It is relatively common for foreign investors to employ the vehicle of dormant investment when they come to invest in China. The recent Chinachem case highlights the legal risks of dormant investment. This article analyses legal issues on the vehicle of dormant investment in the mainland China from the aspects of causes of dormant investment, provisions on dormant shareholder and legal risks of dormant investment.

"Dormant shareholder" is a concept opposite to the concept of "nominee shareholder" and means the investor who conceals his identity and entrusts the nominee shareholder to contribute to the share capital of a company, the shareholding of which as stated in the articles of association, register of shareholders and registration with administration for industry and commerce is in the name of the nominee shareholder.

  1. Causes of Dormant Investment

  2. Causes of dormant investment are complicated but can be summed up in two circumstances: 1) evasion of prohibitive or restrictive provisions of laws with lawful means, for example, evasion of provisions on restriction on the sectors of investment (i.e. evasion of prohibited or restricted sectors as provided in the Catalogue for the Guidance of Foreign Investment Industries by foreign investors), evasion of provisions on restriction on investment ratio (i.e. relevant provisions provide that only when capital contribution by foreign investors accounts for more than 25% in the establishment of a joint venture company the foreign investors may enjoy tax preference), and evasion of provisions on restriction on the identity of investors (i.e. the de facto shareholders making contribution to the capital are state organs or state civil servants but state organs or state civil servants are prohibited from being engaged in investment and profit-earning activities in China). There exist some problems with the above circumstances, however, which may lead to invalidation of relevant shareholding entrustment agreement. 2) rational utilization of provisions of laws in investment, for example, evasion of provisions on restriction on the number of investors (i.e. if the number of shareholders of a limited liability company is more than 50, some of the shareholders need to entrust others to hold the shares of the company), and evasion of restrictions on statutory procedures for establishment of a company (i.e. foreign investors evade the tedious procedures for establishment of a foreign invested company). The above circumstances are not covered by the circumstances of invalid contracts as provided in Article 52 of the Contract Law and therefore may be of supportive and practical significance.

  1. Provisions on Dormant Shareholder

  2. No. 3 Provisions on Certain Issues on Application of the Company Law of the People's Republic of China (hereinafter referred to as "No.3 Judicial Interpretation on the Company Law") issued by the Supreme People's Court on 27 January 2011 and implemented on 16 February 2011 have express provisions on dormant shareholder, details of which are as follows:

    First Paragraph of Article 25: If any dispute arising between the de facto shareholder and the nominee shareholder with regard to the effectiveness of the contract entered into between the de facto shareholder and the nominee shareholder of a company, in which it is agreed that the de facto shareholder shall contribute to the share capital and accordingly enjoy the rights and interests of the investment, is not covered by the circumstances as provided in Article 52 of the Contract Law, the People's Court shall hold that such contract is valid and effective.

    We are of the opinion that this provision indicates the spirit of freedom of contract and, as long as it is the autonomy of will of the parties and there is no illegal circumstance, the agreement should be valid and the dormant shareholder may claim for relevant rights and interests against the nominee shareholder according to the agreement.

    Second Paragraph of Article 25: If any dispute arises between the de facto shareholder and the nominee shareholder as describe in the first paragraph of this Article in respect of the entitlement of the rights and interests of the investment, and the de facto shareholder claims rights against the nominee shareholder on the basis that he has performed his obligation to make contribution to the share capital, the People's Court shall support the claim. If the nominee shareholder denies the de facto shareholder's entitlement to the rights on the grounds of records on the register of shareholders and the registration with company registration authority, the People's Court shall not support these grounds.

    We are of the opinion that the name as set out in the register of shareholders should be the legal basis on which the nominee shareholder claims rights against the company or raises defense against the company, rather than the basis on which the nominee shareholder acts against the de facto shareholder, and therefore the nominee shareholder shall not act against the de facto shareholder on such grounds.

    Third Paragraph of Article 25: If the de facto shareholder, without the consent of more than half of other shareholders of the company, requests the company to change the shareholder, issue capital contribution certificate, record his name on the register of shareholders and the articles of association of the company and conduct registration with company registration authority, the People's Court shall not support the request.

    We are of the opinion that if the request from the dormant shareholder has gone beyond the agreement between the dormant shareholder and the nominee shareholder and the de facto shareholder requires to turn into registered shareholder from dormant shareholder, he shall obtain the consent of more than half of other shareholders of the company.

Case Study

Hainan Hualai Industrial Investment Company Limited vs. Yangpu Xinhuitong Industrial Development Company Limited, Appeal Case (2012) Qiongminzaizhong No.3

Parties

  • Appellant (Defendant of first instance and Defendant of second instance): Hainan Hualai Industrial Investment Company Limited
  • Respondent (Claimant of first instance and Claimant of second instance): Yangpu Xinhuitong Industrial Development Company Limited
  • Third Party of Second Instance: Liquidation Team for Close of Hainan Development Bank

Forum Competens

This case has been heard by Haikou Intermediate People's Court (hereinafter referred to as "Haikou Intermediate Court"), the court of first instance, in 2009, and heard by Hainan Higher People's Court (hereinafter referred to as "Hainan Higher Court"), the court of second instance, in 2011, with the final judgment made by Hainan Higher Court on 25 June 2012.

Facts and Findings

Xinhuitong and Hualai entered into the entrustment agreement in 1996, in which the parties agree that Xinhuitong invests in Changcheng Company holding 6.369% of the shares of Changcheng Company (10,000,000 shares), and shall be the de facto contributor to the company and the de facto holder of the shares; and Xinhuitong entrusts Hualai to hold such shares and to be the registered shareholder of Changcheng Company on behalf of Xinhuitong. As such, Xinhuitong enjoys all equity interest in respect of its shareholding of the company and assumes the responsibilities of shareholders; and Hualai promised to transfer all interest to Xinhuitong and exercise rights of shareholders according to Xinhuitong's direction. In the same year, Xinhuitong transfered 10,000,000 yuan to the account of Hualai and Hualai transferred such amount to the account of Changcheng Company. After that the liquidation team of the former Hainan Development Bank (hereinafter referred to as "HDB") applied to the court for freeze of 12,300,000 share capital of Changcheng Company registered under the name of Hualai because Hualai was unable to perform the debt owed to HDB. After Xinhuitong raised an objection to execution of the court order, it requested the court to rule that the 6.369% of the shares of Changcheng Company (10,000,000 original corporate shares) held by Hualai on behalf of Xinhuitong shall be the actual investment of Xinhuitong and be actually held by Xinhuitong. Xinhuitong won in the first instance. Hualai refused to accept the judgment and appealed to Hainan Superior People's Court.

It was a coincidence that the No.3 Judicial Interpretation on the Company Law was promulgated when the case was in the course of second instance. Hainan High Court made the judgment strictly in accordance with the judicial interpretation as follows:

In respect of the effect of the entrustment agreement, the court held that according to the first paragraph of Article 25 of the No.3 Judicial Interpretation on the Company Law, the entrustment agreement was the real intentions of the parties and there did not exist any circumstance under Article 52 of the Contract Law and shall be an effective agreement; and that the entrustment agreement has provided that Xinhuitong shall be the de facto contributor and the actual owner of the 12,300,000 shares. In the circumstances that Xinhuitong has exercised the rights of shareholders, it shall be ruled that Xinhuitong shall be the de facto shareholder of Changcheng Company and Hualai was only the nominee shareholder which held the shares on behalf of Xinhuitong.

In respect of verification of dormant shareholder, the court held that according to the second paragraph of Article 25 of the No.3 Judicial Interpretation on the Company Law, Xinhuitong's claim in relation to the dispute on the ownership of the investment interest between Xinhuitong and Hualai shall be held by the court and Xinhuitong shall be the de facto owner of the shares of the company.

  1. Legal Risks for Dormant Shareholder

  2. Since dormant shareholder does not register with the administration of industry and commerce, there exist potential risks such as: 1) the position of shareholder is not recognized and there will be obstacles when exercising rights of shareholders; 2) the nominee shareholder maliciously damages the rights of the dormant shareholder, for instance, arbitrarily sells the shares or abuses the voting rights; 3) the nominee shareholder is involved in judicial proceedings and therefore its shares are frozen or executed by the court; and 4) the nominee shareholder is dead by accident and the shares may be inherited.

  1. Advice on Risk Control of Dormant Investment

  2. Since the dormant shareholder is unable to exercise direct control over the shares held by the nominee shareholder, it will face with a good many legal risks. However, such legal risks may be avoided or prevented through the following ways:

    1. Establishment of accounts for contribution of capital and distribution of dividend. The account shall be opened in the name of the nominee shareholder as the account for contribution of capital and managed by both of the nominee shareholder and the dormant shareholder. Time and conditions shall be provided for the nominee shareholder to make contribution to the capital of the target company after the dormant shareholder has paid the contribution to such account. If the condition allows, it shall be agreed that such account shall be the only account for distribution of dividend.
    2. Pledge of shares. It is advised that the nominee shareholder shall be required to pledge the shares it holds to the dormant shareholder, which may prevent the nominee shareholder from disposing of the shares in good faith. Besides, when the shares held by the nominee shareholder are executed by the court or inherited or need to be sold off, the actual contributor may also enjoy the first priority as the pledgee.
    3. Liabilities for breach of the contract and the amount of indemnity shall be explicitly provided in the contract. It is advised that the following issues shall be explicitly provided in the contract: time, amount and form of investment; time, amount, means of transfer of dividend or other proceeds to the dormant shareholder and the ways of exercising rights of shareholders, etc. It is also advised that relatively high amount of indemnity shall be provided in the contract to restrict or prohibit the nominee shareholder from exercising shareholders' rights in breach of the contract.
    4. Exercise of shareholders' rights shall be explicitly provided in the contract. Since the dormant shareholder needs to exercise shareholders' rights through the nominee shareholder, how to exercise the shareholders' rights shall be explicitly provided in the contract so as to ensure the dormant shareholder's control over the company, i.e. the nominee shareholder can exercise the voting rights, the rights to receive dividend and pre-emptive rights to increase share capital only with the consent of the dormant shareholder and the nominee shareholder must exercise such rights according to the dormant shareholder's instruction. What is more effective, it is provided in the entrustment agreement that the nominee shareholder shall irrevocably authorize the dormant shareholder to exercise the shareholders' rights of the company, including but not limited to participation in the shareholders' meeting, voting at the shareholders' meeting and appointment of directors and senior management.
    5. The shares held by the nominee shareholder and the property interests of the nominee shareholder shall be distinguished from each other. When the nominee shareholder dies by accident or divorces, the shares held by him which are not his property as provided in the contract shall not be divided as his heritage or joint property so as to ensure the ownership of the property of the dormant shareholder.
    6. Disclosure of the entrustment agreement to other shareholders or interested parties of the company. In order to prevent the nominee shareholder from exercising shareholders' rights without the dormant shareholder being informed, if the condition allows, it is advised that the entrustment agreement shall be disclosed to other shareholders or by recognized by written confirmation of other shareholders. In this way, other shareholders can also stop the nominee shareholder from breaching the contract. Furthermore, if the nominee shareholder sells the shares to other shareholders without the dormant shareholder's consent, the dormant shareholder can declare that the transfer is void and it has the right to take back such shares on the ground that other shareholders act mala fide with knowledge of the entrustment agreement.
    7. Proper restriction on the rights of the nominee shareholder in the shareholders' agreement and the articles of association of the company. Shareholders' agreement and the articles of association of the company are important documents of the company. If the condition allows, it is advised that the restrictions on exercise of the shareholders' rights shall be provided in the shareholders' agreement and at the same time, in the articles of association of the company.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.