China’s third draft revision to its Company Law released for public comment

Proposed changes relating to the capitalization requirements of PRC companies

1. Shareholders of a limited liability company (LLC)  being required to make the entire contribution to the registered capital of the company that they have subscribed for within 5 years of the LLC’s incorporation

The PRC Company Law has been fully implementing a capital subscription regime since December 2013, under which the timing for the shareholders to make capital contributions to a LLC may be determined by the shareholders at their discretion unless any law explicitly requires otherwise. This offers the investors a high degree of flexibility in the timing of their capital contribution and a common provision in the articles of association of PRC LLCs is that the shareholders will make capital contributions to the subject company within its term of business (which may range from 10 years to 30 years or even an indefinite period). It appears that this regime is currently under review by the Chinese legislative authority. We note that this proposed change was not included in the previous two rounds of the draft revisions. 

The Third Draft Revision also contains various other provisions relating to the payment of the registered capital of a LLC:

• the board of directors of the LLC shall verify the contribution status of the LLC’s registered capital, and shall, in case any shareholder has delayed its contribution, serve a notice (a Payment Notice) on the relevant shareholder(s) requiring prompt rectification;
• if the board fails to monitor and require the shareholder’s contribution as mentioned above and losses have been incurred by the LLC, the responsible director(s) shall be personally liable for such losses; and
• if a shareholder fails to contribute the registered capital after expiration of the grace period as specified in a Payment Notice (which should not be less than 60 days), such defaulting shareholder will lose its rights relating to the unpaid registered capital. If the defaulting shareholder’s rights have not been transferred or cancelled through capital reduction within the next 6 months, other shareholders of the LLC (if any) shall make the capital contribution (which should have been made by the defaulting shareholder) in proportion to their shareholding ratios in the LLC.

2. Introducing flexibility for the board of directors of a company limited by shares (CLS) to approve issuances of shares

With the intention of promoting the development of China’s capital market, the Third Draft Revision proposes that the articles of association or shareholders’ meeting of a CLS may authorise its board of directors to approve, within a period of three years,  the issuance of new shares of not more than 50% of the shares already issued by the CLS.
Such a change is expected to improve the flexibility and efficiency in a CLS’s issuance of shares and offer convenience in the fund-raising activities of a CLS, taking into account the increasing funding needs of companies in recent years.

3. Explicitly allowing a CLS to issue separate classes of shares

Under the current legal regime, various regulations of China Securities Regulatory Commission allow a CLS listed on the Shanghai Stock Exchange, the Shenzhen Stock Exchange or the National Equities Exchange and Quotations (NEEQ) to issue different classes of shares or preferred shares with preferential rights to dividends and proceeds upon liquidation, but with the voting rights of such shares being restricted. In practice, CLSs issuing such classes of shares in accordance with these regulations are mostly those listed on the Shanghai or Shenzhen Stock Exchange. In recent years, the Shanghai Stock Exchange and the Shenzhen Stock Exchange also allowed a limited amount of qualified CLSs listed on the second board (i.e., the Science and Technology Innovation Board (STAR) of the Shanghai Stock Exchange, and the ChiNext of the Shenzhen Stock Exchange) to issue preferred shares with special voting rights. 

Current PRC Company Law is silent on whether a CLS (listed or non-listed) may issue  different classes of shares but merely states that the State Council may release regulations on CLS’s issuance of other classes of shares not provided for in the PRC Company Law.

The Third Draft Revision now explicitly allows CLSs to issue separate classes or preferred shares with preferential rights in relation to dividends, proceeds upon liquidation, voting rights and transfer restrictions, etc. It remains to be seen whether the flexible approach on issuing different classes of shares being proposed under the Third Draft Revision would result in any changes to the current (more restrictive) regime applicable to CLSs listed on the stock exchanges mentioned above.

4. Proportionate capital reduction 

The Third Draft Revision proposes a new provision that in the event that a company conducts a capital reduction, all the shareholders shall reduce their capital contributions in proportion to their shareholding ratios in the company, unless otherwise provided in other applicable laws. It is not entirely clear if this provision is a mandatory requirement, or whether the shareholders of a company may agree otherwise, for instance, to permit a particular shareholder to fully exit from a company by way of capital reduction whilst other shareholders remain.

Proposed changes to shareholders’ obligations and liabilities relating to capital contributions

5. Acceleration of capital contribution obligations

Under current PRC Company Law, a shareholder of a LLC enjoys great flexibility in making contributions to its subscribed registered capital in a LLC. Therefore, a shareholder of a LLC is generally speaking not required to pay the registered capital before its due date (as set out in the articles of association) even if the LLC fails to pay its debts on time. 

The Third Draft Revision, however, proposes that if a LLC fails to pay off its debt when due, such LLC or the relevant creditor of the debt due, has the right to require the shareholder(s) of such LLC to make a capital contribution which has been subscribed but remains unpaid by such shareholder(s), notwithstanding that the payment is not yet due. This change was also included in the First Draft Revision and the Second Draft Revision.

6. Founding shareholders’ joint and several liability for capital contributions

The Third Draft Revision proposes that upon the incorporation of a company (being a LLC or a CLS), if (i) a founding shareholder fails to make capital contributions in full in accordance with the articles of association of the company, or (ii) the actual value of the non-monetary contribution made by a founding shareholder is significantly lower than the amount of that shareholder’s subscribed registered capital, such founding shareholder is required to make up the difference, and other founding shareholders of the company shall bear joint and several liability relating to such required capital contribution.

7. Allocation of responsibility between the transferor and the transferee in case of an equity transfer in a LLC with an unpaid capital contribution

Currently, under the relevant judicial interpretations, when there is a transfer of equity interest in a LLC and the transferor has not fully contributed its subscribed registered capital:

• if the capital contribution obligation was already due, unless the transferee is aware or ought to be aware of this circumstance, the transferor may still be held liable for making the contribution and the transferee may be held to be jointly and severally liable for the shortfall with the transferor; and
• if the capital contribution obligation is not yet due, the legal position is not entirely clear as to which party shall be held liable for making the contribution. A generally accepted view in practice is that the transferor should not bear such liability, but the judicial practice varies.

The Third Draft Revision incorporates the first bullet point mentioned above, and clarifies with regards to the second bullet point that:

• if upon a transfer of equity interest in a LLC, the capital contribution obligation relating to such equity interest is not yet due, the transferee shall bear the future contribution obligations; and
• if the transferee fails to make the capital contribution when it becomes due, the transferor shall bear a secondary (not joint and several) liability to make the overdue capital contribution.

A selling shareholder would need to take note (and consider addressing) this contingent liability when negotiating the transfer of an equity interest in such circumstances.

Corporate governance

8. Qualification requirements on the legal representative of a PRC company

Under PRC Company Law, having a legal representative is a mandatory requirement and such legal representative will be publicly registered with the company registration authority and has, by default, the power of conducting civil activities as well as signing legal documents on behalf of the company. Existing PRC Company Law requires such a role to be assumed by one of the following: the chairman of the board of directors, the executive director (where there is only one director in lieu of a board of directors), or the general manager.

The Third Draft Revision proposes that a director or the general manager who actually manages the affairs of the company shall serve as the legal representative. The intention of this revision appears to be requiring the person who is substantially involved in the business operations of the company to be the legal representative (being the person who will potentially be held accountable if there is any non-compliance by the company). In addition, allowing a director to serve as the legal representative will expand the scope of candidates for this role.

9. Introducing an audit committee as an alternative to the board of supervisors

The Third Draft Revision proposes that a company (including both LLCs and CLSs) may set up an audit committee within (and comprising members of) the board of directors in accordance with its articles of association to exercise the functions of the supervisor(s) or board of supervisors. In such circumstances, the company will no longer be required to have a supervisor or set up a board of supervisors. 

The Third Draft Revision does not impose requirements on the number or qualifications of the members sitting on the audit committee of a LLC. However, the Third Draft Revision requires that  the audit committee of a CLS shall consist of three or more members, and more than 50% of these members shall not take any position in the CLS other than acting as a director. Such members of the CLS’s audit committee are not expected to have any other relationship with the CLS that may potentially have an impact on his / her independence in fulfilling this role.

10. Duties of directors in the liquidation of a company

The Third Draft Revision proposes that director(s) of a company shall be the obligor(s) in the company’s liquidation, and shall set up a liquidation team within 15 days after a liquidation event has occurred. The liquidation team shall comprise the company’s directors, unless the articles of association of the company provide, or the shareholders’ meeting resolves, otherwise. If the liquidation obligor(s) fail to promptly perform the liquidation obligations provided in the PRC Company Law, and such failure results in losses to the company or the creditors of the company, such obligor(s) shall be personally liable for such losses.

Protective provisions on shareholder’s rights

11. Rights of shareholders to inspect and review financial materials of the company

Apart from the articles of association, the shareholders register, corporate resolutions, financial audit reports and the accounting books of the company, the Third Draft Revision also allows a shareholder of a LLC or shareholder(s) holding (alone or in aggregate) more than 3% of the issued shares of a CLS for at least 180 consecutive days, to review the underlying accounting documents (which form the basis of the accounting books) of the company.

To date, the Third Draft Revision has been reviewed and discussed by the NPC but it is unclear whether there will be further amendments and when the final draft will be officially put forward for voting by the NPC.  We are keeping a watching brief on further developments and will provide relevant updates in due course.