Summary and Commentary: Interpretation IV of the PRC Company Law

Interpretation IV does not significantly expand shareholder information rights. The information accessible to shareholders is still limited to the articles of association, shareholder meeting minutes, board meeting minutes, supervisors meeting minutes, financial reports and accounting books. An earlier consultation draft of Interpretation IV included “accounting certificates or original certificates” as accessible information and which are generally more critical for shareholders to safeguard their rights, however this clause was subsequently deleted.

The “unreasonable purpose” circumstances listed in Article 8 include “[t]he shareholder conducts or conducts for others business that is competitive with the company's main business” and “[t]he shareholder reviews the company's accounting books for the purpose of disclosing relevant information to third parties and is likely to compromise the company's lawful interests.” The PRC Company Law, however, does not prohibit shareholders from conducting competitive business. Technically, unless otherwise provided in the articles of association or shareholder agreement, conducting competitive business is a shareholder's statutory right and Article 8 compromises this right. As to the other prescribed circumstance, it is unclear how a company could (and to what extent a company should) prove that the shareholder is acquiring information for the purpose of disclosing it to third parties, which may also pose challenges to judges adjudicating such cases.

III. SHAREHOLDERS' PROFIT DISTRIBUTION RIGHTS

Interpretation IV tries to improve the existing rules in relation to protection of shareholders' profits distribution rights with three articles: 1) where a shareholder brings a lawsuit to claim distribution of profits, the company shall be listed as the defendant (Article 13) and 2) such lawsuit may be brought only after a shareholder resolution containing a distribution plan has been adopted (Article 14; a limited exception is provided in Article 15).

It is widely accepted that whether and how to distribute profits is subject to the company's business judgment and the court shall not step in and compel a company to distribute profits to shareholders by way of a judgment. It is mainly for this reason that Interpretation IV requires a prior shareholder resolution in order to support the shareholder's distribution claim.

In reality, however, the more typical case is that the majority shareholder refuses to adopt a distribution resolution. As mentioned before, Article 15 provides a limited exception to the general rule under Article 14 which provides that, if, because of a majority shareholder's abuse of rights and violation of law, “the company fails to distribute profits…and causes losses to other shareholders,” then other shareholders can request the company to distribute profits without a pre-existing shareholder resolution.

This exception, however, is problematic both in theory and in practice. Under this exception clause, the losses are caused by the majority shareholder instead of the company, oftentimes due to an unreasonable refusal to adopt a distribution plan. Therefore, logically, the defendant should be the majority shareholder rather than the company. The clause also fails to provide explicit rules for judges to determine a distribution plan when necessary, which could cause great difficulty for judges who have neither sufficient information nor expertise to create a distribution plan. Additionally, shareholders may face difficulty in proving 1) that they have suffered losses, 2) that their losses were caused by not receiving distributions from the company (the company failing to make distributions would not necessarily cause the shareholder to suffer losses), and 3) that, taking account of relevant factors, the shareholder's proposed distribution plan/amount is reasonable.

IV. SHAREHOLDERS' PREEMPTIVE RIGHTS

According to the PRC Company Law, when shareholders of a limited liability company transfer equity to outside parties, other shareholders may enjoy a right of preemption under the same conditions. Interpretation IV supplements and improves the PRC Company Law in this regard with seven articles: 1) it precludes preemptive rights for equity transfers caused by inheritance (Article 16); 2) it provides implementing rules for shareholders to exercise preemptive rights, including the notice obligations of transferring shareholders, factors in determining the “same conditions,” and time limit to exercise preemptive rights (Articles 17, 18, and 19); 3) it clarifies the consequences of violating preemptive rights: a) even if preemptive rights have already been exercised, the transferring shareholder may still refuse to transfer the equity to whoever exercised the right, in which case the transferring shareholder may be liable for breach of contract; however, b) if the transferring shareholder jeopardizes other shareholders' preemptive rights by using illegal means such as fraud or malicious conspiracy, then even if the equity had been transferred to a third party, other shareholders exercising the right of preemption may still request the transferring shareholder to transfer the equity to them under the same conditions (Articles 20, 21); 4) it provides rules for transferring equity by auctions or on an equity exchange (Article 22).

The foregoing articles are widely viewed as a sound improvement of the existing rules under the PRC Company Law in terms of balancing the shareholders' ownership rights and preemption rights. On one hand, the articles reaffirm that, if the transferring shareholder duly performs its prescribed obligations (such as providing notice), the other shareholders cannot force the transferring shareholder to transfer the equity to them, which makes the preemptive right not so intrusive to the transferring shareholder's ownership rights. On the other hand, if the transferring shareholder tries to bypass the preemptive rights by means of fraud or malicious conspiracy, it will be forced to transfer the equity to other shareholders who duly exercised their rights, which can in turn encourage the transferring party (and outside third parties) to honor other shareholders' preemptive rights.

V. SHAREHOLDER DERIVATIVE ACTIONS

With regard to shareholder derivative actions, Interpretation IV supplements the PRC Company Law with four articles: 1) it makes clear that the action as provided in paragraph 1 of Article 151 of the PRC Company Law is in fact a direct action (under which the board, executive director or supervisor brings the lawsuit against the company based on their statutory duties) (Article 23); 2) it provides implementing rules to carry out the derivative action as provided in paragraphs 2 and 3 of Article 151 of the PRC Company Law (Articles 24, 25, 26).

The foregoing Interpretation IV articles are still very concise and it is doubtful how much help they can provide to shareholders who choose to file a derivative action. In particular, these articles will face longstanding practical problems. For example, under PRC law, the company, when acting as a plaintiff, will need to file with the court its business license and an identity certificate of its legal representative, both of which need to be affixed with the company chop, an important symbol of the company normally controlled by the chairman of the board or executive director. In this case, if the supervisors wish to bring a direct action against the chairman of the board or executive director on behalf of the company, the chairman or executive director could simply refuse to provide the company chop and readily obstruct the litigation initiative.

VI. Conclusion

The most important change the Interpretation IV made to the PRC Company Law was the creation of unsustainable resolutions, though it also creates inconsistencies to the system. Interpretation IV's improvements on shareholder information rights, distribution rights, and shareholder derivative actions, however, are rather limited, though it does make a wise move on balancing the shareholders' ownership rights and preemption rights.

Like other judicial interpretations the court has made to PRC laws, the promulgation of Interpretation IV is only half the work. We will see how judicial practice will complete the other half of the Interpretation IV.

Andy (Ronghua) Liao, Partner

Alan (Chunyao) Lin, Lawyer

Han Kun Law Offices