Indirect equity transfers cannot circumvent right of first refusal

On December 29, Soho China and the respective parent companies of Greentown and Zhengda entered into an acquisition contract whereby Soho China would acquire 100% equity in Greentown and Zhengda for Rmb4 billion. The contract specifically required Greentown and Zhengda to divest their other assets so that the only remaining asset was their equity in the JV. On the same day, Soho China and Greentown publicly disclosed that Soho China would own 50% indirect equity in the JV after the said equity transactions. Fosun then sued Soho China and the other parties involved in the equity transactions, asking for an annulment of the transactions.

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The decision

The Shanghai First Intermediate Court ruled in April 2013 that the series of transactions leading to Soho China obtaining 100% equity in Greentown and Zhengda were null and void because they were meant to circumvent Fosun's right of first refusal as an equity-holder in the JV.

According to Article 72 of the PRC Company Law (中华人民共和国公司法), if an equity-holder in a limited liability company (as opposed to a stock company) wishes to transfer equity to a party that is not currently an equity holder of the company (outside bidder), it must get the consent of at least half of the other equity-holders. If an equity-holder does not reply within 30 days of receipt of the notice of transfer, it is deemed as consenting. Those non-consenting equity-holders must take the transfer themselves or be deemed as consenting. For those consented transfers, the existent equity-holders have the right to take the transfer on the same terms and conditions as offered by outside bidders (right of first refusal).

According to Article 52 (3) of the PRC Contract Law (中华人民共和国合同法), “a contract is null if it falls under anyone of the following situations: … (3) pursue illicit purposes under the guise of an apparently licit façade.”

The Court held that the right of first refusal is a right provided by the law and hence any act meant to circumvent the right would carry an illicit purpose in the sense of Article 52 (3) of the Contract Law. It found that the series of arrangements of Soho China obtaining 100% equity in Greentown and Zhengda from these companies' respective parent companies had been conducted with the illicit purpose of circumventing Fosun's right of first refusal as an existent equity-holder in the JV and Fosun's such right had indeed been effectively frustrated. Thus, the Court held Soho China's transactions were null and void in accordance with Article 52 (3) of the Contract Law.

As for reasoning, the Judgment stated Fosun's original majority status had been impaired by the transactions, which had resulted in a stalemate where the rivals Fosun and Soho China each controlled directly or indirectly 50% equity in the JV. The Court emphasised the serious consequences to the governance and operations of the JV as well as the development of the land. However, the Judgment was not clear on how this fitted in with the Court's logic in reaching its conclusion. The mention itself though is indication enough that the judges might have considered it when making their decision.

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Criticism

The Judgment has aroused heated debates about its legal correction and possible consequences. The debates focus on whether the circumvention of an equity-holder's right of first refusal would constitute illicit purpose under Article 52 (3) of the Contract Law. Critics hold the view that the illicit purpose should be confined to violation of public policy or mandatory statutes only and not extended to private rights or interests such as the right of first refusal.

Supporters argue that illicit purpose is any purpose that is aiming for a result that runs counter to the purpose of any legal provision be it private or public, discretionary or mandatory. In the supporters' view, the primary purpose of providing for the right of refusal in the Company Law is to conserve the character of association among the equity-holders of a limited liability company and prevent unexpected rivalry with unwelcomed new equity-holders from disrupting the governance and operations of the company. The indirect transfer of equity in the present case has effectively frustrated the purpose of the specific provision of the Company Law and was thus illicit.

In the author's view, there is no logic, literary or policy support for the narrow interpretation as held by the critics. Every statutory provision carries a purpose that may allow the concerned parties to derogate from voluntarily, but does not allow acts of non-concerned parties to render it futile. In this sense every statutory provision has a mandatory tint, be it one for private rights or otherwise. On the other hand, technically speaking there is nothing we can find in jurisprudence that speaks against the supporters' interpretation of the term. The critics' chief concern is that the judgment may lead to an undesirable situation where all acquisitions of equity in a limited liability company are subject to the consent of the company's subsidiary's other equity-holders. This concern may be unwarranted because the findings in the judgment were based on the very special circumstances of this particular case, which are:

• Soho China had had talks with Fosun about the transfer of equity in the JV before it decided to acquire equity in the JV's other parent companies;

• Soho China acquired equity in Greentown and Zhengda only after they had divested all other assets but equity in the JV; and

• Greentown and Zhengda only gave Fosun a few days notice and agreed to a lower price with Soho China than offered to Fosun in the notice.

The above circumstances combined made it clear that the only purpose of Soho China acquiring equity in Greentown and Zhengda rather than the JV itself was to circumvent Fosun's right of first refusal, and in obvious bad faith, which is an inherent element of circumvention. The finding of circumvention or illicit purpose is a matter of fact rather than of law and that is where judges may have much discretion. Despite this particular Judgment, Chinese courts will remain cautious in making the finding where there are legitimate commercial reasons for acquiring equity in a parent company rather than the subsidiary company.

The Court was unwise in mentioning the resultant stalemate in the Judgment, as it is irrelevant to the reasoning and conclusion. The very mention suggests that the Court's decision may have been driven, at least partially, by political or public considerations, as suspected by many critics. It suggests that if a stalemate had not resulted, their decision may have been different.

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Avoiding uncertainty

The Judgment is still subject to appeal to the Shanghai High Court. Regardless of whether the High Court will uphold the decision, which the author believes it will, some precautionary measures can mitigate uncertainty:

• If the controlling equity-holder wishes to maintain control in all situations and avoid a stalemate, it should take a stake higher than 50% in the first place;

• If it is all the equity-holders' desire to pre-empt circumvention, a well-drafted clause should be included in the equity-holders agreement that restricts the sale of equity interests in the equity-holders themselves;

• For a potential acquirer, acquire equity in the operational company rather than its holding company wherever possible;

• Where acquisition of equity in the holding company is more feasible than the operational company, ensure that at least one commercially sensible reason exists;

• Be extremely cautious when acquiring equity in the holding company whose only asset is equity in an operational company (or another holding company of an operational company) in China, which has other equity-holders. Details in the implementation will influence the finding of circumvention. Seek professional advice.

Li Haifeng, Global Law Office