The Supreme People’s Court Several Issues Regarding the Hearing of Disputes Involving Foreign Investment Enterprises Provisions (I) (the Judicial Interpretations) came into effect on 16 August. They were issued primarily to regulate disputes arising during the establishment of and changes in foreign investment enterprises (FIEs). They do not deal with disputes which are increasing as a result of mergers and acquisitions involving foreign parties.
Validity of contracts subject to approval
Pursuant to relevant Chinese laws and administrative regulations, agreements or contracts concluded during the establishment of or changes in FIEs are generally required to be reported to the approval authorities for approval. Before the implementation of the Judicial Interpretations, contracts subject to administrative approval under laws or regulations but not yet approved were generally deemed invalid by the People’s Courts, and the enforceability of the clauses under those contracts denied.
The Judicial Interpretations provide that if any contracts become effective only after being approved by FIE approval authorities under laws or administrative regulations, they will become effective from the date of approval.
The People’s Courts should treat those contracts not yet approved as “not effective” rather than “invalid”. Where contracts have been deemed “not effective”, this will not affect the duty of the parties to perform obligations relating to approval nor alter the effectiveness of clauses created as a result of the obligations for approval.
The Judicial Interpretations also confirm the effectiveness of supplementary agreements to contracts that are subject to approval, saying if a supplementary agreement does not create any significant or substantial change to an approved contract, the granting of an approval by the approval authorities is not an essential requirement for the effectiveness of the supplementary agreement. Nine items are deemed to constitute “a significant or substantial change”, including any change in the registered capital, the type of company, scope of business or term of operation and any transfer of equity.
Disputes over unapproved equity transfer contracts
Where an FIE enters into an equity transfer contract, but the transferor does not perform its obligations relating to approval for any of a number of reasons such as an increase in the value of the equity, the contract is not effective. For this reason, the Judicial Interpretations specify a number of remedies for the transferee. Firstly, if the transferor has not yet fulfilled the obligations relating to approval within a reasonable period after being urged by the transferee, the transferee may request termination of the contract and compensation by the transferor for actual loss suffered. Secondly, the transferee may request both the transferor and the FIE to fulfil the obligations, or may request that the transferee reports for approval on its own if the former fails to perform its obligations. Thirdly, if the transferor refuses to enforce the ruling of a People’s Court on fulfilling its obligations for approval, the transferee may request the termination of the contract. Moreover, the losses that may be claimed may be extended from actual losses to losses of equity price differences, equity earnings and other reasonable losses.
In practice, there are also some cases in which transferees do not pay for equity transfers. The Judicial Interpretations offer two remedies to the transferors: if it is agreed in an equity transfer contract that transferee’s performance of an obligation to pay comes in chronological order before the transferor’s obligations for approval, and if the transferee has not fulfilled its payment obligations within a reasonable period after being urged, the transferor may request termination of the contract and claim damages; if the two parties do not set any chronological order for the fulfilment of their obligations, and they are entitled to different “defensive rights of simultaneous performance” as stipulated under the PRC Contract Law, the court may “order the transferor to complete approval procedures within a certain period of time” and, depending on whether the equity transfer contract is approved or not, determine whether the transferee must fulfil the obligation to pay for the equity transfer.
Protection of shareholders’ rights of pre-emption
Both the PRC Sino-foreign Equity Joint Venture Law Implementing Regulations and the PRC Sino-foreign Cooperative Joint Venture Law Implementing Regulations provide that one party to a joint venture “must obtain the consent of the other parties to the joint venture” if it wants to assign all or part of its equity to a third party. The Judicial Interpretations specifically interpret that “consent” here means “must obtain the unanimous consent of other shareholders”, which is different from the requirement in the PRC Company Law for “consent by a majority of other shareholders”. The Judicial Interpretations cite two scenarios where “consent is deemed by other shareholders”, which are compatible with the PRC Company Law: “a transferor has given a notice in writing of an equity transfer, and other shareholders have not given a reply after 30 days from the date of the receipt of the notice”, or “other shareholders do not agree to the transfer or do not purchase the transferred equity”.
The Judicial Interpretations clearly describe the impact of the failure to protect the rights of pre-emption of other shareholders in an equity transfer on the effectiveness of a contract for the equity transfer: “if a shareholder of an FIE assigns all or part of its equity to a third person other than a shareholder, and other shareholders petition for the rescission of the equity transfer contract on the grounds that their rights of pre-emption have been prejudiced by the equity transfer, a People’s Court should rule in favour of the petition”. However, “if the transferor and the transferee petition that the equity transfer contract be deemed invalid on the grounds that it prejudices the rights of pre-emption of other shareholders, a People’s Court should rule against the petition”. It should be noted that the Judicial Interpretations also set forth a scheduled period for shareholders to exercise their rights of pre-emption: “shareholders must exercise such rights within one year from the date on which they are or should be aware that an equity transfer contract was concluded”.
Disputes over anonymous investments
Pursuant to the Judicial Interpretations, anonymous investment agreements that breach or evade Chinese laws or administrative regulations should be deemed invalid. Moreover, remedies are set forth for anonymous investments under different scenarios.
First, a People’s Court should rule in favour of a petition by an anonymous investor for confirmation of his identity as a shareholder if a number of conditions are satisfied, including: (1) the investor has made an actual investment; (2) other shareholders have approved the identity of the actual investor as a shareholder; and (3) the People’s Court or the parties have obtained consent from the FIE approval authorities of the change from an anonymous investor to a shareholder during the proceedings.
Second, the People’s Court should rule in favour of the petition by an anonymous investor to request named shareholders to execute entrusted investment agreements. Provided the particulars of an entrusted investment agreement are not in breach of prohibitions contained in Chinese laws or administrative regulations, such agreement may not be deemed ineffective or invalid due only to the failure to carry out approval procedures. A People’s Court should rule in favour of a petition by an anonymous investor to request named shareholders to pay the profits for distribution and other interests of an FIE pursuant to agreements. Named shareholders should be liable for compensation if they cause losses to anonymous shareholders due to their breach of contract.
Third, if an entrusted investment agreement is invalid, in order to achieve a reasonable balance between the interests of both parties, a People’s Court should take a different approach to identify the differences in the equity under the name of a named shareholder, whether “the equity value is higher than the actual amount of investment” or “the equity value is lower than the actual amount of investment”. However, if a contract between a named shareholder and an anonymous investor is found to be invalid due to damage to national, collective or third party interests as a result of malicious conspiracy, the property acquired should be recovered by the state or returned to the collective or the third party.
Disputes over capital contributions
In practice, disputes over capital contributions by FIEs commonly occur in relation to the contribution of in-kind land and real property which require registration. For land or real property which has been delivered to an FIE for actual use and has not been registered, the Judicial Interpretations specify that the contributing shareholders should be deemed to have fulfilled their contribution obligations if they have completed registration procedures within a time limit designated by a People’s Court, and the People’s Court should rule against the petition of other shareholders to restrict the interests of the contributing shareholders. However, the contributing shareholders should be liable for compensation if losses are caused to the joint venture due to delay in registration.
The Judicial Interpretations also contain detailed provisions on how to deal with various cases such as disputes over pledge contracts for the equity of FIEs, and disputes over the equity of FIEs due to the approval of changes in equity based on false information provided. It is understood that the Supreme People’s Court will make a separate set of Judicial Interpretations (II) on the application of laws to disputes over the dissolution, liquidation and other aspects of FIEs.
Business Law Digest is compiled with the assistance of Haiwen & Partners. The authors can be emailed at baochen@haiwen-law.com. Readers should not act on this information without seeking professional legal advice.
