By Wu Wang
In China’s commercial practice, the equity transaction parties will usually sign two equity transfer agreements for a same target equity: one is for private purpose, which will provide for the actual conditions and terms and will not be submitted to governmental agencies (the “Private Equity Transfer Agreement”), and the other is for filing purpose, which will provide for a nominal share transfer price in order to circumvent the tax duties and facilitate the filing process with governmental agencies (the “Public Equity Transfer Agreement”).
In a recent case involving a near RMB600 million worth of equities transfer dispute, the PRC Supreme People’s Court held in its judgment in August 2013 that the Public Equity Transfer Agreement and the tax circumventing provisions under the Private Equity Transfer Agreement shall be invalid. Moreover, certain other important legal issues about equity transfers were also debated in this case, such as how to duly exercise the right to terminate an equity transfer agreement and whether the “bona-fide acquisition principle” is applied to the equity transfers.
I. Case Overview
This case involved many parties, huge monies, multiple equity transfers and a number of legal issues concerning equity transfers:
A. Courts and Parties
As to this case, the first instance court is Sichuan High People’s Court and the second instance court is the PRC Supreme People’s Court. And the parties to this case mainly include: (i) Sichuan Jing Long Construction Company (“Jing Long Company”), (ii) Jianyang Sancha Lake Travel Investment Company (“Sacha Lake Company”), (iii) Mr. Guiliang Liu, (iv) Shenzhen Ding Tai Jia Ye Real Estate Investment Management Company (“Ding Tai Company”), (v) Shenzhen He Zhong Wan Jia Real Estate Investment Consultation Company (“He Zhong Company”), and (vi) Hohhot Hua Ren Century Real Estate Development Company (“Hua Ren Company”).
B. Facts Ascertained by Courts
1. First Share Transfer
On July 22, 2009, Mr. Guiliang Liu and Sacha Lake Company (the transferors) and Jing Long Company (the transferee) signed an equity transfer agreement (the “First Equity Transfer Agreement”) with respect to the following five companies (collectively, the “Target Companies”), under which Mr. Guiliang Liu agreed to transfer to Jing Long Company 90% equity interests in each of the Target Companies, respectively; and Sancha Lake Company agreed to transfer to Jing Long Company 10% equity interests in each of the Target Companies, respectively:
(i) Chengdu Tian Cheng Properties Consultation Company (the “Target Company One”); (ii) Chengdu Xing Zhan Properties Consultation Company (the “Target Company Two”); (iii) Chengdu Jin Rong Real Estate Agency Company (the “Target Company Three”); (iv) Chengdu Jin Yun Properties Consultation Company (the “Target Company Four”); and (v) Chengdu Si Heng Properties Consultation Company (the “Target Company Five”);
2. Second Share Transfers
On April 10, 2010, Sancha Lake Company signed an equity transfer agreement with Ding Tai Company, under which Sancha Lake Company agreed to transfer to Ding Tai Company 10% equity interest in each of the Target Company Two and Target Company Three, respectively.
On July 15, 2010, Sancha Lake Company, Mr.Gui Liang Liu signed an equity transfer agreement with He Zhong Company, under which Sancha Lake Company and Mr.Guiliang Liu agreed to transfer to He Zhong Company 100% equity interests in each of the Target Company Four and Target Company Five.
3. Third Equity Transfer
On September 8, 2010, He Zhong Company signed an equity transfer agreement with and Hua Ren Company, under which He Zhong Company agreed to transfer to Hua Ren Company 100% equity interests in each of the Target Company Four and Target Company Five.
C. Claims
On December 22, 2010, Jing Long Company brought a private lawsuit before Sichuan High People’s Court when it knew of the above Second Equity Transfers and the Third Equity Transfer and claimed that (i) the First Equity Transfer Agreement shall be continued to be performed, and (ii) the Second Equity Transfers and the Third Equity Transfer shall be both invalid, and the equity interests transferred thereunder shall be recovered to their original status—being held by Sancha Lake Company and Mr. Guiliang Liu.
On April 7, 2011, Sancha Lake Company and Mr. Guiliang Liu brought counterclaims and asserted that the First Equity Transfer Agreement shall have been terminated already.
II. Abstracts of Court Opinions
A. Public Equity Transfer Agreement Shall Be Invalid
For each of the above first to third equity transfers, the relevant contracting parties signed both Private Equity Transfer Agreement and Public Equity Transfer Agreement. The judges of the PRC Supreme People’s Court in this case (the “Judges”) held that all of such Public Equity Transfer Agreements signed for filing and tax circumventing purposes did not reflect the contracting parties’ real intentions and thus shall be invalid in accordance with Article 52(2) of the PRC Contract Law, which provided that a contract shall be invalid where there is malicious conspiracy causing damages to the interests of the State, the collective or a third person.
B. Tax Circumventing Clause Under the Private Equity Transfer Agreement Shall be Invalid
The First Equity Transfer Agreement and its supplementary agreement provided that: (i) the contracting parties agreed to sign a Public Equity Transfer Agreement thereafter for the filing purpose, which shall be attached therewith as an exhibit; (ii) in any event, Sancha Lake Company and Mr. Guiliang Liu shall not need to provide Jing Long Company with any invoice in any form, meanwhile, they shall deliver receipts signed off by themselves; and (iii) Jing Long Company agreed and undertook that it will only submit the Public Equity Transfer Agreement to the governmental agencies and will not submit the Private Equity Transfer Agreement (namely, the First Equity Transfer Agreement and its supplementary agreement); or otherwise, it shall be deemed that Jing Long Company breaches this agreement and shall pay RMB20 million to Sancha Lake Company and Mr. Guiliang Liu as a default payment therefor.
The Judges held that the above provisions stipulated for circumventing tax duties shall be invalid in accordance with the aforementioned Article 52(2) of the PRC Contract Law. However, except for the above provisions, as the other provisions under the Private Equity Transfer Agreement and its supplementary agreement were reached in conformity with the contracting parties’ real intentions and did not violate the laws and regulations, the other provisions thereunder should be valid and having binding effect to contracting parties in accordance with Article 56 of the PRC Contract Law, which provides that if a part of a contract is invalid but does not affect the validity of the other parts, the other parts shall remain valid.
C. The Second Equity Transfer Shall Be Invalid
The Judges opined that the Second Equity Transfer shall be invalid in accordance with the aforementioned Article 52(2) of the PRC Contract Law and on the ground that Jing Long Company’s interests were jeopardized by the Second Equity Transfers as Sancha Lake Company and Mr. Guiliang Liu sold and delivered the equity interests to their affiliates (Ding Tai Company and He Zhong Company) at an apparently lower price comparing with that offered to Jing Long Company when the First Equity Transfer Agreement has not been terminated, of which Ding Tai Company and He Zhong Company should have been aware.
D. Bona-fide Acquisition Principle Can Be Indirectly Applied To Equity Transfers
The Judges expounded that though Article 106 of the PRC Property Right Law provided that the “bona-fide acquisition principle” is applied to movables and immovables, the PRC Company Law is silent on whether or not the “bona-fide acquisition principle” is applied to equity interests, and the equity interests are neither the movables nor immovables, therefore the “bona-fide acquisition principle” cannot be directly applied to equity interests by referencing to the aforementioned Article 106 of the PRC Property Right Law.
The delivery of equity interests is different from that of movables or immovables. Article 33(3) of the PRC Company Law provided that: “[a] company shall register the names of the shareholders and the amount of their respective capital contributions with the relevant company registration authority. In the case of any change occurred to the registered items, such change shall be registered as well. For the unregistered items and changes, it shall not be held as a defense against any third party’s claims.” As He Zhong Company has been registered as the sole shareholder of each of the Target Company Four and Target Company Five, and which will cause Hua Ren Company to reasonably believe the target equity interests were owned by He Zhong Company, thus the “bona-fide acquisition principle” under the aforementioned Article 106 of the PRC Property Right Law can be indirectly applied to this case.
E. Acts to Terminate Contract Cannot Be Effected During the Court Proceedings
The Judges were of the opinion that Sancha Lake Company and Mr. Guiliang Liu shall have the termination right under the First Equity Transfer Agreement and its supplementary agreement when Jing Long Company failed to fully pay the equity transfer price by the deadline provided thereunder, but Sancha Lake Company and Mr. Guiliang Liu accepted and did not raise objections to the overdue payment of RMB54.6 million made by Jing Long Company after the deadline, which implied that Sancha Lake Company and Mr. Guiliang Liu still agreed to be bound by the First Equity Transfer Agreement and its supplementary agreement. As of the filing of this case by Sichuan High Supreme Court, Sancha Lake Company and Mr. Guiliang Liu neither raised objections to Jing Long Company’s overdue payment nor delivered termination notice to Jing Long Company, therefore, upon the filing of Jing Long Company’s claims, the First Equity Transfer Agreement and its supplementary agreement should still have binding effect to Sancha Lake Company and Mr. Guiliang Liu.
Moreover, during the court proceedings, it should be the court to determine whether or not a particular contract concluded before the trial is valid or terminated. Therefore, the termination notice delivered to Jing Long Company by Sancha Lake Company and Mr. Guiliang Liu during the court proceedings shall not affect the validity of the contract at issue.
III. Suggestions
A. Think Twice Before Tax Saving Arrangement
In 2006, the PRC Supreme People’s Court expounded in another case relating to a land title transfer agreement: “…an invalid contract shall be invalid since its inception, the lapse of time will not affect its invalidity, and the claims for confirming a contract’s invalidity shall not be subject to the statute of limitations.” Therefore, we should not count on the possibilities that the tax circumventing provisions would become valid and enforceable with the lapse of time.
The writer suggests that it would be advisable to have the legal and tax professionals review the deal structures from their respective perspective for the equity-related transactions to achieve the tax saving purposes without in violation of the laws.
B. Exercise Contract Termination Rights in a Due and Timely Manner
Under the judgment, Sancha Lake Company and Mr. Guiliang Liu shall have to continue to perform the First Equity Transfer Agreement for the reason that they did not properly exercise their contract termination right when they have such right.
The writer suggests that the contract termination right be exercised in a written form and delivered to the courter party in a manner provided under the agreement. Also, the terminating party should expressly reject any overdue performance by the counterparty when the terminating party has a contract termination right.
In addition, the exercise period of contract termination right should be also worthy of attentions. Though, there is no clear time limitations provided under the PRC laws with respect to the contract termination right, Article 15(2) of the Interpretation of the Supreme People's Court on Certain Issues Concerning the Application of Laws in Hearing Cases Involving Disputes over Contracts on Purchase and Sale of Commercial Housings provides that:“[i]n the absence of provisions in law or agreement between the contracting parties, the reasonable time limit for exercising the right of termination shall be three months after reminder from the other party. In the absence of remainder from the other party, the right of termination shall be exercised within one year of the date of its occurrence. If the right is not exercised within the time limit, it shall be extinguished.” As such, the writer suggests that the termination assertion be delivered to the counterparty as early as possible and before any legal action.
C. Due Diligence Is Necessary For Equity Transfers
In this case, the Judges held that the Second Equity Transfers was invalid as it was not made in good faith, meanwhile the Third Equity Transfer was valid as it was made in good faith for the reason explained by the Judges that the Target Company Four and Target Company Five were both registered under the name of He Zhong Company before the Third Equity Transfer, and Hua Ren Company also engaged accounting firms and law firms to prepare reports per their due diligences conducted with respect to the target companies’ financial conditions, assets, debts, equities and accounts. On the other hand, Jing Long Company failed to evidence that Hua Ren Company was aware of the First Equity Transfer when He Zhong Company sold and transferred the equity interests to Hua Ren Company.
From the above, we can see that the due diligence is one of the significant factors to determine whether or not the equity transfer transaction is made in good faith. The writer suggests that it would be advisable to have the professionals conduct due diligence so as to on the one hand avoid potential legal risks, and on the other hand evidence the equity transfer is made in “good faith” to some extent.
Mr. Wu Wang is a Beijing-based senior associate with Global Law Office who specializes in merger & acquisition, private equity investment, venture capital investment, foreign direct investment, corporate financing, and corporate public offering and listing. (E-mail: wangwu@glo.com.cn)
