Dormant or anonymous-nominee shareholding investment is a quite popular investment vehicle in mainland China. In this special arrangement, the actual investor (anonymous shareholder) entrusts the nominee shareholder to contribute to the capital of a company and the nominee shareholder is recorded as the shareholder in the articles of association and the register of the shareholders.
As a business lawyer, the author has witnessed many disputes in recent years arising out of this kind of arrangement, together with its popularity. Foreign and local investors choose to adopt dormant investment for such legitimate purposes as privacy, flexibility or convenience. However, many investors have concluded this arrangement just to avoid restrictive or prohibitive provisions of laws and regulations.
Some investors feel more confident in adopting this investment method after the Supreme Court of China (SPC) promulgated two judicial interpretations, i.e., the Regulations on Issues in Adjudicating Cases Involving Foreign Invested Enterprise Disputes (I) of 2010, and the Regulation on Several Issues Concerning the Application of the Company Law (III) of 2011. In both interpretations, formal recognition is granted to dormant investment arrangements, and preconditions to be satisfied are prescribed if the actual contributors request courts to recognize their shareholder status in invested companies.
Although the SPC tries to fill the gap between practice and law, the true colour of the two judicial interpretations is definitely not to encourage investors to adopt dormant investment arrangements. On the other side of the coin, acknowledgement of validity of dormant investment agreements and preconditions to be satisfied for obtaining shareholding position serve as the hurdles for protecting the actual contributor’s rights and interests. These may pose many legal risks to the actual contributors, including the following:
(1) The dormant investment agreement may be held by the court to be invalid. Both judicial interpretations recognize the validity of the dormant investment if there are no invalidating conditions as provided by laws and administrative regulations. The dormant investment contracts must be held invalid in case they violate compulsory provisions of laws and administrative regulations. In some cases we find the courts have adopted stricter tests to negate the effectiveness of those contracts. The SPC in its final judgment [(2002) Minsizhong No. 30] deemed the entrustment agreement between the actual contributor and the nominee shareholder invalid because the agreement was against administrative rules enacted by ministries under the State Council. In China, the effect of administrative rules is lower than that of laws and administrative regulations.
(2) A common risk the actual contributor may face is contract breach. The nominee shareholder may refuse to return the dividend or other interest received from the invested company back to the actual contributor. The nominee shareholder may also transfer, pledge or dispose of the shares registered under his/her name, and the actual contributor has no right to halt this disposal as long as the third-party acquirer acted in good faith. The nominee shareholder may reject to subscribe for the capital increase or purchase the shares as requested by the actual contributor.
(3) Other shareholders may refuse to recognize the shareholdership of the actual contributor, even if the nominee shareholder intends to return shares. As provided in two judicial interpretations, for domestic companies, the actual contributors must obtain the consent of more than half of the other shareholders, except for the nominee shareholders, while for foreign-invested enterprises, all other shareholders aside from the nominee shareholder must agree to accept the shareholding status of the actual contributor.
(4) In case the nominee shareholder is in debt and sued by his/her creditor, the court can freeze or execute all the shares registered in the nominee shareholder’s name.
(5) In case the nominee shareholder is a natural person and deceases, the dormant investment agreement will have no binding force upon heirs after they inherit the shares.
(6) Even if the nominee shareholder contends to give shares back to the actual contributor, in practice the administration of industry and commerce will not accept any dormant investment agreement before they change the shareholders on record. The only solution could be a share transfer agreement. However, the purchase price of the shares may be deemed unreasonably low by the tax authorities, which can levy tax on this share transfer after it adjusts the purchase price.
In conclusion, any careful planning beforehand, and a well-drafted dormant investment agreement, may help investors avoid or prevent a good many legal risks if they still prefer to take this bold step, but they really must think twice after taking into consideration all the provisions and practice surrounding the two judicial interpretations.
John Jiang is a partner at Boss & Young in Shanghai
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