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What do you need to do?Be aware that if this regulation is passed there may be greater clarity regarding dispute resolution affecting your investments in China.
Nicolas Groffman (郭恺)
Partner
Nancy Zhao (赵燕暄)
Associate
John Shi (史卫)
Partner
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Larry Kwok
(郭琳廣)
Stuart Valentine
(萬思陶)
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John Shi
(史卫)
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Martyn Huckerby
(贺墨亭)
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Greg Golding
Melbourne
Stephen Minns
The Supreme People’s Court issued, on 23 November 2009, draft Regulations on Issues in Adjudicating Cases Involving Foreign Invested Enterprise Disputes (Part 1) (the “Rules”). These draft rules could assist in dispute resolution for foreign investors with subsidiaries in China.
The Rules draw on courts' real case experience, and attempt to find ways to stop defaulters from playing on administrative complexity or on courts’ weaknesses to avoid liability. The rules also provide ways for investors to create more sophisticated investment arrangements without needing to go through approval. It remains to be seen if the draft rules will actually take legal effect in their present form.
Not everything needs to go in the joint venture contract
Any contract entered into affecting the establishment or amendment of foreign invested enterprises (FIEs) only takes effect when approved. However, if supplemental agreements do not constitute any “material or substantial” changes to the approved joint venture contract, the court may consider that the supplemental contract is effective.
For years there has been a question mark over the affectivity of “side agreements” that investors often sign to cover various issues that they deliberately omit from the joint venture contract. Side agreements are signed because the main joint venture contract is subject to examination and approval. The more complex the contract, the longer the examination process takes, because the authorities debate the content among themselves and with the investors. To avoid delays, investors insert much of the detail into a side agreement which they do not submit for approval. The new rule seems to allow such side agreements, as long as the change does not constitute a material change to the approved contract.
“Material change” includes changes in registered capital, company type, scope of operations, term, contributions by shareholders, methods of contribution, mergers and divisions, and share transfer.
Failure to contribute
If a party to a joint venture is to contribute “in kind” (rather than in cash), for example by bringing land and buildings, but fails to change the title registration in respect of such assets, then the court will check whether the relevant party has actually provided the relevant assets. If, for example, it has transferred the joint venture land and buildings but simply has not got around to changing the title, then the court can order the title registration to be updated, but should not treat this as a failure to make its capital contribution. But if the land has not even been provided, then the court should treat this as a breach, and require the contribution to be made, and the breaching party to pay additional damages if necessary.
Failure to register a transfer
Sometimes a shareholder sells its interest in an FIE to a third party, but the FIE’s staff fail to register the change. The new rules provide that the court must order the seller and the FIE to apply for approval jointly within a specific period of time. If they still fail to do so, the buyer can get his money back, along with damages amounting to (among other things) the difference in price between the date of entering into the share transfer contract and the date of litigation, as well as “other reasonable loss” incurred by the buyer.
Dealing with default by the Transferee under the Equity Transfer Contract
Occasionally, a sale goes ahead and the buyer comes into the FIE as a new shareholder, exercising all associated rights before the government authority has approved the sale. In such a case, if the seller sues the buyer for unpaid purchase price, then the court must simply order the seller to complete the approval procedure. Only if the approval is actually issued should the court support the lawsuit of the seller.
This is a step away from contract freedom and confirms that pre-approval payments - for example, if the seller has negotiated for a portion of the purchase price to be paid on the day of signing - will not be upheld by the courts. This confirms current practice in contract drafting, but does not rule out such pre-approval payment obligations as consideration for performance of other obligations, such as cooperation bonus payments under separate contracts.
Pre-emptive rights
The parties to a joint venture have statutory pre-emptive rights when one party wishes to sell equity to a third party. Even if the transfer has been approved by the government, the other shareholders of the company can cause the sale to be declared void if they were not given the opportunity to exercise their statutory pre-emptive rights.
However, neither the buyer nor the seller may use this as an excuse to back out of a transaction they have come to regret. The right to undo the sale is granted only to the other shareholders of the joint venture.
Share Pledge Contracts
If the shareholder of an FIE enters into a Share Pledge Contract with a creditor, the contract is valid whether or not it is registered. However, only when the pledge is registered are the “pledge rights” over the equity established.
This separation of pledge rights and contract rights might seem odd to common law lawyers, but not to those familiar with civil law. The Property Law of 2007 provided for this separation (which follows German law), and as a result a pledge agreement becomes effective when formed, but the pledge right itself is only valid when delivered or registered. The creditor would be able to sue for damages under contract, but not be able to exercise its pledge rights until the pledge is properly registered.
Entrustment investment
If the parties have agreed that one party will make the actual investment and enjoy the shareholder’s rights and interests, while the other party acts as nominal shareholder, this trust agreement is effective, provided that it “does not violate the compulsory requirements of laws and administrative regulations, and social public interests.”
The de facto investor, being the principal under the trust, needs to be astute about how it enforces its rights if the nominee investor later decides not to cooperate. If the investor directly requests the court to acknowledge his shareholder identity in the FIE, or to change the shareholder of the FIE, or if he sues the FIE itself for dividends rather than suing the nominee shareholder, the court should not support his claims. But if he requests the court to cause the nominee to perform the relevant obligations as agreed by the parties in the trust agreement, the people’s court should support him.
WFOE contracts also need to be governed by Chinese law
When two or more foreign investors set up a wholly foreign owned enterprise, then the contract governing their rights must be governed by Chinese law. If they select foreign law, this is unenforceable.
Previously, it has been argued that the contract between foreign parties needs not be governed by Chinese law, because such a contract is not a Sino-foreign joint venture contract and has sufficient foreign nexus. The Rules will negate this argument. Some will view this as a step backwards, because Chinese law does not provide flexibility for many of the complex terms and conditions offshore agreements are wont to contain.
Chinese citizens living overseas are treated as foreigners
It is common for foreign investment rules to be extended to cover Hong Kong and Macao (and Taiwan), in recognition of the different legal systems in place in those regions. However, rather oddly, the rules also provide that Chinese citizens with foreign domicile are covered by the rules. It is not clear how this will be carried out, if implemented. Only in exceptional circumstances and in a few locations in China can Chinese citizens be treated like foreigners for investment purposes, so it seems unlikely that this ostensibly nationwide provision will work in practice.
Retroactive effect
The rules are to have retroactive effect on all cases that have not yet reached a final verdict, whether at first instance or on appeal. However, some cases reach final judgment but are then subject to “review,” which is effectively a second appeal. Cases that are subject to review will not be covered by the new rules.
Disclaimer
This publication is only a general outline. It is not legal advice. You should seek professional advice before taking any action based on its contents. As is the case for all international law firms licensed in China, we are authorised to provide information concerning the effect of the Chinese legal environment. We are not allowed to issue opinions on matters of Chinese law.