Deadlock of a Sino-Foreign Joint Venture Company in China
By Sun Jin(Marlow), Chinese attorney at Law,Zhejiang Xinmu Law Firm, republishing this article please indicate author and source of this article.April 5, 2017.
Abstract: Company’s Deadlock is, sadly speaking, a sort of very-often-seen disputes between Chinese and foreign shareholders and/or directors in a Sino-foreign Joint Venture company in China, so this article is about how it comes into being and how to avoid it.
On May 30th, 2010, Mr. A, a gentleman from Netherlands, set up a mechanical industry company which is a Sino-foreign Joint Venture (“JV”) according to Chinese Laws together with Ms. B, a Chinese lady. The registered capital of this company is CNY500, 000. Both Mr. A and Ms. B held 50% shares of this company. Mr. A is the vice-president of this company while Ms. B is the president and her husband Mr. C is the director and there is another Mr. D who is the supervisor. Various approval procedures in the process of setting up this company are handled by B with the written authorization of A. A is abroad all the year around and comes to the company once in one or two years; hence it is too hard for him to be directly involved in the daily operation and management of this company. Over time A has problems with B and C and even fight against B and C. In the end of year 2014 A filed a lawsuit of company dissolution dispute finally. Up to now there are four litigations between A and B and there will be more litigation in the future.
In practice there will often be company deadlock that board of shareholders and/or board of directors of a company cannot make decisions according to legal procedure, and the operation mechanism of the company is completely failed because shareholders and directors have conflicts due to confrontation of interests and ideas, and sometimes difference of cultures.
What are the deep reasons of company deadlock?
On the surface, company deadlock is caused by conflicts of shareholders and directors. Actually one of the essential reasons is unreasonable company system mainly referring to unreasonable establishment of company operation organ such as board of shareholders and/or board of directors etc. Board of shareholders is the supreme power organ in a company, if according to Company Law (“Company Law”) of People’s Republic of China.
It is more likely to have company deadlock if shareholders set equity share as 50:50, or 65:35, or 45:45:10, or set a too centralized equity share ratio. The worst equity structure is to divide equity averagely among shareholders. Firstly every shareholder makes different contribution to company deadlock. If they divide equity on average, what the shareholders get will not equal to what they have invested and there will be various problems. For example the shareholders will not put their heart into the management of the company and shareholders may not come to an agreement when they have different opinions without a core shareholder.
According to Company Law of China a few important matters need two-thirds or more of the voting rights and equity share setting like 65:35 makes shareholders cannot reach a consensus on a few important matters. Another equity share setting like45:45:10 may lead to the condition that two big shareholders hope to unite the minority shareholder to control board of shareholders and it will create a situation that the minority shareholder controls the company. In addition, if the equity share is centralized overly, the minority shareholder cannot defend against the majority shareholder when the decision made by board of shareholders will harm the benefit of company and the minority shareholder.
Board of directors decides the daily business matters of the company and board of shareholders often have no right to interfere decision of board of directors directly. Some companies set the number of directors as even number in practice. However according to Company Law a resolution of board of directors must be approved by more than half of all the directors. So a resolution is more likely to be rejected as a result of equal numbers of support and opposition of directors and hence the company is apt to fall into deadlock.
Another important reason of company deadlock is the doctrine of company capital maintenance. In order to maintain company capital, the revised Company Law stipulates as follows: Firstly shareholder withdrawal is prohibited. China Company Law stipulated in Article 35 that after its establishment, company shareholders shall not withdraw capital contribution and stipulated in Article 91 that upon payment of the share proceeds or delivery of the items as contribution of share capital in lieu of share proceeds, the sponsors and subscribers may not withdraw their share capital except where the shares issued are not fully placed in time, the sponsors fail to hold the establishment meeting in time, or the establishment meeting adopts a resolution not to establish the company.
Secondly the issuing price per share may not be below par value. Company Law stipulated in Article 127 that the issuing price per share may be at par value, or above par value, but may not be below par value.
Thirdly the company may not pay dividends to shareholders when coming across with deficit or without profit. Company Law stipulated in Article 166 that where the statutory reserve fund is not sufficient to cover the company’s loss from the previous year, the current year profit shall be used to cover such loss before allocation is made to the statutory reserve fund and the statutory welfare fund pursuant to the previous Paragraph. Otherwise it means that company allocates its registered capital to shareholders and company will no longer maintain capital.
Fourthly company is prohibited to buy its shares back or accept guarantee provided by share of this company. China Company Law stipulates in Article 143 that company may not purchase its own shares except for some special conditions. Company may not accept its own shares as the collateral under a security arrangement. Company purchases its own shares has the same effect with shareholder withdrawal that both will lead to false capital. Company eventually has to repurchase shares if accepting guarantee provided by share of this company.
Fifthly constraints of non-monetary contribution stipulated in Company Law also reveal the principle of company capital maintenance which makes the contribution of shareholders hard to withdraw. In addition, Limited Liability Company lacks the effective shareholders withdrawing mechanism and shareholders are hard to break deadlock on their own. For example, China Company Law stipulates in Article 71 that transfer of share of capital contribution by a shareholder to anyone other than another shareholder is subject to consent by a majority of all the shareholders. For another example, China Company Law stipulates that the objection shareholder may request the company to buy his share at a reasonable price. However it is difficult to exercise in practice. First of all, company may not agree to repurchase shares of the objection shareholders. Besides the reasonable price of shares is uncertain and has no basis of evaluation.
From the cultural point of view on the formation of company deadlock, the cultural difference between Chinese and foreign citizens, especially cultural difference of company management, is apt to result information of contradiction between Chinese shareholders and foreign shareholders and eventually result in company deadlock.
For example in one of the most developed provinces in China, we are actually talking about Zhejiang province here, a large proportion of the domestic enterprises are family businesses. The top officials of the company and the main business personnel are members of a family or their relatives. Some professors tend to evaluate this kind of enterprise management mode for the backward mode. But we have to admit that the family enterprise management mode has the advantages of efficiency and avoid internal conflict. China Company Law is relatively advanced.
From year 1993 when the Chinese lawmakers legislated Company Law till today, Company Law is only 23 years old. The concept of modern corporate governance structure has not deeply rooted into the Chinese business culture since its short history. So in the family-owned enterprises, generally speaking the supervisors are not in actual operations.
In consequence, the aforesaid mechanical industry company fell into deadlock is the necessity of developing the company to some extent. In the first place, all of the workshops, equipments, money and so on were invested by A. A gave B 50% of company shares in order to encourage B. However this kind of stake setting prepared the way for crisis of company deadlock. In addition, B made her husband as director of company using the rights granted by A, so B and her families kept a firm hand over this company and A lost the control of company. Besides, A is abroad in the long term that both parties cannot communicate in time and effectively and with the deterioration of their business philosophy and personal relationship, their contradiction developed irreconcilable. Finally A had to go onto the way of hard and long action of judicial dissolution of company in order to fight for his rights because the reasonable share price is difficult to evaluate and they cannot reach a mediation agreement.
For some companies with good operating performance, it is a really tragic legend that they fall into deadlock due to the conflict among shareholders and directors. In practice we can use some reasonable methods to prevent this kind of phenomenon. For example, Shareholders may agree not to exercise their voting rights with their investment proportion in Article of Association. Also shareholders may agree to increase the degree of freedom of share transfer and agree that the minority shareholder has the right to request company to repurchase his share at a reasonable price under some specified conditions and clear the definition of reasonable price and shareholders may agree company dissolution conditions in Article of Association.
Shareholders may also prevent the company deadlock through setting the ownership structure of company reasonably. For example avoiding some unreasonable share structures as mentioned above and stipulating avoidance system over rules of procedure that shareholders or directors need to withdraw when they have an interest relationship with the matters discussed. Of course the best way to avoid JV company deadlock is not to take the form of JV. Foreign shareholders can establish a WFOE and Chinese shareholders can establish a domestic company and both parties can cooperate in the form of contract. If JV is inevitable, then it will be wise choice to hire a lawyer who is sophisticated in China Company Law to set good rules of cooperation including JV contract and Article of Association of Company in order to avoid any possibility of company deadlock.