Adapting to the New Company Law, Understanding in one article (3/3)

Our previous article started up the discussion of the change to company governance structures. In this article, we will focus on capital reduction related sharing.

• Capital Reduction

The vast majority of foreign-invested companies maintain commercial reasonableness in setting the amount of registered capital, setting it on the basis of considering capital expenditure, operating expenditure, and reserving a certain margin. Of course, some foreign-invested companies set their registered capital at a relatively high level to avoid future capital increase procedures (under the filing system, capital increase usually does not require government approval, but signing the various documents and registering the changes often takes 1-2 months).

If the company is still insufficient to pay the full amount of the registered capital by the stipulated time limit (we say it is 30 June 2032), a capital reduction will take place.

Capital reductions are broadly categorized into two types. One is Directed Capital Reduction, and the other is Simple Capital Reduction.

Directed Capital Reduction

Directed Capital Reductions are less commonly used. It works in minority investment projects, where investors often request that the company repurchase their shareholdings in the event of certain circumstances, so as to realize the investors’ purpose of exiting the company. In the future, foreign companies may wish to explore the possibility of agreeing on specific conditions for targeted capital reductions in the shareholders’ agreement to provide a feasible path for a shareholder to exit the company by way of a capital reduction.

Simplified Capital Reduction

As mentioned earlier, if the company is not sufficient to complete the full capitalization by the time limit, the company’s first consideration will be to apply for a reduction of capital.

In this case, if the reduction of the company’s registered capital does not result in the payment of consideration to the shareholders, i.e., it does not essentially reduce the company’s property for liability purposes, then it is a “formal capital reduction”. On the other hand, if there is a reduction in the net assets of the company, which reduces the solvency of the company, then it is a “substantive capital reduction”.

Article 225 of the new Company Law stipulates that If a company still has losses after making up for them in accordance with the provisions of Paragraph 2 of Article 214 of this Law, it may reduce its registered capital to make up for the losses. If the registered capital is reduced to make up for the loss, the company shall not make any distribution to the shareholders, nor shall the shareholders be exempted from the obligation to pay the capital contribution or the share capital. … After the reduction of the registered capital, no distribution of profits shall be made until the accumulated amount of legal reserve and arbitrary reserve reaches fifty percent of the company’s registered capital. This is also referred to as the “Simplified Capital Reduction Regime” in the preliminary draft of the Company Law (Draft Amendment).

In particular, it should be noted that in practice, the State Administration for Market Regulation is relatively cautious in dealing with the company’s capital reduction, and often requires the company to submit a statement of reasonableness and necessity of the capital reduction.

It has not even been a month since the enactment of the new Company Law, and we have observed that several companies, in Shanghai, have already encountered problems of one kind or another in the filing process at the administration bureau. Regarding the interpretation of the policy and the implementation rules, the administrations are still waiting for the notification from the central bureau. However, we have received feedback that it is not recommended to blindly submit a modification application before the implementation rules are clarified. Some enterprises, due to the previous plan of capital reduction are in the process of submission, and with the change of policy, their process has been put on hold.

• Consequences of defaulting on the capital contribution

If the shareholders are unable to complete the contribution within the time limit stipulated in the new Company Law, the new Company Law also stipulates a series of new provisions on the consequences of defaulting on the capital contribution, which will become a powerful tool to solidify the obligation of shareholders to make the capital contribution.

1) Liability of shareholders. A shareholder who fails to pay the capital contribution in full and on time shall be liable for the losses caused to the company. In addition, the other shareholders at the time of establishment and the shareholders who have not paid the capital contribution in full shall be jointly and severally liable to the extent that the capital contribution is insufficient.

2) Responsibilities of Directors, Supervisors, and high management. A new reminder system has been added, whereby the directors have the obligation to verify the capital contributions and issue reminder notices by the company, and if the failure to fulfill such obligations in a timely manner causes losses, the responsible directors shall be liable for compensation, and in the case of shareholders’ absconding from the capital contributions, the responsible directors and supervisors shall also be jointly and severally liable for compensation.

3) The new system of “loss of shareholders’ rights”. If a shareholder fails to pay the capital contribution after the grace period of the reminder has expired, he/she shall forfeit the unpaid capital contribution, and such part of the capital shall be transferred according to law, or the registered capital shall be reduced accordingly and the capital shall be canceled.

4) New accelerated expiration provision for capital contribution. “If the company is unable to settle its debts as they fall due, the company or the creditors of the expired claims shall have the right to request the shareholders who have subscribed to the capital contribution but have not yet reached the expiration date of the capital contribution to pay the capital contribution in advance”.

From the perspective of a foreign-invested company, it is possible to think ahead that, from the perspective of a newly established enterprise, a foreign-invested company needs to be more cautious in setting its registered capital.

• on the one hand, it should ensure that the company has sufficient reserve capital to satisfy the company’s needs for continuous operation, and
• on the other hand, the amount of the registered capital should not be too high, to avoid the trouble of subsequent reduction of capital caused by excess capital.

From the perspective of M&A transactions, foreign-invested companies should pay special attention to the paid-up status of the registered capital of the subject of the acquisition, which is not only limited to checking whether the paid-up status is in accordance with the articles of association but also requiring the counterparty to complete the payment of the unpaid portion of the registered capital before the settlement.

CONCLUSION

From our sharing, we have selected the changes that are relatively urgent, or highly concerned by most of the LLCs or foreign-invested companies, to explain and analyze. Of course, there are some other adjustments in the new Company Law, such as the rights of shareholders, the company establishment and deregistration process, etc. In the future, we may share further topics based on our practical experience and supporting implementation rules. Please stay tuned.

If you are interested in this article, or you have more questions, please feel free to contact us.