Delayed closing of property rights transfer triggers unnecessary dispute

In wholly Chinese-owned company X, the original shareholders A and B, and individual shareholder C held 49%, 46% and 5% of the company’s equity, respectively. On 1 December 2009, shareholder A, by virtue of a listing and transaction on the Shanghai United Assets and Equity Exchange (SUAEE), executed a property rights transaction contract with Hong Kong company Y. The contract provided that A would transfer its 49% equity interest to Y for consideration of RMB690 million (US$110 million), and that Y would pay this in one lump sum into the SUAEE’s bank account within 10 days of execution of the contract, whereupon SUAEE would pay that amount to A. A was required to complete the closing of the property rights transfer within two months of the execution of the contract, and any gains or losses in asset value between the valuation reference date (30 September 2008) and the equity closing date would be vested in or borne by A in proportion to its shareholding percentage.

After execution of the contract, company Y remitted the money to the SUAEE in Hong Kong dollars, in an amount equivalent to the specified renminbi amount, on 7 December 2009. However, the closing of the property rights transfer was delayed. Shareholder B only co-operated with company Y in executing the contract and signing the articles of association of the Sino-foreign equity joint venture in October 2010. Approval of the Ministry of Commerce (MOFCOM) and amendment of business registration were completed on 20 March 2011.

Pursuant to existing foreign exchange control policy, A may only convert the foreign exchange it receives after completion of the amendment of business registration in connection with the equity transfer.

As a result, A did not complete the conversion procedure until 20 June 2011. However, due to exchange rate fluctuations, an exchange loss of RMB38 million was incurred during the period between company Y’s remittance to SUAEE and shareholder A’s completion of the conversion procedure. Furthermore, during the transition period before completion of the equity transfer, company X’s profits increased more than RMB60 million.

Afterwards, A demanded that company Y bear all of the exchange loss and pay its share of company X’s increased profit during the transition period. Company Y refused. Accordingly, A instituted an arbitration procedure to resolve the dispute. The two points of contention in the case were exchange loss and transition period profits.

Exchange loss

During the arbitration procedure, A argued that the contract should be deemed to be effective at MOFCOM approval, notwithstanding company Y’s payment being earlier than that. Company Y should be deemed to have completed its payment obligation only after the effective date of the contract. Accordingly, company Y should bear the exchange loss arising prior to completion of its price payment obligation.

In reply, company Y argued that, according to existing laws and regulations on Sino-foreign equity joint ventures, only the Sino-foreign equity joint venture contract and the articles of association require approval, and not property rights transfer contracts. So the contract entered into effect in accordance to the contract terms, rather than upon approval.

As per the contract, company Y remitted to the SUAEE Hong Kong dollars equivalent to the specified price on 7 December 2009, and by virtue of this act company Y should be deemed to have completed its obligation to pay the equity transfer price, and should therefore not be liable for damages in respect of any exchange loss.

Transition period profits

In this case, the term “equity transfer transition period” meant the period between the date of execution of the property transfer contract and the receipt of government approval and amendment of business registration for the equity transfer (with the co-operation of the original shareholders of company X).

The contract only provides for a transition period of two months and that gains or losses during that period are to be vested in or be borne by A in proportion to its shareholding. But it fails to provide for the handling of gains and losses beyond the transition period. Based on these provisions, A asserted that as long as the profits were transition period profits, it was entitled in proportion to its original 49% shareholding. However, company Y asserted that A had no claim on the profit for the extended portion of the transition period.

Our recommendations

There are two main factors that led to the delays: (1) the speed of co-operation by the original shareholders of company X; and (2) the speed of administrative actions of the approval authority, the administration for industry and commerce and the foreign exchange settlement authority.

We would recommend that at the time of the execution of any equity transfer agreement, both the acquiring foreign company and the wholly Chinese-owned company that intends to transfer the equity should pay greater attention to the provisions on gains and losses in exchange rate; and the transition period defining in detail all the factors that could affect the equity closing, and expressly specify the sharing of liability under various circumstances so as to avoid any unnecessary disputes.