Deadline looms on governance reforms for Sino-foreign JVs

Previously, foreign-invested enterprises (FIEs) in China found legal basis for their establishment and operations chiefly in the Law on Joint Ventures Using Chinese and Foreign Investment, the Law on Wholly Foreign-owned Enterprises, and the Law on Chinese-Foreign Contractual Joint Ventures. These three laws, however, were replaced by the Foreign Investment Law and the Regulations for Implementing the Foreign Investment Law (together, the “foreign investment regulations”), which came into effect on 1 January 2020, setting the principle that FIEs shall enjoy treatment equal to that of domestic ones, and requiring FIEs to complete adjustments to their organisational forms within five years from the implementation of these laws, i.e. before 31 December 2024.

Following the recent revisions to China’s Company Law, companies across the board, whether domestic or foreign-invested, face the challenge of having to adjust their own structures and governance documents.

Although it has been more than four years since the foreign investment regulations came out, plenty of FIEs have yet to make the required changes. Sino-foreign joint ventures (SFJVs) in particular may find themselves in a complex situation, as altering the governance structure as required by the new Company Law may lead to clashes of interests between existing shareholders.

With mere months left of the transition period, how can SFJVs make the adjustments under the new Company Law? What are the biggest obstacles in the way, and how do they surmount them?

Top of the list

Switch the highest authority from the board of directors to the shareholders’ meeting. Before the foreign investment regulations, the board of directors acted as the highest authority and decider of all major issues in a SFJV whereas, in domestic enterprises, the shareholders’ meeting assumed this role and the board of directors served as the operating decision maker, responsible for implementing the resolutions of the shareholders’ meeting and deciding on major issues.

One of the most significant transitions that SFJVs must undertake is to switch the highest authority of the company from the board of directors to the shareholders’ meeting. The articles of association should also be amended to reflect the new scope of authority and decision-making procedure of the shareholders’ meetings and the board of directors.

Set up employees’ directors or employees’ supervisors. According to the new Company Law, companies with 300 or more employees should either: (1) set up a board of supervisors that includes employees’ supervisors, which should take up no less than one-third of the board; or (2) have employee representatives on the board of directors.

One-tier governance structure to simplify supervision. Under the new Company Law, companies may adopt one-tier governance where there is no board of supervisors, and instead an audit committee under the board of directors assumes its usual functions. Limited liability companies that are relatively small in scale, or have few shareholders, may appoint only one supervisor in lieu of a board of supervisors. However, there would no longer be any scenario where two supervisors are appointed. With consent from all shareholders, the company may have no supervisor at all.

Not so easy

To some extent, the boards of directors at SFJVs, prior to the governance restructuring, have been shouldering the additional function of shareholders’ meetings, as stipulated by the Company Law.

Shareholding structures can be complicated. With the board of directors as the highest authority, shareholding often cannot be fully linked to the voting rights at the board level. However, with shareholders’ meetings taking over the decision making and approval duties for major matters, SFJVs have a new opportunity to re-evaluate and improve their governance structures. So, what could possibly go wrong during the transfer of the highest authority?

As an example, a certain shareholder has the right to appoint a majority of directors to the board. Since the rules of procedure dictate that motions at the board level can be passed with the approval of more than half of all directors, this shareholder can exercise control over the company’s major matters through the decision-making mechanism, even if his/her proportion of capital contribution does not constitute an absolute or relative controlling shareholding.

Under the new Company Law, the revamped shareholders’ meeting votes according to the proportion of capital contribution or, in joint stock companies, the number of shares held. If the shareholders’ meeting decides the company’s major matters, and such matters must be voted upon as mandated by law, the above-mentioned shareholder can no longer guarantee decision-making power on these matters.

Also, previously in SFJVs with relatively fragmented shareholding, only some of the larger shareholders may appoint directors and have decision making power on major matters.

Following the reform of shareholders’ meetings, minority shareholders who never saw a seat on the board of directors can now participate in decision making by way of their voting rights at the shareholders’ meeting ‒ even uniting their shareholding to veto motions proposed by larger shareholders. This could lead to complex situations or even fundamental changes to the corporate control structure.

In summary, adjustments to the scope of authority, rules of procedure and voting mechanisms of the shareholders’ meetings/board of directors are expected to be the most heavily contested areas, where communication between shareholders is the most crucial and challenging.

In the process of such adjustment, the situation that may lead to the creation or loss of a veto right by some shareholders, or even threaten the company’s control structure, and needs to be carefully handled.

Recommendations

Delineation between the shareholders’ meeting and board of directors. SFJVs should first list the powers of the board of directors, then, according to the new Company Law, transfer the mandatory portion to the shareholders’ meeting and leave the rest to the board. If there are any matters with attribution not explicitly covered in the new Company Law, the SFJV itself may in principle decide who should be responsible.

In order to avoid major adjustments to current scope of authority, adding to the difficulties of shareholder negotiations, SFJVs could consider maintaining to the greatest extent possible the original functions of the board of directors, and transfer only the powers explicitly required by the Company Law to be undertaken by the shareholders’ meeting. Thus, the post-reform board maintains substantial decision making power over the company’s day to day matters.

Rules of decision making, procedures of shareholders’ meetings and voting rights ratios. Except for matters requiring an absolute two-thirds majority and other statutory requirements, a company may, through its articles of association, set the mode of proceeding and voting procedures of the shareholders’ meeting with relative freedom.

The voting rights at the shareholders’ meetings need to be specifically set based on the equity structure of the SFJV, as each company’s situation may vary. In principle, keeping the new voting structure as close to the original one at the board of directors should make it easier for the shareholders to reach a consensus on rules of decision making procedures and voting rights.

However, if the major shareholder only achieves relative control with a shareholding of, for example, more than 30% but less than 50%, voting according to its shareholding ratio may result in losing control.

According to the new Company Law, in such cases it is possible for a limited liability company to set up provisions in the articles of association to exercise voting rights not based on capital contribution or, for a joint-stock company, to increase voting rights by creating different classes of shares.

In practice, the State Administration for Market Regulation (SAMR) may require such articles to be modified due to significant deviations from the common template when the company submits the articles for filing with the SAMR.

Therefore, it is advisable to communicate in advance with the SAMR about the content of articles and make modifications accordingly. The major shareholder is also suggested to co-ordinate with some minority shareholders to maintain concerted actions after adjusting the corporate governance structure, in order to preserve the control of a relative controlling shareholding.

Board seats and rules of procedure. If the original shareholding and control structure of the company were already clear, keeping the seats at the board of directors and rules of procedure unchanged may be the best way for most SFJVs to avoid conflict.

However, for SFJVs with fragmented shareholding where ratios drastically differ from the board seat arrangement, minority shareholders may wish to increase their board representation by adjusting the governance structure, making the board seats match the shareholding ratio.

Substantial re-negotiation may be needed. As the new Company Law removed the limit on the number of board members, theoretically all shareholders have the opportunity to appoint directors and take part in governance, but considering the need for efficiency in board decision-making, it is best to keep the number of seats modest.

The authors recommend somewhat decreasing the number of major shareholders on the board and allowing minority shareholders to jointly appoint one or more directors.

If certain minority shareholders previously held veto power over major board matters, they may be persuaded to relinquish such power through renegotiation, provided their influence is adequately protected while effectively balancing the major shareholders through board seats and voting rights.

Supervisor and board of supervisors. Under the new Company Law, SFJVs may, in accordance with the articles of association, decide whether to have only one supervisor or to establish a board of supervisors with greater flexibility, requiring an assessment of necessity and feasibility based on their actual situations.

For example, small SFJVs or those with few shareholders may skip the board of supervisors and establish only one supervisor. Also, if there are not enough seats on the board of directors, companies with 300 staff or more may opt to not have any employee directors, but establish a board of supervisors that includes employee supervisors, which should take up no less than one-third of all seats.

While the new Company Law allows an audit committee to take over the functions of a board of supervisors, it is inadvisable for most SFJVs to hastily set up such a committee without well-established supporting systems and practical experience.

Companies that insist on setting up an audit committee must deliberate on issues such as how to ensure the independence of members of the committee (given that they are directors), how to delineate their duties as committee members and directors, and other details concerning the rules of procedure. Such issues should be clarified in the articles of association or the audit committee rules.

Amendments to articles of association. SFJVs should ensure that required content under the new Company Law, such as agreements on corporate governance and composition of the liquidation team, are reflected in the articles of association. If these matters only appear in the shareholder agreement or JV contract, their effectiveness and enforceability may be in doubt.

Apart from matters required to be set out in the articles of association, shareholders may nonetheless reaffirm the rights, obligations and commercial arrangements under the original JV contract via a new shareholder agreement.

The new Company Law also requires any modification to the articles of association to be approved by shareholders representing more than two-thirds of the voting rights. In the authors’ understanding, the initial articles of association should be formulated and agreed upon by all shareholders, while the contents of the new articles of association ‒ especially adjustments to the governance structure ‒ may involve significant changes to shareholder rights, so it is recommended that all shareholders pass a new set of articles of association to avoid disputes.

To sum up, it is imperative, following the implementation of the new Company Law, for SFJVs to complete the adjustments, standardisation and unification of their governance structure within the transition period.

During this time, SFJVs should set up a governance structure most befitting their own situation and prudently prepare the scope of authority, and rules and procedures of the shareholders’ meeting and board of directors, striving for the best balance between each party’s interests within the framework permitted by law.

The authors advise SFJVs and their shareholders to plan, prepare and discuss adjustments to corporate governance as early as possible so they can complete the reorganisation of the shareholders’ meeting, as well as other adjustments to the governance structure, by the end of the year.

Joyce Zhang is a contractual partner at Llinks Law Offices. She can be contacted by +86 21 3135 8685 or by e-mail at [email protected]

Aurora Zhang is a contractual partner at Llinks Law Offices. She can be contacted by +86 21 6043 3797 or by e-mail at [email protected]