Chinese Law Prof Blog

Editor: Donald C. Clarke
George Washington University Law School

Saturday, September 25, 2010

New Supreme People's Court provisions on FIE-related disputes

Back to blogging on substantive stuff after a long hiatus, and you might think that today's topic is not exactly one to quicken the heartbeat. But in fact there is some interesting stuff here, so bear with me.

The rules, entitled "Provisions on Several Issues Concerning the Trial of Disputes Involving Foreign-Invested Enterprises (I)" (关于审理外商投资企业纠纷案件若干问题的规定(一)) (the "Provisions"), took effect on Aug. 16, 2010. (News report here.) If word count alone is any indication, it seems that the main sources of controversy in FIEs are (a) agreements to transfer equity that the transferor fails to carry out, and (b) hidden investors who use a nominee as a puppet, where the puppet then starts to have a mind of his own.

In general, the thrust of these rules is to give more strength to the substance of contractual agreements among parties where previously the agreement might have been invalidated on some technicality. This is mostly good news, I think, with one possible exception I'll discuss below.

First, the less interesting (to me) stuff, then the really interesting thing at the end.

  • Strengthening of unapproved contracts

Chinese law has always had the problem of how much force to give to contracts that must by law be approved to be effective (for example, all contracts for the formation of a foreign-invested enterprise such as a joint venture) but haven't yet been approved. So what if the contract calls for one party to use its best efforts to get the contract approved? By its very nature, the obligation is meaningful only prior to approval, so if the contract has no force prior to approval, the obligation is meaningless. The Provisions say that obligations of this kind are binding even before approval.

  • Greater enforceability of equity transfer agreements

The transfer of equity in FIEs requires the approval of the other parties. What if they don't give it? One solution is to try to put it in the original FIE agreement: if one investor wants to transfer its stake to a subsidiary, for example, the other investor agrees in the FIE agreement to permit it. But when the time comes, the other investor may refuse to consent. This isn't a problem in the US - after all, equity views as done that which ought to be done. But it's been a problem in China. The Provisions say that the transfer will be allowed if there is evidence that the other stockholders consented. Maybe a prior consent in the FIE agreement - an agreement to agree, so to speak - would count.

  • Greater enforceability of unregistered stock pledges

Art. 13 seems to be an effort to make unregistered pledges of stock more enforceable. But the way you make a pledge enforceable is to make foreclosure (transfer to the lender) possible. The Provisions say pledges of stock are valid even absent approval from the approval agency (remember, transfers of interest in FIEs require government approval). But how can the pledge really be valid, if to be valid means to allow a transfer, and transfer is supposed to require government approval and consent from the other stockholders? I'm not sure what this ultimately means.

  • Greater power to the puppet-master

It seems that investors in FIEs frequently like to hide their identity and to invest through a nominee. Sometimes this is to avoid the effect of regulations that don't allow them to invest, and sometimes there may be some purely business reason. But sometimes the nominee gets a mind of his own and doesn't do what he's supposed to do. This can be awkward, because if there's an agreement it will often be unlawful. The Provisions give greater power to the hidden investor to protect his interests when the nominee starts getting ideas of his own. I'm not sure if this is all to the good; if as a policy matter we want an investor's identity to be a matter of public record, then we have to have some serious disincentives for evasion. And one disincentive is to give people less confidence that their hidden investment deal will be protected by courts if a problem crops up.

  • Invalidation of duly approved FIE contracts

OK, here's the part I found most interesting. The Provisions state: "When in the course of adjudicating a case, a court discovers that an FIE contract approved by an FIE approval organ is invalid under the provisions of law or administrative regulations, it should deem the contract invalid." (人民法院在审理案件中,发现经外商投资企业审批机关批准的外商投资企业合同具有法律、行政法规规定的无效情形的,应当认定合同无效) Here, "law" means a norm passed by the National People's Congress (NPC) or its Standing Committee; "administrative regulation" means a norm passed by the State Council (as opposed, for example, to a ministry). This provision is very interesting and quite important because it touches on a prominent feature of the Chinese legal system: the tendency of lower-level bodies to issue rules and engage in practices that openly and directly violate higher-level norms in a way that is not allowed under the Constitution, the Law on Legislation, or just general principles of the Chinese legal system, but is nevertheless tolerated.

This is a bit of a hobby-horse of mine, and I have lots of examples. Here's just one: In 2004, the Beijing Municipal Government decided that it would allow Sino-foreign joint ventures in Zhongguancun in which the Chinese investor was a natural person. (News report here.) Fine, but the Equity Joint Venture Law passed by the NPC says that the Chinese party must be a corporate entity, not a natural person, and it is crystal-clear under Chinese that the Beijing Municipal Government cannot override the National People's Congress. (The government official cited in the report fully acknowledges the legal problems.) Therefore, we are getting precisely the situation envisaged by the rules: the Beijing government will approve a JV contract involving a Chinese natural person, but that contract "is invalid under the provisions of law". It should therefore be ruled invalid by any court hearing a dispute involving it. Will this happen? I guess we'll just have to wait and see.

Apologies for typos and infelicities. It's late and writing this took longer than I anticipated.

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I also found this item interesting, but for a somewhat different reason.

To begin, I would translate Clause 3 a bit differently. I would translate it (with the relevant bit in CAPS): "When in the course of adjudicating a case, a court discovers that an FIE contract approved by an FIE approval organ CONTAINS ELEMENTS THAT ARE INVALID under the provisions of law ... it should deem the contract invalid."

情形is quite vague, but the focus of 合同具有法律、行政法规规定的无效情形的 seems to be on invalid parts of the contract, not the whole. Nevertheless (and this is the rub) it seems quite clear that, even for partial invalidity, the courts should invalidate the whole contract, since in cases where contracts 具有...无效情形的the courts 应当认定合同无效.

Illegality in approved contracts has always been a risk, as Don points out.

But, for whatever it was worth, the solution has always been to include savings / severability clauses (those allowing severance of illegal or invalid clauses to save the whole contract) in the transaction documents.

I have been informed that, given the basic purpose of circumventing official determinations of contractual invalidity, savings / severance clauses have always been of questionable acceptability and reliability in China. But, as far as I know (correct me if I'm wrong), no statutory authority expressly rules them out them.

So, this is the issue. Has the situation changed? Are savings / severance clauses now clearly unenforceable and ineffective in this context?

The obvious first answer is "no", since the Supreme Court Provisions are rules of interpretation binding on the courts, not substantive rules fixing the rights of civil actors.

However, if it is strictly enforced at face value and courts automatically rule invalid the whole of any contract with any invalid/illegal part, the new rule would have the effect, in practice, of rendering savings clauses themselves ineffective.

I can't really see that happening in a wholesale way in practice, since the results would probably be mostly unfair, wasteful and distorted.

In the meantime, since the new rule at Clause 3 makes invalidity even more likely in practice on a host of other grounds, even though savings clauses may themselves be weakened under the new rule, it is now all the more important to use them.


Posted by: William | Oct 20, 2010 7:58:35 AM

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