On April 28, 2019, the Supreme People’s Court promulgated the Provisions on Several Issues concerning the Application of the Company Law of the People's Republic of China (V) (最高人民法院关于适用《中华人民共和国公司法》若干问题的规定（五）) (the Fifth Judicial Interpretation) which came into effect on April 29, 2019.
The Fifth Judicial Interpretation is short. It contains only six provisions. However it demonstrates a clear intention to protect the interests of minority shareholders and to encourage the resolution of disputes between shareholders in ways that avoid dissolving the invested company.
The Fifth Judicial Interpretation will apply to all companies established in China, including both domestic and foreign-invested companies.
The right to sue for loss and damage resulting from connected transactions
Under Article 1 of the Fifth Judicial Interpretation, a shareholder of a company who satisfies the conditions under article 151 of the PRC Company Law is entitled to claim for compensation of loss and damage against the company’s controlling shareholder, actual controller, director, supervisor or senior management (each a Connected Party, collectively, Connected Parties) for the benefit of the company, if a connected transaction (which literally means a transaction between a Connected Party and the company) has damaged the interests of the company and the company has failed to take legal action itself.
This provision is based on article 21 of the PRC Company Law which prohibits Connected Parties from prejudicing the interests of the company by abusing their connected relationship with it.
A qualified shareholder under article 151 of the PRC Company Law is any shareholder of a limited liability company or a shareholder of a joint stock company holding, by itself or in concert with others, more than 1 percent shares of the company for at least 180 consecutive days. According to article 151 of the PRC Company Law, a qualified shareholder may request the board of directors/executive director or the supervisory board/supervisor(s) to file claims in court (or otherwise do so by itself if the latter fail or decline to take such action) if any director, supervisor or senior management causes damage to the company in fulfilling their roles or if “another party has violated the company’s legitimate interests and caused damage to the company.”
The Fifth Judicial Interpretation explicitly provides that article 151 shall apply when a qualified shareholder makes claims against any Connected Party for loss and damage caused to the company by connected transactions. It further provides that the compensation liability of a Connected Party will not be exempted merely because the connected transaction has gone through the applicable procedures under the laws and constitutional documents of the company (e.g. disclosure), approval by the shareholders meeting or shareholders general meeting.
The right to sue for invalidating or revoking contracts for connected transactions
Article 2 of the Fifth Judicial Interpretation provides that if a contract for a connected transaction exists, any circumstance which may render the contract voidable or revocable, a qualified shareholder may sue to the court to invalidate or revoke the contract in accordance with article 151 of the PRC Company Law if the company itself fails to take such action itself.
Circumstances which may render a contract voidable or revocable are primarily set out in the PRC Contract Law, under which a contact may be held void in any of the following circumstances
- The contract is entered into by way of one party’s fraud or coercion which damages the interests of the State
- The parties collude to damage the interest of the State, a collective organisation or a third party
- Illegal purpose is disguised by legal forms
- Social public interest is damaged
- It has breached mandatory requirements of laws or administrative regulations
Under the PRC Contract Law, a party may revoke a contract if when the contract was entered into, there existed (i) serious misunderstanding, or (ii) obvious unfairness. The time limit for exercising the right of revocation is one year from the time when the party concerned knew or should have known of the grounds for revocation.
As you can tell from the above, the chances of a connected transaction to falling within any circumstances which render the contract voidable would generally speaking be very low. Realistically, a qualified shareholder would most likely try to revoke the contract concerned by reason of the relevant transaction displaying “obvious unfairness.”
Risks to be noted
The Fifth Judicial Interpretation is obviously intended to give minority shareholders some legal remedy to protect the interests of the company. The interests of minority shareholders will be prejudiced if any Connected Party − in particular the controlling shareholder or the actual controller − abuses its dominant position by entering into connected transactions with the company on terms and conditions that are unfairly favourable to the Connected Party but detrimental to the company itself.
Whilst the rationale of these provisions is fully recognised, the practical effect may not be straightforward. For a Sino-foreign joint venture project, upon entering into a joint venture contract, the joint venture parties typically agree on a series of operative agreements between the relevant shareholder(s) and the joint venture company, and the board of directors of the joint venture company ratify these agreements after the joint venture company is incorporated. Do the provisions in the Fifth Judicial Interpretation, that due fulfilment of all applicable procedures (whether disclosure or shareholders/board approval) do not exempt the Connected Party concerned from compensation liability, potentially mean that a minority shareholder who originally voted for a connected transaction will be able to turn around later and claim compensation on grounds that the transaction was unfair and prejudicial to the interests of the company? On a literal reading of these provisions, the risk cannot be entirely ruled out. The reason or justification for commercial terms of a transaction will not always be obvious. Much depends on market conditions and the relevant parties’ business aims at the time the transaction is negotiated. These are matters for factual and possibly expert evidence. The key questions emerging from this are, first, whether the existence of such a right can be misused by a minority shareholder with a grievance and, second, whether the court is being expected to determine the commercial justification of the relevant connected transaction?
The non-exemption provisions are not contained in Article 2 of the Fifth Judicial Interpretation which seems to mean that a qualified shareholder would not be able to challenge the validity, or apply for revocation, of the contract for a connected transaction if all applicable procedures (e.g. disclosure or approval) have been duly fulfilled in respect of the transaction.
Removal of Directors
The Fifth Judicial Interpretation makes it clear that a director may be removed from the board by effective resolutions of the shareholders meeting or shareholders general meeting prior to the expiry of the director’s term of office. Disputes on remuneration or other compensation which the director may claim shall be dealt with separately without having impact on the effectiveness of the removal of such director.
Time Limit for Profit Distribution
Under the Fifth Judicial Interpretation, when resolutions of a shareholders’ meeting or shareholders’ general meeting of a company have been passed to distribute profits to the shareholders, such profit distribution should be completed in accordance with the times stated in the resolutions, or in the absence of that, in accordance with the relevant provisions of the company’s articles of association, but in any event within one year after the date of the resolutions. If the time period for profit distribution set out in the shareholders’ resolutions is longer than that provided for the articles of association, a shareholder may apply to the court to revoke the time period in the shareholders resolutions within 60 days after the date of the shareholders’ resolutions.
Resolution of Shareholders’ Disputes
Material disputes between shareholders of a limited liability company often lead to termination of the shareholders’ agreement (or joint venture contracts) and dissolution of the company. That would in turn cause some negative impact on the local community and economy, e.g. termination of employment and abandoned projects. The Fifth Judicial Interpretation provides that the court which hears disputes between shareholders should endeavour to mediate and support any agreement between them to resolve the disputes by way of any of the following options
- Redemption of some shareholders’ equity interests by the company
- Transfer of equity interests between the shareholders
- Transfer of equity interests to a third party
- Capital reduction of the company
- Split-up of the company
- Other ways that can resolve the shareholders’ disputes, resume the normal operation, and prevent dissolution, of the company
For any questions regarding the above, please feel free to contact us.