When private funds and other institutional investors invest in a startup, they often include a series of special protection clauses in an investment agreement, such as repurchase rights and liquidation preference, to protect their rights as much as possible. On the other hand, they generally refrain from imposing excessive restrictions on control by the founding shareholders of the target company, which may hinder business development.
However, this model relies heavily on the founders of the target company. Since the effect of special protection clauses is still based on the actual value of the target company, the investment would not be effectively protected if founders were to transfer all major assets/business of the target company to any other affiliate or newly incorporated company, either in disregard for the investors’ interests or after a conflict with them.
In the interests of investors, this article focuses on remedies against such malicious transfer of company assets or business by founders. For this purpose, the following remedies should be considered:
Initiate a lawsuit
(1) Legal basis for claiming that founders should assume liabilities. As the direct legal basis for founders’ liabilities, article 21 of the Company Law provides that “controlling shareholders, actual controllers, directors, supervisors and officers of a company shall not damage interests of the company by taking advantage of their affiliated relations”.
(2) Premise for filing a lawsuit on behalf of the company. The target company is the directly damaged party, so investors can claim rights only on its behalf. In this regard, article 151 of the Company Law expressly provides that the premise for directly bringing a lawsuit to a people’s court by shareholder representatives should be preceded by seeking internal remedies by shareholders, with a litigation request being rejected, or receiving no feedback from the board of directors/board of supervisors within 30 days.
Key to determining damages
(1) In the case of asset transfer. In a dispute over damaging the interests of the company, the fairness of the transaction price, rather than the legality of the decision-making procedures of the founders, is the crucial concern for the court in determining whether the plaintiff’s case is tenable. Therefore, the key point of investors’ response is to collect evidence that the founders transferred company assets at an excessively low price, meaning to determine the transfer price and market value of the assets involved. Investors’ claims could normally be supported as long as the transfer price is significantly lower than the market value.
(2) In the case of business transfer. If founders select to transfer the business (such as transfer of customers, qualifications and employees of the target company), in addition to proving the actual transfer of the business by the founders, investors may be requested by the court to prove that the business transferred is highly related to the business of the target company; and that the transfer directly causes losses to the target company. In this case, it’s more difficult for investors to adduce evidence, and highly uncertain whether their claims are supported.
Alert of risks
(1) About legal effect. Initiating a lawsuit for damaging the company’s interest can only protect the target company’s interest and put some pressure on the founders. However, it’s impossible for investors to exit from the target company with shares sold at an acceptable price via litigation when founders refuse to communicate.
(2) About difficulty in adducing evidence. In recent years, founders have opted to select increasingly hidden ways to transfer a company – like hiding their relationship with the affiliates through nominee shareholding – so investors should exercise the right to know the target company, and collect as much relevant evidence as possible.
Repurchase rights of dissenting shareholders
Legal basis for exercising repurchase rights by dissenting shareholders. Article 74 of the Companies Law stipulates that “under one of the following circumstances, a shareholder voting against the resolution adopted by the shareholder’s meeting may request the company to purchase his shares at a reasonable price: … (ii) The company is merged or divided, or its substantial property is transferred,” granting investors the right to exit when the company is transferred.
- Determination of “substantial property”. Courts usually determine the property transferred as substantial property in conjunction with its value and the effect of the transfer on the company operation, using the proportion of the value of the transferred property to the total assets of the company as the main reference. A proportion higher than 30% is deemed substantial property.
- Determination of “reasonable price”. In most cases, courts determine the reasonable price by engaging an appraisal agency to evaluate the value of shares. If founders refuse to co-operate on the evaluation, courts may, at their discretion, determine the value of the target company’s shares based on prima facie evidence provided by the plaintiff, which will be in favour of the plaintiff.
- Determination of “voting against the resolution adopted by the shareholders’ meeting”. In practice, founders may directly transfer property in the absence of resolutions of shareholders’ meeting. For such an issue, the Supreme People’s Court held, in Yuan v Yangtze River Property Development (2014): “Article 74 of the Company Law is designed to protect legitimate rights and interests of dissenting shareholders, and the condition of ‘voting against resolutions’ requires the dissenting shareholders to expressly state their objections to other shareholders”. Based on the spirit of this precedent, investors will be deemed to have satisfied this prerequisite by expressing objections when the target company does not hold a shareholders’ meeting to adopt resolutions.
In summary, both conditions of application and legal effect for filing a lawsuit for damaging the interests of a company are different from those for exercising the dissenting shareholders’ repurchase rights. In the case of the transfer of the company by founders, the investor may choose legal measures by taking into account the method of the transfer, status of the transferred property, the collection of evidence, and necessity of exit, etc., to achieve the investment objective to the fullest extent possible.
Liu Jing is a partner at Han Kun Law Offices. She can be contacted at +86 10 8525 4692 or by e-mail at email@example.com
Qi Hanwei is a paralegal at Han Kun Law Offices. He can be contacted by e-mail at firstname.lastname@example.org