The Chinese economy seems to be heading into uncharted waters. While analysts agree that China has many economic strengths, some political commentators claim that the Chinese economy is on the fast track to collapse. Yet others say that China’s economy will take over the world and pose an existential threat to the democratic Western bloc. To further complicate any debates about the future of the Chinese economy, on December 29, 2023, the Standing Committee of the National People’s Congress adopted an amendment to the China Company Law that came into effect on July 1st, 2024. These changes have huge implications for both companies in China and investors seeking to enter the Chinese market. While these new laws do protect the interests of the company, they force investors to take on more risk, naturally deterring investments in the Chinese market. This could prove fatal for the future of the Chinese economy.
From an investor’s perspective, one of the largest changes is Article 47. Now, it states that the shareholder(s) of a limited liability company must fully pay the company’s registered capital amount within five years from the company’s incorporation date. Yet, this forced realignment of the capital contribution term poses several practical problems. For starters, what happens when an investor wishes to invest in a company that has been incorporated for four years and 364 days? In order to strictly adhere to the new law, investors must make the full capital contribution in a single day, a clearly unrealistic task. Or what happens when an investor wishes to invest in a company that was incorporated over five years ago? It then becomes physically impossible for investors to adhere to the new capital contribution term of five years after the company’s incorporation date. A more realistic interpretation is that the new Company Law sets the payment date to be five years after the investor becomes a shareholder. However, this reading still poses challenges to the existing structure. Currently, many companies, including foreign-invested enterprises (FIEs), have articles that give shareholders much more time (anywhere from 10-30 years) to pay out their capital contribution.
Not only do investors now have to pay their capital contribution in a much shorter time frame, they also run the risk of having to pay even before the time frame ends. Article 55 now states that if a company cannot pay its debts, the creditors can require the shareholders to contribute their required capital even before the five-year period ends to the extent of the company’s debts. Therefore, under the new structure, many private equity and venture capital investors would have to raise capital in a much shorter period, which would certainly deter many investors.
This situation could possibly be elucidated through an example much more relevant to the common person, namely purchasing a house. Normally, the length of a mortgage is around 30 years, making monthly payments manageable for the average person. Now imagine if the length of the mortgage was shortened to five years, but the total amount that needs to be paid remains the same. Naturally, monthly payments would skyrocket and become unaffordable for most home buyers, and the number of home-buyers would plummet. This is exactly the situation that private equity and venture capital firms are now being put in, and just as there would be far fewer home buyers if mortgage terms were drastically shortened, there would also be far fewer firms willing to invest in companies.
In addition to the much shorter time frame given to investors, they also have to take on much more risk. Another large change comes in the new Article 88 of the Company Law, which states that if a shareholder transfers their shares that have unfinished capital contribution, the transferee shall bear the obligation to pay the capital contribution. If the capital contribution is not paid in full in accordance with the capital contribution date stipulated in the company’s articles of association or if the actual value of the non-monetary property contributed as capital is significantly lower than the value of the shares, the transferor and the transferee shall bear joint liability within the scope of insufficient capital. If the transferee is not and should not be aware of the aforementioned circumstances, the transferor shall bear the responsibility for the missing capital. All of this legalese boils down to the idea that either the transferor or the transferee is liable for the capital not contributed of “flawed shares,” or shares that have not been paid for in full, in the case of a transfer. The assignment of liability is unusual, as the transferee is liable for the debt rather than the transferor. This in itself is not necessarily a problem, as investors (usually the transferee) can simply purchase the shares for only the amount of capital contributed and pay off the capital not contributed later.
The second stipulation is much riskier for potential investors. The only method for the transferee to not bear liability for “flawed shares” is if it could be proven that the transferee did not know and had no responsibility to know if the shares were “flawed.” From a legal perspective, this is quite a tall task. Thus the transferee relies on the good faith of the transferor to acknowledge that the shares are “flawed” and to allow negotiations based on the fact that the shares are flawed. Therefore, the investors must do a lot more due diligence on the shareholders they are buying from to prevent themselves from buying “flawed shares.” And who wants to do more work for the same results? Of course, we could entertain the argument that there is a lot of money to be made, enough to warrant the extra work. However, in some cases, there simply is not enough information for investors to judge whether the shareholders are selling in good faith or not. The investor would surely be hesitant to buy shares and invest in these cases.
Of course, the new Company Law is not all doom and gloom for potential investors. Article 89 of the Company Law states that if the controlling shareholder(s) misuse their shareholder rights to meaningfully damage the company, other shareholders have a right to request to buy back their shares at a reasonable price. This seemingly defends the rights of investors, protecting them from the incompetence and malignancy of the controlling shareholder. In practice, this might not go as well as expected. The execution of this law hinges on the idea that there is a “reasonable price,” without which it seems that there cannot be any transactions. Another point of tension is the difference between the buyback rights in the Company Law and those of a contract. Many companies go through multiple rounds of fundraising, with later rounds often costing a lot more capital due to the rise in stock prices. Therefore, investors in later rounds often have prioritized buyback rights in their contracts, meaning they are offered the option to purchase more stock before investors of previous rounds. But the new Company Law seems to offer all shareholders equal buyback rights. This, combined with the aforementioned reliance of this law on the idea of a “reasonable price,” poses a major roadblock for this section of the Company Law to be implemented smoothly.
The changes to these three sections of the new Company Law seem to suggest hostility towards investors. Not only do investors have to pay their capital contributions on a much shorter time scale than under the old Company Law, they also might have to accept the risk of shareholders selling “flawed shares” in bad faith when further due diligence is not possible. The new legal rights that protect shareholders present practical challenges in their implementation. This new law indeed furthers and protects the rights of the companies insofar as it guarantees a timeline for capital contribution, ensures complete payment of “flawed shares,” and offers methods of ousting malignant controlling shareholders. But all this comes at the cost of stripping away the agency of the investor, which may lead to investors exiting the Chinese market.
This is a cause for concern for China. In 2021, there were over 3,600 private equity and venture capital deals in the Chinese market with a total valuation of over 130 billion dollars. However, since then, that number has been in steady decline, dropping to barely 3,000 deals with a total valuation of slightly over 75 billion dollars the next year. American private equity and venture capital firms in particular only closed two-thirds the amount of deals made in 2021 and invested one-third the money, an even steeper decline than the world as a whole. As of February 2024, there are only 267 private equity or venture capital-funded deals in the Chinese market, with a measly five of them being American firms. These deals combine for a valuation of 3.25 billion dollars. Some simple math reveals that continuing on this pace, there will be 1602 deals closed in 2024 with a total valuation of 19.5 billion dollars. Investments in the Chinese market are rapidly declining, and the Chinese market, like every other market, needs investments to ensure continued growth. Therefore, the Chinese government should be trying to attract foreign investment with investor-friendly policies. But with these new hostile company laws, the Chinese government is pushing investors further away from China. In the very first article of the very first section of the new Company Law, the Standing Committee of the National People’s Congress claims that the goal of this redrafting is to “Perfect the Chinese-style corporate structure and promote the entrepreneurial spirit.” However, with the new laws pushing away investors, who will fund this “entrepreneurial spirit?” It appears that in pursuing “the Chinese-style” of stability through regulation, the “entrepreneurial spirit” is disregarded by the Standing Committee.
Featured/Headline Image Caption and Citation: 中文（中国大陆, Image source from Wikimedia Commons | CC License, no changes made
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