Star Market, and science and technology companies set up in Shenzhen.

But companies need to meet some preconditions to set up this structure. When companies are implementing a dual-class structure, it is recommended to focus on the following issues. First is the effectiveness of the articles of association. Articles of association should avoid obviously unreasonable terms, or the excessive deprivation or restriction of the rights and interests of any shareholder. Otherwise, there is a risk that the validity of the provisions of the articles of association will be negated.

The second issue concerns the filing of the articles. Since there are different documents and procedures required by each administration for market regulation in the different regions, problems may arise where shareholders file articles that do not follow the specific format. Enterprises should therefore pay close and timely attention to the attitude of their local administration for market regulation.

In addition, the legal terms of dual-class shares can also be linked to their transfer, withdrawal and other circumstances. When implementing a dual-class structure, companies should ensure it is based on a fully rounded assessment of the actual situation of the enterprise, the co-operation relationship between shareholders, capital contribution agreement or agreed conditions of capital increase, and the design of the articles of association and other aspects.

Pooling of voting rights

There are many ways of pooling voting rights, including proxy voting and entering into a concerted-action agreement.

Proxy voting means some shareholders delegate their voting power to a representative shareholder. Entering into a concerted-action agreement means that by forming an alliance to achieve a large percentage of votes on a particular matter, shareholders can achieve control over management of a company.

For cases where it is not convenient to adopt the basic way to control a company or a dual-class structure, shareholders can pool voting rights. For companies that do not have a controlling shareholder or actual controller, each shareholder may also make resolutions in this manner.

There is more room in pooling voting rights. For example, shareholders can flexibly design the matters that fall under the pooling of voting rights based on their own concerns. For example, they can set the pooling of voting rights for major voting matters or only for the disposal of important assets, such as land. In this way, resolutions can be achieved while avoiding the potential management problems caused by the indiscriminate long-term binding of different shareholders on all matters.

Pooling of voting rights offers flexibility, but also has its disadvantages – it depends excessively on the personal relations between each shareholder, and if the basis of the personal relationship is lost, control over the enterprise will no longer exist.

Shareholding platform

This approach is mostly based on the establishment of a limited partnership and the partnership’s participation in the company to achieve control. Partners of a limited partnership can be divided into general partner (GP) and limited partner (LP). Only a general partner can execute partnership affairs and take management functions, while a limited partner is only the capital contributor and will not be involved in enterprise management.

The common way such an arrangement works is: The management forms a limited partnership platform as the shareholding entity, and the founding shareholder is the general partner, ultimately achieving control of the voting rights of the company.

A company may be controlled from an operational perspective in addition to the equity one. The board of directors is the operating and decision-making body of the company and plays an important role in the management. In general, control of the board of directors means control of the actual operations of the company. Therefore, the founding shareholders can defend their control by controlling the right to nominate or appoint directors to the board. Certainly, control of the operation of the company also includes control of the position of legal representative, control of the official seal, and other methods. The method used to control a company should also be considered in light of the type, size, and stage of development of the company.

Li Jialin and Xiong Xiaorong are associates at Tiantai Law Firm