Changes on validity of the undisclosed guarantee of a public company

By Wu Jiejang and Hua Han, Jingtian & Gongcheng
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To protect the interests of the minority shareholders, the regulators and exchanges ask a public company to follow certain provisions and requirements of internal approval and information disclosure on the guarantee. The “undisclosed guarantee” used in practice refers to the guarantee that is made without following the internal approval and public disclosure processes as provided for and required. A commonly seen “undisclosed guarantee” is the case where the actual controllers or majority shareholders of a public company, by taking advantage of their control over the company, issue guarantee documents with the stamp of the company for the debts of their own or any affiliated party. The public company might be called to perform the guarantee obligation when the debtor is insolvent – as a result, the assets of the majority shareholders are occupied, and the interests of the company and the minority shareholders are jeopardized.

The Company Law has laid down provisions as to the process by which a guarantee is made in Article 16, as follows:

Wu Jiejiang
Jingtian & Gongcheng
Partner

(1) where the company invests in other companies or makes guarantee to others, the matter shall be decided by the resolution of the board of directors, the shareholders or the shareholders’ meeting as per the articles of association; where the articles of association have made limits to the total amount of the investments or the guarantees, or to the amount of single investment or guarantee, the limits shall not be breached;

(2) where the company makes guarantee for the shareholders of the actual controllers of the company, the matter shall be decided by the resolution of the shareholders or the shareholders’ meeting;

(3) the shareholders provided for in the preceding item, or the shareholders dominated by the actual controllers provided for in the preceding item, shall not participate in the resolution, and the matter will pass by the majority votes of the remaining shareholders with voting rights.

The courts affirmed the legal effect and validity of the undisclosed guarantee made by the public companies in most of the cases in the past:

Case 1: The undisclosed guarantee is not nullified because of violation of mandatory provisions. In 2014, in the debt contract dispute between Dayuandong Port branch of China Merchants Bank, and Dalian Zhenbang Fluoro Coatings and Dalian Zhenbang Group, the supreme court affirmed that the undisclosed guarantee made by the public company Zhenbang is effective and valid. The dispute focuses on whether the guarantee, made without the consent of the shareholders’ meeting, should be nullified because of violating Article 16.2 of the Company Law. The supreme court held the view that the intention of the law is to constrain the activities of the company and prevent the actual controllers or senior management of the company from acting in prejudice of the interests of the company, minority shareholders or other creditors. The essence of the law thus is an internal controlling process, which cannot be used to bind the counterparty of the transaction.

Therefore, the provision shall be interpreted as mandatory management rule, and the violation of such rules does not render the contract null and invalid. The supreme court judged in favour of the transaction security and the interests of the creditor.

Case 2: The undisclosed guarantee is valid as apparent agency, though signed by the legal representative beyond his/her authority. In 2015, in the civil loan dispute between Zhou Ya and Qinghai Xiancheng Mining, Xining Guoxin Investment Holding, etc., the focus is whether the guarantee made by the public company, Xiancheng Mining, is the true and actual manifestation of the intention of the company since it was made by the legal representative beyond his/her authority. The supreme court made the following judgement: where the legal representative acts beyond the authority, the public company has no other alternative but to uphold its own rights through the internal accountability process, and to nullify the guarantee is not an effective alternative. The guarantee holder, as a third party, cannot be aware that the legal representative is acting beyond the authority whatsoever.

The supreme court affirmed that the guarantee holder is a bona fide third party, and the guarantee contract signed by the legal representative with the stamp of Xiancheng Mining legally binds the company. In this case, the court centred around the Company Law without considering the public nature of the company. To maintain the transaction security of the parties remains a judicial priority.

Latest developments

Hua Han
Jingtian & Gongcheng
Paralegal

The supreme court released The Interpretation of the Supreme Court on the Applicable Laws in the Trials of the Disputes of Company Guarantee (Draft for Comment) in August 2018. The draft confirms the principle that the guarantee made in violation of laws and regulations is null and invalid; however, if the counterparty has conducted formality examination of the guarantee contract when singing the contract, the people’s court should recognize the effect of the guarantee contract.

In the case of public companies, the formality examination should be subject to the information disclosed by the public company. If the public company does not disclose the internal approval process and the signing of the guarantee contract, the counterparty will not be able to claim the validity of the guarantee contract because of the performance of the formality examination obligation. In this light, the supreme court has given particular emphasis to the public nature of the public company, which is different from the average commercial entities.

A latest case has manifested this principle. In the first trial of the illegal guarantee made by ST Huiqiu, the guarantee letter was nullified because there were serious doubts over the truthfulness of the letter and thus it could not be adopted. The Shanghai high court affirmed that one of the reasons rendering the truthfulness of the guarantee letter doubtful was that the letter was made without the consent of the shareholders’ meeting and the company failed to disclose the information.

It is fair to foresee that with the formal release of the previously mentioned judicial interpretation of the supreme court and the revision of the Security Law, the legacy regulatory problem of the undisclosed guarantee will be solved as now its validity is predictable.

Wu Jiejang is a partner and Hua Han is a paralegal at Jingtian & Gongcheng.

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