Compliance Checklist for Your Chinese Subsidiaries

On July 1, 2024, the new Chinese Company Law will come into force. 

The possible legal forms of a Chinese company have not changed and remain as limited liability company, stock corporation, and a branch of a (e.g.) European company. The new Chinese Company Law applies to all existing companies on the Chinese mainland. A total of 228 articles have been added or amended. This is the most significant change to China's Company Law since it first came into force in 1993. The new Chinese Company Law has significantly amended the rules on registered capital and created new models for accelerating capital contributions, and forfeiture of shareholder rights, which not only tightens shareholder liabilities but also the personal liabilities of members of the board of directors, of supervisors, and of the management (General Manager and/or Vice General Manager).

The following compliance checklist is directed to all European shareholders who have Chinese subsidiaries (in the forms of a Wholly European-Owned Enterprise or a Joint Venture incorporated as a limited liability), as well as to individuals who take up the position of a director in the board of directors, of supervisors or management positions of the Chinese subsidiaries. This compliance checklist has summarized the most important changes of the new Chinese Company Law in relation to the daily management of a Chinese limited liability company. A stock corporation is not concerned here. Based on our 25 years of experience in China, we have illustrated the following five compliance risks, and provided as well corresponding mitigation measures. Our goals aim at supporting you by all means to better understand the impacts of the legal changes in China and enabling you to make adjustments to the new compliance requirements to minimize or, if necessary, exclude investment risks for investments in China. Our introductions do not claim to be exhaustive and are based on an abstract legal situation. We recommend seeking legal advice with regard to the specific circumstances in individual cases and the respective differences.

1. Please check the contribution deadline of the registered capital of your Chinese subsidiaries and whether the registered capital has been paid in full.

For:All shareholders and individuals who are members of the Board of Directors of Chinese subsidiaries, for example.

Remark

In the case of contributions in-kind with intellectual property and/or technology, please check whether the relevant intellectual property (e.g. patents, utility models, designs, trademarks, but also licensing rights) or technology still exists or, for example, is at risk due to objections or legal disputes, or, as the case may be, whether the preconditions and assumptions stated in the valuation report for contributions in-kind can still be met. If this is not the case, this could also constitute an incomplete contribution of the registered share capital.

Why

• Since 2013, a flexible paid-in period for registered capital has been allowed in China. It means that at many Chinese subsidiaries only part of the registered capital to be paid in has actually been paid. However, the new Chinese Company Law stipulates that all corporate entities must contribute the entire registered capital within five years of the establishment. For existing corporate entities, the registration authority in the respective province will grant a transitional period. Shareholders should then pay the share capital in full within the transitional period. Kindly note that the contribution deadline cannot be extended by the articles of association (“AoA”).
• In addition, all members of the board of directors of the Chinese subsidiaries are obliged to check the status of the capital contributions. If shareholders have not contributed the registered capital in full and on time, the members of the board of directors shall request the shareholders to do so in writing with a grace period of at least 60 days. Otherwise, the members of the board of directors can be personally liable for damages caused to the Chinese subsidiaries.
• If your Joint Venture partner in China does not pay in the capital stipulated in the AoA in full, the other joint venture partner(s), e.g. the European shareholder(s), can be jointly and severally liable for the shortfall.
• If a Chinese subsidiary is unable to pay its due debts and the shareholder has not yet contributed the registered capital in full, creditors may claim from the shareholder and request to make the outstanding contribution in full in advance, regardless of the contribution deadline (accelerated capital contribution).

Next step

If the registered capital stipulated in the AoA has not yet been paid in, either consider

• to make a full additional contribution within the transitional period or
• to decrease capital by notifying creditors or arranging for the corresponding announcements.

*Please feel free to contact us with the respective location information of your Chinese subsidiary. As soon as the transition period is published, we may make the information available to you on a non-binding basis.

2. Collect written confirmation of your contributions from your Chinese Joint Venture partners and the directors appointed by your Chinese Joint Venture partners.

For: European Joint Venture partners who have Joint Ventures in China

Why

• The possibility of forfeiture of shareholder rights is newly created by the new Chinese Company Law. If a shareholder continues to fail paying its capital contribution despite the above-mentioned request by the board members, the shareholder rights will be forfeited as a result of a respective board resolution on the forfeiture of shareholder rights and a written notice from the limited liability company. This means that a late or incomplete capital contribution can jeopardize your shareholder rights. The actual risk increases for a Joint Venture, particularly in the event of possible disputes between the Joint Venture partners. A written acknowledgement can prevent these risks.

Next step

Collect written confirmations of your contributions, and possibly mutual confirmations.

3. Please check whether you have a list of the names of the family members of the members of the board of directors, of supervisors, and of the management of the Chinese subsidiaries and their external shareholdings.

For: All (e.g.) European shareholders

Why

• It is frequently observed that sometimes European shareholders have difficulties exercising effective and efficient control over the local management operating in China. Using companies controlled by family members to affect Chinese subsidiaries to have transactions with those companies or to compete with the Chinese subsidiaries unfortunately are common patterns damaging the interests of the Chinese subsidiaries. However, the European shareholders are not in a good position to detect such self-dealing or competition in China in advance, as they neither have information from family members of the local management nor could they monitor the external shareholdings of the local management and family members. Even in the event of whistleblowing, it is difficult to verify the information about the family members, which makes investigations even more difficult.
• The new Chinese Company Law now provides a good opportunity to restrict competition activities and self-dealing: directors, supervisors, and management are subject to non-competition and self-dealing restrictions unless they notify and obtain prior approval from the shareholder and the board of directors. The aforementioned non-compete regulation also applies to family members and to companies that are directly or indirectly controlled by them.

Next step

If you have not already done so, you can ask the local Chinese management for a written disclosure of:

• All external activities and shareholdings;
• Names of their family members (parents, parents-in-law, children, spouses, and siblings);
• Employers and shareholdings of their family members.

In addition to an English version, an original Chinese version should also be available for possible future reviews and investigations. In order to effectively prevent self-dealing and competition violations, all the above information should be checked against the list of business partners (suppliers, distributors, and customers) of the Chinese subsidiary. In addition, you can ask the local Chinese management to sign a declaration of commitment and to report changes in employee status and as to family members regularly and promptly. You might also monitor it regularly.

4. Please check whether capital was withdrawn after the contribution (without going through an official capital reduction procedure), whether profits were distributed unlawfully, and whether the related transactions with the Chinese subsidiary are fair and reasonable.

For: All European shareholders and individuals who are active as members of the board of directors, supervisors, or management of the Chinese subsidiaries.

Why

• According to the new Chinese Company Law, in the event of questionable capital withdrawals, the share capital of the Chinese subsidiary needs to be repaid, or the shareholder right may be forfeited. The responsible member(s) of the board of directors, supervisors, or the management are jointly liable. Although the Chinese Company Law does not provide a clear definition of illegal capital deduction, the Chinese Supreme People's Court has illustrated several examples and ways in the third judicial interpretation of the Company Law, including capital deduction through connected illegal transactions, such as through transactions without any further actual transactional basis.
• In practice, European shareholders often charge management fees and license fees to their Chinese subsidiaries. These should be reviewed to determine whether there is an actual transactional basis for such fees and whether the pricing is fair and reasonable. For a Chinese Joint Venture, the Chinese Joint Venture partner could challenge the reasonableness of the related transaction between the Chinese Joint Venture and the European shareholder. The legal consequence could be the invalidity of the corresponding transaction (license payment for IP rights, service/management fees, etc.) and the repayment of what was obtained without a legal basis.
• If a Chinese subsidiary unlawfully distributes profits to the European shareholder, the European shareholders are obligated to repay them. In this case, the responsible members of the board of directors, supervisors or the management of the Chinese subsidiaries are jointly liable for the repayment.
• The new Chinese Company Law now allows the use of capital reserves to offset losses. If, for example, there are still losses remaining, registered capital may be reduced to offset the losses. The Chinese company law, like German company law, provides for "capital reserves" in addition to share capital.
• It is not uncommon for venture capital investors to contribute, for example, EURO 50,000 as share capital and pay EURO 500,000 into the capital reserve for a company. The AoA/partnership agreement then stipulate what the contribution in the capital reserve can be used for. Assuming, however, that the company now uses EUR 540,000 from the capital reserve for some purposes and the capital reserve is then minus, the shareholder could offset for this loss in accounting terms by reducing the capital by EUR 40,000 as a result of the new regulation. With such an approach, the amount of reduced registered capital cannot be repaid to the shareholders. Furthermore, it should be noted that, after a reduction in the registered capital, profits may only be distributed to the shareholder when the legal reserve and the free reserve together have reached 50% of the share capital of the Chinese subsidiary again. 

Next step

• If questionable capital deductions or unlawful profit distributions do occur, the corresponding amount should be repaid promptly.
• Future transactions with Chinese subsidiaries should have a further actual transactional basis, and pricing shall satisfy the arm's length principle. All supporting documents, such as pricing bases and agreements, should be documented properly.
• In the case of profit distributions, it must be ensured that the legal requirements are satisfied (proof of a balance sheet profit, shareholder resolution on a profit distribution, special auditor's report if applicable) with proper documentation of a fully executed shareholder resolution and auditing report.

5. Please check whether your Chinese subsidiary has more than 300 employees and whether there is a supervisory board.

For: All European shareholders 

Why

The new Chinese Company Law imposes co-determination for corporate entities with more than 300 employees and provides, either: 

• To form a supervisory board and save a seat for the employee representative, or alternatively
• To create a seat for the employee representative on the board of directors.

Given the actual impacts on the governance structure of the Chinese subsidiary, it would make sense to form a supervisory board for a Chinese subsidiary with more than 300 employees and to reserve one seat for an employee representative. It should be noted that, under Chinese labor law, employee representatives shall be elected by the employees and cannot be appointed by the company at its own discretion.

Next step

If so, please consider forming a supervisory board with one seat for the employee representative.

To be noted:

With regard to board members in Chinese subsidiaries, you should note the following new provisions:

• During the term of office of a board member of a Chinese subsidiary, the shareholder may no longer dismiss him/her from office without cause, otherwise, the board member is entitled to compensation;
• If a board member is also the legal representative of the Chinese subsidiary and resigns from that position, a new legal representative should be appointed within 30 days;
• The Chinese subsidiary is obligated to indemnify a third party for any damage caused to the third party by board members/supervisors/management in the performance of their duties. If the Board of Directors, Supervisory Board, General Manager or Deputy General Manager have acted willfully or with gross negligence, they are also liable to pay compensation themselves. At the same time, the Chinese subsidiary can demand compensation from the General Manager or Deputy General Manager who is at fault.

The new Chinese Company Law will also have an impact on existing Joint Ventures in the following areas:

• The shareholders' information right has been strengthened in that a shareholder may now engage auditing companies and/or law firms to inspect and copy the accounting records of Chinese subsidiaries and European invested subsidiaries;
• Change to the pre-emptive right of shareholders in the event of a share transfer: Unless otherwise provided for in the AoA, a shareholder may now transfer his shares to a third party with the sole condition remaining to notify the co-shareholders in advance. If they do not exercise their pre-emptive right within the period specified in the AoA, there is no longer anything to prevent the acquisition of the shares by the third party. The law no longer requires the consent of the other shareholders.
• The new shareholder may exercise its shareholder rights as soon as it is entered in the list of shareholders.
• Unless the AoA provides otherwise, a shareholder resolution may be passed with the approval of more than 50% of the shareholders with voting rights. Amendments to the AoA relating to an increase or reduction in the share capital or the dissolution of the company by means of a merger, demerger, or spin-off still require the approval of more than two-thirds of the shareholders with voting rights.
• If a majority shareholder abuses his power and harms the interests of the Chinese subsidiaries or the minority shareholders, the minority shareholders have the right to sell their shares at a reasonable price in order to leave the Chinese subsidiaries.