Issues raised by the SPC’s recent judicial interpretation on FIE Disputes

On August 5, 2010, the Supreme People’s Court of the People’s Republic of China issued the Provision on Several Issues on the Trial of Disputes Involving Foreign Invested Enterprises.

The Provision came into effect on August 16, 2010 (the “FIE Judicial Interpretation”).

It is understood that the FIE Judicial Interpretation aims to provide PRC courts an overall and unified guideline for the application of laws in the trial of disputes related to the creation and modification of FIEs, as the number of those disputes has significantly increased in recent years due to the rapid development of foreign investment in China.

The FIE Judicial Interpretation is said to have been prepared by the SPC on the basis of wide research and investigation. A draft version was published in May 2010 for soliciting public opinions before finalization and official release. It is true that the FIE Judicial Interpretation has clarified many issues related to the disputes arising from the creation and modification of FIEs. Nevertheless, it appears that some rules established by the FIE Judicial Interpretation do not sufficiently foresee actual situations the FIEs may face, as well as overlook their compatibility with the rules established by existing laws and regulations. Consequently, confusion and debate are likely to occur during the implementation of the FIE Judicial Interpretation—what follows are two examples of issues that will need further clarification.

Transferee’s Payment Obligation under FIE Equity Transfer Agreement

According to Clause 8 of the FIE Judicial Interpretation, in case an FIE equity transfer agreement provides that the transferee shall pay the purchase price prior to submission for approval conducted by the transferor, and the transferee fails to make the payment or fails to do so within a reasonable time period set by the transferor, the transferor is entitled to request the cancellation of the agreement and claim for compensation for actual loss caused by delay of payment.

The above provision seems to imply that an FIE equity transfer agreement shall come into effect upon signature, despite the fact that the effectiveness of the equity transfer itself shall be subject to the approval. Otherwise, how could the transferee be obliged to pay the purchase price prior to the approval of the equity transfer agreement, if the approval itself is a condition for the effectiveness of the agreement?

The above understanding seems in line with Clause 1 of the FIE Judicial Interpretation, pursuant to which, in the absence of mandatory approval for the effectiveness of a signed contract pursuant to law (法律) or administrative regulation (行政法规), only the clause regarding the obligation of submission for approval as well as relevant clauses arising from such obligation shall have binding force on the parties. As such, an FIE equity transfer agreement is not understood to be a contract whose effectiveness is subject to approval as per law or administrative regulation. As a matter of fact, we have not identified any PRC law or administrative regulation that imposes approval as a condition for the effectiveness of an FIE equity transfer agreement.

One may argue that Article 20 of the Provisions on Change of Investor’s Equity Interest in Foreign Invested Enterprises, jointly issued by MOFCOM and SAIC on May 28, 1997 (the “FIE Equity Change Provision”), clearly provides that an equity transfer agreement shall come into effect upon MOFCOM approval. However, considering the legislation hierarchy, the FIE Equity Change Provision is only a departmental rule (部门规章) and is neither a law nor an administrative regulation, which could legally impose approval as a condition for the effectiveness of a contract as per Article 44 of the PRC Contract Law.

Having said the above, as a result of China’s foreign exchange control, the situation described in Clause 8 of the FIE Judicial Interpretation (i.e. a transferee pays the purchase price prior to the submission of approval) could only be feasible if the transferor and the transferee are both onshore entities/individuals or both offshore entities/individuals. For example, if the transferee is a Chinese company and the transferor is a foreign company, the Chinese transferee will not be able to make the payment to the transferor’s offshore bank account prior to the approval of the State Administration of Foreign Exchange (“SAFE”) or its local counterpart, a step that comes after the approval of the equity transfer by MOFCOM or its local counterpart.

Therefore, if a transferee fails to pay the purchase price prior to the submission for approval of the equity transfer agreement, due only to the administrative formalities required by China’s foreign exchange control, it does not seem entirely fair for the court to allow the transferor to terminate the equity transfer agreement, and, further claim compensation for losses caused by a delay of payment.

Protection of Shareholder’s Pre-emptive Right

Clause 11 of the FIE Judicial Interpretation provides that in case a shareholder of an FIE intends to transfer its equity interest in whole or in part to a third party, such shareholder shall obtain the unanimous consent of other shareholder(s) of the FIE. Without such unanimous consent, the other shareholder(s) can request the cancellation of the equity transfer agreement, unless any of the following circumstances are involved:

(i) there is evidence proving that the other shareholder(s) already agreed to the transfer;

(ii) the transferor already sent written notifications in respect of the equity transfer to the other shareholder(s), but the other shareholder(s) did not respond within 30 days upon the receipt; or

(iii) the other shareholder(s) did not agree to the equity transfer, nor to purchase such equity.

There are two legal issues related to the above provision.

Under the current PRC legal regime, an FIE may take three forms: i.e. equity joint venture enterprises (“EJV”), cooperative joint venture enterprise (“CJV”) or wholly foreign owned enterprise (“WFOE”).

As for equity transfers, the PRC EJV Law (Art. 4) and the PRC CJV Law (Art. 10) clearly provide that they are subject to the consent of other non-transferring shareholder(s). However, the PRC WFOE Law is silent on the issue. In this regard, if a WFOE consists of several foreign shareholders, the equity transfer of any foreign shareholders shall thus be governed by relevant provision of the PRC Company Law.

According to Article 72 of the PRC Company Law, if a shareholder intends to transfer its equity interest to a third party, it shall obtain the consent of a simple majority of other shareholders; if the other shareholders fail to respond within 30 days following the receipt of a written notice from the transferring shareholder, the other shareholders shall be deemed to have agreed to such transfer; if the simple majority of the other shareholders do not agree with the transfer and dissenting shareholders do not purchase the equity interest to be transferred, they shall also be deemed to have agreed with such transfer.

In light of this provision, unless the shareholders agree otherwise, a shareholder of a WFOE does not need the unanimous consent of the other shareholders to approve its equity transfer to a third party. Consequently, Clause 11 of the FIE Judicial Interpretation shall not apply to an equity transfer of a WFOE that consists of more than 2 shareholders, because there is no legal basis to impose unanimous consent as a condition for a valid transfer of equity interest in a WFOE to a third party.

Apart from the above, it is understood that the exceptions (ii) and (iii) listed under Clause 11 of the FIE Judicial Interpretation follow the principles under Article 72 of the PRC Company Law. However, it appears that “deemed consent” shall only apply to a WFOE, the equity transfer of which is governed by the PRC Company Law, rather than to an EJV or a CJV, as both the PRC EJV Law and the PRC CJV Law clearly request the consent of other shareholders in case of equity transfer. Unlike the PRC Company Law, the PRC EJV Law and the PRC CJV Law do not recognize the “deemed consent” of other shareholders in case of equity transfer to a third party.

Article 218 of the PRC Company Law provides that this law shall apply to foreign invested limited liability companies and joint stock companies, unless the laws regarding foreign investment provide otherwise. In this instant case, as the PRC EJV Law and the PRC CJV Law have provided a different rule governing a valid equity transfer to a third party, such rule in those specific laws shall be respected and prevail over the rule under the general company law.

The issues mentioned above could very well arise during the implementation of the FIE Judicial Interpretation. We hope they will be addressed and clarified by the SPC’s subsequent judicial interpretation on FIE related disputes.