Nominee shareholding and rules of dispute hearing

Nominee shareholding is an arrangement where a person makes capital contribution and holds shares on behalf of the actual owner (beneficial owner) due to any special purpose. It is not uncommon that nominee shareholding gives rise to complicated legal disputes.

Q: What are the vital elements of a nominee shareholding arrangement, and what forms does it take?

A: In 2011, the Supreme People’s Court issued the Provisions on Several Issues Concerning the Application of the Company Law of the People’s Republic of China (III) (the company law interpretation), providing the first explicit clarifications about nominee shareholding in limited liability companies.

Pursuant to article 24 of the company law interpretation, a valid nominee shareholding arrangement must meet the following requirements: (1) there is an entrusted shareholding agreement between the nominee shareholder and the beneficiary owner; (2) the beneficiary owner takes the obligation of capital contribution to the registered capital; and (3) the entrusted shareholding agreement does not involve any invalidating circumstances under article 52 of the Contract Law.

As we can infer from article 24, the fact that a beneficiary owner chooses not to have his name appearing on the register of members does not mean that existence of the beneficiary owner is not known to the company, or any other shareholders. Therefore, there are two options for a nominee shareholding arrangement. As option 1, the nominee shareholder may hold shares in his/her own name without making any disclosure about the nominee shareholding arrangement. As option 2, the nominee shareholder may state upon equity acquisition that he/she is holding shares on behalf of another person, whether disclosing the identity of the beneficiary owner or not.

Q: Why does an investor arrange for nominee shareholding?

A: There are many reasons for investors to arrange for nominee shareholding. Usually, nominee shareholding is arranged either to circumvent laws, policies or disciplinary rules, to enable business arrangements of the companies, or to meet any other needs as necessary.

Q: What are the legal risks that may arise out of a nominee shareholding arrangement?

A: Such arrangements generally involve three parties, including a beneficiary owner, a nominee shareholder and the target. For beneficiary owners, the arrangement exposes them to two major risks, including identification of the nominee shareholding relationship and vesting of the investment income. It may be difficult to identify the beneficiary owner as the anony-mous shareholder if there is no entrusted shareholding agreement between the beneficiary owner and the nominee shareholder, or if the agreement is not sufficiently explicit, or if there is any circumstance that invalidates the arrangement. In such cases, the beneficiary owner will not be able to exercise rights as a member. Even if there is a valid nominee shareholding arrangement, it may happen that the nominee shareholder fails to transfer the investment income to the beneficiary owner as agreed, or transfers the equity in his/her possession to any third party without consent of the beneficiary owner.

A nominee shareholder may risk being involved in any debt dispute under a nominee shareholding arrangement. If the beneficiary owner fails to fulfil the obligation of capital contribution, either in whole or in part, the nominee shareholder may have to take a share in the company’s debts to the extent of the subscribed amount that has not been contributed when so required by the company’s creditors, according to details registered with the competent administration for industry and commerce. The nominee shareholder can hardly win support from courts by alleging that it is not the beneficiary owner.

As for the company, the arrangement may pose IPO obstacles and litigation risks. A company that plans for an IPO needs to get rid of nominee shareholding arrangements. If it fails to do so, it may be considered by the IPO reviewer to have an unclear equity structure, which will have an impact on the IPO process. Besides, it frequently happens that the company is included as a third party or a respondent when a legal dispute arises between the actual owner and the nominee shareholder, or any other shareholder or external creditor of the company.

Q: How do courts hear cases involving nominee shareholding?

A: The first issue courts need to address is to identify the nominee shareholding relationship. According to paragraph 1, article 24 of the company law interpretation, article 52 of the Contract Law, and paragraph 1, article 15 of the Provisions of the Supreme People’s Court on Several Issues Concerning the Hearing of Disputes Involving Foreign-funded Enterprises (I) (the FFE dispute provisions), a nominee shareholding agreement is not lawful and valid unless it meets the effectiveness conditions, which include parties with appropriate civil capacity, clear and specific contractual contents, and expression of true intentions by the parties.

It is worth noting that a nominee shareholding arrangement intended to circumvent mandatory provisions under laws or regulations is not entitled to legal protection, and the nominee shareholding agreement concluded in relation to it must be held invalid.

The second issue relates to vesting of investment income. According to paragraph 2, article 24 of the company law interpretation, and paragraphs 2 and 3, article 15 of the FFE dispute provisions, a lawful and valid nominee shareholding arrangement must contain a mutual agreement that imposes the capital contribution obligation on, and vests the investment income to, the beneficiary owner. Courts should uphold beneficiary owners’ claims against nominee shareholders on the ground of actual fulfillment of the capital contribution obligation.

The third issue is about identification of the beneficiary owner as a shareholder. According to paragraph 3, article 24 of the company law interpretation, and article 14 of the FFE dispute provisions, a beneficiary owner must obtain approval from a majority of the other shareholders in order to change to a named shareholder. Government approval is also necessary in the case of a beneficiary owner of a foreign-funded enterprise.

The last issue relates to the protection of bona fide third parties. According to article 25 of the company law interpretation, and paragraph 3, article 32 of the Company Law, where a dispute involves the beneficiary owner, nominee shareholder and any third party that is an outsider of the company, priority must be given to the protection of bona fide third parties.

For example, if the nominee shareholder disposes of any equity in a manner that meets qualifying conditions of the bona fide acquisition rule, the third party to which the equity is transferred becomes the owner of the equity, but the beneficiary owner may hold the nominee shareholder liable for breach or infringement, based on the nominee shareholding agreement.