The new company law of the People’s Republic of China, which came into force on 1 January 2006, is a significant milestone in the reform of China’s company law as it affects the way foreign shareholders may establish and manage their operations in China. However, it is important to note that wherever the statutory regime governing foreign invested enterprises (i.e., joint ventures or wholly invested enterprises) expressly contradicts the new company law, such statutes prevail. It is incumbent on the Chinese legislature to decide whether this statutory regime will be harmonized with the new company law.
Incorporation Thresholds Lowered
The changes to the company law include a lowering of the transaction costs associated with establishing a limited liability company (LLC) in China, such as a joint venture or a wholly foreign owned enterprise. Set out below is a summary of the key changes.
Minimum Registered Capital Requirement
Prior to the introduction of the new company law, the minimum registered capital requirement for establishing an LLC could be as low as RMB 100,000. The minimum registered capital has now been reduced to RMB 30,000. While it would be theoretically possible to establish a wholly foreign enterprise or a joint venture with a registered capital of RMB 30,000, statutory provisions (or approval authority’s discretion) can require a significantly higher registered capital. For example, the provisions relating to the establishment of a recruitment agency joint venture require that the minimum registered capital be no less than USD 300,000.
Capital Contribution by Installment
Company law allows an LLC’s registered capital to be paid by installment. The initial contribution must be 20 percent or more of the total registered capital (but not to be less than RMB 30,000). The balance may be paid up within two years from the date of the company’s establishment (with some limited exceptions). However, significant variations to this investment schedule still exist; an equity joint venture can have as little as 15 percent of its registered capital paid within the first three months of establishment and the balance paid within three years of establishment.
Types of Capital Contribution
The new company law allows capital contributions in the form of technology to be up to 70 percent of the proposed company’s registered capital, an increase of 50 percent from the old company law. The new company law also broadens the types of non-cash assets that can be contributed to a company’s registered capital to include tangible assets, intellectual property rights, land-use rights and any non-cash asset that is transferable and has monetary value. However, variations to this regime exist. By way of example, wholly foreign owned enterprises can have intangible assets make up no more than 20 percent of its registered capital.
Single-shareholder LLCs
Previously, LLCs owned by Chinese shareholders required at least two shareholders. Now, LLCs can be established by a single Chinese shareholder. This has positive implications for Sino-foreign joint ventures as dealing with a single shareholder may be less problematic. In addition, the LLC form allows a single Chinese shareholder to benefit from the limited liability protection afforded by such form.
However, restrictions exist for the single-shareholder LLC. Specifically, the minimum registered capital of such an LLC is RMB 100,000, which must be paid in full upon establishment. Moreover, a person may establish only one single-shareholder company and such company may not invest in or establish any other single-shareholder company.
Re-investment
The new company law removes the restriction that a company may not invest in other enterprises where such amount exceeds 50 percent of its net assets. Under the new legal structure, a company may freely invest in other enterprises, provided it does not assume any joint and several liabilities for the debts of such enterprises. We are monitoring this development to see how it will impact companies’ investment activities and the legal environment for mergers and acquisitions. It is important to note that under the current regime governing foreign invested enterprises, joint ventures and wholly foreign invested enterprises are still bound by the 50 percent limit and cannot freely invest in other enterprises.
Corporate Governance
In order to bring the Chinese company law in line with international norms, the new company law enhances the rights of minority shareholders as well as introducing mechanisms designed to create greater transparency and accountability in corporate governance.
Shareholders’ Meetings and Resolutions
A shareholder in an LLC that holds 10 percent or more of the voting rights of the company is now entitled to convene a shareholders’ meeting if both the board and the supervisory board fail to convene such meeting. The new company law also confers upon the shareholders the right to petition the courts to revoke a shareholders’ resolution or a board resolution if either (i) the convening procedures or voting methods adopted in the corresponding meeting violate the law or breach the company’s articles or (ii) the resolution itself breaches the company’s articles.
Share Repurchase
Another major breakthrough introduced by the new company law is an exit mechanism provided for minority shareholders. A shareholder can require the company to repurchase its shares at a reasonable price if such minority shareholder opposes:
(i) the company’s decision not to distribute dividends for five consecutive profitmaking years;
(ii) any merger or spin-off of the company or the disposition of the company’s major assets; or
(iii) the renewal of the company’s term of operation upon its expiration or the amendment of the company’s articles upon the occurrence of any other grounds for dissolution as specified in the articles.
Dissolution
Apart from the share repurchase mechanism, the new company law provides an alternative exit strategy for minority shareholders in situations in which they have been unfairly prejudiced. Investors of an LLC may petition a court to dissolve the company if:
(i) it encounters serious operational difficulties;
(ii) its continuing existence will seriously prejudice the interests of the shareholder; and
(iii) such difficulties cannot be resolved through any other means. The value of the dissolution exit mechanism depends heavily on how these three criteria are interpreted by a court.
Derivative Suits
The new company law grants minority shareholders a statutory right to initiate a derivative suit. Specifically, a shareholder may initiate legal proceedings on behalf of the company against (i) directors, supervisors or senior management who fail to comply with the law or the company’s articles and thereby cause the company to experience a loss or (ii) third parties infringing upon the lawful rights and interests of the company, thereby causing the company to experience a loss. This measure may create China’s first generation of watch-dog minority shareholders and may be the first step in allowing such shareholders to combat fraud and corruption in, as well as promote the development of a duty of care and duty of loyalty in, corporate China.
Company’s Books and Records
Investors in an LLC have a statutory right to access and copy a company’s financial reports, and the minutes and resolutions of directors’ meetings supervisory board meetings. Investors may also inspect the company’s accounts and records.
Piercing the Corporate Veil
The new company law introduces the common-law doctrine of ‘piercing the corporate veil’ which allows creditors to access the assets of the shareholders to repay company debts. Under the limited liability form, shareholders are not personally liable for the debts of the company. However, shareholders will be jointly and severally liable with the company for the company’s debts if they abuse the independent corporate legal personality in order to evade liabilities and seriously prejudice the interests of the company’s creditors.
In addition, the burden of proof has been shifted onto the single-shareholder LLCs by the new company law. Specifically, if the single shareholder fails to prove that his or her assets are independent from those of the company’s, the single shareholder may be personally liable for the company’s debts.
Mechanisms Enhancing Corporate Governance
LLCs are required to establish a supervisory board which is authorized to act as a watch dog and ensure that the management and directors fulfill their obligations to the company. Such obligations include a duty of care and a duty of loyalty. Further, if a board resolution violates the law, the articles of association or contradicts a shareholders’ resolution and causes a serious loss to the company, directors who approved such resolution may be personally liable for corresponding losses.
Conclusion
The array of concepts and mechanisms introduced into corporate China by the new company law are impressive and reflect the national government’s commitment to creating a more stable and transparent economy. The critical question becomes how will these concepts and mechanism be absorbed, understood and utilized by China’s economy, business community, shareholders and directors, legal community, etc. Are such concepts and mechanisms simply one more edict from the capital or a reflection of a new set of standards that will set the tone for years to come? We watch, with you, to better understand how this will play out.