Innovations proposed by the Company Law Draft Revision of China

Shoushuang Li Senior Partner, Beijing Dentons Law Offices, LLP

Li-Hong Xing Principal Lecturer, BPP University

Meng Tian Paralegal, Beijing Dentons Law Offices, LLP

Bingxuan He Intern，Beijing Dentons Law Offices, LLP

In December 2021, the Company Law of the People’s Republic of China (Draft Revision) (“Draft Revision”) was deliberated at the 32 nd session of the Standing Committee of the 13 th National People’s Congress and published for public consultation. The last time that the Company Law of the People’s Republic of China (“Company Law”) was materially amended was 2013 and this Draft Revision is intended to bring about some significant changes to the present legal framework.

Company law is the cornerstone of a legal system regulating and promoting the development of the market economy as various enterprises are playing an increasingly essential role in all aspects of a nation’s economic activities. The present company laws that are in force in China were selectively transplanted from the legislation of other countries; indeed, some key provisions and regulations are practically duplications of foreign sources. Despite being a non-common law jurisdiction, China’s company laws are deeply rooted in the Anglo-Saxon legal system that prevails in the United States and the United Kingdo

The emergence of companies as an organizational structure in China can be traced back to as early as the Qing Dynasty (1636-1912), but they started to die out following the founding of the People’s Republic of China, also known as the “New China”, due to the establishment of a centrally planned economic regime, inspired by the Soviet socialist economic model. During that period, a work unit or danwei, which is the name given to a place of employment, acted as the foundation of the state apparatus within a multi-tiered hierarchy. As institutions such as factories, schools and hospitals were all part of this danwei system and the economy was dominated by state ownership, there was no place for private enterprises and consequently, no need for legislation specific to the regulation of companies.

It was not until the Reform and Opening-Up, a program of economic reforms launched in the late 1970s, that companies were gradually revived as the economy moved in a more market-oriented direction. The increasing liberalization of China’s economy called for company laws to regulate the conduct of private enterprises and safeguard the social and economic order. The first Company Law was enacted in 1993 and has since been amended five times; three of these amendments led to material changes of the system.

The implementation of new policies and regulations resulted in immense changes in Chinese society. In particular, the business landscape was radically altered by the dot.com boom over the past two decades and the ever-evolving market pressed for updated rules. For example, the new generation of entrepreneurs have been appealing for the legalization of the dual-class share structure, so as to retain control over the company even when their stake shrank significantly after rounds of financing through private equity. This goal has been realized by a considerable number of internet-based businesses via the use of a specially designed corporate structure called “red-chip”, which has been very well-received in overseas listings. This multi-tiered structure employs Special Purpose Vehicles registered in certain offshore jurisdictions, with the Cayman Islands and the British Virgin Islands being the most popular options. Unfortunately, a domestic company in China would not be able to do this, given the restrictions imposed by the Company Law. The recently promulgated Draft Revision aims at addressing such needs.

1. Dual-class Share

One of the key rules worth noting in this Draft Revision is the proposed adoption of the internationally accepted dual-class share scheme. According to Article 126 of the present Company Law, ordinary shares shall rank pari passu and be issued with the same rights. Meanwhile, Article 131 provides that the State Council may formulate separate regulations on companies issuing other types of shares which are not provided for under the Company Law. In 2013, the State Council published the Guidelines on Launch of Preference Shares Pilot Scheme, which allowed listed companies and non-listed public companies to make private offerings of preference shares, while issuers making public offerings of such shares are limited to listed companies stipulated by the China Securities Regulatory Commission.

The current corporate law system in China leaves most companies little leeway to issue non-ordinary shares. Such rigid rules seriously hinder companies from realizing their full potential through a more flexible corporate structure where assigning different rights to ordinary shares is viable. As investment channels become more diversified and the ratio of direct financing is constantly increasing, it is not uncommon for funders of a start-up to lose control of their business after multiple rounds of financing. This is particularly detrimental to tech companies where the founders are normally the key personnel who possess the knowledge and skills essential for the business’s future development and depriving them of their decision-making capacity could have a negative impact on all the parties involved. Consequently, in practice, investors such as VC/PE funds would generally agree to the founders retaining control of the company through a share structure with weighted voting

Article 157 of the Draft Revision proposed a mechanism to overcome the above obstacle, allowing companies to issue shares with rights different from those of ordinary shares: 1. Shares for distributing profits or residual assets in a preferential or inferior manner; 2. Shares with weighted voting rights, either greater or lesser than those of ordinary shares; 3. Shares of which the transfer is subject to the consent of the company; and 4. Shares of other classes prescribed by the State Council. These new rules, once implemented, will loosen the long-standing restrictions on share issuance, which is beneficial to various enterprises, and it is foreseeable that such legal innovation would in turn accelerate industrial innovations

2. Authorized Capital

Rules pertinent to subscribed capital in the Company Law were modified materially in 2013, where shareholders were granted the discretion to determine when and to what extent they would like to make their respective capital contribution. Prior to this revision, the first instalment of capital contribution made by all the shareholders was required to be at least 20% of the subscribed capital, with the balance paid up within two years of the date of incorporation of the company. The requirement was even more stringent before 2005, when shareholders were asked to pay the full amount at once. Although some individuals have been campaigning for the introduction of an authorized capital structure, the arrangement proposed merely extends the time limit for the capital contribution, without authorizing the board of directors to issue new shares at their discretion when

It is truly encouraging to see that the Draft Revision has indeed adopted the authorized capital structure, even though it is only applicable to joint stock companies and does not extend to limited liability companies. Pursuant to Article 97, the articles of incorporation or the shareholders meeting of a joint stock company may authorize the board of directors to decide to issue new shares, in addition to the number of shares issued at the time of incorporation, in the event of reasonable business needs. Nonetheless, where the number of shares to be issued exceeds 20% of the total share capital, the proposal must be submitted to a shareholders’ meeting for approval, in line with international common practice. Additionally, any decision to issue new shares will require the approval of least two thirds of the directors.

We anticipate that this revision, once adopted, will have considerable impact on current M&A practice in China. Specifically, if a listed company wishes to acquire a target company through a share swap, the plan will need to be submitted to a shareholders’ meeting for approval, pursuant to the present Company Law, which could severely prolong the process and add uncertainties to the deal. However, if the board of directors were to be given the authority to issue new shares, they could secretly close the deal in a timely manner in accordance with their plan, as under most circumstances it would only require less than 20% of the total share capital to effectuate an acquisition. It is reasonably foreseeable that a series of relevant regulations, including securities laws, will undergo major changes after the Draft Revision comes into effect.

3. Squeeze-out Mechanis

Squeeze-out is a widely accepted mechanism in M&A deals, which typically involves the right of an acquirer to force out minority shareholders when it owns over 90% of the total share capital of the target company. This practice has been acknowledged in Article 693 of the Companies Ordinance, the principal piece of corporate legislation in Hong Kong and based on the approach of the United Kingdom. Meanwhile, squeeze-out has also gained rapid recognition in Delaware, USA. Specifically, the Delaware General Corporation Law was amended in 2013 to include a provision in section 251 which permits a merger to happen without the resolution of a shareholders meeting in the event that the acquirer has obtained enough shares that meet the threshold quorum requirement for a shareholders meeting.1

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1 DGCL, §251(h): “Notwithstanding the requirements of subsection (c) of this section, unless expressly required by its certificate of incorporation, no vote of stockholders of a constituent corporation that has a class or series of stock that is listed on a national securities exchange or held of record by more than 2,000 holders immediately prior to the execution of the agreement of merger by such constituent corporation shall be necessary to authorize a merger if: …

There is no similar provision under the current company laws and regulations in China. As such, even if a shareholder owns only one share of a company, no one has the power to force him or her to sell. This gives the minority shareholders powerful leverage against the proposed deal and in the event of related party transactions, they could eventually become the ones deciding the company’s destiny as the majority shareholders lose

The Draft Revision proposes the adoption of the squeeze-out mechanism and provides in Article 215(1) that where a company merges with any other company in which it holds more than 90% of the share capital, the target company is not required to pass a resolution at a shareholders meeting, but shall instead notify the other shareholders, who shall have the right to request the company to buy out its equity or shares at a reasonable price. This mechanism is similar to what is referred to as an “appraisal right”in some other jurisdictions. In addition, Article 90 also confers this appraisal right on the dissenting shareholders.

The adoption of a squeeze-out mechanism is expected to materially change the landscape of China’s M&A market. Considering the unique value of being a listed company and maintaining this status with stocks tradable on China’s A-shares exchanges, domestic M&A transactions are generally executed through block trades rather than mergers and acquiring corporations are usually hesitant to give up a shell target company, especially when it is a listed one. However, it is anticipated that with the reforms of the stock market moving forward, the value of acquiring a shell listed company will gradually diminish to the point that it is no longer cost-effective. Until then, a merger will become a more attractive alternative for M&A transactions and utilizing the squeeze-out mechanism will be necessary to close a deal.

4. Corporate Governanc

Discovering the most appropriate and effective way to regulate corporate governance related matters has been a long-standing issue for almost every jurisdiction. This Draft Revision demonstrates the efforts which the state has mad

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(3) Immediately following the consummation of the offer referred to in paragraph (h)(2) of this section, the stock irrevocably accepted for purchase or exchange pursuant to such offer and received by the depository prior to expiration of such offer, together with the stock otherwise owned by the consummating corporation or its affiliates and any rollover stock, equals at least such percentage of the shares of stock of such constituent corporation, and of each class or series thereof, that, absent this subsection, would be required to adopt the agreement of merger by this chapter and by the certificate of incorporation of such constituent corporation.”

o optimize the governance structure of Chinese companies. First and foremost, it proposes strengthening the position of the board of directors, stipulating that the board shall exercise all rights other than those belonging to the shareholders’ meeting as prescribed by its articles of incorporation. This is a great leap towards the board-centered leadership model, even though the shareholders still have the dominating power in domestic companies. Second, the Draft Revision proposes simplifying the existing dual board governance system borrowed from Germany; instead, where a company that has set up an audit committee under the board of directors, it is no longer obliged to set up a supervisory board. This is of great practical importance, as under the current Company Law, the board of supervisors is simply tasked with supervising the directors and the management team. This supervision in practice rarely occurs, leaving the supervisory board with a very limited role in the day-to-day operation of a company.

further change worth noting is the requisite employee engagement clause. Article 63 provides that companies with more than 300 employees shall include at least one staff representative in their board of directors. This can be positively interpreted as a response to the trend of stakeholder capitalism; on the other hand, some have also raised the concern that it will become another tool for the state to curb the alleged disorderly expansion of capital.

The promulgation of the Draft Revision has sparked a heated debate as the Company Law is the key piece of legislation relating to companies in China, encompassing rules that have a great impact on their operation. Some scholars, such as Professor Deng Feng of Peking University Law School, hold the view that these proposed revisions are of little actual substance and leave many long-standing problems unresolved. They argue that the entire Company Law should be redesigned, as the fundamental problem is that companies are categorized under the law as either limited liability companies or joint stock companies, but are basically governed by similar, if not identical, rules, save for certain specific clauses that are only applicable to joint stock companies. Personally, although I accept that their opinion is not without its merits, I nonetheless think that this Draft Revision is a meaningful step towards the establishment of a more rational and practical corporate law system in China.