Chinese Court Rules on the Effect of Shareholders’ Agreement
By Patrick Zheng | Charles Qin
A shareholders’ agreement is a contract between shareholders which governs the relationship between shareholders (or between shareholders and the company). It is of contractual nature and shall be governed by general principles of contract law.[1] Nonetheless, the interpretation and effect of a shareholders’ agreement also hinge upon the statutory backdrop, particularly, if the shareholders’ agreement aims to negate and supersede certain rules of company law and provisions of articles of association.
For a shareholders’ agreement to be effective and enforceable, it shall be free from the general vitiating factors under the PRC Contract Law, such as fraud, duress, unconscionability, violation of public interest, etc. The PRC Company Law also provides mandatory requirements that may trigger invalidation, such as the rule of providing guarantee for a shareholder, the rule of voting on the revision of the company’s articles of association, etc. [2]
Subject to the above limitations, a shareholders’ agreement can be drafted to replace the majority rules of company law and enhance the position of minority or other shareholders with certain rights and protective devices, such as a right to appoint or remove directors and, in particular, a right to veto in relation to specified company decisions.
In a recent case,[3] the PRC Supreme Court held that the shareholders’ agreement entered into by all shareholders and the company on the protection of venture capitalist shareholders has the same legal effect as the articles of association, upholding a protective device of the shareholders’ agreement designed to limit the candidacy of the chairman of board. This decision goes beyond the subjective intent of law makers of the PRC Company Law and is another example in China that Chinese judiciary is not only applying law but also making law.
Background
Yang and Shu, the original shareholders of Century Shengkang Pharmaceutical Co., Ltd. (“Century Company”) entered into an Agreement on Capital Increase and Share Subscription (“Shareholders’ Agreement”) with Zhongzheng Wanrong Pharmaceutical Investment Group (“Zhongzheng Company”), a financial investor, and Century Company.
It was agreed that Zhongzheng Company shall subscribe the increased shares of Century Company, becoming the majority shareholder. Upon the completion of capital contributions, Yang and Shu were entitled to jointly designate 2 directors, from which the Vice Chairman of the Board of Directors shall be elected; Zhongzheng Company was entitled to designate 3 directors, from which the Chairman shall be elected (“Venture Capitalist Protection Clause”). The Shareholders’ Agreement further provided:
“Unless otherwise agreed by the parties in written and without prejudice to the Articles of Association of Century Company, this Agreement construes the rights and obligations of the shareholders of Century Company and has the highest legal effect.”
Accordingly, the shareholders designated their respective directors. Century Company also revised its Articles of Association, according to which the Board of Directors shall elect the Chairman and Vice Chairman. In a board meeting convened absent the attendance of the directors designated by Zhongzheng Company, Century Company passed a resolution replacing the Chairman with another director not designated by Zhongzheng Company (“Resolution 320”). Subsequently, Zhongzheng Company filed an action before the competent court and requested for determination on whether Resolution 320 violated the Articles of Association.
Decision
The Trial Court considered that the Venture Capitalist Protection Clause in the Shareholders’ Agreement restricted the way of electing the Chairman and Vice Chairman under the Articles of Association. In principle, a company’s articles of association stand for the highest protocol of corporate governance, and are not subject to expansive or restrictive interpretation. Therefore, the Shareholders’ Agreement cannot impose restriction on the election of the Chairman. Consequently, Resolution 320 was held to be in compliance with the Articles of Association.
The Court of Appeal took another approach and sustained the conclusion. It held that the wording of “without prejudice to the Articles of Association of Century Company” in the Shareholders’ Agreement suggested that the Articles of Association should prevail in the event of conflict. Therefore, the court gave priority to the way of election in the Articles of Association, instead of the Shareholders’ Agreement.
In the retrial, the PRC Supreme Court upheld the effect of the Venture Capitalist Protection Clause on the election of the Chairman of Board, reasoning that:
1. the parties to the Shareholders’ Agreement included all shareholders and the company per se;
2. the Shareholders’ Agreement touched upon matters to be specified in the Articles of Association, and had the highest legal effect only second to the Articles of Association; and
3. it should be considered as a specific interpretation of the Articles of Association.
Therefore, the restriction imposed on the election of the Chairman was effective and enforceable, and became part of the Articles of Association. Accordingly, Resolution 320 violated the rule that Chairman was to be designated by Zhongzheng Company and should be revoked.
Comment
Under Chinese law, a resolution of the board of directors is invalid in violation of laws or administrative regulations, or is subject to revocation in violation of the articles of association.[4] In the present case, the Supreme Court, in essence, broadly interpreted the statutory requirement “in violation of the articles of association” to include the violation of shareholders’ agreement, holding that the shareholders’ agreement was an interpretation of the articles of association, with the same effect. This case manifests Chinese court’s stance that a properly drafted shareholders’ agreement, free from any vitiating factors, may be considered as an interpretation and incorporated into the company’s articles of association. So parties to a shareholders’ agreement should be wary of the effect of such agreement in corporate governance.
【Endnote】
[1] Hongsheng Real Estate Co., Ltd. v Chen, Shanghai No. 2 Intermediate People’s Court, (2012)沪二中民四(商)终字第65号.
[2] Articles 16, 43, Company Law of the People’s Republic of China (2018).
[3] Zhongzheng Wanrong Pharmaceutical Investment Group v Fengjun Cao, Shiji Shengkang Pharmaceutical Co., Ltd. and others, Supreme People’s Court, (2017)最高法民再172号.
[4] Article 22, supra note 2.
Authors:
✎ 往期分享
Chinese Court Upholds Pathological Singapore Arbitration Clause
Chinese Court Decides on Res Judicata of Arbitration Award
Chinese Court Grants Interim Injunction Against Apple
Chinese Court Narrowly Construes Scope of Arbitration Agreement
SPC Gives Effect to All Terms in Contractual Interpretation
Llinks Review | SPC Further Clarifies on Liquidated Damages
长按下图识别二维码关注我们
© 通力律师事务所
本微信所刊登的文章仅代表作者本人观点, 不代表通力律师事务所的法律意见或建议。我们明示不对任何依赖该等文章的任何内容而采取或不采取行动所导致的后果承担责任。如需转载或引用该等文章的任何内容, 请注明出处。