On 29 December 2023, China’s top legislature, the Standing Committee of the National People’s Congress, adopted the amended Company Law of the People’s Republic of China (the “New Company Law”), which will come into effect on 1 July 2024. This represents the most extensive revisions to Company Law since its enactment in 1993, following the last updated version issued and effective in 2018 (the “Existing Company Law”).
The New Company Law aims to:(i) recognise current practices in China that have not been codified in the Existing Company Law; (ii) tighten up the obligations of controlling shareholders, directors, supervisors and senior management with a view to providing more protection to minority shareholders; and (iii) introduce new capital and governance structures (e.g., multiple classes of shares structure) that are similar to those in common law jurisdictions with which foreign investors are more familiar. However, some changes under the New Company Law may create a host of new issues for existing companies, meaning they will need to reassess their current business plans and make timely changes (e.g., to meet the capitalisation requirements in the New Company Law). This article will highlight some key developments and changes under the New Company Law, which may be relevant to foreign investors or companies that currently operate in China and those that plan to invest in China alike.
Key changes and developments
Capitalization requirements
- Contribution Period and Transitional Period
The Existing Company Law does not provide for a deadline for shareholders to make contributions to a company’s registered capital; rather, it allows the shareholders to agree on a capital contribution schedule and so stipulate in the company’s articles of association. The New Company Law, however, mandates that the registered capital for a limited liability company (“LLC”) must be fully paid within five years of establishment. Compliance with this five-year period is mandatory unless exempted by other laws, regulations, or decisions of the State Council. Although the exceptions still require further clarification from the authorities, most LLCs will be expected to be subject to the aforesaid five-year requirement.
Rather than providing a grandfather exemption for the existing LLCs that may have imposed a time limit longer than five years for shareholders’ capital contribution obligations, the New Company Law requires the LLCs to gradually align their contribution timeline with the requirements under the New Company Law. Nonetheless, the New Company Law does not specify an exact deadline for this adjustment, indicating a gradual approach that will consider existing LLCs' business operations. Instead, it requires the company registration authority — the State Administration for Market Regulation (“SAMR”) — to require companies with a “clearly abnormal” capital contribution schedule or amount, to make adjustment in a timely manner. Further guidance on this transitional arrangement is expected from the State Council. LLCs should monitor closely further developments in this space and consider whether to reduce registered capital in response to a shortened capital contribution timeline.
- 'Authorized Capital' system for a Company Limited by Shares (“CLS”)
As background, Existing Company Law mandates that all shares of a CLS be issued and fully subscribed by shareholders at the time of incorporation. In comparison, the New Company Law introduces an authorised capital system, which provides that, if authorised by the articles of association or a shareholders’ meeting of the CLS, the board of directors of such CLS is entitled to, within three years of the aforesaid authorisation, issue additional new shares, which must be no more than 50% of the already issued shares of the CLS.
This new system potentially gives CLS in China more flexibility in raising capital. Note that the newly introduced authorised capital system only applies to CLS but not LLC under the New Company Law.
- Different classes of shares
“Each share confers equal right” has been a general principle in the current legal regime of China. In practice, although certain preference shares are recognised in the Chinese capital market under certain specific conditions, multiple types and classes of shares were never formally recognised until the New Company Law. According to the New Company Law, a CLS may issue different classes of shares as provided in its articles of association, including, among others, shares with preferential dividend rights, shares with super voting power, etc.
While the New Company Law provides that only CLS can issue various classes of shares, based on current market practices, we expect LLCs’ shareholders to continue making special arrangements to grant them special rights through LLCs’ articles of association and/or shareholders' agreements. Companies that need to attract external investments may consider taking the corporate form of CLS, given the flexibility in assigning different rights to different classes of shares.
- Failure to pay contributions and forfeiture of shareholders' rights
The New Company Law strengthens the liability regime and provides more remedies under circumstances where shareholders fail to make capital contributions. Specifically, the New Company Law provides the following (none of which are featured in the Existing Company Law):
- The board of directors of a company (be it LLC or CLS) shall verify the capital contributions of its shareholders. If a shareholder is found to have failed to pay its capital contribution in full and on time in accordance with the articles of association, the company shall issue a written reminder to such shareholder to call for the payment of the capital contribution;
- Directors who fail to fulfil their verification obligation as described above shall be liable for any losses caused to the company; and
- if a shareholder fails to make capital contributions after the expiration of the grace period (which should be no less than 60 days) as specified in a payment notice issued by the board of directors, the company may, upon resolution of the board of directors, issue a notice to the shareholder, pursuant to which the shareholder will lose its shareholding rights corresponding to the unpaid capital.
Corporate governance
- Audit Committee as an alternative to the Board of Supervisors
The New Company Law provides an option between the traditional dual-layer system (board of directors or executive director on the one hand, and board of supervisors or supervisor on the other) and a single-layer system (board of directors, and its ancillary audit committee), in setting up the company’s supervisory body.
Under the New Company Law, companies may choose to establish an audit committee under their board of directors, as an alternative to a supervisory board (or a supervisor). Although both the audit committee and supervisory board (or supervisor) exercise in general the same supervisory powers according to the New Company law, the former is ancillary to the board of directors which naturally reports to the directors, while the latter is a parallel corporate body with the board that reports directly to the shareholders. Making the audit committee available for a corporate governance structure represents a shift towards a more director-centric governance model.
- Qualification requirements for a legal representative
In China, a legal representative is an individual who has the authority under the law to bind the company he or she represents. Acts of representation by the legal representative are binding on the company, even when acting beyond his/her powers, unless the counterparty knew, or should have known, that he/she was acting beyond his/her authority. This makes a legal representative a special and crucial role within the corporate governance structure of a Chinese company.
Under the Existing Company Law, a legal representative is selected from either the chairman of the board (or the single executive director if the board is not established) or the general manager of the company. The New Company Law further broadens the pool of potential legal representatives to any "director or manager who represents a company to carry out corporate affairs". It remains to be seen how this would be determined in practice.
- De facto directors, shadow directors, and shadow executive personnel
The New Company Law introduces the roles of de facto directors, shadow directors and shadow executive personnel.
Specifically, the New Company Law provides that:
- the controlling shareholders or actual controllers (collectively “Controllers”), even if not the company’s directors, shall be subject to the same fiduciary duties as the company’s directors if they actually perform relevant corporate duties (i.e. De facto Directors); and
- the Controllers shall be jointly liable with the company’s directors and executive personnel who are instructed by such Controllers and thus harm the company or shareholders’ interests (i.e., shadow directors, and shadow executive personnel).
Interference of corporate governance by Controllers is not an uncommon issue in many Chinese companies. The key implication of this new provision is that the Controllers would no longer be effectively exempted from the fiduciary duties to the company, as compared with the documented directors and executive personnel. That being said, how to apply and enforce this new mechanism awaits further testing in Chinese judicial practice.
- Shareholder’s meeting
The Existing Company Law generally allows an LLC in China to agree and specify in its articles of association the voting procedure and threshold for passing resolutions in a shareholders meeting (except for that, below three matters are mandatorily required to be approved by shareholders holding at least two-thirds of the voting rights, i.e.: (1) amendment to articles of association; (2) increase or decrease registered capital; and (3) merge, split, dissolve or change the company’s form).
In addition to the requirements in the Existing Company Law, the New Company Law further specifies that resolutions made at a shareholders’ meeting must be approved by shareholders representing a simple majority of the voting rights, which is silent in the Existing Company Law.
In practice, most LLCs apply a simple majority threshold for adopting resolutions at a shareholders' meeting. However, it is not uncommon for companies to provide in their articles of association or shareholder agreements that a lower (less than 50%) threshold is sufficient to pass a resolution in certain circumstances, such as a voting deadlock, or where decisions must be made at an adjourned shareholders' meeting if, on the originally scheduled date of a meeting, a quorum was not met. This, however, seems no longer permitted by the New Company law and we expect LLCs to re-visit their corporate constitution documents to verify if any changes are necessary to adapt to the statutory voting thresholds under the New Company Law.
Protections to the shareholders
- Buy-back equity interest
The New Company Law introduces a new right for a shareholder of an LLC to demand a buy-back of their equity interest. Specifically:
- If a company's controlling shareholder abuses its shareholder rights and seriously damages the interests of the company or other shareholders, other shareholders have the right to request the company to buy-back and purchase their equity interest at a reasonable price.
- The equity of the company bought back by the company due to aforementioned circumstances shall be transferred or cancelled within six months.
This new rule facilitates the minority shareholders protecting their rights by enabling a buy-back. That being said, how to apply and enforce this new mechanism awaits further testing in practice. One may foresee that it might still be difficult for a minority shareholder to enforce against the company being controlled by the majority shareholder to comply with the new rule, as effecting a buy-back may require all the formalities including the execution of a shareholders' resolution and equity transfer agreement, and lodging a registration for such buy-back, which cannot be complete without the cooperation of the majority shareholder and the majority-controlled company.
- Rights to inspect and review financial materials
In addition to the articles of association, the shareholders register, corporate resolutions, financial audit reports and the accounting books of the company, which are already specified in the Existing Company Law, the New Company Law also specifically grants the right to shareholders of an 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 of the company, which gives a broader information right to minority shareholders.
Responsibilities of controlling shareholders and executive personnel
- Fiduciary duty
The 'duty of loyalty' and 'duty of care' are not new concepts in China, as both terms are specifically mentioned in the Existing Company Law. The New Company Law further elaborates on both terms. Specifically:
- For duty of loyalty, directors, supervisors and executive personnel shall take measures to avoid conflict of interests between their own and the interests of the company, and shall not use their powers to seek improper benefits.
- For duty of care, directors, supervisors and executive personnel shall exercise reasonable care that a manager is normally expected to have, and act in the best interests of the company when performing their duties.
There are also more specific requirements on directors, supervisors and executive personnel under the New Company Law, which include among others, not engaging in a business that is of the same type as the company’s, for themselves or other persons, without reporting to, and getting the approval from, a company’s shareholders' meeting or the board of directors, reporting their (including their close relatives' and affiliates’) transactions with the company to a company’s shareholders' meeting or the board of directors, and seeking approvals.
- Compensation liability extended to third parties
The New Company Law provides that, if a director or executive personnel of the company causes any damage to third parties when carrying out their corporate duties, the company shall be liable to compensate the third parties. The director and executive personnel involved shall also be liable if they are found to have committed any intentional misconduct or gross negligence.
The above enables the third party to sue the company’s director and executive personnel directly, which is a new feature under the New Company Law. In practice, it is not common to see cases where outside creditors struggled to find a legal basis to claim directly against directors and executive personnel, especially where the company is in financial difficulties and an action against the company may not bring much value.
Other important Changes
In addition to the above, there are also a number of other modifications in the New Company Law worth noting, including:
- Streamlined capital reduction procedure: the New Company Law introduces a “simplified capital reduction mechanism”, applying to companies that reduce the registered capital to make up for the losses. Unlike the Existing Company Law which requires notifying creditors in cases of capital reduction, the New Company Law mandates only public announcements in a simplified capital reduction process, which potentially simplifies the process and enables a more efficient capital reduction.
- Pro rata capital reduction: the New Company Law provides that, where a reduction of capital occurs, the shareholders of a company (both for LLC and CLS) shall reduce their respective capital contributions in proportion to their respective shareholding interest. However, the New Company Law allows a company to reduce capital by other means (for example, as we may envisage that only certain shareholders reduce capital contribution while others remain unchanged), provided that it is agreed unanimously by shareholders in the case of an LLC, or provided under the company’s articles of association in the case of a CLS.
- Requirements for employee representatives on the board of directors: employee representatives on the board of directors are silent under the Existing Company Law (other than state-owned companies). In comparison, the New Company Law provides that, for any company (both for LLC and CLS) with more than 300 employees, it is mandatory to include employee representatives on the board of directors, unless the company has established a board of supervisors and the representatives of employees already have a seat on the supervisory board.
- Directors’ obligation to liquidate: the New Company Law provides that the directors of the company (both for LLC and CLS) are obliged to initiate the liquidation upon occurrence of the events triggering liquidation as prescribed under law. Directors who fail to fulfil such obligations, resulting in damages to the company or its creditors, shall be liable for compensation.
- Equity and debt contribution: the New Company Law specifically recognises equity interests and debt interests as valid forms of capital contributions, which a shareholder may pay (transfer) to the company in satisfying their capital contribution obligations to the company. As a result, we expect that share swaps and convertible loans will become more viable tools in corporate transactions.
Looking ahead
Before the New Company Law takes effect on 1 July, 2024, we expect implementing rules to be issued to shed light on the changes made in the New Company Law. While the shortened timeline of shareholders’ capital contributions and expanding responsibilities of directors, supervisors and senior management will create new challenges, the dynamic business environment in China that propelled the New Company Law will also create new opportunities. Engaged and well-informed investors, both strategic and financial, that can leverage external advisors’ expertise would be uniquely situated to navigate the new corporate law landscape and identify new growth potential in China.
Hogan Lovells will continue monitoring the New Company Law and its upcoming implementation. Please reach out to any of the listed Hogan Lovells contacts should you have any questions or queries.
Authored by Lu Zhou, Mo Chen, Wensheng Ren, and Xu Xu.
