Transferring shareholder’s potential continued liability for capital contributions under China’s New Company Law

Recent legislative change

On 24 December 2024, the Supreme People’s Court of the People’s Republic of China (the SPC) issued the Reply on Non-retrospectivity of Paragraph 1, Article 88 of the Company Law of the People’s Republic of China (in Chinese: 关于《中华人民共和国公司法》第八十八条第一款不溯及适用的批复) (the SPC Dec. Reply), which took immediate effect. The SPC Dec. Reply clarifies that paragraph 1, Article 88 of China’s New Company Law (the New Company Law) which came into effect on 1 July 2024 (the Effective Date), shall only apply to equity transfers occurring after the Effective Date when determining the extent of a former shareholder’s capital contribution obligations to the target company which were not as yet due at the time of the equity transfer. This provides some clarity and assurance as there were concerns that this aspect of the New Company Law had retrospective effect and would apply to deals and transfers which had taken place before the Effective Date.

Here are our previous articles on the various changes introduced by the New Company Law:

China’s third draft revision to its Company Law released for public comment | Global law firm | Norton Rose Fulbright

China releases its newly revised Company Law | Global law firm | Norton Rose Fulbright

Relevant background and the significance of the SPC Dec. Reply

Paragraph 1 of Article 88 of the New Company Law (the Article 88(1)) provides that:

“When a shareholder transfers its equity interest in a company for which the agreed capital contribution deadline has not been due yet, the transferee shall assume the obligations to contribute the unpaid capital. If the transferee fails to make the capital contribution on time and in full, the transferor shall bear supplemental liabilities for such unpaid capital.”

According to the Several Provisions on the Timing Effect of Applying the Company Law of the People’s Republic of China (in Chinese: 最高人民法院关于适用《中华人民共和国公司法》时间效力的若干规定) issued by the SPC in June 2024 (the SPC Jun. Provisions, which took effect on the Effective Date), Article 88(1) not only applies to equity transfers taking place after the Effective Date but also applies to equity transfers which had taken place before the Effective Date, meaning it has retrospective effect.

Such a stance taken by the SPC sparked concerns amongst shareholders who had already transferred their equity interest before the Effective Date, fearing that they might be called back by the courts to bear the capital contribution obligations which are not fulfilled by the transferees, without knowing the existence of such risks when conducting the transactions. In fact, there have been several cases after the Effective Date where the courts, by citing the SPC Jun. Provisions, have held that the former shareholders are liable to make the capital contributions to the target companies when the transferees failed to do so, notwithstanding that the equity transfer had been completed before the Effective Date and the capital contribution obligations relating to the equity interests subject of the transfer were not yet due at the time of the equity transfer.

The significance of the SPC Dec. Reply is that it rectifies this position under the SPC Jun. Provisions and makes it clear that Article 88(1) shall not apply to equity transfers occurring prior to the Effective Date. Instead, disputes arising from those transactions in this regard shall be adjudicated in accordance with the spirit of the previous Company Law and other relevant legislations.

Summary of a transferring shareholder’s capital contribution obligations

To illustrate the potential risks and outcomes for transferring shareholders to consider, here are a few different scenarios which highlight their capital contribution obligations:

Scenario I: The equity transfer occurs after the Effective Date whilst the capital contribution obligations were not due nor fulfilled yet at the time of the equity transfer:

In this scenario, Article 88(1) is applicable and the transferee bears primary capital contribution obligations and the transferring shareholder shall bear supplemental liabilities. This effectively means that if the transferee fails to fulfill the capital contribution obligations, the transferring shareholder shall be liable for the entire sum which should have been but is not contributed by the transferee.

Scenario II: The equity transfer occurs after the Effective Date whilst the capital contribution obligations were already due but not as yet fulfilled by the transferring shareholder at the time of the equity transfer:

In this scenario, pursuant to paragraph 2 of Article 88 of the New Company Law, the transferring shareholder and the transferee shall be jointly and severally liable for such unpaid capital except where the transferee was not aware or ought not to be aware of such circumstance, in which case the transferring shareholder shall be solely liable.

Scenario III: The equity transfer occurs before the Effective Date whilst the capital contribution obligations were not due nor fulfilled yet at the time of the equity transfer:

This is the scenario that the SPC Dec. Reply seeks to address. As explained above, disputes are adjudicated in accordance with the spirit of relevant laws such as the previous Company Law. However, the previous Company Law was silent on this point.

We note from the judicial practice prior to the Effective Date that the courts came to different decisions based on different factual backgrounds, and generally speaking, unless the former shareholder, by virtue of the equity transfer, had malicious intent to willfully evade from such obligations and frustrate the debt collection by the target company’s creditors, the former shareholder would not normally be liable to make capital contributions to the target company when such contribution obligations were not due yet at the time of the equity transfer.

Notwithstanding this, there would be a great degree of uncertainty in future judicial practices given the position under the law was unclear and court decisions on this issue were inconsistent. Further, China is a civil law jurisdiction where generally speaking previous court cases do not form binding judicial precedents which apply to future cases.

In this scenario, it is crucial to mitigate the risks with a well-drafted equity transfer agreement which clearly sets out the obligations and liabilities of the transaction parties in this regard.

Scenario IV: The equity transfer occurs before the Effective Date whilst the capital contribution obligations were already due but not as yet fulfilled by the transferring shareholder at the time of the equity transfer:

According to various SPC interpretations relating to the previous Company Law prior to the Effective Date, the legal position is the same as that under Scenario II above. In other words, the New Company Law confirmed the legal position on this point as previously set out in the relevant SPC interpretations.

Given the issues and related risks discussed in this article, it is important for the transaction parties to carefully consider and mitigate such risks when effecting and documenting equity transfers in China in future.