China Special Situations Insight (May June July 2024)
JunHe's Special Situations team led by Catherine Miao has been actively involved in the special situations and alternative investment practice since 1999 and has been at the forefront of providing legal services in this area in China. The team has represented numerous landmark cases in the market such as representing a financial AMC in the first foreign investment in the disposition of non-performing assets in China in 2002, and representing Citigroup Global Markets Asia Limited in the first acquisition by a foreign investor of a NPA portfolio through buyout in China in 2004.
We have advised financial AMCs, local AMCs, investment banks, commercial banks, special situations funds, mezzanine funds, private credit funds, hedge funds, real estate companies, trusts, large private AMC, asset exchanges and large non-financial businesses, on various special situations transactions, including acquisition and disposition of NPLs, acquisition and restructuring of distressed businesses, debt to equity swaps, cross-border acquisition financing, structured financing, leveraged financing, direct lending, acquisition of distressed listed companies, and other investments including turnaround investments, investment in bailout funds, investment in property at court auctions, investment in bankruptcy reorganization, alternative investment, other high-yield investments and the financing of debt and equity in distressed and opportunistic situations. Our representation has involved special situations transactions with an aggregate asset book value of more than RMB 100 billion.
We have been sharing our insight in the special situations market in China, and this newsletter assembles all articles we published in May, June and July of 2024 for your easy reference.
Introduction
On December 29, 2023, the Standing Committee of the National People's Congress officially passed the newly amended Company Law of the People's Republic of China (the “New Company Law”), which came into effect on July 1, 2024. The New Company Law represents a significant overhaul of the Company Law amended in 2018 (the “2018 Company Law”), with substantial amendments touching upon approximately 112 articles, introducing significant changes to the current legal landscape. Given that setting up an onshore corporate vehicle has long been a notable avenue for foreign investors to participate in China's non-performing loan (“NPL”) market, the implementation of the New Company Law will hold implications for both their existing corporate entities and prospective investments employing such vehicle. In this article, we will delve into the key amendments introduced by the New Company Law. It is important to note that as the limited liability company (“LLC”) stands as the most commonly adopted legal form of corporate vehicle for foreign investments in China, this article will focus on the amendments relevant to LLCs.
I. Reinforcement of Shareholders' Capital Contribution Obligation
(First published on JunHe's LinkedIn page on 8 May 2024)
One noteworthy amendment introduced by the New Company Law concerns the reinforcement of shareholders' obligation regarding capital contributions.
1. Significant Changes
1.1 Five-year Capital Injection Requirement
Under the 2018 Company Law, there was no specific timeline mandated for shareholders of an LLC to make their capital contributions. Shareholders of LLCs have the flexibility to determine the schedule and timeline for shareholders' capital contributions within its operational term and as stipulated in its articles of association. However, the New Company Law requires that shareholders of an LLC must pay their subscribed capital in full within five years of the company's establishment (Art.47). This requirement also extends to scenarios involving capital increase, where shareholders must fully pay in the increased capital they subscribed for within five years from the completion of the capital increase (Art.228).
As for LLCs incorporated prior to the implementation of the New Company Law (the “Existing LLCs”), according to the Provisions of the State Council on Implementation of the Registered Capital Registration Management System of the Company Law (the “Provisions on Registered Capital Registration”) issued by the State Council on July 1, 2024, a three-year transition period, from July 1, 2024, to June 30, 2027, is granted to such Existing LLCs. During this transition period, Existing LLCs are required to adjust its capital contribution timeline in its articles of association to no more than five years if their original capital contribution timeline exceeds five years after June 30, 2027. In other words, the registered capital of all Existing LLCs is generally required to be fully paid in no later than June 30, 2032.
1.2 Forfeiture of Equity Interest
The New Company Law mandates the board of directors (the “BoD”) of an LLC to demand that the shareholders make any capital contribution that is due through a written notice (Art.51), specifying a grace period of no less than sixty days. If a shareholder fails to make the capital contribution within the specified grace period, the BoD may issue a forfeiture notice, leading to the immediate forfeiture of the shareholder's equity interests corresponding to the outstanding capital contribution. The equity interests forfeited can then either be transferred to another party or cancelled through a reduction of registered capital. If these forfeited equity interests are not addressed within six months, the remaining shareholders of the LLC will be responsible for making up for the outstanding capital contribution based on their respective equity ratio. However, Shareholders disputing the forfeiture have the right to file a lawsuit within thirty days of receiving the notice (Art.52).
1.3 Acceleration of Capital Contribution
Before the implementation of the New Company Law, the acceleration of shareholders' capital contribution obligations is constrained, which can only be triggered under limited circumstances, such as bankruptcy procedure, company dissolution, or instances of deliberate debt evasion by shareholders. However, with the implementation of the New Company Law, an LLC and its creditors shall have the right to require shareholders to advance their capital contribution once the LLC is unable to repay a due debt (Art.54). Referring to the Bankruptcy Law of the People's Republic of China, the people's court shall determine that a debtor is unable to repay a due debt when 1) the debtor-creditor relationship has been legally established; 2) the term for repayment of the debt has become mature; and 3) the debtor has not fully repaid the debt. Whether the New Company Law will adopt similar criteria to define a company's incapacity to repay a due debt is pending further judicial interpretations and accompanying implementation rules.
Our observations
The introduction of the five-year capital injection requirement, along with the mechanisms of forfeiture of equity interest and acceleration of capital contribution obligations to prompt shareholders to make timely contributions, reflects the New Company Law's tilt towards protecting the interests of creditors. In light of this, foreign investors intending to establish an LLC in China to participate in the NPL market are advised to prudently assess and decide on the subscribed registered capital amount.
For Existing LLCs, it is recommended that foreign investors promptly review their articles of association and, where necessary, make amendments to ensure compliance with the new capital contribution period requirements mandated by the New Company Law and the Provisions on Registered Capital Registration. Additionally, it is important to ensure that full and timely capital contributions are made in accordance with these requirements.
II. Heightened D&O Obligations and Liabilities
(First published on JunHe's LinkedIn page on 22 May 2024)
In this chapter, we focus on the amendments in the New Company Law regarding the obligations and liabilities of directors, supervisors and senior officers (collectively, “D&O”) of LLCs.
Compared to the 2018 Company Law, the New Company Law imposes more obligations and greater liabilities for D&O, which are worth foreign investors' attention when selecting candidates for these positions.
2. Key Amendments
2.1 Defining Fiduciary Duty and its Scope of Application
The 2018 Company Law generally stipulates that D&O owe a fiduciary duty to a company, encompassing both the duty of loyalty and the duty of care. However, it does not specify the meaning of these duties, which has caused confusion in practice. The New Company Law establishes precise definitions for fiduciary duties under Article 180, providing clearer guiding principles for D&O in fulfilling their roles:
Furthermore, the New Company Law extends fiduciary duty to the controlling shareholder or actual controller of a company, who may not serve as a director but have de facto control of a company's operations (Art. 180). If any controlling shareholder or actual controller of a company instructs any director or senior officer to act in a way detrimental to the interests of the company or its shareholders, they shall bear joint and several liability with such director or senior officer (Art. 192).
2.2 Maintaining Capital Adequacy
As introduced in the previous chapter, the New Company Law mandates a five-year capital injection requirement for shareholders, who face the risk of the forfeiture of equity interest if they fail to make full and timely capital contributions. To ensure compliance with these new mandates, the BoD is now obligated to verify shareholders' capital contributions according to the injection schedule provided in the company's articles of association within the five-year time limit. If a shareholder is found to have not made the required contribution on time, the BoD shall call upon the shareholder for the outstanding contribution. Should the BoD fail in the said duties, resulting in losses to the company, the accountable director(s) will be held liable for compensation (Art.51).
Additionally, the New Company Law states that all accountable D&O will be held personally liable for the compensation of losses incurred by the company due to the illegal withdrawal of contributed capital by a shareholder, unlawful profit distribution and unlawful capital reduction.
2.3 Tightened Regulations on Related-party Transactions, the Pursuit of Business Opportunities and Competitive Business Practices
As part of D&O's duty of loyalty, the 2018 Company Law prohibited directors and senior officers from engaging in related-party transactions, pursuing business opportunities from the company, or engaging in business in competition with the company (collectively, the “Matters”) without first obtaining proper internal approval in the company. The New Company Law further strengthens regulations for D&O on the Matters as follows (Arts. 182-185):
(1) Expanding the scope of regulation to include supervisors, in addition to directors and senior officers;
(2) Establishing the obligation for D&O to report any Matters;
(3) Requiring interested directors to abstain from voting on the Matters at BoD meetings. (If the number of unrelated directors present is less than three, the Matters shall be further submitted for deliberation at the shareholders' meeting).
For related-party transactions, the definition of “related parties” has been broadened to include: (i) close relatives of D&O; (ii) enterprises directly or indirectly controlled by D&O or their close relatives; and (iii) other related parties with any other related-party relationship with D&O.
Any income obtained by D&O not in compliance with the above requirements will be entirely allocated to the Company.
2.4 Compensation liability for third parties
Under the 2018 Company Law, third parties could only claim damages against the company for harm caused by the acts of its directors and/or senior officers in the performance of their duties. The New Company Law allows third parties to directly claim against and hold directors and/or senior officers personally liable if the damages result from their willful misconduct or gross negligence (Art.191).
Our observations
The New Company Law imposes greater obligations and liabilities on D&O. This is to enhance independence in their roles and strengthen the power balance within corporate governance, thereby fostering the development of the company while safeguarding the interests of its creditors. Candidates for D&O positions in foreign-invested enterprises (“FIEs”), however, may be concerned about the increased professional risks.
To mitigate against the repercussions of these growing responsibilities, companies may consider purchasing D&O liability insurance or adjusting their existing coverage to protect their D&O. For the first time, The New Company Law encourages companies to purchase D&O liability insurance (Art.193). It is important to note that the BoD is required to report all details regarding their purchased D&O Insurance at a shareholders' meeting.
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III. Reshaping Corporate Governance
(First published on JunHe's LinkedIn page on 19 June 2024)
In this chapter, we focus on the amendments in the New Company Law regarding the corporate governance of LLCs.
Compared to the 2018 Company Law, the New Company Law has significantly reshaped the corporate governance landscape of LLCs, offering greater flexibility in governance structures and arrangements.
3. Significant Changes
3.1 Relaxing the requirements for setting up a separate supervisory organ
Depending on whether the supervisory function is integrated within the executive board or conducted by a separate supervisory board, the corporate governance structure can be classified into one-tier and two-tier board models. The 2018 Company Law adopted the two-tier board model, under which the BoD was responsible for the day-to-day management of an LLC while a separate board of supervisors were tasked with overseeing both the BoD and the executive management.
The New Company Law introduces the option for LLCs to adopt a one-tier board structure. However, if an LLC opts for a one-tier board, it is mandated to establish an audit committee under the BoD, composed of directors, which may assume the functions and powers of the board of supervisors (Art.69).
The New Company Law permits small-scale LLCs or those with fewer shareholders to forgo setting up a board of supervisors and appoint a sole supervisor instead. With the unanimous consent of all shareholders, LLCs may opt not to appoint a supervisor at all (Art.83). However, it is important to note that neither the New Company Law nor any existing legislation specifies the criteria for defining "small-scale LLCs" and "LLCs with fewer shareholders". Given that FIEs usually operate as wholly owned LLCs or joint venture LLCs with only two shareholders, subject to future legislation and practice, we believe that they typically meet the criteria of “fewer shareholders”. It is also noteworthy that the option to have two supervisors, in lieu of a board of supervisors, will no longer be available.
3.2 Inclusion of employee directors
To better safeguard the interests of employees, the New Company Law mandates that any LLC with more than 300 employees that establishes a BoD must include employee representatives on its BoD, unless the board of supervisors has already been established with employee representatives included (Art.68). Thus, these LLCs have the option to establish a board of supervisors with the inclusion of employee representatives as an alternative to directly integrating them within their BoD. The selection of these employee representatives is facilitated through democratic processes, such as an election through employee representative assemblies or general staff meetings. Despite the above, LLCs with fewer shareholders can opt out of establishing both a BoD and a board of supervisors. In this case, if neither board exists, the requirement to directly include employee directors on the BoD of LLCs with over 300 employees may also be waived.
3.3 Legal representative
A legal representative (“LR”) is a unique role within Chinese corporate governance. To put it simply, an LR is the person designated by the LLC to externally represent it with general and statutory authority. The New Company Law states that legal consequences incurred from civil acts conducted by the LR in the name of the LLC shall be attributed to the LLC (Art.11).
The New Company Law introduces key changes to the LR as follows:
3.4 Revised statutory authorities of governance bodies
The New Company Law has revised the statutory authorities of the governance bodies (Arts. 59, 67 and 74), providing LLCs with greater flexibility to customize the powers of these bodies in their articles of association to suit their specific needs. Notably, operational matters such as determining operational policy and investment plans, as well as reviewing and approving annual financial budgets and final accounts, have been removed from the statutory authorities of the shareholders' meeting. The shareholders' meeting may delegate authority to the BoD to make decisions regarding the issuance of corporate bonds or other matters. Additionally, the authority of the manager is now defined by the articles of association or as authorized by the BoD, rather than being explicitly listed in the law.
Our Observations
The New Company Law has significantly reshaped the corporate governance landscape for LLCs, offering greater flexibility in governance structures and arrangements. Foreign investors are advised to thoroughly review their existing corporate structures and corporate documents (such as articles of association and joint venture agreements) to identify necessary adjustments. Notably, the five-year transition period provided under the Foreign Investment Law expires on 31 December 2024. FIEs must ensure their corporate governance aligns with the Company Law by this deadline. FIEs should consider updating their governance in line with the New Company Law. For new LLC establishments, foreign investors should design their corporate governance in compliance with the New Company Law to avoid any future modifications.
Key considerations for foreign investors when reviewing or designing corporate structures in accordance with the New Company Law include:
IV. Refining Exit Mechanisms
(First published on JunHe's LinkedIn page on 17 July 2024)
In previous chapters, we have highlighted key amendments in the New Company Law concerning LLCs, including strengthened shareholders' capital contribution obligations, increased responsibilities and liabilities for directors and senior officers, and reforms in corporate governance. This chapter focuses on the refined exit mechanisms, encompassing both shareholders' exits from LLCs and LLCs' exits from the market, introduced by the New Company Law. Compared to the 2018 Company Law, the New Company Law introduces notable changes in the rules regarding exit mechanisms, which is worth noting for foreign investors.
4. Significant Changes
4.1 Simplifying Equity Transfer Rules
The New Company Law makes it easier for shareholders to transfer their equity to external parties. Under the 2018 Company Law, transferring equity to non-shareholders required the consent of more than half of the other shareholders. The New Company Law eliminates this requirement (Art.84), allowing shareholders to transfer equity to non-shareholders by providing written notice to the other shareholders. The notice must include details such as the amount of equity for transfer, the price, and the method and terms of payment. If the other shareholders do not exercise their right of first refusal within 30 days of receiving the notice, the transfer can proceed without further approval. However, LLCs can still impose specific restrictions on equity transfers in their articles of association, and these restrictions will take precedence over the statutory rule.
4.2 Expanded Shareholder Redemption Rights
The New Company Law broadens the circumstances under which shareholders can request the company to buy back their equity. Previously, the 2018 Company Law specified three scenarios for such requests. Now, if controlling shareholders abuse their position and significantly harm the LLCs or other shareholders, the affected shareholders can demand the LLCs repurchase their equity at a fair price (para. 3 of Art.89). This new provision offers minority shareholders a more robust mechanism for protecting their interests. Additionally, the New Company Law mandates that repurchased equity must be transferred or canceled within six months.
4.3 Clarifying Targeted and Simplified Capital Reduction Rules
Targeted Capital Reduction: This enables a company to reduce its capital selectively rather than uniformly across all shareholders in proportion to their existing holdings, also known as disproportionate reduction. Under the New Company Law, when a company reduces its registered capital, the corresponding reduction in the contribution amount should be made according to the proportion of the shareholders' contributions in principle, unless all shareholders agree otherwise (Art.224). These agreements can be documented in the company's articles of association or through separate agreements and shareholder resolutions. This provision provides a legal pathway for investors to exit through targeted capital reduction, enhancing the flexibility and security of their investments.
Simplified Capital Reduction: This allows companies to reduce their registered capital to offset losses without returning capital contributions to the shareholders, also referred to as formal capital reduction. This procedure is first introduced in Article 225 of the New Company Law. Companies that have suffered losses and whose asset value is significantly below the registered capital may opt for this reduction and announce capital reduction through the National Enterprise Credit Information Publicity System, bypassing the general requirement to notify creditors or publish an announcement in newspapers. This new procedure is designed to ensure that such companies' registered capital aligns with their actual operational and financial capabilities and to prevent the companies' assets from flowing back to their shareholders.
4.4 Enhancing the Practicality of Liquidation Procedures
The New Company Law improves the liquidation procedures for LLCs to enhance practicality and clarity. One of the key revisions is the designation of directors as the liquidation obligors, shifting this responsibility from the shareholders (Art.232). Furthermore, the law allows for flexibility in forming the liquidation committee. In principle, the liquidation committee consists of directors of the LLC. However, other candidates can be included if specified in the LLC's articles of association or decided by a shareholders' resolution.
Additionally, the scope of parties eligible to initiate compulsory liquidation has been broadened beyond shareholders and creditors to include "interested parties" (para.1 of Art.233). In case where an LLC's business license is revoked, or it is ordered to close, the competent department or company registration authority responsible for such actions can request the court to form a liquidation committee to initiate compulsory liquidation as well (para. 2 of Art.233).
4.5 Introducing Simplified and Forced Deregistration
Under the New Company Law, deregistration procedures have been streamlined to include simplified deregistration (Art.240) and forced deregistration (Art.241) options, bypassing the standard liquidation process before deregistration.
Simplified Deregistration: If a company has no debts or has settled all its debts (confirmed by unanimous agreement among shareholders), it can apply for simplified deregistration. This process involves announcing the deregistration through the National Enterprise Credit Information Publicity System, with a minimum notice period of 20 days. This formalizes a practice that has been in effect since March 1, 2017.
Forced Deregistration: In cases where a company fails to complete its liquidation within three years of having its business license revoked or being ordered to close, the company registration authority can initiate forced deregistration. The authority announces its intention through the National Enterprise Credit Information Publicity System, providing a notice period of at least 60 days. If there are no objections from the company during this period, the authority can proceed with deregistration. This measure aims to address the issue of "zombie companies" which are no longer operational but remain registered.
Our Observations
With the expansion of various scenarios and the broader scope of parties eligible to initiate compulsory liquidation against LLCs under the New Company Law, we anticipate a rise in compulsory liquidation cases. NPL investors, as creditors, must stay informed about their debtors through public channels to safeguard their rights and interests by participating in liquidation procedures promptly. While simplified deregistration procedures will significantly reduce exit costs for businesses, the provision for compulsory deregistration will require FIEs to place a greater emphasis on compliance and proper business conduct.
Foreign investors are advised to review and adjust existing corporate documents of their LLCs, such as their articles of association and joint venture agreements, in accordance with the New Company Law. Key considerations include: