In response to the rapid increase in the number of disputes involving equity transfers, equity pledges, and other similar transactions for foreign-invested enterprises, the Supreme People’s court recently released the Interpretations of the Supreme People’s court on Several Issues Concerning the Trial of Disputes Involving Foreign-Invested Enterprises (“Interpretations”) – effective as of 16 August 2010.

The Interpretations are the first judicial interpretation adopted by the Supreme Court on foreign-invested enterprise disputes, and impact numerous issues including the validity of contracts without administrative approval, share transfer agreements lacking approval, disputes between nominal shareholders and actual investors, requirements on contribution of property to a foreign-invested enterprise (FIE), and disputes on equity pledge contracts.

1. Contract without administration approval may not be unilaterally terminated

Contracts for the establishment or registration amendment of Chinese-foreign joint ventures should always be submitted for approval by the competent authority. Normally, such contracts will take effect only upon such approval. According to the Interpretations however, rather than being identified as invalid, contracts without valid approval shall be identified as pending valid and prevent either party from unilaterally canceling or terminating the contract.

2. New rules on avoiding share transfer contracts by withholding approval

Upon execution of a share transfer contract, the transferor will sometimes refuse to perform its obligations of applying for approval if the share value increases immediately after execution, using this in negotiation for a better price. The Interpretations offer a number of remedies, such as litigating to terminate the share transfer contract, to force the party to fulfill its obligation and complete approval, and/or to claim for compensation. These remedies still require recourse to the courts, which will undoubtedly lead to delays and can be costly; however, this at least presents options to a frustrated party, and the threat of litigation may motivate the other party to concede or at least compromise.

3. Rules on disputes concerning dormant investments

In practice, dormant investments – where one party makes the actual investment in an FIE, but another party serves as the nominal shareholder of the FIE – are not uncommon among foreign-invested enterprises, due to the various restrictions on foreign investment that have marked China’s legal landscape for decades and, to a lesser extent, continue to prevent some foreign investors from developing their business in China. However, the validity of related side agreements has been controversial under China laws and in practice. The Interpretations attempt to clarify this critical issue by addressing two fundamental questions: whether the actual investor can be admitted as a shareholder, and whether side agreements should bind investors.

The binding effect of a side agreement between the actual investor and the nominal shareholder is not subject to administrative approval from the Ministry of Commerce or subordinate departments, and therefore binds the parties provided that it is deemed a valid contract under the Contract Law. Among others, contracts that are deemed invalid include contracts formed by means of fraud and duress, contracts concluded based on a bad-faith conspiracy of the parties, contracts designed to conceal illegal objectives, and contracts detrimental to the public interest.

If a side agreement stands the general test of validity under the Contract Law, however, the actual investor may claim the proceeds obtained by the nominal shareholder from the FIE, and can also demand to be compensated for damages caused by the nominal shareholder’s breach of the side agreement. Moreover, the actual investor may be admitted as the shareholder of the FIE if the actual investor has actually made the investment, the shareholders other than the nominal shareholder (if any) recognize the actual investor as the shareholder of the FIE, and the change of shareholder from the nominal shareholder to the actual investor is approved by the competent approval authorities.

4. Liability of shareholders for failing to register real-estate or land contributions

Chinese law allows foreign investors to contribute their capital in various forms, including cash, intellectual property, in kind, etc., but disputes can arise when contribution is in the form of property for which registration is required. According to the Interpretations, where the property has been delivered and it is in use by the FIE, but the procedural change-of-ownership registration has not been completed, then the investor may appeal to the courts to limit the relevant rights of the shareholder. If upon filing the case, and within the period prescribed by the Court, the shareholder completes the transfer registration procedure, the said claim will be rejected by the Court. However, the shareholder shall still be liable to for compensation of losses to the joint venture caused by any delay in conducting mandatory registration procedures.

5. Equity pledge contracts no longer require registration

In 2008, Chinese law determined that registration is a strict condition to the validity of an equity pledge contract for the benefit of a third-party creditor. With the recent Interpretations, however, the law has taken an about-face. The Interpretations now provide that any equity pledge contract that has been approved by the shareholders and creditors of an FIE shall be held valid upon execution. Only if the pledge registration is in fact carried out, the pledge shall be deemed to be created at the time of registration. These new Interpretations limit the opportunity of legal challenges to improperly-registered, but otherwise legally-formed, equity pledge contracts.

Conclusions

The Interpretations will have a considerable impact on how disputes involving FIE’s are resolved. Investors should be aware how these Interpretations will protect their rights and assets, especially when formulating new joint venture contracts, seeking the performance of share transfer agreements, contemplating a dormant investment, contributing land or real estate as part of an investment, or when resolving an equity pledge contract dispute. On the other hand, the law concerning FIE’s is also constantly changing; investors should therefore continue to monitor this area for new developments to ensure their rights and investments are best protected.

In this regard, it should also be noted that in accordance with the follow-up working arrangements of the Supreme People’s court, a second juridical interpretation of how the law applies to disputes concerning the termination of foreign-invested enterprises will soon be issued, and will focus on dissolution and liquidation processes.