Company law update in China impacts foreign-invested enterprises

Foreign-invested enterprises (FIEs) will need to familiarise themselves with amendments relating to shareholder capital contribution requirements, corporate governance requirements, enhanced duties and liabilities of senior management personnel, corporate resolutions, and company registration.

It is the sixth time that company law has been amended in China since 1993. This reflects the needs of economic development and changes in the market environment in recent years.

Capital contribution obligations

Define capital contribution deadline

The new company law imposes certain restrictions on the subscription of registered capital of a limited liability company. Article 47 requires that "the amount of capital contribution subscribed by all shareholders shall be paid in full by the shareholders within five years from the date of establishment of the company in accordance with the provisions of the articles of association".

With respect to existing companies established before the implementation of the new company law, i.e. before 1 July 2024, the law provides two directions:

• if an existing company has a capital contribution period that exceeds the time limit specified in this law, it shall gradually adjust the capital contribution schedule to comply with the new law, and
• if a company’s capital contribution period and amount are obviously abnormal, the company registration authority may require it to adjust the capital contribution period in a timely manner in accordance with this law.

However, with regard to these two points, the new law states that the specific implementation measures are to be formulated by the State Council, which means it is still unclear as to by when existing companies with capital contribution schedule of longer than five years should take actions to be fully compliant with the new law. We anticipate that the State Council will soon issue a new regulation that clarifies the two points mentioned above, which is likely to provide a transition period to allow existing companies with different levels of registered capital to reduce their capital or amend their articles of association to become compliant.

Enhanced liabilities relating to capital contribution

According to the new company law, after the establishment of a limited liability company, the board of directors is obliged to verify the capital contribution of the shareholders. If it is found that the shareholders fail to pay the capital contributions in full and on time, the company must issue a written reminder to the shareholders to call for the payment of capital contributions. If the directors fail to perform the above obligations and this causes losses to the company, the responsible director is liable for compensation.

If a shareholder fails to fulfil its capital contribution obligation within the time limit specified in the company's written reminder, the company may, by resolution of the board of directors, issue a notice of loss of rights to the shareholder, in which case the shareholder will lose its equity in the unpaid capital contribution from the date of issuance of the notice. If the lost equity is not transferred or cancelled within six months, the other shareholders of the company must pay the corresponding capital contribution in full according to the proportion of their capital contributions.

In the case of Sino-foreign joint ventures, this mechanism could potentially pass the liability of failure to contribute capital from one shareholder to the other shareholder(s). Therefore, it is important for a foreign investor to address this risk properly in the shareholders agreement when setting up a new joint venture.

Change of governance structure

Legal representative

The new company law specifies that the legal representative for the company should be determined by reference to the company’s articles of association. It must be a director or company manager representing the company for the execution of company affairs.

The new company law also clarifies issues pertaining to the liability of companies in respect of their legal representative. For example, it provides that:

• the legal consequences of civil activities conducted by a company’s legal representative in the name of the company shall be borne by the company;
• restrictions on the powers of a company’s legal representative by the company's articles of association or shareholders' meeting shall not be enforceable against bona fide third parties.
• if a company's legal representative, in the course of performing duties, causes harm to others, the company shall bear civil liability. After assuming civil liability, the company may seek compensation from the legal representative at fault in accordance with the law or the company's articles of association.

Board composition – employee representation

The new company law also requires all types of limited liability companies to consider whether they need to have employee representation on their board of directors.

For limited liability companies will less than 300 employees, it will be optional to have an employee representation on the board.

For limited liability companies with 300 employees or more, it will be mandatory for there to be employee representation on the main board if there is no employee representative already on the board of supervisors in the company.

The law provides that an employee representative to the board must be elected by the company’s employees through an employee representative assembly, employee assembly, or another form of democratic election.

Companies with 300 employees or more may wish to consider appointing an employee representative to the board of supervisors before 1 July 2024, to avoid having to ensure there is employee representation on the board of directors.

Further guidance on the extent to which the employee representative requirements apply to companies whose employee numbers fluctuate around 300 over time, would be welcomed. Currently, it is not clear if the requirement will be assessed at specific dates – i.e. on an annual basis – or on an ongoing basis.

Creation of audit committee

Drawing on the experience of corporate governance in the common law system and the practice of listed companies in China in terms of corporate governance, the new company law provides for both limited liability companies and companies limited by shares to establish an audit committee.

A limited liability company may, as stipulated in its articles of association, establish an audit committee under the board of directors. One director from the board must sit on the audit committee where the company takes this approach. An employee representative among the members of the board of directors may also become a member of the audit committee.

The function of the audit committee is to exercise the functions and powers of the board of supervisors when the company does not have a board of supervisors or supervisor.

A company has freedom to decide which form of corporate governance – an audit committee or board of supervisors – is more suitable for its operation. While establishing an audit committee under the board of director may seem like a straightforward option to provide for internal scrutiny, the structure may result in tension between the audit committee and other directors as to how checks and balances are applied.

For existing companies which already established a supervisor or board of supervisors, maintaining the status quo may be good for the stability of the company, especially for wholly foreign-owned enterprises and joint ventures with few shareholders.

Change to supervisor structure

The new company laws also improve the supervisor system. A limited liability company must have a board of supervisors with at least three members, unless:

• the company has established an audit committee as per Article 69; or
• for a limited liability company with a smaller scale or fewer shareholders, it may appoint one supervisor; upon consensus of all the shareholders, it may have no supervisor.

In light of the above, existing joint ventures that have two supervisors need to adjust the number of supervisors accordingly.

Delegate powers of relevant corporate organs

The new company law amends the functions and powers of the shareholders' meeting to highlight the governance status of the board of directors. For example, the law removes the power of the shareholders' meeting to "decide on the company's business policy and investment plan" and instead confers that power on the board of directors, leaving it to the company's articles of association for flexible arrangements. The law also removes the "formulation of the company's annual financial budget plan and final account plan" from the functions and powers of the board of directors. The shareholders' meeting may grant other functions and powers to the board of directors.

Enhanced liabilities of directors, supervisors and senior executives

The new company law strengthens the obligations of directors, supervisors and senior executives. For example:

• the board of directors must verify and call on the shareholders' capital contributions and the responsible director is liable for compensation if it fails to perform those obligations and that causes loss to the company;
• in cases where a shareholder withdraws its capital contribution, in addition to the shareholder’s obligation to repay the capital contribution, the directors, supervisors and senior executives who are responsible are jointly and severally liable with the shareholders for the losses caused to the company;
• the directors, supervisors and senior executives are liable for compensation if the financial assistance provided is in violation of the new company law and causes losses to the company; and
• for losses caused to others by a director or senior executive during the performance of their duties, the company is liable for compensation; however, if there is intent or gross negligence on the part of the director or senior executive, the person is also liable for compensation.

Optimisation of exit options

Paragraph 3 of Article 224 of the new company law clearly stipulates that "equal proportion of capital reduction" is the general principle of capital reduction of a company, but there could be exception to such principle if all shareholders of a limited liability company agree otherwise.

This new change provides legal basis for the company's "targeted capital reduction" arrangement. However, in practice, whether the “targeted capital reduction” is workable or not may depend on other factors, such as whether the foreign investor has achieved the minimum investment commitment which has been made by the foreign investor to the local government under the investment agreement. 

The new company law also provides a simplified procedures for capital reduction. How this will work in practice remains untested. It cannot be ruled out that the local company registration authority may impose stricter rules on “targeted capital reduction”.

Improving the share transfer mechanism

With regard to the transfer of equity of shareholders of a limited liability company, the new company law has introduced some changes.

The requirement that the consent of other shareholders is required for the transfer of equity by shareholders of a limited liability company has been abolished. However, the other shareholders need to be notified and will have pre-emptive right to purchase such transferred shares under the same conditions. The new company law further broadens the definition of “same conditions” by clarifying that the specific matters to be notified in writing in case of transfer of equity to third parties include the quantity, price, payment method and time limit of the share transfer.

In addition, the new company law provides that a shareholder must notify the company in writing of the transfer of equity, and has the right to request a change in the register of shareholders and handle the change of registration. In the event that the company refuses or fails to reply within a reasonable period of time, the new law gives the transferor and the transferee the right to sue for relief. The law also makes it clear that, in those circumstances, the transferee has the right to claim the exercise of shareholder rights against the company from the time it is recorded in the register of shareholders. This amendment will help solve the problem of difficulty in registering changes after equity transfer in judicial practice.

Implications for FIEs

Transition period under the FIE laws

According to the Implementing Regulations of the Foreign Investment Law of the People's Republic of China (the FIL Implementation Regulations), FIEs have to adjust their organisational form and organisational structure according to the current company law by 31 December 2024.

The new company law, however, will take effect as of 1 July 2024. It is not currently clear whether and when the competent authority will promulgate further implementation rules to clarify the extent to which there will be a transition period for FIEs to conform to the new law and how issues such as capital contribution schedule adjustment and corporate government structure changes should be addressed in that transition period. In particular, it is unknown whether the deadline of 31 December 2024 will also apply for conforming to the new law, or whether the authority may give an additional grace period. 

For FIEs that have not yet adjusted their organisational structure – for example, those yet to ensure that the highest authority in their organisation rests with shareholders and shareholder meetings as opposed to the board of directors, the major challenge will be meeting both the deadline of 31 December 2024 to effect the change required by FIL Implementation Regulations and adjusting the corporate structure and articles of association as required by the new company law, although no deadline has been specified yet for this latter requirement. It is likely to be most cost-efficient perspective to effect these changes in one go, in particular in respect of Sino-foreign joint ventures.

If FIEs fail to make the necessary adjustment in time, the legal consequences are still not clear. According to the FIL Implementation Regulations, as of 1 January 2025, any existing FIE which has not yet legally adjusted its organisational form and organisational structure to conform to the regulations, the competent department for market regulation must refuse to handle other registration matters applied for by it and make public the relevant circumstance.

In light of the above, before the competent government authority makes any further clarification, we strongly recommend FIEs get prepared in advance. They should review the current articles of association and find out what they need to amend to align with the new company law. Joint ventures, in particular, may face a tight schedule to implement the new company law on time, as it may require more time for them to negotiate with Chinese partners on several critical issues such as capital contribution schedule amendment, historical breach in relation to capital contribution or underpaid capital, capital reduction, if required, and corporate governance restructuring etc.

How FIEs might redefine their existing governance structure

For wholly-owned foreign enterprises (WFOEs), important points to consider will include:

• whether to adjust the legal representative to a specific director or manager;
• whether to delegate some powers of the shareholders' meeting to the board of directors;
• for WFOEs with more than 300 employees, whether to avoid triggering employee director requirement by adjusting the structure of the board of supervisors.
• for the average small and medium-sized WFOEs, consider whether establishing an audit committee is necessary or whether to keep to only one supervisor.

For Sino-foreign joint ventures, negotiations on governance restructuring will be more nuanced and complex.

Generally speaking, to reduce the difficulty of negotiation, the parties generally prefer not to change arrangement of matters, such as which party's representative is the legal representative, the authority of the shareholders' meeting, and the voting mechanism. However, in view of the amendments to the new company law, both parties still need to consider:

• whether to replace the original common two-supervisor structure with a board of supervisors or even remove the supervisor role;
• whether to set up an audit committee to replace the board of supervisors, or whether to retain the board of supervisors which include an employee supervisor in order to avoid triggering employee directors.

Necessary amendments to articles of association and shareholders agreements

FIE should consider what amendments they need to make to their articles of association to comply with the new company law. Important terms to consider will include:

• the capital contribution schedule – this will need to be adjusted to “within five years upon the establishment of the company”, subject to the specific implementation measures to be formulated by the State Council;
• registered capital – a company may need to review the reasonableness of its registered capital amount, and may go through a capital deduction if necessary;
• legal representative – the legal representative needs to be the director or company manager representing the company for the execution of company affairs, and this needs to be stipulated in the articles of association;
• audit committee – consideration needs to be given to whether to set up an audit committee to replace the board of supervisors;
• board of supervisors/supervisors – thought needs to be given to whether to reduce the supervisor to one if no board of supervisor is established, or in the case of companies with few shareholders, to remove the supervisor entirely. Consideration should also be given to whether to establish a board of supervisors to avoid triggering the employee director requirement;
• powers of shareholders’ meeting and board of directors – FIEs should consider whether to delegate some powers of the shareholders' meeting to the board of directors as permitted by the new company law.

Other recommendations

FIEs may also need to be aware of the following and take necessary actions:

• with respect to the increased liabilities for directors, FIEs should consider whether it intends to undertake director liability insurance to cover the risk and losses caused by directors;
• the new company law stipulates that if a director is dismissed without good cause before the end of their term, the director may claim compensation from the company. It is advisable to have a written agreement with the director that sets out in detail issues such as the compensation trigger, standards and circumstances;

• when carrying out a M&A transaction, special attention should be given to the situation where a shareholder transfers equity without paying the contributions by the deadline as stipulated in the company's articles of association or where the actual value of non-monetary assets contributed falls significantly below the subscribed capital amount. In that case, the transferor and transferee will bear joint and several liability for the shortfall in contributions; if the transferee does not know or should not have known of the above situation, the liability is borne by the transferor. During the due diligence, the buyer should carefully check the capital contribution status, and make proper arrangements in the transaction document for circumstances where the seller fails to pay the capital in time or it finds the non-monetary assets contributed falls significantly below the subscribed capital amount.