*Originally distributed on January 13, 2024. 

On December 29, 2023, the National People’s Congress passed the new amendment to the Company Law of the People’s Republic of China (the “New Company Law”), which will take effect on July 1, 2024. This marks the second comprehensive revisions of the PRC Company Law since its initial promulgation in 1993, garnering significant attention both domestically and internationally.

Since China’s implementation of reform and various opening-up policies, foreign investors have flocked to the Chinese market. According to the Statistical Bulletin of Foreign-invested Enterprises in China (2023) released by the Ministry of Commerce of the PRC, the number of foreign-invested enterprises in China has exceeded 1.12 million as of 2022. Prior to the implementation of the PRC Foreign Investment Law on January 1, 2020, foreign-invested enterprises in China (the “FIEs”) were governed by a separate set of laws, including the Law on Sino-Foreign Equity Joint Ventures, the Law on Wholly Foreign-Funded Enterprises, and the Law on Sino-Foreign Cooperative Joint Ventures (collectively, the “Old FIE Laws”). If the Old FIE Laws did not cover specific matters, the PRC Company Law would apply. Under this dual-system structure, as far as FIEs are concerned, the PRC Company Law had less impact compared to the Old FIE Laws.

The Old FIE Laws were repealed upon the effectiveness of the Foreign Investment Law, necessitating FIEs to align their corporate governance structure (and other relatively minor aspects) with the PRC Company Law within a transition period of five years expiring on December 31, 2024. Consequently, after the expiry of the transition period, the PRC Company Law will apply equally to FIEs and non-FIEs.

This article discusses several key issues that we consider crucial for FIEs, but it is not an exhaustive list. As most of FIEs take the form of limited liability companies, this article does not cover FIEs in other forms such as joint stock companies or partnerships.

1. Transition under the Foreign Investment Law

In accordance with the Foreign Investment Law, FIEs that were established under the Old FIE Laws are required to adjust their organizational form, organizational structure, and operational rules to align with the Company Law within the specified five-year transition period. Failure to do so may not result in administrative penalties, but lead to the company registration authority (known as SAMR) rejecting their applications for other company registration matters and issuing public notices regarding such non-compliance. This can have a negative impact on the reputation and operations of such FIEs.

• For FIEs that have completed the aforementioned adjustments, they will need to further revise and amend their articles of association and joint venture contracts/shareholders’ agreement (collectively, the “Constitutional Documents”) in accordance with the New Company Law after July 1, 2024. The adjustment process will be relatively straightforward and manageable for wholly foreign-owned enterprises (the “WFOEs”). However, for FIEs operating as joint ventures, the adjustments under the New Company Law may trigger a new round of review, negotiation, and amendment of the Constitutional Documents, which may be challenging as it will involve the joint venture partner. The key adjustments for these FIEs include[1]:
  1. Adjusting the time limit for capital contributions to be completed within five years from the establishment of the FIE;
  2. Modifying the composition of the board of directors and supervisor(s). For instance, the board of directors may establish an audit committee, and under certain circumstances, the FIE may not be required to have a supervisor(s)[2] (and it will no longer be allowed to have two supervisors, which is common for FIEs operating as joint ventures); and
  3. Introducing the new role of an “employee director,” which is further discussed in Section 2.5 below.
• For FIEs that have not yet completed the aforementioned adjustments, the situation is more complex. These FIEs now face the urgent task of transitioning directly from the Old FIE Laws to the New Company Law by December 31, 2024. This process can be particularly challenging for FIEs operating as joint ventures, as the required adjustments under the Foreign Investment Law have not been addressed for the past four years. In comparison to the first category of FIEs, the Constitutional Documents of these joint ventures still adhere to the Old FIE Laws and lag further behind the requirements of the New Company Law. As a result, the necessary adjustments for these FIEs are expected to be more comprehensive and intricate.

It remains unclear how soon FIEs must complete the transition to ensure compliance with the New Company Law. It is anticipated that the State Council will issue implementing regulations to provide further guidance in this regard.

2. D&O and Legal Representative

2.1 – Expansion of Powers and Responsibilities

One significant amendment introduced by the New Company Law is the expansion of directors’ powers and responsibilities in relation to capital adequacy and the liquidation process of FIEs. It also strengthens the duty of loyalty and duty of care of directors, supervisors, and senior management personnel (collectively, the “D&O”), as well as their liability for compensation to the FIE and third parties. Specifically[3],

1. The New Company Law provides clearer guidelines and standards for fulfilling the duty of loyalty and duty of care of D&O. However, it is important to note that these provisions still maintain a principle-based nature and lack specific implementing details.
2. If a director or senior management personnel (excluding supervisors) cause losses to a third party while performing their duties, an FIE shall be held liable for such losses in the first place. Additionally, the director or senior management personnel involved may also be liable for compensation if the losses are a result of their willful misconduct or gross negligence.
3. Directors and senior management personnel (excluding supervisors) are obligated to exercise independent judgment and ensure compliance with applicable laws while performing their duties. They will bear joint and several liability if they are instructed by the controlling shareholder or actual controller of an FIE to engage in any act that violates the law and harms the interests of the FIE or its shareholders.
4. D&O have a responsibility to safeguard and maintain an FIE’s capital. Failure to do so may result in joint and several liability or compensation liability.
5. Directors are responsible for handling an FIE’s liquidation, and failure to fulfill this responsibility may subject them to liability for compensation.

For the first time, the New Company Law provides a clear definition of the duty of care, moving beyond a mere mention of the principle or concept. According to this definition, D&O are required to act in the best interests of a company and exercise a reasonable level of care that is typically expected from management personnel. The fiduciary duty of D&O to a company represents a fundamental principle of company law in many countries, encompassing both the duty of loyalty and the duty of care. In China, the current Company Law outlines the duty of care and duty of loyalty that directors and senior management personnel owe to a company in principle, primarily through Article 147. Additionally, Articles 147 and 148 provide a list of prohibited behaviors that D&O should avoid concerning the duty of loyalty. However, there has been a lack of definition and specific criteria regarding the duty of care. As a result, courts at various levels and in different regions have ruled on numerous cases related to this matter, but many of these cases lack sufficient reasoning and exhibit inconsistencies with each other. The definition of the duty of care included in the New Company Law is considered a significant advancement in PRC laws, but its practical application and interpretation will need to be further tested in judicial practice.

The New Company Law provides additional clarity by stating that the controlling shareholder or actual controller of a company, who may not serve as a director but is responsible for the actual execution of the company’s affairs, is also bound by the duty of loyalty and duty of care towards the company.

2.2 – Increased Liabilities Faced by D&O

The management structure of FIEs often follows a regional or business line-based approach, such as Global, Asia-Pacific, Greater China, and Mainland China. Internal reporting and the delegation of authorities are established within this structure. In such a management setup, D&O are responsible for the FIE where they hold their position and are required to comply with the management system and restrictions of the entire group structure. In many instances, the two may align harmoniously or have minimal conflicting aspects. However, conflicts may arise.

For instance, a director of a joint venture nominated by a foreign shareholder approves a significant investment plan following instructions from the overseas headquarters. If the investment subsequently fails and causes losses to the FIE, the fulfillment of the duty of care by the director will be subject to scrutiny and evaluation, i.e. whether the director is merely a “puppet” appointed by the overseas headquarters.

It is essential for D&O to be mindful of potential conflicts of interest and exercise their duties with care and diligence to mitigate any potential liabilities that may arise.

Another common issue in FIEs is that some D&O, particularly those associated with the overseas headquarters and primarily based abroad, may have limited involvement in the FIE’s day-to-day operations and decision-making processes due to objective factors such as the office location and cross-border travel challenges. With the New Company Law providing further clarification on the duty of care, we recommend addressing this issue by appointing individuals as D&O who possess a deep understanding of the FIE’s operations and actively participate in its daily affairs. This will help mitigate the risks associated with their performance, ensuring they meet the heightened standards of the duty of care as outlined in the New Company Law.

2.3 – Remedies for Dismissed Directors

The New Company Law introduces a new provision regarding remedies for dismissed directors. For the first time, Article 71 stipulates that if a director is unjustifiably dismissed by the shareholders’ meeting (or the sole shareholder) before the completion of their tenure, the director has the right to seek compensation from a company. This provision marks a departure from the previous understanding held by many foreign shareholders that they could dismiss nominated directors without compensation in any case. Under the New Company Law, if such dismissal is not justifiable, the dismissed director will be entitled to compensation.

Currently, this remedial rule exists in principle only, lacking specific guidance on determining the amount of compensation and what qualifies as justifiable cause. For both WFOEs and joint ventures (where board members are typically nominated by respective joint venture parties), careful consideration will be required in assessing the grounds for dismissing directors in the future.

It may be advisable for FIEs to seek written confirmation from directors at the time of dismissal, ensuring there are no pending disputes or claims for compensation. This may help mitigate the potential for disputes in relation to this matter.

2.4 – Directors’ Liability Insurance

The New Company Law introduces directors’ liability insurance for the first time. According to Article 193, a company has the option to purchase liability insurance to cover the compensation liability of directors for their actions during their tenure.

As the New Company Law increases the risks associated with D&O’s performance of their duties, it is possible that some individuals may become hesitant to take on D&O roles or resign due to concerns about heightened liabilities. This could have a negative impact on the operation and management of FIEs. To address this, we recommend providing necessary legal education to D&O to clarify their roles, responsibilities, and limitations. Additionally, obtaining liability insurance may provide a certain level of protection and help alleviate some of the concerns faced by D&O.

2.5 – Employee Director

According to the New Company Law, limited liability companies with more than 300 employees are required to include employee representatives on the board of directors, unless the company has established a board of supervisors with employee representatives. In cases where a board of supervisors exists, the New Company Law mandates the inclusion of a certain proportion of employee representatives. Therefore, if an FIE has a board of supervisors, it is not necessary to have an employee director on the board of directors.

For an FIE with more than 300 employees, the consideration of appointing an employee director or employee supervisor becomes necessary. However, the introduction of employee directors and employee supervisors may raise concerns among shareholders. On one hand, the involvement of employee directors or employee supervisors in decision-making processes related to employee interests helps to reflect and protect the interests of employees. On the other hand, the majority of board decisions are not directly linked to employee interests, and concerns may arise regarding the knowledge, capability, and confidentiality obligations of employee directors or employee supervisors.

As a short-term strategy, one option is to have a D&O (such as the general manager) who is also an employee of the FIE to serve as a director. It is important to note that the employee director or employee supervisor should be elected through the employee representative assembly or other forms of democratic elections, rather than being directly appointed by the shareholders. Another alternative is to establish a board of supervisors that includes employee representatives. This approach allows for the inclusion of employees in the supervisory structure, without requiring significant modifications to the existing board of directors.

2.6 – Legal Representative

According to the New Company Law, the legal representative is appointed from the directors or managers who “represent the company in executing company affairs.” This broadens the selection scope while imposing substantive requirements for the role.

In essence, the individual serving as the legal representative should actively participate in the FIE’s operations and possess a relatively high level of influence and decision-making authority.

Additionally, the New Company Law outlines the procedures for the resignation of the legal representative. If the director or manager serving as the legal representative decides to resign from the position of director or manager, they will also step down from the position of legal representative.

3. Capital Contribution

3.1 – Change in Timeline of Capital Contribution

Currently, shareholders have the flexibility to determine the timeline for capital contribution as long as it can be completed within the operational term of a company. Our observations indicate that the majority of FIEs set their registered capital amount based on commercial reasonableness, considering factors such as capital expenditure, operating expenses, and the need to maintain certain buffers. Some FIEs opt for a relatively higher registered capital amount to be contributed in an extended timeframe to avoid procedures associated with future capital increases. Although record-filing is generally sufficient for capital increases that do not require government approval, the preparation of various documents, registration formalities and other relevant procedures with banks can typically take 1-2 months.

A significant revision introduced by the New Company Law is outlined in Article 47, and states that “the amount of capital contributions subscribed by all shareholders shall be fully paid within five years from the date of a company’s establishment, in accordance with the provisions of the company’s articles of association.” Additionally, Article 228 of the New Company Law specifies that the same rule for initial capital contributions applies to newly subscribed capital in the case of capital increases.

3.2 – Consequences of Delays in Capital Contribution

Failure to complete capital contributions within the prescribed time limit set by the New Company Law leads to various consequences, as outlined in Articles 49-54 of the New Company Law. These include:

1. Shareholder Liability: Shareholders who do not fulfill their capital contributions in full and on time will be held accountable for the losses incurred by a company resulting from the shortfall in capital contribution. Furthermore, shareholders of the company at the time of its establishment, along with the defaulting shareholder, will bear joint and several liability to cover the shortfall in capital contributions.
2. D&O Liabilities: The New Company Law introduces a mechanism whereby directors are responsible for verifying contributions and issuing notices on behalf of a company to urge shareholders to fulfill their capital contributions. The director failing to do so will be held liable for the resulting loss suffered by the company. In cases where a shareholder unlawfully withdraws its capital contribution, the responsible D&O (not only the directors) will also be jointly and severally liable for compensation.
3. Deprivation of Equity Interests: If a shareholder fails to make the required contributions after the grace period stated in a company’s notice, the corresponding equity interests in the company relating to the unpaid contributions may be deprived.
4. Accelerated Contribution: In cases where a company is unable to repay its debt when due, the company or creditors may demand that shareholders who have already subscribed but have not reached the contribution deadline fulfill their contributions ahead of schedule.

It is important to note that these consequences aim to enforce promptness in capital contributions and promote the stability and financial health of FIEs.

When establishing a new FIE, foreign investors should exercise caution when determining the amount of registered capital. It is important to ensure that the new FIE has adequate funds to start and sustain its operations, but setting the registered capital excessively high should be avoided to mitigate the risks mentioned above.

In the case of M&A transactions, buyers should conduct thorough due diligence to verify the actual payment of the target company’s registered capital. In most circumstances, it is advisable to require the seller to fulfill their capital contribution obligations prior to completing the equity transfer. This helps mitigate potential risks and ensures that the company’s financial position is accurately reflected upon the transfer of equity interests.

3.3 – Capital Decrease

Considering that many existing FIEs have not fully paid their registered capital within the stipulated five-year period since establishment, some may opt for capital decrease to eliminate the obligation to pay the outstanding registered capital. In such cases, only the unpaid portion of the registered capital will be decreased, without any consideration being paid to the shareholders and without reducing the FIE’s assets. This type of capital decrease is referred to as a “pro forma capital decrease.” It should be noted that this is distinct from a “substantive capital decrease,” which would actually reduce the FIE’s net assets and weaken its ability to repay debts.

***

The comprehensive amendment of the current law through the New Company Law will have a substantial impact on FIEs. This article highlights some key issues that FIEs must address under the New Company Law. To effectively manage compliance risks following the implementation of the New Company Law, FIEs, shareholders, and D&O should familiarize themselves with the latest legal requirements and closely monitor subsequent detailed regulations issued by regulatory authorities. It is essential to make necessary adjustments and updates based on the specific circumstances and needs of each FIE.

[1] Please note that these adjustments may not cover all aspects and further considerations may be necessary depending on the specific circumstances of each FIE.

[2] Under the PRC Company Law, a supervisor (also known as a “supervisory board” or “board of supervisors”) is a corporate governance body that serves as an oversight mechanism within a company. The main role of a supervisor is to monitor the company’s finances and the activities of the company’s directors, managers, and officers to ensure compliance with laws and the company’s articles of association.

[3] Please note that these are some key highlights, and further provisions and considerations may exist within the New Company Law.