Risk and Its Prevention for Dormant Investment in China

By Luo Yanjie

Recently, Shanghai Huangpu People’s Court issued white paper about cases involved Non-State-Invested Units. The white paper disclosed that the dormant investment is ubiquitous in Non-State-Invested Units during the process of their establishment, and that not only makes investors’ rights and interests unguaranteed, but also cause a serious threat to the commercial good-faith. As introduced, some actual investor would not like to establish the company in their own names considering various factors, but registered the company in others’ name. It results lots of disputes. Now we would like to discuss the risk of “dormant investment” and introduce how to reduce the risk as follows:

I. The legal risk of “dormant investment”

The risks brought by “dormant investment” are mainly as follows:

1, The risk from incomplete agreement between the dormant investor and he registered shareholder.

“Dormant investment” relates a series of rights and obligations between actual investor and named shareholder. In practice, both sides will sign an agreement similar with “entrusted shareholding agreement” about all matters such as share capital, interest allocation, dispute resolution, the liability for breach of contract. In specific practice, the agreement is often not clear enough and the actual investor think it could be count on the “friendship” and just sign a simple “gentleman” agreement before execute.

But according to our experience, once there is a dispute, if the written agreement is not clear, it is regular that both sides shirk responsibility and compete interests. Therefore, the agreement, as the basis, should be as perfect as possible. As for foreign dormant investment, due to different language and law, a clear and perfect “entrusted shareholding agreement” is more important.

2. The risk from uncertainty of the agreement validity

The legal basis is article 25 of “Rules of the Supreme People’s Court on Some Issues Concerning the Application of the Company Law of the People’s Republic of China (III)”:“Where the real capital contributor, without consent of majority of other shareholders of the company, claim that the company should alter its shareholders, issue a capital contribution certificate, record it into the shareholder register or record it into the articles of association or handle registration with the company registration authority, the people’s court shall not sustain.”

But for the situation of foreign “dormant investment”, because its purpose is to circumvent China mandatory provisions related foreign investment, the agreement may be judged to be invalid (see our previous article). After being determined to be invalid, in addition to the various rights and obligations agreed by two sides will be invalid, the most important is that the foreign trader will lose the qualification of shareholder so that unable to participate in the company’s actual operation. Though the relationship between both parties will be judged as the ordinary lending relationship, but the investor can get part compensation at the share price at that time. [ Rules about Disputes Involving Foreign-Funded Enterprises by Supreme Court ( I ), Article 18: the agreement between actual foreign investor and the nominal shareholder is held invalid, the share’s value is higher than the actual amount of investment, the actual investor requests to return the investment and distribute income according management, the people’s court shall support. ]

3, The legal risk involving third people

Due to the special characteristics of “dormant investment”, the third party doesn’t know the truth about the investors and the nominal shareholder. In the dispute, the actual investor can not use industrial and commercial registration against the third party. In this case, if the nominal shareholders transfer, mortgage, pledge shares to the third party, although according to the agreement, the actual investor can held significant shareholder ‘s liability for breach of contract, but it cannot change the facts that stock has been transferred, mortgaged or pledged.

II, The prevention for the risk of dormant investment

In view of the risk above, we put forth the following suggestions for investors:

1, to draft the agreement with the help of lawyers

It has been described in detail about the importance of the agreement. It is the best choice to hire a lawyer to draft the agreement. It can effectively improve the agreement of the effectiveness and safety of investment

2, Pledge stock rights at the same time

At the same time with “dormant investment”, both sides can also apply for the pledge of shares. It can pledge the stock recorded under the nominal shareholder to the actual investor. so as to prevent the name of contributive person unauthorized transfer of equity act. But the plan is not suitable for foreign dormant shareholding situation, because according to “the administrative department for Industry and commerce registration of equity pledge shall approach “, ” Application of the pledge registration shall be in accordance with the law of equity can be transferred and pledged equity. ” Domestic company shares without approval and cannot be transferred to the foreign, so in foreign dormant investment circumstances, unable to handle the stake out the procedures.

3. Prohibitive regulations in articles of corporation

By the Corporate Law, it could be agreed in the articles of corporation that the registered shareholder shall not transfer the share option within certain years, and the lasting of such period shall be subject to the schedule when the actual investor could be take the registration. With such an arrangement, the registered shareholder is less likely to dispose the share option under his/her name, yet it could not prevent or stop in thorough the misfeasance concerning the shares by the registered one, which could also be feasible with the amendment to the articles by the registered shareholder before the disposal.

4. The dormant investor takes the post of legal representative

Despite the rigorous regulation on the foreign investment in China, we have seen no resolute prohibitive regulation on foreigner as the legal representative. Hence, when the foreign investment is made in incognito way, it is suggested that the dormant investor shall take the legal representative and being engaged in the daily operation. But before that, by Management Regulations on the Employment of Foreigners in China, the foreign employees shall be first approved the labor license in China which application could be submitted in the company’s name. Thereafter, the registration of the legal representative could be made in the local administration of industry and commerce in China.

Lawyer Contacts

You Yunting

86-21-52134918

youyunting@debund.com, yytbest@gmail.com

For further information, please contact the lawyer as listed above or through the methods in our CONTACTS.

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