On 29 December 2023, the People’s Republic of China (PRC) national legislature adopted proposed amendments to PRC Company Law. The amended Company Law (2023 Company Law) will enter into force on 1 July 2024 and makes substantial changes to the corporate law, governance and practices in China.
This client alert is intended to provide a summary of the more significant changes introduced by the 2023 Company Law and the practical implications for existing companies, prospective investors and lenders to PRC companies.
Changes relating to shareholder capital contribution obligation
The 2023 Company Law introduces the following changes in respect of shareholder’s capital contribution obligation:
Mandatory five-year term to pay up subscribed registered capital
- Article 47 of the 2023 Company Law requires that shareholder(s) of a limited liability company must fully pay up the company’s registered capital amount in accordance with the company’s articles but within five years from the company’s incorporation date (the Capital Contribution Term). The existing Company Law, by contrast, does not impose such a deadline and many existing companies – including foreign-invested enterprises (FIEs) – have, in their articles, provided for a long-term (e.g., 10, 20 or 30 years after the incorporation date) shareholder’s capital contribution obligation.
- To the extent its term for capital contribution is longer, a company incorporated under the existing Company Law is required to “gradually” adjust its term in line with the new Capital Contribution Term. The 2023 Company Law also authorises the company registration authority1 (the Company Registry) to request a company to make adjustments if it thinks the company’s capital contribution term or registered capital amount are “apparently abnormal”. The 2023 Company Law delegates the State Council to issue specific implementing rules on these transitional measures.2
- The new five-year paid-up capital period requirement aims to enhance creditor protection. Going forward, lenders may consider requesting evidence that the company’s share capital has been paid up in accordance with its articles and the 2023 Company Law as a condition precedent for granting loans to a company. The lender may also consider stipulating it as an ongoing obligation in the loan agreement(s) until the capital contribution is fully paid up. Moreover, the amount of paid-up share capital may be incorporated into their financial covenants or used as a component for ratio tests in loan deals.
Acceleration of shareholder’s capital contribution obligation
- Under article 54 of the 2023 Company Law, if a company is unable to pay its debts when due, either the company or its creditors with due claims are entitled to demand shareholder(s) to make the capital contribution before expiry of the capital contribution term provided in the company’s articles.
- Under the existing laws and judicial practices, accelerated expiry of the capital contribution period is only permitted in limited exceptions (such as where the company is in insolvency proceedings or in the execution proceedings where the company as judgment debtor has no sufficient assets to satisfy the judgment debt).
- While it remains to be seen how article 54 will be interpreted and enforced by PRC courts, this provision could expose shareholders to the risk of being sued directly by company creditors for unpaid company debts.
- In view of the above new provisions relating to shareholder’s capital contribution obligation, existing companies, including FIEs, should consider whether their registered capital amounts and the Capital Contribution Terms under their articles of association need to be amended.
- From a lender’s perspective, given that both the company and the creditors could potentially accelerate and demand the shareholders to pay up their share capital, the lender may consider requiring the company and/or the company’s other creditor(s) to assign its respective rights to accelerate to the lender and undertake not to exercise such rights unless required and at the direction of the lender, as additional collateral in favour of the lender. Also, in loan transactions where security and/or credit enhancement documents include a borrower’s shareholder pledging its shares in favour of the lender or subordination by the shareholders of its shareholder loans to the lender’s loan, additional arrangements may need to be put in place by the lender, as the lender may not want the company and/or the company’s other creditor(s) to accelerate the capital without its knowledge and control of the funds.
- Whether and what additional arrangements would be put in place will depend on the bargaining power between the lenders and the borrowers, shareholders and other creditors. It is more likely to be the case in a project finance arrangement that relies heavily on bank loans.
Forfeiture of shareholders’ rights
- Under articles 51 and 52 of the 2023 Company Law, where a shareholder fails to contribute capital in accordance with terms of the company articles, the company board of directors must issue a written demand to the shareholder to make up the capital contribution. If the shareholder fails to make up the capital contribution according to the written demand (which may include a minimum 60-day grace period), the company board may, by written notice, forfeit the defaulting shareholder’s rights in respect of the unpaid capital contribution.
Liability for non-fully-paid equity interest between the transferor and transferee
- If a shareholder transfers its equity interest (i.e., the registered capital it subscribed to) in a company before the transferor’s capital contribution term expires, article 88 of the 2023 Company Law provides that the transferee assumes the obligation to make the remaining capital contribution. However, if the transferee fails to perform, the transferor will bear supplementary liability to contribute the unpaid capital.
- If the transferor fails to contribute capital in accordance with the terms of the company articles, or if the actual value of the transferor’s in-kind capital contribution is significantly lower than the capital contribution value claimed by the transferor, the transferor and transferee will be jointly and severally liable to the shortfall unless the transferee can show that it did not know or should have no reason to know such shortfall.
- In view of the above statutory allocation of liability between buyer and seller in an M&A (share deal) transaction involving a PRC target company, it is important that:
(a) the buyer conduct a thorough due diligence on whether the seller has paid up its subscribed capital pursuant to the company’s articles, and whether the seller’s in-kind capital contribution is reasonably valued; and
(b) the appropriate reps and warranties and indemnification provisions addressing the above liabilities between the parties are included in the transaction agreement.
- From a lender’s perspective, we are still observing the impact of this new amendment, particularly on share pledge arrangements in loan transactions and especially in cases where the pledged shares were acquired through purchases. It remains to be seen how this amended new requirement under the 2023 Company Law will affect the documentation and practical handling of share pledge arrangements in loan transactions. We will continue monitoring the evolving market, and a clearer picture may emerge once the detailed implementation measures of the 2023 Company Law are issued.
Changes relating to corporate governance
Governance structure
- Legal Representative .Under article 10 of the 2023 Company Law, the legal representative of a company could be one director (under the existing law, the legal representative must be the chairperson of the board of directors or, if the company has only one director, the sole director) or manager of the company who executes the company affairs.
- Board of Supervisors or Supervisor. Under the 2023 Company Law (articles 66 and 121), companies can elect to set up an audit committee within their board of directors to perform supervisory functions without having to establish a separate board of supervisors or a supervisor. A limited liability company of small scale or with few shareholders may also elect to not establish a board of supervisors or a supervisor provided all shareholders agree in writing (article 83).
Employee representative’s participation in governance
- Article 68 of the 2023 Company Law provides that a limited liability company with more than 300 employees is required to include employee representative(s) on its board unless the company has established a board of supervisors with employee representative(s). Employee representatives shall be democratically elected by the employees of the company through the employees’ congress, employees’ meeting or other forms.
- The amended article 17 expands the scope of corporate matters for which a company is required to consult with and seek opinions and suggestions of employees to include the company’s decision on dissolution and filling for insolvency in addition to formulating important company regulations and policies.
Procedural requirements for board meetings
The 2023 Company Law introduces specific requirements for company board meetings, including, among others:
- A quorum, being more than half of all directors, is required for holding valid board meetings; a board resolution shall be passed by more than half of all the directors; and meeting minutes containing the resolutions shall be prepared and signed by directors present at the meeting.
- Interestingly, article 27 of the 2023 Company Law states that a board resolution is not “formed” where a board meeting is not held or the matter to which the resolution relates is not voted on at the board meeting. The 2023 Company Law is silent on whether a board resolution can still be adopted validly by written consent of directors without a board meeting pursuant to the company’s articles. Pending further clarification, these new provisions could cast doubt over whether written board resolutions in lieu of board meetings would be valid under the new law.
- If a board resolution is declared by a court to have not been “formed”, the company shall rescind the registration that has been made with the Company Registry based on such resolution. However, a board resolution that is declared invalid, rescinded or not “formed” by a court does not affect the validity of legal actions of the company taken under such resolution vis-a-vis a bona fide counterparty. It would be prudent for a party (such as a lender) to conduct diligence on whether the counterparty’s resolution approving the transaction has been passed validly.
Fiduciary duty and controlling shareholder or de facto controller’s liability
- Besides reiterating the duty of loyalty and care of directors, supervisors and senior officers, article 180 of the 2023 Company Law extends such fiduciary duties to the controlling shareholder or the de facto controller of a company who is not a director but executes company affairs.
- Furthermore, under article 192 of the Company Law, a controlling shareholder or de facto controller would be held jointly and severally liable for acts of the directors, supervisors and senior officers that harm the interests of the company or shareholder(s), if such acts are taken at the direction of the controlling shareholder or de facto controller.
- In view of the above heightened duty and liability imposed on the controlling shareholder or de facto controller, we would strongly recommend that controlling shareholders or de facto controllers of companies (including wholly foreign-owned enterprises (WFOEs) that operate in China but have only one shareholder) carefully review and set out clear protocols in exercising their shareholder rights in subsidiary companies to avoid being held to owe fiduciary duty of loyalty and care to the subsidiaries or otherwise liable for damages caused to subsidiaries and other shareholders of such subsidiaries.
Conclusion
- The 2023 Company Law made a number of substantial changes that would materially impact on shareholder’s capital contribution obligation, corporate governance structure, the requirements of board meetings and resolutions, and the manner in which a controlling shareholder or de facto controller should exercise its shareholder rights.
- In view of these changes, we would suggest companies and their shareholders consider the appropriateness of the registered capital amount of the company, the current corporate governance structure and corporate procedures for board and shareholder meetings, the current protocols of interacting between the controlling shareholder or de facto controller and its subsidiary company and make appropriate amendments to the company’s articles of association and/or policies to ensure compliance with and mitigate risks that could arise 2023 Company Law.
- The State Administration for Market Regulation and its local counterparts
- Article 266 of the 2023 Company Law
In-depth 2024-010
