Handling foreign investment disputes

The courts have a certain degree of discretion on deciding whether specific performance should be granted in order to enforce a party's obligation to apply for approval of an FIE contract. Generally, under the PRC Contract Law (中华人民共和国合同法), specific performance is available as a form of remedy when a valid obligation is breached. Except for the equity transfer situation where the transferee brings a lawsuit against the transferor for its failure to perform the approval application obligations (see Article 6 of the Provisions), the Provisions keep silent on the availability of specific performance as remedies for other major changes of FIEs, such as establishing an FIE, increasing capital, etc. The lack of specific provisions on the foregoing point may cause unpredictability in the courts' decision to grant specific performance as remedies to cure a party's failure to perform its approval application obligation. Article 110 of the PRC Contract Law provides that if a non-monetary remedy is considered inappropriate or impractical for enforcement, the courts can decide not to order specific performance as a remedy. Therefore, if a court has concern that specific performance of applying for approval may not be feasible or may not be fair, it may not grant such remedy. For example, if a dispute arises during the creation of an FIE between its founding parties, the court may not deem it appropriate to grant the remedy of specific performance so to avoid forcing the establishment of an FIE. This flexibility that the court has to grant specific performance is in line with provisions under the Interpretation on Several Issues Concerning the Application of the PRC Contract Law (II) (关于适用《中华人民共和国合同法》若干问题的解释（二）) (the Contract Law Interpretation). Article 8 of the Contract Law Interpretation also provides that “according to actual situation” the court may grant the specific performance to the non-breaching party to apply for approval or registration of contracts by himself if the party that originally has the obligation to make the application fails to do so. Therefore, except for cases of equity transfer, it remains uncertain whether the non-breaching party may be awarded remedies of specific performance by courts to make relevant contracts effective.

ii) Monetary remedies

A liquidated damages clause may reasonably be regarded as “relevant contract clauses” relating to the duty to apply for administrative approval as discussed above. Generally speaking, liquidated damages are available in a case of a breach of the duty to apply for approval according to the Provisions. But the Contract Law Interpretation includes such breach as one relating to pre-contractual obligations (see Article 8 of the Contract Law Interpretation) under the PRC Contract Law. A general view is that the amount of compensation for breach of pre-contractual obligation should be limited to actual and direct losses, which are much less than that for a breach of an effective contract. Article 5 of the Provisions also follows this approach, which provides that only compensation for actual losses shall be granted where a transferee requests the termination of the contract based on the ground of transferor's failure to submit the contract for approval. Article 6 gives more remedies for cases where the transferor of equity and an FIE fail to perform their approval application obligations and the transferee brings a lawsuit to request specific performance of the approval application obligations, and such remedies may include the price disparity of the equity and returns on the equity. It is worth noting that the PRC Contract Law and the Contract Law Interpretation grant the breaching party a right to an appropriate reduction of the amount of liquidated damages when it is more than 130% of the actual losses incurred. Therefore, the non-breaching party might receive less than the liquidated damages as agreed even though the contract clause itself is valid.

The effectiveness of supplementary agreements

Since the principal contracts regarding establishment or modification of FIEs are subject to approval by relevant authorities in most cases, in practice the contracting parties sometimes circumvent this mandatory requirement by putting key terms, such as preferred stock clause, co-sale clause, valuation adjustment mechanism clause, and drag-along clause, in supplemental agreements without filing them for approval out of the concern that such terms may not be easily approved by the relevant authorities. However, once a dispute arises, the effectiveness of such supplemental agreements that are not properly approved by the authorities is always a key issue. Article 2 of the Provisions addresses this issue. It provides that if the supplementary agreement does not constitute a material or substantive change to contract terms that have been approved by the authorities, the court shall not rule that such supplementary agreement has not come into effect due to its failure to be approved.

Though the Provisions do not include a definition on the term of “material or substantive change”, it contains a wide range of examples, such as changes in registered capital, corporate type, business scope, term of operation, the capital contributions subscribed for by shareholders, method of capital contribution, as well as corporate mergers and divisions, and equity transfers. It is noted that the foregoing examples were taken from the Implementing Opinions on Several Issues Concerning the Application of the Law in the Administration of the Examination, Approval and Registration of Foreign-invested Companies (关于外商投资的公司审批登记管理法律适用若干问题的执行意见) jointly promulgated by multiple authorities including State Administration for Industry and Commerce, Ministry of Commerce, General Administration of Customs and State Administration of Foreign Exchange in 2006. Theoretically speaking, if the supplementary agreement will cause the change as provided in the examples, it needs to be approved before taking effect. In practice, the view of the government authorities may put a heavy weight on judicial decision-making. Further, it seems that the court might inquire with the administrative branches about whether the supplementary agreement constitutes major changes for which approval is required. In summary, the Provisions give deference to the opinion of the administrative authorities on the status of supplementary agreements, which might limit judges' discretion to honour the validity of the supplementary agreements without approval by the relevant administrative authorities.

Legal consequences of failure on ownership registration of capital in-kind contribution

The draft of the Provisions clearly specified that it was a breach of contract when the party failed to file a registration of the ownership change for the capital in-kind contribution. However, the final version of the Provisions deleted this clause. In the past, there were inconsistent judicial decisions on this issue. Some courts believed it was not a breach of contract if capital in-kind was delivered and used by the FIE though the party delayed in changing the ownership registration, while other courts ruled differently. It seems that the drafting of the Provisions attempted to make judicial rulings consistent, but it did not give a brightline rule on this issue.

The draft of the Provisions further provided that if the party changes the ownership registration within the period prescribed by the court, its shareholder's right will be secured. Meanwhile, the FIE or other shareholder(s) of the FIE can claim compensation if they can prove the delayed registration for change of ownership caused damage to the FIE. After the release of the final version, it is debated whether the deletion of the “breach” from the draft and stipulation on the requirement of “damage to the FIE” in the final version of the Provisions deprive other shareholders from claiming breach and liquidated damages according to the shareholders' agreement. Further, under the Provisions, both the FIE and its shareholders can seek compensation for losses caused by the delay in the registration of the ownership change. Therefore, it also is debatable that when the FIE seeks compensation, the liquidated damages claimed by other shareholders might be deemed as double remedy according to the Provisions because the other shareholders would have benefited from the compensation obtained by the FIE as well.

The choices of the remedies for the transferee under the equity transfer situation

Article 5 to Article 7 of the Provisions provide for a scheme of remedies for the transferee when the transferor and the FIE fail to submit the equity transfer for approval, which is illustrated overleaf:

Comparing the draft of the Provisions relating to situation A in the chart overleaf with the final version, it seems that the scope of losses is limited to actual and direct losses only, while the scope of remedy under situation B is wider as if the contract were effective. The possible reasons for the foregoing difference may be: first, since the court order has been disobeyed by the transferor and the FIE, the punishment shall be more severe; second, since the transferee intends to proceed with the transaction, he thus has right to foreseeable interests and can claim for the loss of profits; third, in this case, the transferee has to file two lawsuits and the legal cost inevitably increases. Therefore, it is reasonable to order the defaulting party to compensate more to recoup the losses for the transferee.

If the transferee asks for a self-help remedy, for example, to submit for approval by the transferee himself, and is granted so by the court, it seems that the Provisions are not clear whether such action will limit the transferee's right to terminate the contract directly without recourse to the self-help remedy and claim the loss under Article 6 if the transferor and FIE refuse to perform its application obligation ordered by the court's judgment. Furthermore, the Provisions keep silent on the scope of losses under the situations C and E, where the transferee may still suffer great losses. In addition, how to calculate the losses under situation B may also invoke a lot of potential disputes.

Dormant shareholders rights

Dormant investments are quite common in FIEs. Article 14 of the Provisions is a breakthrough to the current judicial practice regarding rights of dormant shareholders. For the first time, the Supreme People's Court officially provides an approach for dormant shareholders to have their status as shareholders acknowledged, even though the legal standards for such acknowledgment are high. In normal circumstances, dormant shareholders are not eligible for shareholder status. However, under Article 14 of the Provisions, the dormant shareholder may request the court to acknowledge his status as shareholder and to petition for a change in the list of shareholders of FIEs if the following conditions are met: 1) he actually has made the investment; 2) registered shareholders other than the nominee shareholder recognise the actual investor's status as a shareholder; and 3) the court or the concerned party has obtained consent from competent authorities for this change of the actual investor into a shareholder while the legal action is pending.

In practice, there still remain questions to be clarified in dealing with rights of dormant shareholders: what if the dormant shareholder has actually contributed only partial capital? What if only some, not all, registered shareholders give consent? Is a consensus required or a majority vote sufficient? And the last element in Article 14 re-emphasised that the authorities will have the final word over the change which might again limit judges' judicial power in this regard. Overall, the Provisions reflect a balance between the judicial and administrative powers in resolving the foreign investment disputes. It is still too early to predict how governmental branches will react to and cooperate with the Provisions and how judges will apply and interpret the Provisions in adjudicating actual lawsuits. The Provisions, although not quite comprehensive and full-fledged, will cast a significant impact on the judicial practices and business behaviour in foreign investment activities in China.

Harry Liu, King & Wood, Shanghai and Bingna Guo, O'Melveny & Myers, Beijing