How the new Company Law’s classified share system affects corporate M&A?

China’s newly revised Company Law will be in effect from 1 July 2024. This law introduces a classified share system for the first time, with articles 144 to 146 detailing the issuance of classified shares. This change is significant for the operation and governance of the capital market.

The introduction of the classified share system is a legislative measure aimed at addressing corporate governance issues, enriching differentiated equity governance structures, and meeting the diverse financing needs of the capital market. Historically, investment institutions have played a crucial role in the capital market, with successful project exits being their ultimate goal. Investment institutions primarily viewed the IPO of invested enterprises as their main exit strategy.

However, with the recent slowdown in the pace of IPOs on the domestic capital market, encouraging invested enterprises to engage in corporate M&A has gradually become another preferred exit route for these institutions.

This article interprets the classified share system under the new Company Law, analyses its connection with corporate M&A transactions, and discusses its impact on differentiated pricing.

Share system. Classified shares differ from ordinary shares by having special provisions on share price, shareholder rights and liquidity.

Article 144 of the new Company Law explicitly lists three types of classified shares: “preferred shares”; “special voting shares”; and “restricted transfer shares”; as well as a catch-all provision for “other classified shares prescribed by the State Council”.

Articles 144 and 145 also provide rules for the issuance and voting of classified shares. Overall, the new Company Law clearly expresses the legislature’s intent to establish a flexible equity distribution and transfer system to resolve shareholder conflicts.

The classified share system’s contractual nature allows companies and shareholders broad autonomy to issue special shares based on company development and market trends. This system not only effectively regulates the relationships among different classes of shareholders and further protects the rights of minority shareholders, but also offers a more convenient financing route for companies.

Although classified shares have existed in China’s investment and financing sector, they were previously governed only by contractual agreements due to an absence of overarching legal rules at the level of company law.

With the implementation of the new Company Law, the classified share system can be further clarified in articles of association and more widely applied in investment and financing transactions. Companies can issue classified shares different from traditional ordinary shares to raise capital, enhancing solvency and optimising repayment structures, and providing more flexible transaction design options for M&A.

Differentiated pricing impacts. Transaction pricing is crucial for investment returns. According to article 11(3) of the Administrative Measures for the Material Asset Reorganisation of Listed Companies, asset pricing must be fair and not harm the legitimate rights of a company and its shareholders. Given that pricing must be fair but not identical, differentiated pricing is common in M&A transactions involving listed companies.

In practice, the principles and standards for differentiated equity distribution in M&A transactions have often been unclear, leading to disputes. This is because the Company Law has not codified the equity differences among different classes of shareholders.

Consequently, issues like whether some shareholders should receive preferential rights in the case of the same shares with different prices have always been a point of contention among parties involved in valuation during M&A processes.

In the capital market context, evaluating the equality of capital requires not only considers formal factors such as the number of shares and voting rights, but also pays attention to substantive factors like the status of the holder, the order of exercising rights, and the type of contributions.

Establishing standardised transaction pricing rules for different equity types and implementing differentiated payment schemes is the best way to achieve substantive fairness in the capital market. With the new Company Law’s clarification of the classified share system, its role in differentiated pricing will become more prominent and its application smoother.

Additionally, the differentiation of payment methods as a form of differentiated pricing will also be influenced by the classified share system. Currently, M&A transaction payment methods primarily include all-cash payments, all-stock payments, and mixed payments (stocks/convertible bonds and cash).

The classified share system enriches the regulatory implications of stock payment rules, significantly enhancing the functionality and importance of company shares in the M&A distribution process.

When disputes arise during M&A negotiations, an acquiring party can propose diverse payment schemes based on the rights associated with specific classified shares, such as dividend rights and liquidation rights, effectively resolving conflicts.

Unlike IPOs, current laws and regulations do not mandate the clearance of preferential rights for shareholders of a target company during an acquisition. Therefore, for investors in target companies, the classified share system under the new Company Law has become a reasonable choice for enhancing investor protection in M&A.

In this sense, the introduction of the classified share system marks a new stage in the construction of corporate equity governance norms, providing new ideas for M&A transaction design and legal protection for differentiated pricing.

Yang Jie is an partner and Jiao Yufan is an associate at Grandway Law Offices

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