(By Lear Gong) Regulation No.3 on Several Issues Concerning the Application of the Company Law issued by the Supreme People’s Court (“Corporation Interpretation III”), which was promulgated and came into effect on January 27, 2011, contains specific regulation on application of law with respect to dormant investment. Regulation No.1 on Several Issues Concerning the Hearing of Disputes Involving Foreign Invested Companies by Supreme People’s Court (“Foreign Investment Interpretation I”) also contains detailed regulation on dormant investment in companies.
In practice, however, company investors, especially those from foreign countries, still face great confusion in controlling legal risk from dormant investment and when applying Company Interpretation III and Foreign Investment Interpretation I. Therefore, the author believes it is necessary to further clarify these issues.
Dormant investment is also known as shareholding in others’ name or share option trust. For the sake of convenience, we will refer to all of this as “dormant investment.” Neither Corporation Interpretation III nor Foreign Investment Interpretation I actually use the name “dormant investment,” but instead provide an explanation of dormant investment in the relevant articles. Investors need to know the following three things:
I. Confirm the documents showing the status of the actual investing shareholder
As provided in Article 23 of Company Interpretation III on the issue of shareholder confirmation:
“When a dispute breaks out among the parties break concerning shareholder qualifications, and one party files an application to the court for confirmation of its share option, it must demonstrate the following:
(1) It has lawfully made an investment or contribution, which does not violate the compulsory regulations in the laws and regulations;
(2) It has had the share option transferred to it or has received the share option by other methods, which do not violate the compulsory regulations in the laws and regulations”
Foreign Investment Interpretation I also speaks to this issue:
Article 14: When the parties agree that one party takes the actual investment, while the other party is only a dummy shareholder of the foreign invested company, and the actual investor applies to confirm its status as the actual investor in the company or demand to change the shareholder of the foreign invested company, the court may not support the application. But, this excludes the following situations:
(1) The actual investor has made actual investment;
(2) Other shareholders in addition to the dummy shareholder accept the actual investor as the shareholder;
(3) The court or the parties have gained consent to change the shareholder to the actual investor from the authority approving the foreign investment during the course of the lawsuit.”
Article 15, Paragraph 1: “If it is agreed in the contract that one party is the actual investor, while the other is only the dummy shareholder of the foreign invested company, and the agreement cannot be found invalid according to the laws and regulations, the People’s Court will confirm the effectiveness of the contract. When one party claims the contract is invalid or not in effect because it was not approved by the authority, the People’s Court may not support the application.”
As the two judicial interpretations clearly show, in trying shareholder confirmation cases, the court does not rely on the information in the company registration but comprehensively depends on whether the party is able to prove that it holds the documents providing the basic legal relationship of its shareholding. Acquisition of the shareholding status of the actual investor can be divided into original acquisition and derivative acquisition.
In practice, the investment certificate is the key document for the original acquisition shareholder to prove its status. Due to non-compliance with China’s corporation governance, however, many companies have failed to issue investment certificates to their shareholders. For this reason, the actual investor who made the original contribution must remember to keep the bank’s remittance files, which show the fund transfer to the dummy shareholder, and the amounts indicated on it can be identical to the share contribution claimed by the actual investor. Moreover, the dormant investor must be notified to agree in the dormant investment contract that an investment certificate will be issued by the company. According to Article 32 of the Company Law, the investment certificate must clearly show the name of the company, the establishment date of the company, the capital of the company, the name of the shareholder, the subscribed or the invested amount, the investment date. and the number of the certificate. The date of the issuance must also be clarified. The certificate must be stamped with the company seal.
Derivative acquisition depends on the share transfer contract, share gift contract, will, or other legal document. The actual investor in the derivative acquisition must be noted to provide the investment certificate.
II. Confirm the legitimacy
As stipulated in Article 15 of Foreign Investment Interpretation I:
“If it is agreed in the contract that one party is the actual investor, while the other is only the dummy shareholder of the foreign invested company, and the agreement cannot be found invalid according to the laws and regulations, the People’s Court will confirm the effectiveness of the contract. When one party claims the contract is invalid or not in effect because it was not approved by the authority has not approved the agreement, the People’s Court may not support the application.”
Corporation Interpretation III also clarifies that the contribution made by the actual investor “is not against the compulsory regulations in the laws and regulations,” and Article 25, Paragraph 1 further clarifies:
“The actual investor of a limited company executes a contract with a nominal investor in which the actual investor enjoys investment rights and the nominal investor serves as a dummy shareholder. When a conflict breaks out in this situation between the dummy shareholder and the actual investor over the effectiveness of their contract, and there is no invalidity as provided in the Contract Law, the People’s Court must affirm the effectiveness of the contract.” According to Article 52 of the Contract Law: “A contract is invalid in any of the following circumstances: (i) One party induced conclusion of the contract through fraud or duress, thereby harming the interests of the state; (ii) The parties colluded in bad faith, thereby harming the interests of the state, the collective or any third party; (iii) The parties intended to conceal an illegal purpose under the guise of a legitimate transaction; (iv) The contract harms public interests; (v) The contract violates a mandatory provision of any law or administrative regulation.”
In practice, the most common element that can lead to the invalidity of the dormant investment agreement is when the contract is “against the compulsory regulations in the laws and regulations.” As is widely known, China has adopted a strict approval system over foreign investment. For foreign invested companies, once their investment involves restricted or prohibited items indicated in the Guideline of Foreign Investment, the dormant investment contract may thereby be invalid. For the same reason, even it is not a foreign invested company, once the actual investor makes its investment in the field of finance, national defense, natural resources, or related fields, the investment agreement would also be deemed invalid.
For this reason, the actual investor must first carry out due diligence over any possible restrictive or prohibitive regulations over the company it plans to invest in if it would like to set up a company or get the company’s share option through dormant investment, so as to avoid any losses in the investment.
III. Confirm who the shareholders other than the dummy shareholder
In dormant investment, aside from the dummy shareholder, with whom a dormant investment contract must be made to establish both parties’ shareholding relationship, the actual investor must also pay attention to getting the consent from other shareholders. According to Article 25, Paragraph 3 of Company Interpretation III: “When the actual investor applies for shareholder change, signs and issues the investment certificate, records the shareholder certificate, records administrative registration of the articles of association but does not receive consent from fifty percent or more of the company’s shareholders, the People’s Court may not support the application.” Foreign Investment Interpretation I further stipulates that “shareholders other than the dummy shareholder endorse the position of the actual investor”.
To prevent the risk that the actual investor has no means to prove its status, and the other shareholders deny the actual investor’s position when the actual investor applies to the court, the actual investor should acquire a resolution from the shareholder’s meeting when it signs the “dormant investment contract” with the dummy shareholder. The resolution should indicate that all of the shareholders confirm the actual investor’s status as the shareholder. Or the other shareholders can sign their names on the dormant investment contract to prove their acceptance of the actual shareholder of the company.
In conclusion, if the actual investor would like to enjoy shareholder rights through the dormant investment, it must first check the law to ensure compliance and then prepare the following documents:
- The dormant investment contract (the entrusted shareholding contract);
- The resolution of the shareholder meeting;
- The contribution certificate;
- The investment certificate from the bank or the proof of share transfer by the bank;
- Other legal documents prepared according to the actual situation that help prove the actual shareholder status.
Nevertheless, the above law does not remove all the legal risk of dormant investment. For this reason, investors should, as much as possible, make their investments through the investment methods with clear names so as to avoid any unnecessary legal risks.
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