One Hesitant Step Forward: New Company Law Brings Mixed Feelings

While the lowering of registered capital requirements may appear spectacular on paper, it should be noted that the amounts stated in the New Company Law are indicative at best. In practice, authorities often require investors to contribute much higher amounts to registered capital in order to ensure that a new company owns funds sufficient to carry on its intended business. In addition, regulations specific to foreign investment in certain industries may require higher amounts of minimum registered capital.

NON-CASH CONTRIBUTIONS TO REGISTERED CAPITAL

The New Company Law broadens the range of methods by which investors may contribute to the registered capital of companies, permitting the allocation of "non-cash assets which can be monetarily valued and legally transferred" for up to 70% of a new company's total registered capital. Under the old law, a 20% limit was applied to such contributions. In 1997, this limit was raised to 35% for contributions in the form of high technology to allow more flexibility for the establishment of high-tech companies. Given the desire to attract foreign cash into the PRC, it remains to be seen how foreign investment approval authorities will implement this new provision.

Regrettably, the new law does not clearly state whether shares can be contributed to the registered capital of companies.

INTRODUCTION OF THE SINGLE SHAREHOLDER COMPANY

The New Company Law allows a domestic limited liability company to be established by a single shareholder. Domestic residents may only establish one single-shareholder company. A single-shareholder company is not allowed to invest in, or establish, any other single-shareholder company.

INTER-COMPANY INVESTMENT AND UPSTREAM SECURITIES

The cap on company investments in other companies has been removed under the New Company Law, leaving the setting of a limit for such investment at the discretion of the shareholders. However, the investing company cannot undertake joint liability for the invested entity's debts. Under the old law, the aggregate amount of such investments was not allowed to exceed 50% of the company's net assets. This rule has, in the past, deterred many companies, including foreign-invested enterprises ('FIEs'), from setting up subsidiaries or acquiring equity interests in other enterprises. Unfortunately, due to a similar restriction on inter-company investments by FIEs (found in the Tentative Measures on Investments in China by Foreign-invested Enterprises, effective since September 1 2000), FIEs will not be able to benefit from this relaxation until such restriction is repealed.

The New Company Law now clearly allows the provision of upstream security by a company for securing the liabilities of its shareholders, the de facto controller of that company's shareholder, or a third party. Such security provisioning is permitted provided it is approved by the board of directors and by non-interested shareholders at a shareholders' meeting.

ISSUANCE OF BONDS

Non state-owned limited liability companies are now allowed to issue bonds under the New Company Law. Listed companies are allowed to issue convertible bonds that can, at the option of the bond holder, be exchanged for shares in the company, instead of cash, during a specified time period and according to a pre-announced conversion ratio. To issue corporate bonds, a company must comply with requirements of the new PRC Securities Law, which was also made effective on January 1 2006. The issuance of bonds requires approvals from the relevant authorities and is rarely seen in practice.

TRANSFER OF EQUITY

The New Company Law introduces a chapter on the transfer of equity interests in limited liability companies. Shareholders opposing equity transfers to a third party are deemed to consent to the transfer unless they express their intention to purchase such equity within 30 days after being served with a notice by an exiting shareholder. This clarifies the situation which prevailed under the old law where shareholders were not required to express their dissent within any specified time. The new law also states that shareholders enjoy pre-emptive rights over equity transfers ordered by a People's Court and that the lawful inheritor of a deceased shareholder may act as a shareholder, unless otherwise provided in the company's articles of association.

Importantly, the period of prohibition on the transfer of promoters' shares in a company limited by shares has been shortened from three years to one year following the date of incorporation of the company.

SHAREHOLDERS EQUIPPED TO FIGHT

The New Company Law contains certain key provisions aimed at protecting minority shareholders' rights. Shareholders holding 3% or more of a company's shares may put forward proposals to the board of directors. Shareholders also may require the company to repurchase their shareholding when they oppose:

· The acquisition or the merger of the company or a disposition of the company's major assets;

· The company's decision not to distribute profits for five consecutive years despite having been profitable for those years; or

· The renewal of the company's term after its expiry.

Shareholders are entitled to bring actions against directors, supervisors and/or senior managers for violation of PRC regulations, or the company's articles of association. Shareholders holding 10% or more of a company's shares have the right to petition the People's Court to liquidate the company when the company's managerial problems threaten to damage shareholders' interests.

MORE FLEXIBLE VOTING SYSTEM

The New Company Law allows the articles of association of a limited liability company to allocate voting rights between shareholders in proportions different from their respective contributions. Shareholders may also receive dividends and/or enjoy priority subscription for new equity in proportions different from their capital contribution ratios.

In addition, the New Company Law enables a company limited by shares to adopt a cumulative voting system at shareholders' meetings for the appointment of directors. Under the cumulative voting system, the number of votes available to a shareholder is equal to the number of shares held by this shareholder multiplied by the number of positions up for election. All votes may be cast for the same director.

The provision under the old law requiring the chairman of the board of directors to be the legal representative of the company has been omitted from the new law. The New Company Law provides that the appointment mechanism of the chairman and vice-chairman of the board of directors shall be specified in the articles of association. However, the PRC Sino-foreign Equity Joint Venture Law (中华人民共和国中外合资经营企业法)and PRC Sino-foreign Cooperative Joint Venture Law (中华人民共和国中外合作经营企业法)stipulate that the chairman of the board of directors is the legal representative of a joint venture company. It is expected, therefore, that corresponding amendments will be made to the joint venture laws following the implementation of the New Company Law.

CATCHING UP WITH GLOBAL CORPORATE GOVERNANCE TRENDS

The New Company Law allows the corporate veil to be lifted where the controlling shareholder of a company abuses the privileges of incorporation, which may result in the controlling shareholder being held personally liable for the company's debts. Shareholders using the independent corporate legal personality to evade liabilities and thereby damage the interests of the company's creditors will assume unlimited personal liability for their wrongful acts. It remains to be seen how this new rule will be applied in practice. Forthcoming implementing rules are expected to provide additional guidance to the People's Courts.

The New Company Law introduces rules on conflicts of interests. A controlling shareholder, effective controller, director, or senior manager of a company incurs personal liability when taking advantage of a relationship with a third party which damages the interests of the company. Directors of listed companies are ineligible to vote on matters in which they have an interest.

The New Company Law also introduces the concept of corporate social responsibility. This is a noble move that is in line with international trends in corporate law. It may prove difficult to implement in practice, however, and will be of little use unless the People's Court gives the concept definition and provides guidelines to directors.

EXECUTIVE COMPENSATION

Although clear references to stock options are nowhere to be found in the New Company Law, there are new provisions covering the disposal of shares held in the company by senior management. Under the new law, directors, supervisors and senior officers of the company may transfer the shares they hold in the company after one year from the date of the company's shares being listed on a stock exchange. Under the old law, they were not allowed to transfer their shares in the company during their term of office.

MAKING RECORDS TRANSPARENT AND ACCESSIBLE

The New Company Law provides practical means for shareholders to exert supervision over companies. For the first time, the new law recognizes the right of shareholders to view and copy a company's articles of association, financial reports and board meeting minutes. Shareholders are also entitled to consult the company's accounting books. After a shareholders' or board of directors' resolution is made, a shareholder may, within 60 days of the resolution, petition the People's Court to revoke a resolution that breaches the company's articles of association.

The New Company Law takes another step towards market transparency by stating that the State Administration of Industry and Commerce ('SAIC') must provide search facilities for members of the public. Previously, under the Implementing Rules for the Administration of Enterprise Legal Person Registration Regulations (last modified on December 1 2000), the SAIC had discretion whether or not to open its registry to the public. As of today, the registered information on non-listed companies kept under the SAIC is still not open to inspection by the public.

WHAT WE EXPECTED BUT DID NOT GET

Regrettably, the PRC legislator has left out of the New Company Law many important items suggested in the various draft amendments circulated in the last year, including in particular:

· Provisions allowing a company to structure its share capital into common and preferred shares;

· An unambiguous and explicit statement that investors are able to contribute the shares they hold in an existing company as an investment; and

· More sophisticated provisions on mergers and acquisitions and restructurings of companies. For example, drafts of the New Company Law included useful provisions on shareholders exchanging their equity for shares in a holding company.

Foreign investors should note that, in many respects, FIEs and and domestically-invested companies are subject to different regimes and rules. Article 218 of the New Company Law states that, where the laws governing foreign investment differ from the provisions of the New Company Law, the former shall prevail. Consequently, the New Company Law applies to foreign investors and FIEs only in circumstances where legislation on FIEs is silent. For this reason, few of the benefits of the New Company Law will actually flow through to foreign investors and FIEs.