In the dynamic landscape of multinational corporations undergoing strategic group restructurings in China, a notable surge in contract disputes surrounding equity transfer agreements has emerged in recent years. As these disputes become more prevalent, General Counsels of multinational companies urgently seek answers on whether termination of equity transfer agreements governed by Chinese law is possible and what repercussions ensue from such termination.

Leveraging PureLaws' legal team's expertise in cross-border company equity disputes, we meticulously scrutinized the current landscape and developmental trajectory. This article delves into the intricate legal nuances and potential repercussions associated with terminating Equity Transfer Agreements governed by Chinese law, offering comprehensive insights for our clients facing such challenges.

The Legal Consequences of Terminating Equity Transfer Agreements

Terminating an agreement invokes specific obligations as outlined in Article 566 of the Civil Code. The non-performing party is obliged to cease performance, and the performing party must restore the status quo, employing either restitution or remedial measures. Article 584 further defines the scope of compensation, covering actual losses and foreseeable benefits within the breach's ambit.

In terminating equity transfer agreements, a nuanced approach involves identifying recoverable losses or benefits for both equity transferors and transferees. Post-termination claims for equity transferors may include the equity itself, accounting for equity discount, dividends, losses due to equity depreciation, and costs related to exercise of rights. On the flip side, equity transferees may seek the equity transfer price, interest on tied-up capital, appreciation or depreciation of equity value, subsequent investments, loss of investment opportunities, and costs associated with exercise of rights. These claims broadly fall into three categories: restitution, remedial measures, and compensation for losses, each requiring a meticulous exploration, as detailed in the following discussion.

Restitution of Equity after Termination of Equity Transfer Agreement

Restitution of Equity

Restitution of equity is based on the assumption that the equity transferee has already acquired the equity. The method of equity restitution should align with the form of equity transfer. After termination, if the transferor has delivered the equity, the transferee must return it unless impractical or unnecessary. The intangible nature of equity sparks debates on its delivery time, with the most acccepted perspectives asserting alignment with the equity transfer form recorded in both shareholders' and commercial registers.

Restitution of equity does not trigger other shareholders' priority purchase rights, nor does it necessitate consent from over half of the shareholders. While some argue for additional consent, we think that, as the equity transferor regains its original shareholder status post-termination, equity restitution doesn't impact the limited liability company's capital, thus not falling under Article 71 of the Company Law. Restitution of equity and repayment of the equity transfer price are reciprocal and can be simultaneous, invoking Article 34 of "The China National Conference Minutes" in case of the transferor's inability to refund the price due to a lack of liquid assets.

Return of Equity Transfer Price

Following the termination of an equity transfer agreement, the transferor must refund the actual agreement price received. While money, as a specific form of property, doesn't present non-returnability issues, a controversy exists over the amount to be returned. Perspectives range from the return being based on the actual amount received to the market value of the equity or corresponding shareholder rights at the time of equity restitution. The interplay between restoring the status quo and compensation for losses adds complexity to this debate, a point to be explored further on a case by case basis.

Return of Dividends and Other Benefits and Payment of Fund Occupation Fees

After termination, when the agreement price and equity are reciprocally returned, questions arise regarding refunding dividends and benefits accrued during the equity holding period and covering fees for occupying the agreement price. The retrospective effect of agreement termination is pivotal in determining these actions. If termination has a retrospective effect, implying the agreement never existed, the transferee should return dividends and benefits, and the transferor should pay fund occupation fees. If there's no retrospective effect, these actions might be deemed unnecessary. The termination of equity transfer agreements theoretically lacks a retrospective effect, with ongoing effects observed in continuous exercise of shareholders' rights, emphasizing the need for a balanced approach.

Valuation of Shares after Agreement Termination

Situations Applicable to Share Valuation

Following the termination of a share transfer agreement, compensation through discounted valuation of subject shares becomes relevant when shares cannot be returned or when it's deemed unnecessary. Article 566 of the Civil Code outlines situations where this compensation is applicable:

Lawful Acquisition by a Third Party: If the share transferee lawfully transfers subject shares to a third party before agreement termination, and the transaction's effectiveness is unchallengeable, returning the shares becomes practically impossible, constituting an "unable to return" scenario.

Significant Changes in Management or Asset Structure: Substantial alterations initiated by the share transferee in the management philosophy, operation mode, or asset structure of the target company make the subject shares distinct, justifying their non-return. The significance of these changes necessitates a case-by-case assessment.

Major Organizational Changes in the Target Company: Post-agreement termination, if significant organizational changes like mergers, spin-offs, or cancellations occur in the target company, the subject shares cannot be returned, warranting the application of discount compensation rules.

Calculation Method of Share Discount

In legal practice, after termination, when delivered shares cannot be returned or it's unnecessary, compensation claims often involve either discounting the market value at the time of share return for increased share value or determining the discount amount based on the agreement price or market value at the time of share transfer for decreased share value. Deciding who bears the appreciation or depreciation of the shares from transfer to return hinges on the perspective that the termination lacks retroactive effect.

Whether returning the original shares or applying share discount, both methods aim to provide parties with equity or an alternative at agreement termination. Share discount should be based on the market value of shares at the time of agreement termination. Confirming the market value of most limited liability company shares is challenging, and in the absence of ample evidence, the share transfer agreement serves as a reference for determining share value based on the agreed-upon transfer price. After determining the share discount amount, parties can adjust for share appreciation or depreciation through damages compensation methods, factoring in each party's fault and causality.

Loss Compensation after Share Transfer Agreement Termination

Handling of Share Appreciation or Depreciation

Upon termination of a share investment agreement, both parties must return the property acquired through the agreement. Managing shares demonstrating appreciation or depreciation compared to the contractually agreed price requires a nuanced approach. Addressing the distribution or sharing of appreciation or depreciation in shares post-termination can be guided by Article 33 of the "Joint Statement of the 9th National People's Congress and the Supreme People's Court," outlining rules for addressing non-formation, invalidity, or rescission of agreements. A comprehensive evaluation of fault and causality factors for each party is pivotal in deciding the distribution or sharing ratio.

Weighing Fault Degrees: Assessing the degree of fault for the termination of the share transfer agreement is fundamental, guided by the fault principle in civil law compensation. The court should determine which party bears primary responsibility for the agreement's termination to prevent one party from benefiting from its own breach. If one party is at fault, options include allowing the non-fault party to enjoy appreciation benefits or imposing depreciation losses on the at-fault party. When both parties are faultless or share fault, consideration can be given to dividing or sharing appreciation or depreciation benefits proportionately.

Evaluating Causal Power: Unlike physical objects such as real estate, share value changes are linked to market factors and company operating conditions. In addressing share appreciation or depreciation, consideration is given to whether the parties actively participate in and control the target company's operations. If the share transferee has minimal impact on the target company's control, their causal power over share appreciation or depreciation is limited. If the share transferee actively participates or controls the target company's operations, their causal power over share value changes is significant. When dividing or sharing appreciation or depreciation benefits, the share transferee's business activities are factored in for a reasoned and equitable allocation.

Handling of Subsequent Investment by the Share Acquirer

In business practice, the share acquirer often engages in further investment and operations post-acquisition, involving shareholder loans, capital increases, and shareholder gifts. Claiming the return of subsequent investment funds from the share transferor after agreement termination involves specific considerations.

We posit that the share acquirer's subsequent investment via shareholder loans or capital increases cannot be directly claimed from the share transferor. The legal relationship is established between the share acquirer and the company, an independent legal entity. Post-agreement termination, the share acquirer can seek debt repayment from the company based on the loan legal relationship or claim capital reduction and return if conditions are met. The share acquirer's investment in the form of shareholder loans or capital increases on financial statements does not impact the value of the target shares.

PureLaws Advice

We recommend Multinational General Counsels who deals with equity transfer agreements in China navigate the evolving legal landscape strategically. Key considerations include understanding the nuances of termination consequences, addressing complexities in equity restitution, resolving controversies in the return of equity transfer prices, and managing valuation and compensation for shares. Handling subsequent investments requires a clear understanding of legal relationships and financial impacts. Proactive legal guidance is essential for effective dispute resolution. A thorough grasp of Chinese legal intricacies and continuous monitoring of developments will empower General Counsels to swiftly and effectively safeguard multinational companies' interests in equity transfer agreements in China.

Recognized as one of the most innovative legal service providers, PureLaws (A&E Law Firm China) offers a different perspective to commercial thinking and the client experience.