Introduction to the Resolution to the “Two Boards” Issue in China Listed Companies

(By Yu Zhiyuan) Recently, the author was interviewed by the media on the issue of the “two boards” of Jiulongshan, a Chinese listed company. The author would like to analyze the basic legal principles concerned in the “board battle” in this particular case.

I. The Summary of the Issue

Shanghai Jiulongshan Travelling Co. Inc. (hereinafter “Jiulongshan”) is a listed company, and recently, its original biggest shareholder (represented by Mr. Li Qin Fu, chief of the company board) transferred approximately 29.9% of the company’s share options to HNA Property (hereinafter “HNA”). As a result of that transaction, HNA became the biggest shareholder and company registration with the Ministry of Industry and Commerce was amended to reflect those changes. However, HNA has not completed its payments in consideration of the stock transfer. On 21st December 2012, HNA called an impromptu shareholders’ meeting as the company’s biggest shareholder. At the meeting, it passed on the suggestion to recall Mr. Li Qin Fu to act as head of the board of the company, and thereafter voted in new board members. Beijing Kang Da Law Firm filed a brief to affirm the legal effectiveness of the decision and the voting. In reply to Kang Da’s brief, Jiulongshan held its own board meeting on 25th December 2012, at which most board members claimed that HNA lacked the ability to hold its own impromptu shareholders’ meeting. In addition, the board made an announcement, supported by the legal opinions of Shanghai-based Yan Yi Ming Law Firm, that any decisions made by the temporary shareholders at their previous meeting on 21st December 2012 were invalid.

With both meetings convened, a rather contradictory situation occurred where a single company had two boards both claiming to have authority to hold shareholders’ meetings, and who both had persuasive legal opinions to support their actions; with these legal weapons, they began to fight over control of the company.

In view of both parties’ legal opinions, HNA’s main contentions are: firstly, that the shareholder meeting held on 21st December 2012 was conducted according to proper procedure; secondly, that the shareholders present at HNA’s meeting make up more than 10% of the company’s total share ownership; and thirdly, that the time and place of the meeting, as well as the participating shareholders’ actions, all met the relevant regulations according to corporate law and the company’s articles of association. As a result of these arguments, they contended that the meeting was legally effective. However, as advocated by Mr. Li Qin Fu, due to the fact that the articles in the transfer agreement do not become effective until full payment has been made for all shares transferred, no changes made by the board members are legally effective.For that reason, what HNA did had violated the agreement, making any actions by HNA, done in its role as a shareholder, invalid.

II. The Basic Principles of Company Governance

After reading the published information, the calling of the temporary shareholders’ meeting by HNA is legitimate and legally effective. There are two standards that shall be taken into account in judging the effectiveness of the decisions made at the shareholders’ meeting: firstly, the legitimacy of the procedure, and secondly, any conflict arising between the decisions made and the statutory regulations in law.Based on the current information, the procedures undertaken to convene the meeting were lawful, and moreover, Li Qin Fu’s side has not filed any opposition to the meeting. As for the decisions made at the meeting, we can see no evidence that the contents of the decisions (to change the members of the board) violated the law or the company’s relevant articles of association. Since no law breaking or violation of internal rules have been found in either procedure or content, it cannot be concluded that the decisions made at the meeting shall be deemed invalid. To follow relevant procedures provided in the company’s articles of associations is one of the basic principles of company governance.

To reflect on Li Qin Fu’s claims, his argument was based mainly on the grounds that the decisions made at the temporary shareholders’ meeting violated the share transfer option. However, according to the author’s understanding, the share transfer agreement is a binding agreement once both parties execute it, whereas the holding of a shareholder meeting is more of a legal act, which may involve the company, all the shareholders (including the investors of the listed company), its employees (including the supervisor and other high-level management personnel), and legal relations in other aspects. The effectiveness of a share transfer agreement shall only be binding upon the signing parties, and when no other public interests are involved, it cannot be construed to alter the legal effect of shareholder meeting decisions. If HNA had done something that violated the share transfer agreement, then they would be liable for a breach of contract, rather than assuming any actions taken by the board at its shareholder meeting are legally ineffective.

III. Battles Over the Right of Control and Company Deadlocks

This is not the first time we have seen a case where two boards fought over the control of a single company. In 2010, another company, ST Hongsheng, experienced a very similar type of situation, where a disorderly shareholder meeting turned sour, resulting in two boards claiming leadership of the company. Such company deadlocks or so-called “semi-deadlocks” are primarily the result of a lack of governance structure among Chinese companies, including listed companies, which tend to exercise power and conduct “battles” without full legal backing or the backing of articles of associations. ST Hongsheng settled its dispute through the judiciary, and in like manner, the parties involved in the Jiulongshan case discussed above have also chosen to take the dispute to court. The resulting costs in adjudicating the dispute, and especially the costs in time alone, will no doubt result in the shareholders of this listed company having no choice but to endure the inevitable losses they will incur as a result of this company deadlock.

When the rules of the game have been set, a board deadlock, which will only harm the investor’s interests, can only be avoided when parties settle substantial issues through well-regulated procedures and thereby cultivate a type of “concede defeat” legal culture among the public.

IV. The Forecast of the Controlling Power of the Company Belonging

In the case discussed above, the original shareholders want to restrict or exclude the opposing party from entering into board-related issues through the articles set in the transfer agreement. It can be reasonably concluded from the aforesaid analysis that this is not the most dependable way to get this done. Battles over controlling power can happen amongst current shareholders and between share transaction parties hostile to the opposing party. When a purchasing party wants to obtain the share-controlling rights of a company, and therefore gain entrance to the board, but the current board of that company disagrees with the shares being purchased under that sort of agreement, it typically fights back with whatever legal weapons it may have at its disposal. The most commonly seen scenarios usually involve a set of “special” articles located in the articles of association, which typically indicate that once a stated proportion of the share options has been gained by the purchasing party, then other shareholders may exercise prior-regulated rights to increase the difficulty of said share purchase.Another option available is the introduction of a third party in the share option purchase, thus increasing the purchasing price, and resulting in a higher purchasing cost.Alternatively, they may purchase back some of the company’s share options in order to avoid any transfer of power to the opposing party.

Keep in mind, the methods discussed above are primarily culled from judicial practices in developed countries like the United States, and as of now may not yet be applied in China. However, it can be foreseen that with economic development and societal progress, such disputes will become more prevalent, and the above-mentioned existing or future legal measures will be incorporated in the corporate governance practices of many companies. It can be stated with relative certainty that company boards of directors and the judicial organs will soon have a new challenge to face.

Quoted from DeBund Newsletter of February, 2013

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