Protecting pledgee’s interests during a capital/share increase

By Ma Yue, Yuan Yimeng and Luo Xue, AnJie Law Firm
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The creation of a pledge over the company equity held by a borrower is a common way of providing security. However, the need to increase or reduce registered capital also often arises in the course of a company’s operations. Current laws and regulations do not place restrictions on a capital/share increase by a company during the term of an equity pledge by a shareholder of a company.

Ma Yue
AnJie Law Firm

In principle, as long as a capital increase is conducted according to law and the company’s articles of association, it is permissible. However, in practice, where a capital increase occurring during the term of a pledge of company equity results in a reduction of the original shareholder’s shareholding percentage, the pledgee may challenge the capital increase by the new investor.

Possible challenges by pledgee

Administrative action

The pledgee may institute a legal action against the registrar that amended the registration, and request revocation of the relevant administrative act. In Dongbao Huimin Village Bank v the Dongbao Municipal Market Regulation Bureau, the plaintiff argued that the registration by the defendant of the capital increase by the third party resulted in the dilution of the pledge of 100% of the equity that it enjoyed against the third party, and requested the revocation of the registration.

The Jingmen Municipal Intermediate People’s Court held that the current legal framework does not place restrictions on increasing the capital contributions to a company with equity that has been pledged, nor does it provide that a registrar is required to notify a pledgee when it amends registration for a capital increase. From this, it can be seen that the registrar’s review obligation did not extend to inquiring about the pledgee’s wishes.

However, in practice, some registrars still set extra-legal requirements to avoid being sued, e.g., releasing the pledge burden before the capital increase, and submission of a written document evidencing the pledgee’s consent to the capital increase, if a pledge exists.

袁亦萌, Yuan Yimeng, Trainee, Anjie Law Firm
Yuan Yimeng
AnJie Law Firm

Civil action

Where a capital increase harms its lawful rights and interests, the pledgee has the right to request invalidity of such civil act based on article 154 of the Civil Code.

In Shenzhen Huirun Investment v Loncin Holdings, a contract dispute case, the Supreme People’s Court (SPC) found the capital increase to be lawful and valid. The court held that the capital increase was an injection of new funds into the target company, and, although the shareholding of the original shareholder of the company was reduced, the value of the company assets did not decrease.

There was no change in the substantive rights of the pledgee when comparing the priority right of repayment, in respect of the relevant reduced equity percentage enjoyed by it before and after the company’s capital/share increase. This means that, in a situation where the capital increase is actually paid in, such capital increase does not harm the lawful rights and interests of the pledgee.

However, in Shenzhen Shengkangda Investment et al v Shenzhen Limingtai Equity Investment Fund, an appeal in a tort dispute, the SPC had a different view and held that, because the new shareholder did not actually pay in after the capital/share increase of Longqiao, the actual assets of the company did not increase. The pledgee’s (Jiuce) 100% equity holding was diluted to 29.98%, which also reduced the value of the actual assets associated with its equity.

Jiuce lost the right to make business decisions for, and to control, Longqiao, resulting in a potential impairment of its original control premium benefits and a drop in its actual market value, and affecting the realisation by Limingtai of its pledge rights. Accordingly, the capital increase in question harmed the interests of the pledgee, Limingtai.

Some recommendations

From the above-mentioned cases it can be seen that, in determining the validity of such capital increases, the review focuses on whether there is malicious collusion, between the new investor and the original shareholder, to the detriment of the pledgee’s interests.

The timing of, deadline for, and entity involved in a capital increase must be reasonable.

For example, in the Limingtai case, the capital increase was made by an affiliate of the target company, and the resolution on the capital increase was approved less than half a month after the pledge, but the deadline for the capital increase was set as the two years before the expiration of the term of operation, making it impossible not to suspect that the purpose of the capital increase was to dilute the pledgee’s equity percentage and transfer the control over the target company.

Accordingly, when the capital of a company with equity that has been pledged is being increased, the investor is required to fully consider the rights and interests of the pledgee, and the capital increase must be reasonable.

The new investor must have a reasonable capacity to make the capital increase.

Under the registered capital subscription system, the actual investment capacity of a company is not fully reflected in its registered capital, but if there is a significant gap between its registered capital and the capital contribution to the target company it has subscribed for, suspicions may arise as to its capacity to make the capital increase. Accordingly, the investor needs to provide financial information evidencing its financial strength.

A capital increase should ensure that the pledgee’s rights and interests are not affected.

The key to the protection of the pledgee’s rights and interests depends on whether the new capital contribution is paid in. If paid in, the value of the company’s assets associated with the original shareholder’s shareholding percentage after the reduction does not change, and the actual benefit that can be derived from priority repayment in connection with the pledge set before the capital increase does not change, so the capital increase is likely to be valid.

Finally, if a capital increase has genuinely been fully paid in, the question of whether a premium loss brought on by a loss of control arising due to a dilution of the shareholding percentage will be found to have harmed the pledgee’s interests, and result in the invalidation of a capital increase, still awaits further exploration in judicial practice.

Ma Yue is an associate and Yuan Yimeng is a trainee at AnJie Law Firm. Luo Xue, a trainee at the firm, also contributed to the article

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