The New Company Law: Part 2 - Shareholders

Obligations of Shareholders in Case of Share Transfer

If a shareholder transfers its shares without the corresponding share capital being fully paid in, the buyer of the shares is liable for paying the unpaid share capital. In the event that the new shareholder defaults (that is does not pay the remaining unpaid capital in full or in time), the new regulations stipulate that the selling shareholder has a secondary (and not a joint and several) liability to pay in the unpaid share capital (that is a claim against the selling shareholder may be brought forward only after enforcement against the acquiring shareholder is unsuccessful).

If, on the other hand, the shareholder transferring its shares is already in breach of the capital payment obligation at the time of the share transfer (i.e., payment has not occurred within the specified terms, has been made for a lesser amount, or assets of lesser value have been contributed), the selling shareholder and the acquiring shareholder are both jointly and severally liable for the amount of unpaid capital. 

The acquiring shareholder can avoid such liability only by proving that it was unaware, and ought not to have been aware, of the circumstances regarding the insufficient capital payment (such a fact being, in any case, difficult to verify and even more difficult to demonstrate).

Right of Withdrawal of Minority Shareholders

The new regulations provide for a particular case of right of withdrawal granted to minority shareholders in the event a controlling shareholder abuses its rights deriving from its position and seriously harms the interests of the company or the other shareholders. In such a situation, minority shareholders are given the right to have their shares purchased back by the company at a reasonable price. 

The new provisions also state that the relevant shares must either be transferred or cancelled within six months.

The new rules regarding payment of share capital aim to ensure an effective and adequate capitalisation of companies, in line with the stated scope of business, thereby guaranteeing a sufficient and consistent contribution of financial resources to the company. At the same time, the new provisions give greater weight and offer a higher level of protection - when compared to the previous provisions - to the rights and expectations of creditors, as opposed to the rights of shareholders which appear now to be relatively diminished.

Also, the reformed regulations imply the recommendation that the shareholders control the situation of the share capital payments of the other shareholders, so as not to risk being held responsible for the defaults of others.

Moreover, the new rules on capital payment and the resulting liabilities for the shareholders selling or acquiring shares strongly suggest additional caution both at the moment of incorporation of the company, where the amount of the share capital must be determined with greater care and judgment, and when shares are transferred. 

Such accrued caution in verifying the level of capitalisation, implies a careful analysis of the compliance of the shareholders vis-à-vis their obligations of capital payment, as well as a verification of any possible liability that may arise on the transferees of shares (and, in some cases, also onto the transferors).

Similarly, the new rules on share capital payment assign stronger duties of verification on, and require a more proactive attitude from, the directors, who may find themselves in situations of opposition or actual conflict of interests with the shareholders when called to perform their duties.

Although a separation and sometimes opposition of roles is in line with the principles governing the functions of company organs and their relationships in other legal systems, it is important to keep in mind such increased distinction of roles and distribution of responsibilities in the Chinese company legal system, especially with regard to those small foreign-invested companies where the management body (often a sole director) is a direct emanation of the shareholders (or, often, the sole shareholder) and has a close contact and relationship with the ownership.

In this regard, particular attention should be paid to the provisions of the articles of association where a detailed regulation of the roles and responsibilities of shareholders and directors should be included to avoid any situation of potential conflict.

Finally, depending on circumstances, some situations can also be adequately dealt with in shareholders’ agreements, the contents of which are binding only between the parties to the same and prevail over the provisions of the articles of association (that, instead, are meant to be applicable to all current and future shareholders).

Prohibition of Financial Assistance

The new Company Law introduces basic rules regarding the prohibition of financial assistance, like in many other legal systems. This prohibition intends to prevent (or, better, limit) the possibility for a company to provide loans or guarantees aimed at facilitating the acquisition of its own shares (or shares of its controlling company), primarily to protect the minority shareholders and creditors of the company.

The prohibition is not absolute: financial assistance is still allowed if it is finalized towards the implementation of a plan promoting the purchase of shares by employees of the company or is in the interest of the company (as expressly established by a resolution of the shareholders or directors, in the latter case based on the provisions of the articles of association or an explicit authorization of the shareholders', and in any case with the positive vote of at least two thirds of all the directors).

However, the total amount of financial assistance cannot exceed 10% of the issued share capital.

Exceptions to the Limited Liability of Shareholders

In Chinese LLCs - like in limited liability companies under many other legal systems - the shareholders are not personally liable for the company's debts and obligations, even if they have acted on behalf of the company.

Therefore, in principle, a limited liability company is liable for its debts and obligations only with its own assets, and its shareholders generally benefit from a liability that is limited to what they had committed to contribute. 

Such a principle implies that, in the event a company does not pay its debts, its creditors do not have a right of recourse against the personal assets of the shareholders.

The Company Law sets forth exceptions to the principle of limited liability of shareholders by establishing that if a shareholder abuses its rights and prevents the company from paying its debts and, in doing so, causes substantial damage to the company's creditors, the abusing shareholder is jointly and severally liable for the debts of the company.

The regulations consider not only the abuse by the shareholder of the advantages of the limited liability relating to the company of which it is a shareholder (so-called "vertical" abuse), but also situations where the abuse involve other companies controlled by the same shareholder (so-called "horizontal" abuse), providing for in this latter case a joint and several liability of all the companies involved.

Still on the topic of the limited liability of the shareholders, it is interesting to note the provision that establishes a joint and several liability of the sole shareholder for the debts of the company if the sole shareholder fails to demonstrate that the company's assets are actually independent from the shareholder’s assets. The burden of proving that the assets are indeed separate lying, therefore, with the sole shareholder.

Liability of the Controlling Shareholder and Actual Controller of a Company

The new Company Law contains some provisions for those subjects that control a company and interfere or exercise influence on the management of the company.

Controlling subjects are defined by the company law (both in the current version and in the reformed one) in two categories: 

The new regulations establish that a controlling shareholder or an actual controller who, although not appointed as a director of the company, effectively carries out activities on behalf of the company, is then obliged to abide by the duties of loyalty and diligence towards the company (similarly to a director, supervisor, or other senior manager) and, consequently, assume the responsibilities for any breach of such duties.

Likewise, if a controlling shareholder or the actual controller gives instructions to a director or a senior manager to engage in behaviours that damage the company or its shareholders, the controlling shareholder or actual controller will be considered jointly and severally liable together with the involved director or manager.

The provisions regarding the controlling shareholder add to those mentioned above concerning the abuse of such a position and the consequent granting of a right of withdrawal to the minority shareholders that have been damaged.

The new Company Law will most certainly require LLCs to amend their articles of association or adjust their corporate or governance structure so as to comply with the new provisions. Such amendments and adjustments will be easier to implement in LLCs with a sole shareholder (or multiple foreign shareholders that are somehow connected, coordinated, or otherwise sharing the same objectives and interests regarding their investment in China). 

However, such adjustments could prove more complicated to implement where the collaboration and consent of one or more Chinese shareholders are necessary (like in the case of joint venture companies), as the need or request for adaptation to the new legal environment could also give rise to a pretext for renegotiating some elements of the existing agreements between shareholders, thus redefining the equilibrium in the control and management of the company.

At this stage, it is advisable for those who hold a position of shareholder, director, supervisor or senior manager within a Chinese company to start becoming familiar with the new provisions of the Company Law, while closely monitoring the development of the law, so as to be ready to implement the necessary adjustments when the implementation provisions will be issued to supplement and clarify the new regulations.

(to be continued)