China Issues a Draft Revision of the PRC Company Law: What Investors Need to Know

On December 24, 2021, China’s National People’s Congress issued a draft revision (“Draft Revision”) to the Company Law of the People’s Republic of China (“PRC Company Law”) and made it available for public comment. The Draft Revision adds and amends about 70 articles to the PRC Company Law on the basis of the 13 chapters and 218 articles of the existing PRC Company Law (the “Existing Company Law”). This alert highlights some key revisions that could impact investors in companies located in China[1].

1. Equity transfers no longer require the consent of a majority of non-selling shareholders.

Many investment transactions in China are conducted by investors purchasing equity in a PRC limited liability company from existing shareholder(s). The Existing Company Law 1) requires sellers to obtain the consent of a majority of the other existing shareholders; and 2) provides the other existing shareholders with a right of first refusal (Article 71 of the Existing Company Law). In the past, investors/shareholders that wanted to exit an investment in a Chinese limited liability company by transferring equity to a third party faced an effective “veto” against such an exit if they failed to secure the consent of the other shareholders.

Article 85 of the Draft Revision removes the requirement of obtaining the consent of a majority of the other existing shareholders for the equity transfer and only retains the right of first refusal. Thus, the selling shareholder only needs to notify the other shareholders of the proposed equity transfer and provide them with an opportunity to purchase the equity. If the other shareholders do not purchase the equity within 30 days after the receipt of the notice, the selling shareholder will be free to proceed to sell the equity to the proposed buyer.

Article 87 of the Draft Revision further provides that the target company must cooperate with the new shareholder to modify the register of shareholders and complete modification registration formalities with the local Administration for Market Regulation. Both the new shareholder and the selling shareholder have a right to sue if the target company refuses or fails to cooperate within a reasonable time limit.

2. When purchasing equity, buyers should determine whether all corresponding capital contributions have been made and the equity is fully paid up.

Under both the Draft Revision and the Existing Company Law, even if a shareholder has not made all capital contributions corresponding to the underlying equity, it still can transfer such equity. The Draft Revision however suggests that there are certain risks to a new shareholder purchasing equity from a selling shareholder where the seller has not fully paid all corresponding capital contributions. These risks include:

a) The purchaser may lose rights in the purchased equity corresponding to the amount of unpaid capital contribution. According to Article 46 of the Draft Revision, after a limited liability company is established, the company shall verify the capital contributions made by the shareholders. If the company finds that any shareholder has failed to make its capital contributions in full within the time limit provided by the articles of association, or the actual value of the non-monetary property used as capital contributions is lower than the amount of capital contributions to which that shareholder has subscribed, the company must send a written call for capital contributions to such shareholder. When calling for such capital contribution, the company may indicate a grace period for making capital contributions. The grace period must be at least 60 days from the date when the company sends out the written call for capital contributions. At the expiration of the grace period, if the shareholder fails to make its capital contributions, the company may send a notice of loss of power to the shareholder. As of the day when the notice is sent out, the shareholder loses its ownership of the equity to the extent its capital contribution has not been made. For example, if a shareholder has paid only 50% of the capital contributions for its underlying equity, it will lose 50% of the ownership of equity it did not pay up.

b) The shareholder may need to make the capital contributions in advance.According to Article 48 of the Draft Revision, where a limited liability company is unable to pay off its debts and is insolvent, the company or the creditors thereof shall be entitled to require shareholders who have subscribed for equity but not made their capital contributions to accelerate their capital payments.

c)The purchaser may bear joint and several liability together with the selling shareholder to the extent of insufficient capital contribution. According to Article 89 of the Draft Revision, where a shareholder of a limited liability company fails to make its capital contribution in full when required or the actual value of the non-monetary property used as capital contribution is lower than the amount of capital contribution to which the shareholder is required to make and the purchaser knows or should have known of such circumstances, the purchaser and shareholder will be jointly and severally liable for all consequences resulting from the insufficient capital contribution of the underlying equity at issue.

Thus, prospective purchasers of equity in Chinese limited liability companies should conduct due diligence, including by examining all equity subscriptions and deadlines and determining whether required capital contributions have been made. Also, if a selling shareholder used non-monetary property (such as real estate or intellectual property rights) to make its capital contribution, the purchaser should determine whether the value of the property contributed is consistent with the amount of the required capital contributions corresponding to the equity to which the selling shareholder subscribed.

3. Director, supervisor and senior management responsibilities are strengthened.

In investment and acquisition transactions in which investors appoint or replace some or all directors, supervisors and senior management after closing, the Draft Revision adds a few circumstances, under which the new director, supervisor, and senior management could be liable for compensation of company losses.

a) When a director, supervisor or senior manager knows or should have known that a shareholder failed to pay required capital contribution and fails to take necessary action. According to Article 47 of the Draft Revision, after a limited liability company is established, if a shareholder fails to make its capital contributions on a timely basis and in full, or the actual value of the non-monetary property used as capital contributions is lower than the amount of capital contributions to which the shareholder subscribed, the shareholder must make up the difference with interest (at the deposit interest rate applicable to PRC banks) for the corresponding period of the delinquency. Where any director, supervisor or senior manager knows or should have known that a shareholder has committed such acts and fails to take any necessary action, which causes any loss to the company, such director, supervisor or senior manager will be personally liable to the company for such loss.

b) When a director, supervisor or senior manager knows or should have known that a shareholder has withdrawn its capital contributions and failed to take necessary action. According to Article 52 of the Draft Revision, after a limited liability company is established, no shareholder may withdraw its capital contributions. Where a director, supervisor or senior manager knows that a shareholder has withdrawn its capital contributions or should have known about the shareholder's withdrawal, but fails to take any necessary measure, thus causing any loss to the company, such director, supervisor or senior manager shall be personally liable to the company for such loss.

c) When the company provides financial support for others to acquire shares of such company in violation of the provisions provided by the Draft Revision. According to Article 174 of the Draft Revision, no company limited by shares or any of its subsidiaries may provide any donation, loan, guaranty or other financial support for any other person to obtain the shares of such company limited by shares (except where an employee stock ownership plan or financial institution takes such action in the ordinary course of its business operations). Under certain circumstance, a company may provide financial support to assist another person in acquiring shares in the company or its subsidiaries, provided that the cumulative amount of the financial support does not exceed 10% of the company’s total issued share capital. In such case, the board of directors must adopt a resolution and at least two-thirds of all the directors shall approve such provision of financial support. In case of any loss caused to the company under these circumstances, the responsible directors, supervisors and senior managers will again be personally liable to the company for such loss.

4. The Draft Revision provides an additional procedure to expedite liquidation.

Under both the Existing Company Law and the Draft Revision, liquidation of a company can be a complicated and lengthy process often taking months or years to finalize in China. The Draft Revision provides an additional option that allows a company to expedite its liquidation. Article 235 of the Draft Revision allows a company to cancel its registration under simplified procedures, provided that the company has incurred no debt during its existence or in the case where all of a company’s debts have been paid off.

If a company plans to cancel its registration under such simplified procedures, it must announce its prospective cancellation no less than 20 days prior to such cancellation through the PRC uniform enterprise information publicity system, which provides a platform that the public can access to check on the status of PRC companies. If there are no objections, the company may apply to the local Administration for Market Regulation (the PRC company registration authority) to cancel its registration.

Where a company cancels its registration under simplified procedures, all the shareholders have joint and several liability for debts incurred prior to the cancellation of registration.

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The Draft Revision is still in the process of solicitation of public comments and we expect additional revisions to the Existing Company Law. We anticipate providing more updates as developments arise.