The impact of the new PRC Foreign Investment Law on foreign investments in China
FIRST PART | Governance Issues1
1. Background
The Foreign Investment Law of the People’s Republic of China (“FIL”) will become effective as of January 1st, 2020. Upon such crucial date, the FIL will replace the Law on Sino-foreign Equity Joint Ventures, the Law on Wholly Foreign-Owned Enterprises and the Law on Sino- foreign Contractual Joint Ventures, which have been the governing laws of foreign-invested enterprises (“FIEs”) since late Seventies.
The FIL stipulates that the “organizational form (公司形式), governance (组织机构) and activitie’s criteria (活动准则)” of FIEs shall be subject to the PRC, Company Law, to the PRC, Partnership Enterprise Law and other relevant laws (art. 31 of FIL).
With regard to the FIEs incorporated before January 1st, 2020, the FIL provides that they may keep their operations “as-is” for a 5-years’ transition period (i.e. ending on January 1st, 2025, the “Transition Period”).
The FIL thus gives rise to two main issues, strongly affecting foreign investments in China:
Which law to apply until 1/1/2020 | Which law and incorporation procedures shall be followed by foreign investors who are currently negotiating / incorporating foreign invested enterprises?
“Must-Do” for the Five Years’ Transition Period | What actions shall be taken by existing FIEs, in the next five years, to ensure compliance to the PRC Company Law and, more in general, to the newly established unified corporate regime?
1 This article shall be formed by more than one Part, in order to address each major difference between the existing FIEs regime and the unified Company Law regime applicable as of January 2020. Therefore in this article we list only differences related to corporate governance.
2. FIE existing legal regime vs Company Law unified regime: governance of the new FIEs
In order to preliminary ascertain the existing uncertainties and plan the actions to be taken in the next months / years, we shall analyze the major differences existing between the two regimes, with particular focus on the those differences affecting corporate governance and the rights and interest of the minority shareholders of Equity Joint Venture (“EJV”) and Contractual Joint Ventures (“CJV”).
The Highest Authority of the FIE
Under the Current regime | The highest authority of EJV and CJV, in the form of limited liability companies, is the board of directors. EJV and CJV usually do not have a shareholders’ meeting.
Under the Company Law system | According to the PRC, Company Law the highest authority of a limited liability company is the shareholders’ meeting, which shall thus be established (art. 36 of PRC Company Law).
The Board of directors
Under the Current regime | The attendance quorum to ensure validity of the board’s meeting is no less than two-thirds.
Under the Company Law system | The attendance quorum is flexible under the PRC, Company Law and may be agreed upon by the parties in the articles of association.
Appointment of directors
Under the Current regime | The directors are appointed directly by each joint venture shareholders.
Under the Company Law system | The directors shall be appointed and dismissed by the shareholders’ meeting (art. 37 of the PRC Company Law).
Decision quorum
Under the Current regime | The decisions on major issues regarding a joint venture, such as amendment of the articles of association, increase or decrease of the registered capital, approval of the merger, division, dissolution, liquidation or conversion of the company form, must all be passed by the board of directors, with unanimous decision.
Under the Company Law system | The resolutions on major issues regarding a limited liability company shall be adopted by the shareholders’ meeting, with the affirmative vote of shareholders representing more than two thirds of the voting rights (based on the contribution ratio) (artt. 42 and 43 of the PRC Company Law).
Transfer of equity
Under the Current regime | Any equity transfer within an EJV is subject to the consent of the other shareholders to such EJV.
Under the Company Law system | A transfer of equity is subject to the approval of more than half of the other shareholders (unless otherwise stipulated in the articles of association) (art. 71 PRC Company Law).
Incorporation procedure
Under the Current regime | Incorporation of EJV and CJV is subject to the approval of the competent approval authorities (local delegated office of the Ministry of Commerce) and to subsequent issuance of the business license, by the local Administration for Industry and Commerce (AIC).
Under the Company Law system | A limited liability company is incorporated by filing the relevant application, articles of association and related documents directly with the competent AIC.
3. Ensuing Governance Issues
The key issue is that the bylaws of the newly incorporated companies with foreign investment, after January 1st 2020, shall be drafted in compliance with the Corporate Law regime.
One of the most obvious change regards the corporate governance: a number of powers which originally belonged to the board of directors will be vested on the shareholders’ meeting, in accordance with the PRC Company Law. Besides, key decisions which have been so far subject to unanimous approval of the board of directors, shall be passed, according to the FIL / PRC Company Law, either by the shareholders meeting or, when still within the competence of the board, by a decision quorum to be agreed upon according to the law, not necessarily unanimously.
The perspective of joint venture governance is thus materially changing and shall be carefully evaluated, above all considering the impact on the rights of minority shareholders. Whereas in the past, minority shareholders have been enjoying a sort of “right of veto” on all major decisions of a joint venture (from capital increase, equity transfer, up to liquidation and dissolution), by applying the new unified corporate regime, their decision weight shall be strongly resized: passing from one-director-one-vote to voting based on the capital contribution ratio and waiving unanimity, shall inevitably reduce their power in the decision process of the FIE.
However, we shall also highlight that, the PRC Company Law stipulates a number of rules and measures to protect minority shareholders of a limited liability company2: such rules range from the explicit prohibition for the shareholders to exploit their power within the company to damage the interests of the company itself or of the other shareholders (art. 20 of PRC Company Law3), to the prohibition for controlling shareholders (including actual controlling parties), directors, senior managers to exploit relationship with related parties, to damage the interest of the company or of the other shareholders (art. 21 of PRC Company Law).
Shareholders holding not less than 10% of the capital, shall have the right to call for an interim shareholders meeting or even, as a last protection measure, to apply for liquidation of the company (artt. 39 and 182 of PRC Company Law).
All shareholders, including minority shareholders, enjoy the right of access to and copy the company’s bylaws, records, resolutions and accounting records, where in case of failure of the company to allow exercise of such right, the relevant shareholder may refer the request to the competent court (art. 33 of PRC Company Law). Courts are actually quite regular in granting such rights and ensuring enforcement of relevant decisions.
The rights of shareholders, including minority shareholders, are further protected by the right to commence derivative actions against directors, senior managers and supervisors, for damages caused to the company and/or to the shareholders.
Last but not least, any shareholder may request the company to repurchase its equity, upon occurrence of certain circumstances, thus eventually granting to shareholders of foreign invested enterprises the right to exit the company, a right whose absence in the current regime has so far caused unending troubles, with hundreds of joint ventures, blocked by deadlock and unable to reach a consensus on liquidation.
In conclusion, minority shareholder will still be able to protect their interests, even if no more under the peculiar unanimity system of the existing FIE regime, but by means of well-established methods, recurring within the corporate laws of all major jurisdictions.
2 The specific rights of minority shareholders shall be analyzed in a separate article.
3 Art. 20 of PRC Company Law: “The shareholders of a company shall abide by the laws, administrative regulations and bylaw and shall exercise the shareholder’s rights under the law. None of them may injure any of the interests of the company or of other shareholders by abusing the shareholder’s rights, or injure the interests of any creditor of the company by abusing the independent status of legal person or the shareholder’s limited liabilities. Where any of the shareholders of a company causes any loss to the company or to other shareholders by abusing the shareholder’s rights, it shall be liable for compensation. Where any of the shareholders of a company evades the payment of its debts by abusing the independent status of legal person or the shareholder’s limited liabilities, if it seriously injures the interests of any creditor, it shall bear several and joint liabilities for the debts of the company”.
4. What regime shall be followed until January 1st 2020
The FIL does not clarify what regime shall be applicable from the date of its promulgation, until January 1st, 2020.
The rules introduced by FIL are expected to be detailed within implementing rules which will certainly follow before the end of the year, but currently there are no formal guidelines from the competent authorities.
Since such uncertainties may certainly not stop ongoing negotiations and projects, we would like to make some reflections on this issue and to try some forecasts to help those, like us, who are to write a joint venture contract in these days.
In this connection we shall consider that, until 2018, the procedure for incorporation of EJV and CJV was characterized by a first mandatory phase, consisting in the approval of the local delegated office of the Ministry of Commerce and, a second phase, i.e. registration with AIC. However, since the second half of 2018, such procedure has changed, and has been unified with that of Chinese invested entities, despite the new Foreign Investment Law had not been promulgated yet: lately equity transfers of EJV have been completed directly with AIC, while the local government was reassuring investors that its approval was no more needed. Such practice has actually anticipated the FIL, which clearly stipulates that, during the set up phase, a FIE shall be treated like a Chinese invested company4. Therefore, local authorities have already been instructed to follow the new FIL, even before its promulgation.
We would thus dare to forecast that the competent authorities will endeavor to allow foreign invested companies to be incorporated in compliance with the Company Law even before January 1st, 2020, at least in the second half of this year, also considering that such companies would in any case start to operate in 2020. However, specific liaison shall be arranged with the competent authorities at the place where the FIE is to be incorporated, in order to ascertain their specific stance on such issue. At this very moment, AIC still requests any procedure to be completed by a FIE to be in line with the currently effective laws.
Alternatively, the contract for incorporation of new “joint venture” (which would be called LLC after January 1st, 2020) could be enriched with specific “change of law” clauses, referring to the two different regimes, and stipulating application of certain rules before January 1st, 2020 and to other rules after such date5. Such rules are however unlikely to be accepted as part of the Articles of association to be filed with the local AIC, which are used to compel the parties to adopt standard templates and to leave complex clauses to documents which are not subject to official filing.
4 According to the FIE. the only difference shall be due by the Negative List, restricting foregoing investment in certain “sensible” fields.
5 Please refer to the clause template that we will publish on our website.
5. “Must-Do” for the Five Years’ Transition Period
With regard to existing joint ventures and to those companies which are going to be incorporated this year, in line with the FIEs laws, instead of in line with the unified Company Law regime, uncertainty is even greater.
The FIL grants a five years’ transition period, during which the existing FIEs may keep their bylaws “as-is”, but does not specify how the new legal system shall be implemented on existing contractual agreements within the end of such Transition Period.
In the past, changes of the applicable laws have been implemented at company bylaws’ level with the intervention of the local competent authorities: for example, after the Company Law has been declared applicable to Wholly Foreign Owned Enterprises (WFOE) in year 2006, whenever WFOEs had to amend their articles of association for any reason (capital increase, equity transfer, enlargement of business scope, etc.), the approval authorities used to request them to add those provisions required by the Company Law, like the board of supervisor and the shareholder meeting, as highest corporate authority; therefore, in a few years, all WFOE eventually had completed update of their articles of association.
In fact, we expect that, during the Transition Period of five years, the AIC will require each existing EJV and CJV, whenever an amendment of the company information registered with AIC shall become necessary, to proceed also with those changes needed in order to ensure compliance of the bylaws to the PRC Company Law.
Such changes shall affect existing joint venture contracts and articles of association, with particular impact on the company’s governance: the shareholders meeting shall be established and its powers stipulated in specific added-on clauses in the Articles of Association according to the PRC Company Law. As a consequence, certain decisions, so far falling within the scope of power of the board of directors, shall be referred to the shareholders meeting.
A key issue will be the decision quorum: major shareholders will certainly insist to get an amendment of the existing bylaws to ensure compliance to the PRC Company Law, thus deleting unanimous approval as decision quorum, while minor shareholders will insist on maintaining such veto power.
In this regard, it is worth noting that the PRC Company Law does not prevent the shareholders from reaching a more specific or stricter agreement, with respect to the stipulations of the law; therefore, special quorum, like unanimous approval of certain decision, should not be subject to mandatory update under the new unified regime.
Future amendment of existing joint venture contracts and articles of association will thus be the result of an equilibrium to be reached between the two legal regimes, the pressures of major shareholders and the influence of the local authorities.
At the same time EJV and CJV shareholders shall keep in mind that, by law, the existing agreements may not be amended without the consent of all original contractual parties and that rule of law is generally reaffirmed by the FIL.
One last uncertainty is worth of mentioning: we wonder what shall happen to hundreds of joint ventures that have been incorporated in the past decades and were not liquidated, even after years of lack of operations, due to failure to reach a consensus on liquidation between the shareholders. Will they be left aside, with their bylaws, or will the authorities search them out, push them towards amendment of bylaws and/or liquidation?
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