Important Changes to the PRC Company Law in 2024 - Part Two

1. A five-year time limit for full contribution of the registered capital

In the context of an LLC, shareholders' equity interests are represented by the amount of registered capital the shareholders have committed to contribute to the LLC. A shareholder's liability is generally limited to the amount of the registered capital to which they have subscribed. Historically, shareholders had the discretion to decide when to contribute the registered capital as specified in the LLC’s Articles of Association (“AoA”), except for certain regulated industries such as financial institutions.

The 2023 Company Law now requires full payment of the registered capital subscribed by the shareholders within a five-year period. It applies to both the initial capital contribution upon the incorporation of an LLC and any subsequent capital increases. Existing companies that were re incorporated before July 1, 2024, are not exempt from these requirements. The State Administration for Market Regulation ("SAMR") has not yet released guidelines outlining how existing LLCs must comply with this mandate. For instance, it is still unknown if these LLCs — particularly those that have been in operation for more than five years by July 1, 2024, but have not paid their full registered capital — will be given a grace period, possibly lasting until June 30, 2029, to meet the full registered capital payment.

2. Liability of the shareholders who fail to pay the registered capital subscribed within the specified timeframe

Shareholders who fail to fulfill their obligations to contribute the registered capital in full within the committed timeframe (as detailed in the AoA and subject to the five-year limit), may be subjected to the following liabilities:

1. Civil liabilities: compensate the company for any losses resulting from the delay or non-payment.

   
   In addition, upon the incorporation of an LLC, if a shareholder fails to pay its registered capital subscribed as stipulated in the AoA, or if the actual value of its contributions-in-kind significantly falls short of the subscribed amount, the other shareholders of the LLC existing at the time of the incorporation may be held jointly and severally liable for the unpaid capital contribution. The 2023 Company Law is silent on whether this rule would also apply to capital increases.

2. Administrative penalties: the SAMR may order rectifications and impose fines ranging from RMB 50,000 to RMB 200,000 (approximately US$7,000 to US$28,000) on the shareholders. In more severe cases, fines of up to 5% to 15% of the unpaid or underpaid capital contribution may be imposed on the shareholders. The responsible person, which may include the senior management personnel of the LLC overseeing this matter, may be subject to a fine of RMB 10,000 to RMB 100,000 (approximately US$1,400 to US$14,000).
   
   Moreover, shareholders are prohibited from withdrawing their capital contributions from LLCs except through legitimate capital reduction procedures. Otherwise, if any action is deemed illegal withdrawal of capital (in Chinese, “抽逃出资”), the SAMR may order rectification and impose fines of up to 5% to 15% of the capital wrongfully withdrawn on the offending shareholders. The responsible person could also be subject to a monetary fine of RMB 30,000 to 300,000 (approximately US$4,200 to US$42,000).

3. Mandatory mechanisms to enforce the full contribution of registered capital

The 2023 Company Law provides the following mandatory mechanisms to enforce the full contribution of the registered capital of LLCs within the prescribed timeframe:

a. Oversight of the registered capital contribution by the directors, supervisors and senior management personnel of LLCs (together the “SMPs”)

The board of directors is required to oversee the shareholders’ capital contribution by seeking payments, confirming the contribution of the shareholders, and causing the LLC to issue written demands for overdue capital contribution to the shareholders in a timely manner. If the directors fail to perform these duties, which results in losses suffered by LLCs, they may face personal liability for such losses.

In addition, as mentioned above, shareholders are prohibited from withdrawing their capital contributions except through legitimate capital reduction procedures. Should an illegal withdrawal lead to losses suffered by an LLC, the SMPs involved and the shareholders may be held jointly liable for damages caused. Furthermore, if an LLC reduces its registered capital without complying with the mandatory legal procedures and requirements for capital reduction, which results in losses suffered by the LLC, the SMPs involved could also be held liable.

b. Equity forfeiture mechanism

The 2023 Company Law introduces a new equity forfeiture mechanism. Should a shareholder fail to fulfil its capital contribution obligations within the grace period stipulated in the company's payment notice, the LLC may, by resolution of the board of directors, issue a notice to disqualify the shareholder from making further capital contributions and forfeit the equity representing the amount of the unpaid capital. The disqualification shall take effect upon issuance of the notice. After the equity forfeiture, the LLC has a six-month window to either transfer the forfeited equity to a new shareholder, or deregister it via capital reduction. Failure to act within this period obligates the remaining shareholders to cover the capital shortfall in proportion to their respective capital contributions.

c. Accelerated capital contribution mechanism

The 2023 Company Law introduces an expanded mechanism for "accelerated capital contribution". Under this provision, should the LLC default on its debt repayments, either the LLC or its creditors may demand that the shareholders contribute capital before the scheduled due date. This mechanism, previously limited to specific situations such as bankruptcy, now has a broader application. Subject to further clarification to be provided through additional implementation rules or regulations to be promulgated, the accelerated capital contribution may be triggered upon the LLC’s failure to repay its debts, which can be a low threshold. While this amendment offers more protection to the creditors, it also introduces new obligations and risks for the shareholders.

4. New capital contribution framework in the context of M&A transactions

The 2023 Company Law introduces a new mechanism whereby, if a seller transfers its unpaid registered capital to a third party before the committed schedule to contribute capital, the buyer shall be subrogated to the seller’s role to contribute the capital in the future. However, if the buyer subsequently fails to contribute the unpaid capital as required, the seller must assume supplementary liability for any shortfall. This mechanism may create a peculiar scenario in which an outgoing shareholder, i.e. the seller, remains liable for any unpaid registered capital they have transferred to a third party.

Moreover, the 2023 Company Law provides that if a seller transfers equities with defective capital contributions (such as defaulting on payment within the stipulated timeframe or providing non-monetary capital contributions with significantly lower actual value than claimed), both the buyer and the seller will be jointly and severally liable for any shortfall in the capital contribution. The buyer can only be exempted from such liability if they were actually unaware of and were not in a reasonable position to find out about such defects.
The above mechanism will no doubt introduce additional layers of uncertainty into M&A transactions involving a transfer of equities that have not been fully contributed. It increases the potential liability of the seller, who may be held responsible for the buyer’s financial incapacity if they fail to make the contribution in full after closing. On the buyer’s side, it is imperative to conduct thorough due diligence to identify any defective capital contributions and proactively address such issues before closing the transaction.

5. Some practical notes

Considering the amendments introduced by the 2023 Company Law on the capital contribution mechanism, below are some practical notes for consideration:

1. Establish a realistic amount for the registered capital at the incorporation stage and any subsequent capital increases. Registered capital can be easily further increased through a capital increase process if the need arises in the future. This becomes more important for an LLC with multiple shareholders given the potential joint liabilities amongst the shareholders for unpaid capital contributions.
   
   
2. Undertake a capital reduction process if it is determined that the existing amounts are excessively high and unlikely to be fully contributed before the mandatory contribution deadline. This may include LLCs that have been acquired that have outstanding capital contributions on the equities.
   
   
3. For M&A transactions involving LLCs with unpaid registered capital where the buyer does not intend to subsequently fulfil the outstanding capital contribution obligations, the parties involved need to implement appropriate measures to address potential risks, such as completing a capital reduction registration immediately before or after the transaction closes. If the capital reduction is to be undertaken before the closing, it may delay the transaction timeline since it generally takes at least three months to complete a capital reduction registration and third parties, such as creditors of the target company, may potentially raise unexpected objections during the process. Therefore, it is also recommended that the parties agree upon an appropriate allocation of risks and liabilities associated with unpaid capital contributions, depending on the risk appetite of the parties and the actual circumstances of the target company.

Shareholders of LLCs should be aware of the abovementioned changes in order to comply with the new requirements under the 2023 Company Law. We expect there will be a series of more detailed rules and practice notes to provide further guidance on how the changes will be implemented in practice before the July 1, 2024 effective date. We will keep a close eye on the developments and post updates when they occur.