China’s new Company Law – key changes for MNCs

Capital contribution – more protection for creditors

The amendment was the result of almost three years of efforts on the part of lawmakers and four rounds of proposed changes. Since the new law will impact all 48 million plus companies in China, including limited liability companies (LLCs) and joint stock companies (JSCs), its effective date has been postponed to July 1, 2024. As most multinational companies (MNCs) in China are LLCs rather than JSCs, in this article we focus on the key changes impacting a foreign investor’s LLC subsidiaries or joint ventures in mainland China.

One of the most striking changes in the new Company Law is the requirement that shareholders of an LLC must contribute all of their subscribed capital to the company within five years of the LLC’s incorporation. This is a stark deviation from the current Company Law, which allows shareholders to decide when and how they contribute their subscribed capital in full. Since this subscription-based regime was introduced in 2013, investors have had significant flexibility in controlling their funding of the company. However, as a side effect, many investors have deliberately delayed their capital contribution, sometimes leaving enterprises with insufficient equity to fulfil their obligations toward their creditors. The new Company Law puts more emphasis on the protection of creditors by pushing the shareholders to contribute their committed capital within five years of incorporation, unless the relevant laws and regulations state otherwise.

This accelerated timeframe immediately raises the question of how the millions of companies should respond that are still waiting for their shareholders’ full capital contributions. To ensure a smooth transition, the new Company Law requires existing companies to make gradual adjustments that will bring them into compliance with the new legal code. Unfortunately, no specific guideline is provided as to how adjustments should be made; rather, the State Council is empowered to promulgate specific measures. The new Company Law also allows company registration authorities – currently the State Administration for Market Regulation (SAMR) or its local counterparts – to require firms to make timely adjustments to the period and amount of the capital contributions if they are “obviously abnormal.” Defining “obviously abnormal” and simultaneously balancing the business needs of shareholders and companies and protecting the interests of creditors and business partners will be a daunting task for SAMR – one clearly worth monitoring.

The new Company Law contains other provisions relating to LLCs and their capital, including the following:

• The board of directors of the LLC must verify the status of the company’s registered capital and, if there are any delays, serve notice on the relevant shareholders demanding prompt payment.
• Shareholders failing to contribute their registered capital within the relevant grace period will lose the shareholder rights associated with their unpaid capital. If a defaulting shareholder’s rights are not transferred or cancelled through capital reduction within six months of the forfeit notice being issued by the board, other shareholders of the LLC (if there are any) must contribute the deficient capital in proportion to the shares they hold in the LLC.
• If a company cannot pay its debts when due, it or the creditor of the debt can demand that shareholders who have capital subscriptions but who have not yet contributed must execute their payment ahead of schedule.

Amendment of the AoA for foreign-invested companies

The new Company Law introduces significant changes to the corporate governance of LLCs. If a foreign invested company has updated its Articles of Association (AoA) in accordance with the current Company Law as required under the Foreign Investment Law (FIL 2019), it will have to do so once again to comply with the new Company Law. Key changes in the area of governance include:

1. Legal representative
Under the current law, only the chairman of the board of directors (or executive director) or the general manager can be the legal representative of an LLC. The new Company Law expands the pool of candidates to all directors and the general manager, as long as they are involved in the company’s operations. This gives the company more flexibility as to who has the authority to represent the company and enter into legally binding agreements. If this person is removed as director or manager, the legal representative must be changed as well.

2. Shareholders’ meeting
Compared with the present situation, the new Company Law reduces the statutory powers of the shareholders’ meeting, which will no longer “decide on the company’s business policy and investment plan” or “consider and approve the company’s annual financial budget plan and final accounting plan.” This does not mean that all LLCs must remove such activities from the list of duties addressed by the shareholders’ meeting. Rather, shareholders should take them into account when they re-allocate responsibilities among shareholders, and among the shareholders’ meeting and other corporate governance organs such as the board of directors.

3. Directors
The new Company Law effectively expands the authority of the board of directors. One the one hand, the board has the power to “decide on the company’s business policy and investment plan,” which used to be exercised by the shareholders’ meeting. On the other hand, the new law no longer sets out the responsibilities of management but leaves it to the board of directors to decide. A board of directors may also set up an “audit committee” to replace the supervisory board or supervisor(s).

Under the new Company Law, there is no longer an upper limit of 13 on the number of board members, and the protocols for board meetings have been updated accordingly. For example, for any board resolution to pass, the matter must be approved by more than half of all directors, and not merely all directors attending the board meeting in person, by proxy or by telecom. This may necessitate changing the AoA with respect to board practices, especially for boards with a large number of directors appointed by different shareholders, since many companies have adopted a relatively flexible practice through which a small number of directors can approve a given matter. If a quorum is not met for either convening a board meeting or approving a resolution, the board resolution is invalid, or the board is considered deadlocked.

Another significant change is the possibility of having an “employee representative” on the board of directors. The new Company Law stipulates that an LLC with more than 300 employees must have employee representatives on its board of directors, unless it has already established a supervisory board that includes workforce representation. Given that most LLCs do not have a supervisory board, a company must have at least one employee representative on its board of directors if it has a workforce of over 300. This will have a huge impact on the dynamics of the firm’s corporate governance structure, and many other practical issues will also have to be addressed. For example, the employee director must be elected by an employee congress or similar institution made up of employees, bodies that generally do not exist at many companies in China. Therefore, the first step will be organizing an employee congress and properly navigating the relationship between it and the trade union, if one is already present. Other issues regulators and management must consider include who is qualified to be an employee representative and whether such representatives are entitled to additional protection, for example from termination or other reprisals.

4. Supervisors
Under the new law, it is no longer mandatory for a company to have one or more supervisors or a supervisory board. A small LLC or one with a limited number of shareholders can now have one supervisor exercising the powers and functions of the supervisory board. The LLC may also elect not to have any supervisor at all if all shareholders agree.

5. Management
As mentioned above, the new Company Law relieves managers of statutory responsibilities, allowing the board of directors to decide about them instead. This may streamline or complicate an LLC’s current management structure. For example, under the current law, a general manager can decide basic management rules and policies for the company or nominate and dismiss deputy managers or financial directors. Under the new Company Law, the board of directors will need to decide whether and how to restructure the management team to suit the company’s business needs.

Change in right of first refusal and right of cancellation

The new Company Law redefines some rights held by shareholders, as well as some of the obligations they face. Key changes include:

1. Right of first refusal simplified
Currently, if shareholders of an LLC want to transfer their equity to a non-shareholder, they need to obtain consent from the other non-transferring shareholders, who enjoy a right of first refusal. Withholding such consent sometimes makes equity transfers difficult to implement. The new Company Law simplifies this issue, since, if non-transferring shareholders do not respond to the transferor’s notice within 30 days and exercise their right of first refusal on equivalent terms and conditions, they effectively waive their right and the transferring shareholder can proceed with the transaction accordingly.

2. Right to know clarified
The current Company Law stipulates that shareholders have the right to inspect and copy the firm’s AoA, its register of shareholders, along with minutes of shareholders’ meetings, resolutions, financial statements, and other corporate information. The new Company Law also allows shareholders to inspect the firm’s accounting books and accounting vouchers, and inspect any such materials belonging to the company’s wholly owned subsidiaries. They can do so themselves or by delegating accounting firms, law firms or other intermediaries to act on their behalf. This change benefits minority shareholders who do not oversee the company’s operations, and it will put more pressure on the company’s controlling shareholders and management.

3. Right to withdraw
Compared with the current law, the new Company Law provides more scenarios in which minority shareholders can demand the company buy back their equity in the company. This is the case when a company merges with a subsidiary in which the company holds more than 90 percent of the equity/shares, or if a company’s controlling shareholder abuses his or her rights and seriously jeopardizes the interests of the company or other shareholders. Investors will need to consult judicial decisions and guidelines issued by other regulators as to what actions constitute “abuse” and what damages are considered “serious.”

4. Further restrictions on controlling shareholders
Under the new Company Law, controlling shareholders and the company’s actual controllers may also have a duty of loyalty and diligence to the company. They should therefore take measures to avoid conflicts between their own interests and the interests of the company and should not utilize their positions to gain undue advantage, if they act as if they were directors, supervisors and senior management. If a company’s controlling shareholders and actual controllers instruct directors and senior management to engage in acts detrimental to the interests of the company or its shareholders, they will be jointly liable.

Significant extension of the responsibility of directors, supervisors and managers

The new Company Law has significantly enhanced the responsibilities of directors, supervisors and managers (DSMs) and imposes personal liabilities on them in multiple instances. For example:

1. DSMs must compensate the company if they abuse their affiliation with it and cause losses to the company.
   
2. Directors must compensate the company for losses caused by their negligence in identifying delayed or deficient capital contributions from shareholders.
   
3. DSMs must jointly compensate the company for losses caused by a shareholder withdrawing contributed capital.
   
4. DSMs providing financial assistance to a third party to acquire company shares must compensate the company for any losses incurred from the transaction.
   
5. DSMs must compensate the company if they are responsible for losses caused by the company distributing profits before it has made up for existing losses and allotted provisions for the statutory reserve.
   
6. If a reduction in a firm’s registered capital is made in violation of the law and causes losses to the company, the responsible DSMs must compensate the company.
   
7. If the directors of a company fail to form a liquidation group or otherwise fail to commence liquidation procedures and the company incurs losses, the responsible directors must compensate the company.
   

Naturally, we believe many DSMs will require the company they serve to take out insurance for the fulfilment of their business roles. In addition, under the new Company Law, the shareholders’ meeting could dismiss a director by resolution at any time. However, if the dismissal is made before the expiration of the director’s term without valid justification, the director can demand compensation. In our experience, a large number of LLCs do not have service agreements with directors or supervisors, let alone specific agreements on events triggering termination or compensation mechanisms. Hence, we believe more companies and DSMs will enter into formal written agreements clarifying these aspects.

Reporting obligation for shareholders and DSMs

It is not uncommon for a company’s shareholders or DSMs to do business with the company in ways that are sometimes not in the best interest of the enterprise. Under the new Company Law, DSMs who directly or indirectly enter into contracts or conduct transactions with the company must report these activities to the board of directors or the shareholders’ meeting. These situations will then be resolved by the board of directors or the shareholders’ meeting in accordance with the company’s AoA.

These restrictions also apply to “close relatives” of DSMs, entities directly or indirectly controlled by any close relatives, and other persons affiliated with DSMs. According to the Civil Code, close relatives include spouses, parents, children, siblings, grandparents and grandchildren. The scope of these restrictions on such “connected transactions” could therefore be very wide-ranging. In certain other sectors, such as financial services, the restrictions are even more stringent.

When the board of directors resolves such situations, the director or directors in question must abstain from voting and their voting rights are not included in the final tally. If the number of unrelated directors present at the meeting of the board of directors is less than three, the matter must be submitted to the shareholders’ meeting for consideration.

Disclosure obligation for certain company information

In contrast to the current law, the new Company Law confirms that online registration and publication systems can be used, with the National Enterprise Credit Information Publicity System (“Credit System”) being the preferred alternative to filing and publishing in paper form. For example, the new Company Law specifically requires all companies to publicize the following:

• the amount of capital contributed and paid in by an LLC’s shareholders, the manner and date of capital contributions, and the number of shares subscribed by a JSC’s promoters;
• the amount, method and date of capital contributions subscribed and paid in by the shareholders of an LLC, and the number of shares subscribed by its promoters;
• LLC shareholders, promoters of equity in joint stock limited companies, information on share changes;
• information on the acquisition, change and cancellation of administrative licenses; and
• other information prescribed by laws and administrative regulations.

When a company carries out a merger, separation, capital reduction, liquidation or deregistration, this information must be published in the Credit System as well.

Taking action

The new Company Law has been comprehensively and substantially revised compared to the current law, which means foreign invested companies in China must start reviewing and preparing for changes that are either required or desired. Taking action is particularly important because SAMR and other authorities will undoubtedly be more proactive in exercising their power to enforce the law.

In terms of wholly foreign-owned subsidiaries, shareholders should start by identifying the gap between current practices and the new law as it applies to shareholder obligations, board composition, corporate governance, DSM liabilities, and interactions with other stakeholders, such as employees.

Non-Chinese shareholders of Sino-foreign joint ventures will need to clarify their desired position and start negotiating with other shareholders on allocating or reallocating the rights and obligations relating to the shareholders’ meeting, board of directors, supervisors and management, connected transactions and other areas affected by the new Company Law. Special attention should be paid to the extra compliance obligations that apply if the Chinese shareholder is a state-owned or state-controlled entity with a substantial stake in the joint venture.

Complying with China’s new Company Law is by no means a tick-the-box exercise. Foreign invested companies and their shareholders should act now to map out what must be done before July 1, 2024.