By Wu Wang
On April 23, 2013, the No.1 Intermediate People’s Court of Shanghai (the “First Instance Court”) made its judgment (the “First Instance Judgment”) with respect to a case well-known as “Shanghai Bund Land Case”, which judgment ruled that the indirect share transfers taken by SOHO China with the purpose of circumventing other shareholders’ right of first refusal shall be invalid. As it was reported that SOHO China has lodged an appeal against the First Instance Judgment, the result of this case may still be subject to the final judgment.
I. Case Overview
In order to invest into the development and operation of the project on the “Bund Land 8-1”, Zhejiang Fu Xing Commerce Development Co., Ltd. (“Zhejiang Fu Xing”) and certain other entities (the “Minority Shareholders”) set up a company named Shanghai Haizhimen Real Estate Investment Co., Ltd. (“Haizhimen Company”), which subsequently acquired the “Bund Land 8-1” through a vehicle company (the “Project Company”).
After that, the Minority Shareholders intended to exit from Haizhimen Company by selling all of their equity interests in Haizhimen Company to SOHO China (which aggregated 50%, and the remaining 50% was owned by Zhejiang Fuxing). However, if the Minority Shareholders directly transfer their equity interests in Haizhimen Company to SOHO China, Zhejiang Fuxing would have a statutory right of first refusal with respect to such transfer, which was not desired by the prospective buyer—SOHO China.
Therefore, in order to circumvent Zhejiang Fuxing’s right of first refusal, it was at last not the Minority Shareholders directly transferred their equity interests in Haizhimen Company to SOHO China, but the owner of the Minority Shareholders transferred all of their equity interests in the Minority Shareholders to SOHO China (the “Indirect Share Transfers”). As such, SOHO China became the owner of the Minority Shareholders while which remained to be the shareholders of Haizhimen Company.
Subsequently, Zhejiang Fuxing claimed that the Indirect Share Transfers infringed upon its right of first refusal and brought a lawsuit before the First Instance Court on May 30, 2012.
II. Relevant Rules
With respect to the shareholders’ right of first refusal, Article 72 of the PRC Company Law (2006) provided that:
“The shareholders of a limited liability company may transfer all or a portion of their equity interests among themselves.
The proposed transfer of equity interests by a shareholder to any non-shareholder party shall be subject to the consent of more than half of the other shareholders. The transferring shareholder shall notify the other shareholders in writing of the matters on the proposed equity transfer for their consent. Failure to reply by any of the other shareholders within 30 days upon receipt of the written notice shall be deemed to be consent to the proposed transfer. Where more than half of the other shareholders do not consent to the proposed transfer, such non-consenting shareholders shall purchase the equity interests to be transferred; failure to purchase the equity interests shall be deemed to be consent to the proposed transfer.
With respect to any equity interests to be transferred with the consent of the shareholders, those shareholders other than the transferring party shall have the preemptive right under the same conditions. Where two or more shareholders claim to exercise their preemptive right, they shall determine the proportional ratio for purchase through consultation. Where the consultation fails, the preemptive right shall be exercised in proportion to their respective capital contribution at the time of the transfer.
The provisions on equity transfer otherwise provided under the articles of association of a company shall prevail.”
However, the above Article 72 only provides for the shareholders’ right of first refusal with respect to the “direct share transfers” and dose not provide for “whether or not the shareholders shall have the right of first refusal with respect to the Indirect Share Transfers.”
III. Comments on First Instance Judgment
Though, there are no specific rules can be directly applied to this case, the First Instance Court is of the opinion that:
(A) The Indirect Share Transfers taken by SOHO China to acquire 50% equity interests of Haizhimen Company, “though, from the perspective of form, did not directly jeopardize the equity interests currently held by the plaintiff (namely, Zhejiang Fuxing) in Haizhimen Company, it substantially deprived the plaintiff of the right of first refusal with respect to the other 50% equity interests of Haizhimen Company”;
(B) “From the perspective of substance, the Indirect Share Transfers caused the same effect, and the result thereof directly harmed the plaintiff’s benefits and interests, in other words, the plaintiff’s controlling position in Haizhimen Company has been materially affected and damaged, and the “personal nature” and the internal reliance relationship among the original shareholders of Haizhimen Company has been destroyed fundamentally”; and
(C) “The consequences of the above-mentioned transactions will do harm to the operation and management of Haizhimen Company and the Project Company; also, it will be hard to ensure the due development of the construction project on Bund Land 8-1.”
Therefore, the First Instance Court held that the share transfer agreements entered into for the Indirect Share Transfers shall be null and void in accordance with Article 52 of the PRC Contract Law, which provides that “[t]he contract shall be null and void under any of the following circumstances:…(iii) concealing illegal purposes under the disguise of legitimate forms.”
When the relevant PRC laws are silent on whether or not the Indirect Share Transfers violate the other shareholders’ right of first refusal, it can be seen from the First Instance Judgment that the judge took a view of “Substance Over Form” and adopted the following notion when considering the order of legal values such as justice, efficiency and safety, etc.:“when hearing a dispute concerning shareholders’ right of first refusal…the maintenance of the internal reliance relationship shall be given first priority, the second is to consider the degree of restrictions as to the principle of “shares can be transferred at discretion”, and the third is to protect the safety and stabilization of the transactions…” (Please note that the above notion was quoted from a book written by the First Instance Court, which heard this case.)
In addition, please note that China is not a case law county, as such, different judges may have different understandings and opinions to an identical issue. However, the First Instance Judgment of this case may send a message to the other courts and affect the judge’s understanding on the issue discussed herein.
IV. Practice Overview
In practice, to fully protect the shareholders’ right of first refusal, the relevant parties will agree to provide for certain restrictions on the indirect share transfers. Set forth below are some exemplary language for reference:
“In the case that any shareholder is an entity, and in the event that (i) such shareholder proposes to sell or issue to any other persons any of its equity interests, (ii) such shareholder proposes to redeem or repurchase any of its equity interests, or (iii) any equity holder of such shareholder proposes to transfer to any other person its/his/her equity interests in such shareholder, then, the abovementioned sale, issuance, redemption, repurchase, transfer, or the like, shall constitute the transfer of equity interests of the Company by such shareholder, and shall thus be subject to all requirements and restrictions provided herein on the transfer of equity interests of the Company by the shareholders.”
V. Suggestions
(A) When there are no specific rules can be applied, the legality of the proposed transactions may need to be considered prudently from the perspective of “Substance Over Form”.
(B) As the provisions regarding the shareholders’ right of first refusal under the PRC Company Law do not cover all possible situations in real life, for the purpose of avoiding any possible disputes caused by the absence, vagueness or ambiguity of the relevant provisions, the concerned parties may need to consider providing for the shareholders’ right of first refusal in detail to the full extent possible. In practice, some particular “share transfers” caused by donation, inheritance, share swap, etc. may also need to be taken into consideration.
(C) Not to establish a shareholding structure which may lead to a company deadlock, especially for those persons who desire to control a company. Assuming that Zhejiang Fuxing held 51% or more equity interests (not 50% in this case) in Haizhimen Company, let SOHO China acquire all of the remaining equity interests, it will still be hard for SOHO China to exercise decisive influences on the operation and management of Haizhimen Company.
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)
