(by Bai Lituan) After six months of tense negotiation without any satisfactory result over a dispute of the 8-1 Pearl Project land plot on the Bund, Fosun (00656.HK) and SOHO China (00410.HK) finally chose to take the case to court in Shanghai. The first hearing of the case was in late November 2012. Before then, Fosun insisted that the share transaction between SOHO China and Shanghai Zendai Group damaged its right of preemption.
As stipulated in Article 72 of the Company Law, when a shareholder of a limited liability company transfers equity to a nonshareholder, all of the other shareholders shall have the right of first refusal under equal conditions. The value of this legislation lays in respect of the person joint. In the case, SOHO China sought to acquire the shareholding company of Shanghai Hai Zhi Men Real Estate Investment & Management Co., Ltd (“Hai Zhi Men”), which is the company holding rights over the Bund land plot, and thus indirectly acquire Hai Zhi Men’s equity. As to the application of the right of preemption in this situation, we have found no supporting regulation in the law. Therefore, this case caused the legal field to await the result of the final decision by Shanghai People’s High Court on the circumvention of the law of preemption by this kind of indirect investment.
Background of the case
The 8-1 plot belongs to Hai Zhi Men, with share options held by Zendai, Fosun, Greentown, and Panshi. Their shareholding ratio is 35%, 50%, 10%, and 5% respectively.
On December 29, 2011, SOHO acquired the shares of Hai Zhi Men’s shareholding company and thereby indirectly acquired 50% of Hai Zhi Men’s equity. According to an announcement by SOHO China, its purchase of 50% equity of Hai Zhi Men includes 35% from Zendai, 10% from Greentown, and 5% from Panshi. On the second day after the conclusion of the transaction, Fosun expressed its dissatisfaction, claiming that Hai Zhi Men’s articles of association stipulated a right of preemption for Fosun. With such a regulation, Fosun could acquire the entire plot without sharing with SOHO China. At the same time, Fosun said it would protect its rights through lawsuit.
In late May 2012, Fosun filed a lawsuit with the Shanghai No.2 Intermediate People’s Court, demanding exercise of its preemption right. To counter Fosun’s litigation, SOHO China replied that the lawsuit had no basis in either law or facts. SOHO China also held the opinion that its purchase of 50% equity in the 8-1 project has relation to the equity of Hai Zhi Men, and therefore Fosun does not enjoy a preemption right.
Preemption relies on the person joint
As a form of enterprise existing between a partnership and a joint stock company, the liability limited company not only has joint stock but also person joint. The person joint of a liability limited company refers to the personal dependence among the shareholders of the company. The person joint of the liability limited company not only focuses on overcoming inadequate dependence among the shareholders coming from the limited liability system, but also on suiting the self operation system of the company. Typically, limited liability companies are operated by the shareholders themselves. If common trust cannot be established among all of the operating shareholders and there are mutual suspicions between them, this could cause operations to drag and cause damage to the interests of the company and its shareholders.
Based on the ideas above, currently, most countries have established preemption systems for the purchase of companies’ share options. This is a legal liability of the seller of the company shares, which sacrifices third party interests in order to guarantee the interests of other shareholders. Aside from special agreements in a company’s articles of association, preemption demands that the seller of the share send official notice to the other company shareholders before selling to an outside buyer. This doctrine also stipulates that inner shareholders may claim the first refusal to the share transfer within a certain scope under equal conditions.
Equal conditions
The “conditions” are the main elements for determining whether the shareholder has the right to preempt the share transfer. Article 72 of the Company Law states that the right of preemption should be exercised “under equal conditions,” but what are equal conditions? The majority of people believe that share transfer is selling one’s share to another for a definite sum. In judicial practice, the so-called “equal conditions” refers to the main transfer conditions agreed to for the share transfer by the shareholder and the third party, excluding the other shareholders. The investment, business cooperation, and assumption of debt agreed to between share transferor and the transferee shall all be deemed as the main conditions. First, equal conditions means the transaction price. It is of no doubt that the transaction price shall be listed among the core articles in the transaction agreement. And, only this same price can ensure the exercise of the preemption and the protection of the seller’s interests. Second, the payment period and method are also elements to be evaluated for equal conditions. Finally, in some special circumstances, the investment, business cooperation, and assumption of debt agreed to between the shareholder and the transferee are also considered.
Indirect transaction to circumvent the right of preemption
Despite the mandatory regulation of the right of preemption in the law, there have been many challenges against it in practice. A common situation involves a corporate shareholder of the target company that intends to transfer the shares it holds but faces the objection from other shareholders. Therefore, the parent company of the shareholder transfers all the shares of the corporate shareholder to a third party of the target company. In such a situation, scholars often call the corporate shareholder a shell company, and the shares held in the target company are actually all the assets of the shell company. The profits of the target company can entirely or almost entirely belong to the shell company. This is particularly clear in investment and investment management companies. On its face, such behavior seems to circumvent the limit regulated in Article 72 of the Company Law. Through the shell of the corporate shareholder of the target company, the transferee can successfully enter the target company. Even if the company’s other shareholders vehemently object, there is still no clear regulation in law to fight against these actions, and the other shareholders have no choice but to accept it. But, disputes centered on the controlling right of the target company always follow soon after, damaging the basis of the human joint of the company. As a consequence, the interests of the company or the shareholders are damaged, which can also further influence the creditor’s rights of the company. This certainly is a kind of loss in efficiency of social economic development. Although similar cases occur commonly, the indirect investment made by SOHO China in this case can be said to be the epitome of this kind of behavior. The simple fact of the matter is that SOHO China could have purchased the remaining 50% share of the company, so why did it go through such a large process to indirectly obtain Hai Zhi Men’s 50% equity?
The situation described above clearly shows a defect in the corporate legal system, and it also reflects an inadequate understanding of the human joint of the limited liability company. This could lead to the careless arrangement of the corporate system. When the shareholder intends to transfer its shares is an individual, Article 72 of the Company Law will no doubt somewhat prevent unusual controlling rights transactions. But, when the shareholder is a liability limited company (a corporate or legal person shareholder), there are always means of circumvention that can be found.
Solution
As of now, it is difficult to predict the result of the lawsuit between Fosun and SOHO China. But, the case does provide a lot of enlightenment. Considering the complexity of the share transfer and the outdated law governing it, using the articles of association to design an effective system can be an efficient scheme.
The articles of association are the guidelines for the conduct of the corporation, and it are also called the constitution of the company. The matters of the company, major or minor, can all be handled with the reference to the regulations in the articles of association. The above noted transfer of the controlling share of a corporate shareholder from its parent company can also be stipulated in the articles through the extension of the right of preemption. For the extension, when the liability limited company confronts the parent company of its corporate shareholder selling the controlling right, which may lead to the change of the actual controller or the controlling right, the articles of the association would grant a chance to the other shareholders to claim their preemption against the share being sold. But, such preemption claims surely could only be limited to the situation in which the assets of the target company are the sole or nearly sole property of its parent company, and the profit of the target company’s margin occupies 100% or nearly the whole margin. This design is to maintain the liquidity of the share options, while also preventing control over the subsidiary when its parent company transfers its controlling equity.
It is said that the head of Fosun, Guo Guangchang likes Tai Chi. For Guo, Tai Chi is more than just a means of exercise, and he has integrated the philosophy of the sport into his business. For the lawsuit filed by Fosun against SOHO China on the Bund land plot, winning the case may not be Guo’s true purpose, rather, strengthening control over the project is his true intention. Despite this, based on the human joint of the liability limited company and the awareness of the indirect investment made by SOHO China into the project, we admit that this investment could ensure the legitimacy of Fosun’s claims. Because justice and fairness absolutely are not mechanically assembled in the law, that apparently strict legal design may actually be violating the overriding rule of good faith.
Quoted from DeBund Newsletter of January, 2013
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