Equity transfer: How to avoid possible damage to corporate assets

By Zhao Sheng, Co-effort Law Firm
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Once a shareholder duly fulfils his capital contribution obligation, he acquires equity in the company, which entitles him to rights as a shareholder of the company that has fictive independent personality. However, there may be occasions where the shareholder behaves in a manner detrimental to the company’s assets if he neglects the independence between his equity and the company’s assets, owing to the intangibility of equity and the fiction of independent personality of the company.

Let’s start with a case in which the author was involved. In a real estate enterprise that was a Chinese-foreign equity joint venture (JV), Party A, Party B and Party C held respectively 30%, 40% and 30% equity, until in 2015 when they signed an equity transfer agreement (ETA) with the JV (the “quartet agreement”), which specified that: (1) it was agreed among the parties A, B, C and D that certain stores of Party D in the X project shall be transferred to Party A for a total consideration of RMB25 million (US$3.8 million). Party D shall assist Party A in selling these stores and the sales proceeds shall be the property of Party A; and (2) the 30% equity of Party A in the JV shall be transferred to parties B and C without consideration when they sign the agreement. Parties A, B and C subsequently signed an ETA relating to the RMB18 million that Party A represented in the registered capital. It was approved by the competent commerce authority and registered with the industrial and commercial bureau.

赵胜  ZHAO SHENG  协力律师事务所  合伙人  Partner  Co-effort Law Firm
赵胜
ZHAO SHENG
协力律师事务所
合伙人
Partner
Co-effort Law Firm

However, parties B and C neither transferred the stores to Party A as agreed, nor paid any equity transfer price. Party A brought a suit against Party B, Party C and the JV requesting specific performance of the quartet agreement by the three parties and completion of title transfer registration by the JV for the relevant stores.

It was a typical case illustrating how corporate assets were disposed of to pay for an equity transfer between shareholders: Party A transferred his equity in the JV to parties B and C; as the consideration for the equity transfer, certain stores owned by the JV were transferred to Party A. The arrangement was indeed designed so that the transferees (Party B and Party C) transferred stores of the JV without consideration to Party A as the price for the equity transfer, since it was agreed that the proceeds from selling these stores shall be the property of Party A. The quartet agreement was also typical because of the JV’s corporate seal.

Subject matter of an ETA: shareholder’s equity vs. company’s assets. A shareholder transfers the title to his certain property to the company in order to fulfil the obligation of capital contribution. Before the shareholder fulfilling the obligation of capital contribution, the title remains with the shareholder. Once capital contribution is made through the transfer, the company acquires the title to the property, while the shareholder acquires equity in the company as the consideration for the transfer. To sum up, the shareholder’s equities derived from, but shall not be deemed equivalent to, his capital contribution.

A company’s independent personality is reflected particularly in its autonomy and independence as to assets, liabilities and organizations. The 2005 amendment to the Company Law that replaced the expression “transfer of capital contribution” in Article 35 of the 2004 Company Law with “transfer of equity” also made it clear that what is being disposed of under an equity transfer is the transferor’s equity in a company but not any of the company’s assets to which the transferor’s capital contribution relates.

Validity of ETA provisions that dispose of corporate assets. As these provisions are designed maliciously by contracting parties to the detriment of the company, other shareholders and even creditors, they shall be held invalid in accordance with Article 52 (2) of the Contract Law, which considers such provisions “malicious collusion that is detrimental to interest of the state, collectivity or any third party.” Indeed, verdicts for the first and second instances of the above-mentioned case ruled that the provisions designed to cause payment of the equity transfer price with corporate assets shall be held invalid according to Article 21 of the Company Law, which prohibits the controlling shareholder, actual controller, directors, supervisors and officers of a company from doing any harm to the company’s interest by taking advantage of their identity as related parties to the company.

Besides, any declaration of intention shown by the company has to be realized through its organizations. Since the quartet agreement was negotiated and concluded through manipulations of parties A, B and C that comprised all members of the company, the company was not provided any opportunity to show its declaration of intention in the formation of the agreement. In other words, the agreement did not reflect the company’s true declaration of intention despite the fact that the company affixed the seal on it. Moreover, given the company’s nature as a Sino-foreign joint venture, its board of directors is the authority of the company. This means that shareholders (even though representing 100% equity) are not in a position to make decisions on behalf of the company. Even if the company is 100% Chinese-funded, a resolution of the general meeting to dispose of assets under similar circumstances can be invalidated according to Article 22 of the Company Law, which says that “any resolution of the shareholders’ meeting, general meeting or board of directors of a company that violates any laws or regulations shall be invalid”. That is why an ETA that disposes of corporate assets is considered invalid even though it bears a corporate seal.

Liability for disposing of corporate assets in connection with an equity transfer. While the ETA provisions that disposed of corporate assets were held invalid, the courts of both first and second instances upheld validity of the provisions relating to equity transfer, recognizing that they reflected the true declaration of intention of both parties. They ordered the transferees to pay for the equity transfer at an agreed price with their own assets. In practice, if any corporate assets have been disposed of, the company may request the relevant party to return its assets, or liability for compensation will emerge if the relevant party fails or is unable to do so.

In general, the transferee shall pay for the equity transfer with his own assets instead of proceeds from disposal of the company’s assets. We would be pleased if entrepreneurs find this article helpful for them to avoid mistakes and disputes in connection with operations and equity transactions.

Zhao Sheng is a partner at Co-effort Law Firm in Suzhou

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