Provisions on Several Issues Concerning the Hearing of Cases in Disputes Involving Foreign-Invested Enterprises (I)

Issuing Body: Supreme People's Court
Issuing Date: August 5, 2010
Effective Date: August 16, 2010

In a long-awaited effort to help Chinese courts handle cases that involve disputes arising from the establishment of or changes to foreign-invested enterprises (FIEs), the Supreme People's Court has released the Provisions on Several Issues Concerning the Hearing of Cases in Disputes Involving Foreign-Invested Enterprises (I) (FIE Dispute Provisions). Published on August 5, 2010, after seven years of discussion and public comment, the FIE Dispute Provisions provide guidance to lower courts on how to resolve several types of conflicts where the law had been ambiguous or even contradictory. The provisions took effect on August 16, 2010.

Most FIE-related disputes in China are resolved through arbitration or mutual settlement. Some 10 to 20 percent of such disagreements, however, are submitted to Chinese courts for judgment. The FIE Dispute Provisions provide guidance to trial courts in cases that involve the establishment of and changes to foreign-invested enterprises, particularly disagreements that involve joint venture contracts, equity transfers, and the operational or management rights of shareholders. The FIE Dispute Provisions do not apply to foreign-invested joint stock enterprises or foreign-invested partnership enterprises.

Joint Venture Contracts

A joint venture company is one established by at least one foreign investor and at least one domestic Chinese enterprise. Joint ventures were a common investment vehicle used by foreign investors in the early stages of China's economic opening to world markets, when fewer industries were open to foreigners; in other industries, foreign businesses were forbidden to own a controlling stake. As a result, foreign investors had to find a Chinese partner before entering China. As China has gradually opened more industries to foreign investment, the wholly foreign-owned enterprise (WFOE) has become the most common model of foreign investment.

Whether an FIE is structured as a joint venture or a WFOE, however, certain key constitutional documents must be approved by Chinese authorities before coming into effect under relevant Chinese laws: for joint venture companies, the joint venture contract and the joint venture's articles of association; and for a WFOE, the company's articles of association.

If no such government approval is granted, the FIE Dispute Provisions provide that any contracts between the parties to the joint venture that pertain to the joint venture, as well any "material or substantive changes" thereto, will be considered not to have come into effect (i.e., never became valid). However, the failure to obtain such government approval does not affect the validity of contract provisions regarding the obligation to submit documents and contracts for approval or other provisions that set forth fulfillment obligations and remedies for failing to comply with any such provisions.

As used in the preceding paragraph, the term "material or substantive changes" includes changes in registered capital; corporate type; business scope; operating term; capital contributed by shareholders; capital contribution methods; corporate merger or division; and equity transfers.

The FIE Dispute Provisions say courts should not support any claim that other changes to the joint venture contract —those which are not "material or substantive" (usually in the form of a supplemental agreement)—have not come into effect due to their failure to be approved by the appropriate government authority.

Equity Transfer

As mentioned above, an equity transfer is deemed to be a material change to an FIE, and the equity transfer agreement is subject to approval before coming into effect.

In accordance with the FIE Dispute Provisions, after the execution of an equity transfer agreement involving an FIE, if the transferor and the FIE fail to perform their obligations to file for approval, and they continue to fail to perform such obligations within a reasonable period of time after a demand for payment by the transferee (the company acquiring the equity interest), the following circumstances may apply:

• In the event the transferee makes a claim for revocation of the contract, the return of amounts paid for the equity transfer, and compensation for actual losses suffered by the transferee, the court shall support all such claims.
• Where the transferee brings an action against the transferor (foreign investor) as defendant and the FIE as a third party, and the transferee asks that the transferor and FIE jointly perform their obligations to file for approval within a prescribed time, the court should support such a claim, if, at the same time, the transferee seeks to file for approval by itself on the condition that the transferor and the FIE have failed to perform their filing obligations within the prescribed time limit determined by a final judgment.
• In the event the transferee fails to pay the equity transfer price, if the transferor makes a claim for the transferee to pay the equity transfer price, the court should suspend hearing of the case and order the transferor to file for approval within a prescribed time limit. If and when the equity transfer contract is approved by the authorities within the prescribed time limit, the court should support the claim by the transferor for payment of the transfer price.

Under the FIE Dispute Provisions, the scope of compensation includes losses in equity prices, equity proceeds, and other reasonable losses.

Operational and Management Rights of Shareholders

In practice, where one party does not want to be known as a shareholder of an FIE, that party (the Actual Shareholder) may enter into a nominal shareholder agreement with another party granting the second party the right to serve as nominal shareholder of the FIE (Nominal Shareholder) and receive compensation for doing so. Such arrangements, however, sometimes prove troublesome for both parties when disputes arise between the Actual Shareholder and the Nominal Shareholder.

According to the FIE Dispute Provisions, courts should not support a claim by the Actual Shareholder seeking recognition of its status as the real shareholder and a change from the Nominal Shareholder to itself with approving authorities unless all of the following conditions are simultaneously satisfied:

• The Actual Shareholder has paid up its contributed registered capital;
• Shareholders other than the Nominal Shareholder recognize the shareholder status of the Actual Shareholder; and
• The court or the relevant parties have obtained the approval from relevant authorities for the change in the process of the litigation.

In addition, the FIE Dispute Provisions say, the court should not support claims where the Actual Shareholder seeks to require the distribution of profits or to exercise other shareholders' rights against the FIE based on the nominal shareholder agreement.

Application

The FIE Dispute Provisions should prevail along with other relevant provisions on this subject issued by the Supreme People's Court. The FIE Dispute Provisions apply to cases that are tried or heard on appeal after the provisions came into effect. Chinese law does allow, on a very limited basis, for the re-trial of some cases that were already settled on appeal. The FIE Dispute Provisions do not apply to the re-trial of cases in which the appellate court's decision was made prior to implementation of the FIE Dispute Provisions.

Conclusion

The FIE Dispute Provisions provide important guidance to trial and appellate courts on how to handle disagreements that involve "material or substantive changes" to foreign-invested enterprises, including both joint ventures and wholly foreign-owned enterprises. Because such changes require government approval to be valid, courts had previously been unsure how to resolve certain types of disputes. The SPC has provided welcome guidance, which should clarify some issues. Nevertheless, while the FIE Dispute Provisions will make it easier for foreign investors to resolve some disputes in China, it is still advisable to do everything possible to make sure transaction documents comply with the law, paying particular attention to dispute settlement and compensation provisions when entering into deals.