China's Supreme People's Court Issues Rules On Foreign Investment Disputes

Tuesday, November 2, 2010 - 00:00

On May 17, 2010, the Supreme People's Court of the People's Republic of China ("SPC") passed the "Provisions of the Supreme People's Court on Several Issues Concerning the Trial of Disputes Involving Foreign-Invested Enterprises" (the "FIE Dispute Rules"), which were issued and came into force on August 16, 2010.

The FIE Dispute Rules address issues arising during the creation and change of foreign invested enterprises("FIEs"). The Supreme People's Court is expected to issue additional rules on disputes related to termination of FIEs.

This article will concentrate on three specific issues addressed by the FIE Dispute Rules:

The effectiveness of contracts subject to approval by the FIE examination and approval authority ("FIE Approval Authority").

• The resolution of FIE equity transfer disputes.

• The resolution of disputes concerning nominal investment in FIEs.

The Effectiveness Of Contracts Subject To Approval By The FIE Approval Authority

The FIE Dispute Rules provide that contracts concluded during the course of an FIE's establishment, which in accordance with applicable laws and regulations become effective only upon approval by the FIE Approval Authority, will come into effect on that date. Article 1 provides that where approval has not been obtained, the court will hold that the contract has not yet become valid. If the parties to the contract request a determination that the contract is invalid, the court will not uphold this request.

Article 2 further provides that where the parties enter into a supplementary agreement concerning an FIE that does not amount to a significant or substantial change to the contract already approved by the FIE Approval Authority, the court will not hold the supplementary agreement invalid simply because it had not been approved by the FIE Approval Authority. The "significant or substantial changes" referred to above include changes to the registered capital of the company, the type of company, the term of the company's operation, the proportions of the capital contributions by the company's shareholders, changes to the method of capital contribution to the company, and the merger or division of the company or transfer of shares in the company.

Article 4 states that the court must hold that a party has performed its capital contribution obligation if the following occur:

• A party to the FIE uses a property whose change of ownership needs registration as its capital contribution or its condition of cooperation;

• The property is delivered to the FIE and is being used by the FIE; and

• The party under an obligation to conduct the change of ownership registration procedures completes the registration within the time limit prescribed by the court.

Before the release of the FIE Dispute Rules, the courts often ruled contracts invalid if they had not been examined and approved by the FIE Approval Authority. Now, the courts are not permitted to rule such contracts invalid, but rather, that they are more correctly to be held as "not yet valid." This is an important distinction. On the other hand, the Chinese Contract Law does not address the treatment of contracts that are "not yet valid." There may be confusion as to the effect of other provisions of such contracts that are not related to the registration obligation.

The Resolution Of FIE Equity Transfer Disputes

The following provisions attempt to cover the situation that might occur while an FIE contract is being examined and approved by the FIE Approval Authority. During this period, the value of the shares may change and, in some cases, the transferor might prefer to sell the shares when the value of the shares is high, rather than go through the process of approval.

Article 5 of the FIE Dispute Rules provides that a transferee can request the termination of the contract and compensation for actual losses incurred due to the failure to submit the contract for approval if the transferor and the FIE:

• Fail to perform their obligations to submit the contract for approval by the FIE Approval Authorities after a contract for the transfer of equity in an FIE has been formed, and

• Continue to fail to perform their obligations within a reasonable period after being requested to do so.

In this case, the court will uphold the transferee's request.

The court will also uphold a request by the transferee for specific performance by the transferor and the FIE (Article 6), or alternatively it will allow the transferee to submit the contract for approval if the transferor and the FIE fail to carry out their obligation to submit the contract for approval within a period prescribed by the court (Article 6).

Another situation addressed in the FIE Dispute Rules is where, after the formation of a contract for the transfer of equity in an FIE, the transferee has not paid the consideration for the transfer of the shares, and the transferor and the FIE have also not carried out their obligation to submit the contract for approval by the FIE Approval Authorities. In this case, if the transferor files a case requesting that the transferee pay the consideration for the transfer, the court will adjourn the case and order that the transferor conduct the approval procedures within a prescribed time limit. If the share transfer contract is then approved by the FIE Approval Authority, the court should uphold the transferor's request for payment of the consideration for the transfer (Article 9).

Finally, an equity pledge contract executed between the shareholders and creditors of an FIE becomes effective upon its conclusion, except as otherwise provided by laws and administrative rules and regulations, or as otherwise agreed in the contract. Failure to register the pledge will not affect the validity of the contract. Article 13 provides that the court will not uphold a party's claim that an equity pledge contract be held invalid or ineffective merely on the ground that the contract has not been approved by the FIE Approval Authority. Article 13 in effect invalidated Rule 12 of the Rules on Foreign Invested Entities' Equity Transfer, issued by the State Administration for Industry & Commerce and the previous Ministry of Foreign Trade and Economic Cooperation (now the Ministry of Commerce), which provided that an equity pledge contract is invalid unless it has been registered. The Supreme People's Court's reasoning is that an equity pledge contract itself does not change the ownership of shares. To effect the change of ownership, the party still needs to register with the authorities.

The Resolution Of Disputes Concerning Nominal Investments In FIEs

It is often the case that the shareholders of an FIE reach an agreement whereby one party makes the actual investment in the FIE, and the other party simply serves as a nominal shareholder in it. The FIE Dispute Rules make it clear that the court will uphold such agreements, provided that they are not invalid pursuant to other laws and administrative regulations (Article 15).

Article 14 provides that the court will not grant a request by the actual investor for confirmation of its identity as a shareholder in the FIE or for an amendment of the shareholders of the FIE, unless:

• The actual investor has already invested in the FIE;

• Shareholders other than the nominal shareholder recognize the actual investor's identity as a shareholder; and

• During the period of the court proceedings, the court or the parties receive the consent of the FIE Approval Authority for the actual investor to become a shareholder in the FIE.

Article 15 states that the court will not allow one of the parties to claim that the contract is invalid or has yet to become valid because it has not been approved by the FIE Approval Authority. Further, where the parties have not reached any agreement regarding the distribution of benefits, the court will allow the actual investor to request that the nominal shareholder pay it the earnings received by the nominal shareholder from the FIE. On the other hand, Article 15 empowers the court (after careful consideration of the circumstances) to allow the nominal shareholder to request that the actual investor pay necessary remuneration to the nominal shareholder.

Articles 18 and 19 deal with the tricky question of valuation. Article 18 provides that if the contract between the actual investor and the nominal shareholder is held to be invalid, and the value of the shares held by the nominal shareholder is higher than the actual amount of investment, the court will allow the actual investor to request that the nominal shareholder return its investment and also allocate the benefits it received from its participation in the management and business operations of the FIE.

Alternatively, where the nominal shareholder in the FIE clearly indicates that it wishes to give up its shares or refuses to continue to hold them, the court may order that the actual investor's investment be returned to it through the proceeds of an auction or forced sale of the nominal shareholder's shares in the FIE.

In Article 20, the court is given the power to requisition or return any property obtained by the parties where the contract between the actual investor and the nominal shareholder in the FIE is deemed invalid on the grounds of malicious conspiracy, or on the grounds of harming the state or the interests of any collective or individual. In practice, many nominal investor arrangements were set up to escape the limitations on the types of industry in which a foreign-invested enterprise can conduct business. Article 20 raises a potential issue: Will violations of China's industrial policy be deemed as harming the state interest and therefore invalidate the contract between the nominal investor and the actual investor? This question remains to be answered by the courts.

In summary, the principle underlying the nominal investment rules is to decide disputes between the actual investor and the nominal investor according to the contract they have entered into. One cannot automatically assume, however, that Chinese law applies to such a contract. Instead, because such contract is not covered by the Law on Chinese-Foreign Equity Joint Ventures, the Law on Chinese-Foreign Contractual Joint Ventures, and the Law on Foreign Capital Enterprises, the court applies the general choice of law principles in deciding which jurisdiction's laws will apply.

Conclusion

Overall, the FIE Dispute Rules are a welcome clarification of the law as it affects FIE disputes in China. In many ways, the SPC is taking a very practical and pragmatic approach to FIE investment disputes, which is consistent with approaches adopted in many foreign jurisdictions.

It should be noted that the FIE Dispute Rules also apply to companies established by investors from Taiwan, Hong Kong, and Macau, as well as Chinese citizens with permanent residence outside of China.

Victor Chang and Ashley Howlett are Partners in the Beijing office of global law firm Jones Day. Mr. Chang is a seasoned litigator with more than 20 years of experience in complex litigation, white-collar criminal defense, corporate control fights, and construction and IP disputes. Mr. Howlett leads the Firm's Construction Practice in Asia and advises clients on dispute avoidance and dispute resolution by means of mediation, arbitration, and litigation. Associates Jackie Jernejcic and Leanne Zheng assisted with the preparation of this article.

Please email the authors at vchang@jonesday.com and ahowlett@jonesday.com with questions about this article.