The Company Law (Third Review Draft), deliberated by the 5th session of the Standing Committee of the 14th National People’s Congress on 1 September 2023, for the first time adds a provision (article 224) stating: “A company shall reduce its registered capital by reducing the amount of capital contributed, or shares held by shareholders, in proportion to their capital contribution or shareholding, except as otherwise provided for by any law.”
This provision limits the company’s capital reduction to proportional capital reduction, and is sparking great controversy.
The current Company Law does not distinguish between the proportionate capital reduction of shareholders and disproportionate capital reduction of individual or minority shareholders, known as “targeted-specific capital reduction”.
It only stipulates in article 43 that a resolution of the shareholders’ meeting on the decrease of registered capital can be approved by shareholders representing two-thirds of the voting rights.
Compared to proportional capital reduction, targeted-specific capital reduction causes company property to flow to individual or minority shareholders and changes the equity structure. As a result, these shareholders may reduce their holdings or withdraw from the company.
Therefore, targeted-specific reduction can easily be utilised by principal shareholders to jeopardise the lawful rights and legitimate interests of minority shareholders.
For example, shareholders representing more than two-thirds of the voting rights can make a resolution on targeted-specific reduction by majority voting method, obtaining the company’s property, and even withdrawing their money, without the consent of minority shareholders. Especially when the company is suffering from a loss, the minority shareholders will de facto disproportionately bear more or all of the deficit.
To protect their legitimate rights and interests, the newly added provision of the third draft stipulates that companies must reduce the amount of capital or shares according to the proportion of their shareholders’ capital or shares; and prohibits individual or minority shareholders from withdrawing their contribution, or even exiting from the company through targeted-specific reduction. This aims to realise the legislative purpose of “equal protection of property rights”.
Targeted-specific capital reduction has already been extensively used in commercial practice, such as in the valuation adjustment mechanism (VAM). It is one of the major ways for investment institutions to obtain returns and withdraw from the target company.
Existing judicial practice has also formed a certain consensus on the rules of VAM and targeted-specific capital reduction. For example, the Minutes of the National Courts’ Civil and Commercial Trial Work Conference determine that targeted-specific reduction is indispensable to fulfilling equity repurchase VAMs.
However, as mandatory provisions, the new provision limits the company’s reduction procedure to proportional capital reduction, which leaves no room for autonomy of will for targeted-specific reduction. Even if it is unanimously agreed by all shareholders, or otherwise provided for in the articles of association, such reduction may still impose a legal risk by violating the provision.
This provision, if adopted, will have a great impact on the practice of the Company Law.
It not only violates the autonomy of will and freedom of transaction in commercial practice, restricting the paths for investment institutions to obtain investment returns and withdraw from the target companies, making institutions more cautious in equity investment and leading to an increase in enterprise financing cost in disguise.
It also denies the judicial practice and rules that have been determined in recent years, distorting the basic expectation of rules on VAMs and the targeted-specific reduction in commercial transactions.
In Hua Hongwei v Bugs and neighbours, an outstanding case of the national court system in 2019, judicial practice gave a reasonable response on how to protect the rights and interests of minority shareholders in the case of targeted-specific reduction.
This judgment pointed out that a disproportionate capital reduction will directly reshape the distribution of equity established when the company was founded, and should be unanimously agreed by all shareholders unless otherwise agreed by all shareholders or the company’s articles of association.
The authors believe that the existing Company Law does not distinguish between proportional and disproportionate capital reduction, and is probably utilised to jeopardise minority shareholders, so it therefore requires amendment.
However, the proposed revision should also consider existing commercial and judicial practice, and should not completely block legitimate paths for targeted-specific capital reduction.
The above-mentioned judgment is worthy of reference. The current revision of the Company Law may consider adding effective conditions for targeted-specific reduction, requiring the articles of association to preset applicable conditions or procedures, or unanimous consent of all shareholders, or approval from more than two-thirds of non-affiliated shareholders with voting rights.
Such a provision would not only prevent principal shareholders from obtaining the company’s property or even withdrawing completely from the company through the capital reduction procedure without the consent of minority shareholders, realising the legislative purpose of protecting the legitimate rights and interests of minority shareholders.
It would also retain the access for investment institutions to obtain returns and withdraw from target companies, striking a balance between the protection of minority shareholders’ rights and interests and the autonomy of will and freedom of transaction.
Written by the Company Legal Affairs Department of Lianyue Law Firm