Share Pledges in China: Prospects under the New Property Law

The Security Law

The first PRC law governing share pledges is the 1995 PRC Security Law(中华人民共和国担保法), which states: "if the share certificates that can be transferred according to law are pledged, the pledgor and the pledgee shall enter into a written pledge contract and register with securities registration organization. The pledge contract goes into effect as of the date of the registration. If the shares of limited liabilities companies are pledged the pledge contract goes into effect as of the date the share pledges are recorded in the register of shareholders."

According to the Interpretations on Certain Issues in Implementing the Security Law issued by the Supreme People's Court on September 9 2000 (the Judicial Interpretations), the "share certificates that can be transferred according to law" only refers to the shares of listed companies.

In consequence, the Security Law and the Judicial Interpretations establish different types of share pledges for listed and non-listed companies, and stipulate different commencement dates for their effectiveness.

The 1997 Provisions

Though most foreign-invested companies are limited liability companies and the share pledge thereof can logically be covered by the provisions of the Security Law, there arises a practical problem concerning the enforceability of the share pledge of foreign-invested companies.

Under PRC law, the transfer of shares of foreign-invested companies shall be subject to approval by the Ministry of Commerce (MOFCOM) or its local counterparts. If the shares of a foreign-invested company are pledged without MOFCOM's approval, the enforceability of such share pledge will be confronted with substantial risk, as the authority may refuse to give approval to the consequential transfer of such shares. This risk would prevent most lenders like banks from accepting a share pledge as the security for their lending to shareholders.

In order to resolve this dilemma, the former Ministry of Foreign Trade and Economic Cooperation (now known as the Ministry of Commerce), in conjunction with the State Administration of Industry and Commerce (SAIC), promulgated the Provisions for the Alteration of Investors' Equity Interests in Foreign-invested Enterprises on May 28 1997 (the 1997 Provisions) to regulate the share pledges of foreign-invested companies.

According to the 1997 Provisions, the approval of the examination and approval authority (MOFCOM) and registration with SAIC or its local counterparts are required for any share pledge of foreign-invested companies. Any share pledge of foreign-invested companies without such approval or registration will be deemed invalid.

Types of Share Pledges

The Security Law and the 1997 Provisions establish three kinds of share pledges according to the nature of target companies: the share pledge of listed companies; foreign-invested companies,² and non-listed domestic companies. The relationship between the three kinds of share pledges and their respective effective dates are shown in Figure 1.

LISTED COMPANIES

According to the Security Law, the shares of listed companies (including domestic or foreign-invested companies) can be pledged and such share pledge agreements become effective as of the date of registration with the securities registration organization.³

Effective Date of Security

The effectiveness of the share pledge agreements of listed companies commences from the date of registration with the securities registration organization, not from the execution date of share pledge agreements. The stipulation makes a time gap between the execution date of a pledge agreement and the date of its registration. This is not good news for pledgees, as pledgors may refuse to register the pledge with the securities registration organization during such time gap.

To reduce the refusal risk of registration by pledgors, what pledgees can do is to incorporate a term of liquidated damages into pledge agreements to cover its potential losses or, in case of syndicate borrowing, make the advances available to pledgors only after the registration of the pledge.

Rules for State-owned Shares

According to a circular issued by the Ministry of Finance on October 25 2001, an authorized unit representing the state shareholder⁴ can pledge only 50% of the state-owned shares of a listed company under its holding and such shares can only be pledged to secure its own obligations or the obligations of its subsidiaries. Furthermore, such a pledge shall be subject to a feasibility study and shall be approved by the board of directors (in the case of no board of directors, by the office of the general manager).

After the execution of the pledge agreement, the authorized unit shall file such agreement with the finance administrative department at or above provincial level and obtain a Filing Form for the Pledge of State-owned Shares of Listed Companies, only by which the authorized unit can register the pledge of state-owned shares with the securities registration organization.

FOREIGN-INVESTED COMPANIES

As mentioned above, the share pledge of foreign-invested companies is mainly governed by the 1997 Provisions, which state that MOFCOM's approval and registration with SAIC are required for any share pledge of foreign-invested companies. The examination and approval authority of such share pledge shall be the commercial administrative department which originally approves the establishment of the foreign-invested company.

Special Rules

According to the 1997 Provisions, a shareholder of a foreign-invested company can only pledge its shares attributable to the paid-up registered capital and any non-contributed shares cannot be pledged. Meanwhile, any company shall not accept its own shares as the subject target of a security.

After the execution of a share pledge agreement by and between a shareholder and a pledgee, the following documents shall be submitted to MOFCOM to approve the pledge:

i) a board resolution of the company and a shareholder resolution, both of which approve the share pledge by the pledging shareholder;

ii) the share pledge agreement;

iii) the investment certificate issued by the company to the pledging shareholder, and

iv) a capital contribution verification report issued by an accounting firm and signed by certified public accountants registered in China.

Within 30 days of receiving all required documents, the examination and approval authority shall decide whether to approve the pledge. After obtaining MOFCOM's approval, the company shall register the pledge with the registration authority within 30 days.

The Effectiveness of the Pledge

As to the effectiveness of the share pledge of foreign-invested companies, there is an inconsistence between the Security Law and the 1997 Provisions. According to the Security Law, the effectiveness of the share pledge of a limited liability company⁵ shall commence from the date of recording the pledge in the register of shareholders. However, according to the 1997 Provisions, such pledge will be deemed invalid without obtaining MOFCOM's approval and registration with SAIC. This inconsistency leads to different practices by different local governments in this regard.

The Security Law was promulgated by the National People's Congress, while the 1997 Provisions is just a "department regulation"⁶. According to the Legislation Law, a law shall prevail over other forms of regulatory documents, including department regulations in case of discrepancy between them. This means, after recording the pledge in the register of shareholders, the share pledge agreement can go into effect even without obtaining MOFCOM's approval and SAIC's registration. In order to smooth the enforcement of the pledge, however, it is strongly preferred to go through the approval and registration procedures in the places where such approval and registration are available.

Practices by Different Local Authorities

Though most local examination and approval authorities follow the 1997 Provisions, the approval for the share pledges of foreign-invested companies in Shanghai has been cancelled according to a decree made by the Shanghai municipal government on October 25 2001.

As the examination and approval authority in Shanghai, the Shanghai Foreign Economic Relation and Trade Commission (SFERTC) has ceased to give approvals for share pledges of foreign-invested companies. The reason why they cancel such approval lies in the inconsistency between the Security Law and the 1997 Provisions. Officials of SFERTC hold that MOFCOM's approval is not required pursuant to the Security Law and the recording of the pledge in the register of shareholders is sufficient to give effectiveness to a share pledge agreement.

Besides Shanghai, sometimes it is hard to obtain approvals for the share pledge of foreign-invested companies from the examination and approval authority of Hebei province. Therefore, it is very important for lawyers engaged in share pledge transactions to confirm with the local examination and approval authorities whether they will approve share pledges of foreign-invested companies.

NON-LISTED DOMESTIC COMPANIES

Non-listed domestic companies comprise limited liability companies and non-listed companies limited by shares. As discussed above, the share pledge agreement of non-listed domestic companies comes into effect after recording the pledge in the register of shareholders.

Limited Liability Companies

Share pledges of limited liability companies are governed by the Security Law(担保法) and the 2005 Company Law(公司法). The Security Law stipulates the effectiveness of the share pledge and the Company Law regulates the conditions for the share pledge. According to the Company Law, the share transfer by a shareholder of a limited liability company to a third party other than the existing shareholders shall be subject to the pre-emptive right of the other shareholders. In order to smooth the share transfer after the security becomes enforceable, it is strongly suggested to obtain the consent of the other shareholders for potential share transfers and their waiver of preemptive rights before the execution of a share pledge agreement.

Another obstacle for share pledges of limited liability companies is that there is no public registration system for such pledges in most areas in China⁷. Without a public registration system, a creditor cannot know the status of the shares of a limited liability company, which could prevent the creditor from accepting the share pledge as a security. This obstacle is so substantial that the share pledge of limited liability companies is rarely used as a kind of financing tool in China. However, this issue may well be resolved after the implementation of the Property Law.

Non-listed Companies Limited by Shares

Unlike the share pledges of limited liability companies, the shares of non-listed companies limited by shares can be pledged without the consent of the other shareholders. In China, there is no nationwide registration system for the share pledges of non-listed companies limited by shares, but many provinces (or autonomous regions or cities directly under the State Council) like Shanghai, Jiangxi, Jilin and Chongqing have established their own registration system for the share pledges of non-listed companies limited by shares. Normally, the registration organization is the local asset and equity exchange centres.

PROSPECTS UNDER THE NEW PROPERTY LAW

The Property Law(物权法) was promulgated by the National People's Congress on March 16 2007 and will be effective from October 1 2007. One of the most meaningful breakthroughs of the Property Law is that it establishes a registration system for share pledges of non-listed companies.

According to the Property Law, the share pledge of a non-listed company comes into effect when the pledge is registered at the registration authority. Under the Property Law, anyone can enquire about the status of the shares of a company through a public registration system, and it will become much safer for a creditor to accept the shares of a non-listed company as the security of obligations. Given that most PRC companies are non-listed ones, it can be expected that the Property Law will boost the share pledges of non-listed companies greatly.

The Property Law also smoothes the inconsistencies between the Security Law and the 1997 Provisions with respect to the effectiveness of the share pledge of a foreign-invested company. Under the Security Law, the share pledge of a foreign-invested company becomes effective after its registration with the register of shareholders of the company, while under the 1997 Provisions, such a share pledge comes into effect only after it is approved by the examination and approval authority and registered with registration authority. As a law more recently passed by the National People's Congress, the Property Law prevails over the Security Law and makes it clear that the share pledge of a foreign-invested company shall be registered with the registration authority.

Endnotes

1. Under the PRC Corporate Law, there are two kinds of companies, limited liability companies and companies limited by shares. Usually, the capital share of a limited liability company is referred to as equity interest or equity, while for a company limited by shares the capital is divided into shares. For convenience, the term share pledge herein refers to the pledge of both the equity interest of a limited liability company and the shares of a company limited by shares.

2. Except as otherwise expressly stated, the term foreign-invested companies refers only to non-listed foreign-invested companies, as most foreign-invested companies in China are not listed in exchanges.

3. The China Securities Depository and Clearing Corporation is the exclusive securities registration organization in China, with branches in Shanghai and Shenzhen, where the only two exchanges of China are located.

4. 'Authorized units representing the state shareholder' is a concept under the PRC law which means the units (enterprises, companies or even competent governmental agencies) authorized to represent the state to hold state-owned shares of listed companies.

5. In China, most foreign-invested companies are limited liability companies.

6. 'Department regulations' is a concept under the laws of the PRC which means regulatory documents promulgated by a department directly under the State Council.

7. Jilin province in northeast China has established a registration system for the share pledges of limited liability companies.