Protecting private enterprises in mixed ownership acquisitions

By Moon Yan, Concord & Partners
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Coal Company originally had individual shareholders A and B. On 10 October 2009, A and B executed an equity transfer contract with state-owned enterprise (SOE) C, specifying that A and B were to transfer their 60% equity interest in Coal Company to C for a total price of RMB480 million (US$78 million). Given that Coal Company would then become a joint stock limited company jointly organised by natural persons A and B and the enterprise C, in which C held a 60% controlling interest, the equity transfer contract set forth the following special terms:

延丽 Moon Yan 共和律师事务所 合伙人 Partner Concord & Partners
延丽
Moon Yan
共和律师事务所
合伙人
Partner
Concord & Partners

“Within three months after A and B submit a written application to transfer the [remaining] 40% equity interest held by them, C must agree to acquire such equity interest, and A and B shall assist in duly handling the procedures for the equity change and paying the price in full. If A and B propose to transfer the [remaining] equity interest within two years after completion of the contemplated [60%] equity transfer, the transfer price shall be based on the calculation basis of RMB320 million for the 40% equity interest and increased at a rate of 15% per year; if they propose the transfer more than two years after completion of the contemplated equity transfer, the transfer price shall be determined by the parties through consultations based on the principle of value preservation/increase and the evaluated net asset value of Coal Company at the actual time of the equity transfer.”

On the day of executing the equity transfer contract, A, B and C amended the company’s articles of association, specifying that when the shareholders’ meeting resolves to increase or reduce the company’s registered capital, divide, merge, dissolve or change the corporate form of the company, or amend the company’s articles of association, the votes of shareholders representing two-thirds of the voting rights were required for adoption, and other matters required the votes of shareholders representing more than one-half of the voting rights for adoption.

On 20 October 2009, Coal Company completed the procedures for registration of the change in the 60% equity interest and C paid the full transfer price by 30 November 2009. Thereafter, a serious difference of opinion on the business philosophy arose between the parties. On 15 November 2011, A and B submitted a written application to C for the transfer of the remaining 40% equity interest.

In the course of the said transfer, a serious difference of opinion arose between the parties over the special terms of the equity transfer contract. Accordingly, A and B submitted an application for arbitration. The points of dispute were as follows:

Special terms

A and B argued that by the special terms they secured the right to divest at any time, and that the terms were lawful and valid; additionally, from the perspective of contract theory, the special terms were of the nature of a pre-arranged agreement, an agreement that was fully capable of being performed in reality. Therefore, C was required to perform it accordingly.

C argued that as it was an SOE, the provisions of the special terms specifying that it must agree to and complete the acquisition within three months and the locked price, if A and B proposed the transfer within two years, violated regulations on the valuation and administration of state-owned assets and were therefore invalid; and the invalid special terms did not have performance validity ab initio. Accordingly, A and B did not have the right to require C to purchase their 40% equity interest in accordance with the special terms.

Point in time

A and B argued that in an equity transfer the transferor normally bears two major obligations: (1) completing the procedures for registration of the equity change; and (2) handing over the right to manage the target company to the transferee. The transferee usually bears one major obligation, namely payment of the transfer price. It was only once the above-mentioned obligations were entirely completed, and neither party had any further rights against or obligations owing to the other, that the equity transfer was deemed completed. In this case, the date on which C paid the last instalment of the transfer price, 30 November 2009, should be deemed the date of completion of the equity transfer in question. Accordingly, for the transfer price for the 40% equity interest, the calculation method for when A and B submit a transfer application within two years should apply.

C argued that since laws and regulations are silent on the “completion of an equity transfer”, and since completion of registration of the change had notification effect, 20 October 2009, the date of completion of registration of the change, should be deemed the date of “completion of the equity transfer”. Accordingly, for the transfer price for the 40% equity interest, the calculation method for when A and B submit a transfer application more than two years after the transfer should apply.

The recommendations

With the powerful encouragement given to the mixed ownership economy by the state since the Third Plenum, there will be an increasing number of equity acquisitions between private enterprises and SOEs. Although the pursuit of profit is a demand common to both, it cannot be denied that there exists a certain conflict between the business philosophy of SOEs – which are required to consider political results, social responsibility and other such matters while also pursuing profit – and private enterprises that seek to maximise profit.

Accordingly, we recommend that in carrying out an acquisition and executing a contract with an SOE, a private enterprise needs to actively design individualised articles of association terms to protect its rights and interests, and should not simply use the administration for industry and commerce’s standard version. If it fails to do so, when it becomes a minor shareholder, and the articles of association solely comply with the principle of the minority submitting to the majority, it is entirely possible that it will find itself in an untenable position.

It is also necessary to pay closer attention to SOE-related laws and regulations so that the design of the acquisition clauses complies with current laws; additionally, the key terms in the contract provisions should be clarified by defining them so as to avoid unnecessary disputes arising in the course of the performance of the contract.

Moon Yan is a partner at Concord & Partners

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