China currently implements an approval system for foreign investment, with the establishment, division, merger and changes in the major particulars of a foreign-invested enterprise (FIE) all subject to the approval of the approval authority and the relevant registration with the administration for industry and commerce.
Article 3 of the Several Provisions on Changes in the Equity of Investors of Foreign-Invested Enterprises specifies that “changes in the equity of investors of foreign-invested enterprises shall comply with the relevant laws and regulations of China and, pursuant hereto, be subject to the approval of the approval authority and registration of the change by the registration authority”.
From this, it can be seen that changes in the equity of FIEs fall within the scope of matters subject to approval, and equity transfer contracts that have not been approved by the approval authority do not enter into effect.
However, in practice, the counter-
parties to many contracts are negligent in performing their approval obligations, or refuse to co-operate in such procedure, after the execution of an equity acquisition contract. If it is to their advantage, they will carry out the approval procedure, but if not, they do not.
They may even go as far as not performing the contract on the grounds that the equity transfer contract is invalid because it was not approved. Accordingly, control of the legal risks before an FIE equity acquisition contract is submitted for approval is of particular importance.
Article 1 of the Provisions of the Supreme People’s Court on Several Issues Concerning the Trial of Disputes Involving Foreign-Invested Enterprises (1) specifies: “if, pursuant to laws or administrative regulations, a contract entered into by concerned parties in the course of the establishment, modification, etc., of an FIE enters into effect only upon approval by the FIE’s approval authority, such contract shall enter into effect on the date of approval.
If such a contract has not been approved, the people’s court shall render a finding that such contract has not entered into effect. If a party requests that such contract be confirmed as invalid, the people’s court shall reject such request. That a contract has been found not to have entered into effect due to its not having been approved shall not affect the performance by the parties of the provisions of the contract on their approval obligations or the validity of the provisions specified therein relating to their approval obligations.”
From the above provisions, it can be seen that an equity transfer contract that has not been submitted for approval is not invalid, but its validity is in abeyance. If it passes approval, it becomes valid ab initio, but if it fails to pass approval, it is invalid.
As to the validity of the approval provisions in the equity transfer contract, they are severable from the validity of the entire contract, that is to say that regardless of whether the equity transfer contract is ultimately valid or invalid, the validity of the approval provisions in the contract is not affected, and such provisions enter into effect upon formation of the contract.
Breach of good faith
The failure to carry out the approval procedures in accordance with the law, or as specified in the contract by the party with the obligation to do so, constitutes “another breach of the principle of good faith” as set forth in item (3) of article 42 of the Contract Law, and the people’s court may, based on the specific circumstances of the case and the request of the other party, render a judgment to the effect that the other party carry out the relevant procedures itself, and that the party in breach of its obligation to carry out the approval procedures be liable for damages in respect of the expenses arising as a result of this, and the actual losses incurred by the other party.
Such judgments have been supported in the Supreme People’s Court gazette. Accordingly, the non-breaching party may, pursuant to the relevant breach of contract clause in the equity transfer contract, require the party in breach to perform its approval obligations, bear liability and compensate for its losses.
Accordingly, we recommend that, when executing an equity transfer contract that needs to be submitted for approval, the times for payment and submission for approval be expressly specified in the contract, and that compensation for the delayed carrying out of the approval procedures be set out separately.
Through expressly setting out in the equity transfer contract the liability for breaching the obligation of carrying out the approval procedures, it is possible to effectively avoid a party to the contract breaching the principle of good faith by preventing in bad faith the contract from entering into effect.
One exception that needs to be mentioned in particular is that the Decision Authorising the State Council to Provisionally Adjust in the China (Shanghai) Pilot Free Trade Zone (FTZ) Administrative Approvals Specified in Relevant Laws, adopted by Standing Committee of the National People’s Congress, authorises the State Council to provisionally adjust in the FTZ administrative approval items specified in relevant laws, including suspending the implementation of administrative approvals for changes in equity and making them instead subject to recordal.
Accordingly, when an FIE in the FTZ carries out a change in equity, it does not require the approval document from the approval authority, and the equity transfer contract enters into effect upon execution by the parties, rather than after approval.
Upon execution, all of the provisions of the contract become legally binding on the parties, and the failure by either party to perform the contract will make it liable for the attendant liability for breach of contract, and a court may, directly on the basis of the valid contract, render a judgment ordering the party in breach to perform the equity transfer contract and compensate for losses.
At such a time, the control of risks in respect of the approval obligations before submission for approval to the government, as mentioned above, is no longer required.
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