Shareholding ratio and corporate control

What is the impact of different shareholding ratios on shareholders’ rights? What are the risks to the right of control brought by a decline in the shareholding of the original shareholders after the introduction of new investors? What measures are available to protect the right of control? As a legal adviser to companies, the author often receives inquiries from the actual controllers of companies on similar matters, and this article provides a brief analysis and legal advice on those issues.

SHAREHOLDERS’ RIGHTS

From the perspective of corporate governance structure, competition for corporate control mostly arises at the shareholders’ general meeting level. Before analysing how the actual controller can maintain its right of control through a shareholders’ general meeting, it is necessary to first understand the different shareholders’ rights conferred by law under different shareholding ratios.

Shareholders with a shareholding ratio of up to 67% have absolute control of the company and the right to decide, at the shareholders’ general meeting level, on major corporate matters such as amending articles of association, registered capital increases or decreases, and company mergers, divisions and dissolutions or corporate form changes. With a shareholding of up to 50%, shareholders have relative control and the right to vote on ordinary decisions made at shareholders’ general meetings. Shareholders with a ratio of up to 34% have security control and a one-vote veto to directly rule out major decisions made at shareholders’ general meetings.

A shareholding ratio of up to 10% gives shareholders the right to propose convening an extraordinary shareholders’ general meeting and apply to the court for dissolution of the company. Shareholders with a ratio of up to 5% are important shareholders for listed companies and NEEQ-listed companies, entitled to information disclosure, banner acquisitions, and identification of related parties. Shareholders with a ratio of up to 3% have the right of proposal at shareholders’ general meetings.

Shareholders with a shareholding ratio of up to 1% have the right to shareholders’ derivative action. If a director, supervisor or senior manager causes losses to the company due to misconduct, the shareholders may request, in writing, that the board of supervisors or board of directors/executive director bring a suit in court. Under special circumstances, the shareholders also have the right to bring a suit in their own name for the company’s benefit.

In terms of the actual controller’s control over the company alone, in general, the actual controller should be granted: absolute control for more than two-thirds of the shareholding during the start-up period; relatively control over half of the shareholding during rapid development; and secure control over one-third of the shareholding in the mature and listing period. This is a relatively stable and suitable shareholding structure arrangement.

MEASURES TO MAINTAIN CONTROL

Entering into voting rights proxy agreements. Voting rights proxy agreements allow consolidation of the voting rights of minority shareholders (mainly employees/executives/some financial investors) in the hands of the actual controller, increasing the actual controller’s number of voting rights.

Advantage: simple to operate as long as both parties are willing participants.

Disadvantage: the scope of proxy needs to be determined as the share transfer of minority shareholders may lead to changes or invalidation.

Entering into concerted action agreements. The actual controller may sign agreements with other shareholders to vote on matters of the company according to a unified will; when other shareholders disagree with the actual controller, they shall nevertheless vote in concert.

Advantage: simple to operate as long as both parties are willing participants.

Disadvantage: a change in the shareholding of shareholders acting in concert may cause invalidation.

Issuing preferred shares. As preferred shareholders have priority in dividends and compensation, they do not have the right to vote on most matters at shareholders’ general meetings, so the proportion of voting rights of the actual controller will not be diluted.

Advantage: the company can solve financing problems by issuing preferred shares, and the voting rights of the actual controller will not be diluted.

Disadvantage: mainly applicable to listed companies as a higher level of cash flow and dividends are required for the company.

Amending the articles of association. The actual controller may amend the articles of association to specify that shareholders shall exercise the voting rights according to a certain proportion of capital contribution, thereby ensuring the actual controller’s effective control, specifically including setting a higher voting threshold and adding special voting matters and provisions for one-vote veto.

Advantage: through specific provision in the articles of association to increase the proportion of voting rights of the actual controller or reduce the threshold of the one-vote veto, the actual controller ensures its control over major matters.

Disadvantage: amending the articles of association requires the approval of two-thirds of the votes at a shareholders’ general meeting, and such an amendment is bound to be noticed by other shareholders. Establishing a special voting mechanism is a double-edged sword, with each shareholding change requiring an amendment to the articles of association.

Special voting rights mechanism. The special voting rights mechanism, also known as “weighted voting rights mechanism” or “dual-class share structure mechanism”, and commonly referred to as “same share with different rights”, enables the actual controller to get more voting rights than the shareholding structure of “same share with same rights”.

Advantage: the actual controller needs to hold only a small amount of equity to control voting rights at a shareholders’ general meeting. The disadvantage: this mechanism requires an amendment to the articles of association. and conflicts with some existing provisions of the Company Law, so it is currently only applicable to certain Star Market/GEM-listed companies.

Special clause protection. When a company engages in external financing, the actual controller and the investor may agree on a series of clauses including share repurchase in the investment agreement.

Advantage: providing the company develops smoothly and meets the share repurchase requirements, the actual controller may repurchase its shares and increase control over the company in a short time.

Disadvantage: to trigger the share repurchase clause, there are generally certain requirements on the company’s performance or IPO, and the repurchase price is mostly higher than the investment cost, which may put more cash pressure on the actual controller.

Zhang Bo is a partner at Zhilin Law Firm