China: Keep corporate structures simple

Author: | Published: 1 Jul 2008
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With the adoption in September 2006 of the new public company takeover and cross-border M&A regulations, Chinese government officials congratulated themselves on completing a set of world-class corporate laws. The centrepiece of this suite of legislation was the new PRC Company Law, which took effect on January 1 2007.

Judging from the response of foreign venture capital and private equity investors in China, such self-congratulations are premature. Foreign financial investors continue to set up their primary investment vehicles offshore where available structures are both more flexible and more stable, and thus better suited to support multiple rounds of debt and equity financings. The new Company Law makes a weak attempt to open the door to more complex corporate structuring onshore. But against the backdrop of a cumbersome and relatively simplistic legal infrastructure, onshore structuring options overall remain unattractive to most investors.

The corporate structuring requirements of foreign financial investors are relatively straightforward – they expect to be issued preferred shares with some or all of the following preferential rights: dividend preferences, liquidation preferences (participating or non-participating preferred), redemption rights, conversion rights, anti-dilution adjustments, special board appointment rights, enhanced voting rights and other protective provisions such as registration rights, drag-along and tag-along rights.

Prior to the new Company Law there was no legal basis for different classes of shares. There were some limited precedents involving dual classes of shares, typically in smaller domestic enterprises in which the investors provided in the articles of association for voting and non-voting shares. The legal validity of this arrangement was uncertain at best, and the parties proceeded on the presumption that in the absence of a clear legal prohibition, the agreement of the parties would be given effect under the general principle of freedom of contract.

In the eyes of some PRC lawyers, registration of the articles of association providing for different classes of shares with the local branch of the Administration of Industry and Commerce (AIC) added a certain level of comfort, as it was seen as a form of official sanction. Whether as a practical matter the relevant local AIC would register articles of association providing for preferred shares was an open question and depended on how liberal or conservative the local AIC officials were. Even if the local AIC did register the articles, the general view was that this was a small fig leaf to cover such a fundamental structuring element.

More conservative PRC legal practitioners took the view that under the Chinese legal principle of tong gu tong li (literally "same benefit for same shares"), different classes of shares were not permitted. However, a strict interpretation of this principle would not preclude the existence of preferred shares so long as each class of shares was treated equally within its class.

The new Company Law appeared to remove much of this legal uncertainty by providing for the first time a legal basis for preferred shares. Under the Law, limited liability companies (LLCs) may, with the unanimous consent of the shareholders, adopt a shareholders' voting scheme and a dividend distribution plan that is not based on relative shareholdings. This is a de facto recognition that LLCs may create different classes of shares.

That is good news, but it does not go very far as a practical matter. There is no express recognition for preferred shares with all of the other bells and whistles commonly seen in offshore structures (for example liquidation distributions are still based on relative shareholdings), and there is no reference to warrants, options or other convertible securities (other than convertible bonds) in the new Company Law.

Consequently preferred shares are still extremely rare in China. Domestic investors tend not to be familiar with the concept and so do not seek to push for preferential rights or protections. The basic analysis seems to be that, without more detailed implementing regulations, there is more to lose than there is to gain from being among the first test cases.

There are even more fundamental impediments for foreign investors. First and foremost, the default vehicle for the majority of foreign investments, including FIEs created by way of cross-border acquisition of a domestic target, will take the form of an equity joint venture (EJV), wholly foreign-owned enterprise (WFOE) or (less common in recent years) cooperative or contractual joint venture (CJV). None of these FIE vehicles issues shares, so there is no possibility to create different classes of shares (a CJV can be designed to achieve dividend, voting and liquidation preferences, but equity interests in a CJV do not take the form of shares).

There is a foreign investment vehicle that appears to promise a share-issuing entity incorporated with foreign capital. The foreign-invested company limited by shares (FICLS) does, as the name implies, issue shares, but approvals for such FICLS entities are all managed on a centralised basis at the Ministry of Commerce (Mofcom) in Beijing. This centralised approval requirement has dampened whatever enthusiasm there may have been for this investment vehicle. The inclusion in the articles of both ordinary and preferred shares will probably only compound the problem, since central Mofcom may decline to take action on the submission in the absence of clear legislative guidance, particularly if the preferential rights exceed the modest scope expressly permitted in the new Company Law.

Offshore investment vehicles also provide more flexibility in tax planning and exit options. Since foreign financial investors understandably prefer the full panoply of rights together with additional legal flexibility and certainty provided by offshore investment vehicles, the long-standing trend remains unchanged. The key to avoiding frustration: keep it simple onshore and continue to push the more complex bits offshore.

By Robert Lewis of Lovells Beijing

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