As a direct financing tool for non-listed companies,equity investment has shown a rapid increase in transaction volume and capital scale in recent years. However, along with its rapid development, it has also generated many disputes and controversies. Therefore, we plan to launch a series of articles to provide an overview of the clauses and typical case analyses of common disputes in equity investment, including disputes related to performance-based guarantees, put options, preemptive rights, and liquidation preferences and summarize risk prevention insights from the perspectives of investors, target companies/original shareholders, and actual controllers.

As a direct financing tool for non-listed companies,equity investment has shown a rapid increase in transaction volume and capital scale in recent years. However, along with its rapid development, it has also generated many disputes and controversies. Therefore, we plan to launch a series of articles to provide an overview of the clauses and typical case analyses of common disputes in equity investment, including disputes related to performance-based guarantees, put options, preemptive rights, and liquidation preferences and summarize risk prevention insights from the perspectives of investors, target companies/original shareholders, and actual controllers.

In the previous article "Equity Investment Disputes | Brief Analysis of Disputes over Performance-Based Guarantees and Put Option of Non-Listed Companies", we have analyzed the disputes over Performance-Based Guarantees and Put Option. This article will mainly analyze the disputes over preemptive rights and liquidation preference.

Dispute over preemptive rights Overview of Preemptive Rights Preemptive rights, although not explicitly defined in law, can be understood by referring to Article 34 of the Company Law. According to Article 34, when a company increases its capital, shareholders have the right to subscribe for the new shares in proportion to their paid-up capital. However, this does not apply if all shareholders agree to waive their preemptive rights based on their respective capital contributions.

An example of the description of the preemptive rights clause is as follows:

If the company increases its registered capital or issues an offer for other equity securities, the investor has the right but not the obligation to give priority to subscribing for the new registered capital or other equity securities based on the proportion of subscribed capital held by the investor in the company under the same conditions.Typical Case [1] Issue: What are the consequences of infringing on the original shareholder's preemptive rights?

On December 16, 2003, the Science and Technology Innovation Company held a shareholders' meeting to discuss Chen Mugao's share subscription agreement, which agreed to absorb Chen Mugao as a new shareholder, and agreed to the internal share transfer of the Science and Technology Innovation Company. However, shareholders Jiang Yang, who owns 14.22% of the shares, and Hongri Company, who owns 5.81% of the shares, expressed their explicit opposition to the decision.

On the 18th of the same month, without giving priority to Jiang Yang and Hongri Company to subscribe for capital,the Science and Technology Innovation Company signed a "Share Subscription Agreement" with Chen Mugao, in which Chen Mugao contributed 8 million yuan to subscribe for 6.1538 million shares of the newly added capital of Science and Technology Innovation Company (accounting for 56.42% of the total capital of 10.9075 million shares), and completed industrial and commercial registration on December 25, 2003.Later, the Science and Technology Innovation Company held a shareholders' meeting and passed a resolution that Chen Mugao would donate some of his equity to Gusheng Company. Hongri Company and Jiang Yang attended the meeting without expressing any opposition.

On March 30, 2005, according to the application of Science and Technology Innovation Company, Chen Mugao's 6.1538 million shares were changed and registered under the name of Gusheng Company.

The Supreme People's Court held that:In the resolution passed during the shareholders' meeting of TechInnovation Company on December 16, 2003, regarding the subscription of 6.1538 million newly issued shares by Chen Mugao with a capital contribution of 8 million RMB, the portions corresponding to 14.22% and 5.81% of the newly issued shares are deemed invalid due to the infringement of preemptive rights of Jiang Yang and Hongri Company, respectively. However, whether Hongri Company and Jiang Yang can exercise the preemptive rights over the aforementioned newly added capital would depend on whether they appropriately asserted their rights.

In this case, it is stated that Hongri Company and Jiang Yang were already aware of the infringement of their preemptive rights during the shareholders' meeting of TechInnovation Company held on December 16, 2003, and they expressed their intention to exercise their preemptive rights. However, they did not take timely and proactive measures such as filing a lawsuit to assert their rights. Subsequently, when TechInnovation Company held another shareholders' meeting and passed a resolution proposing the transfer of some shares to Gusheng Company by Chen Mugao, Hongri Company and Jiang Yang attended the meeting and did not express any opposition. It is mentioned that Hongri Company and Jiang Yang initiated the litigation regarding the disputed equity value after nearly two years of the equity change. Allowing them to exercise their preemptive rights at this stage would disrupt the already stable legal relationship and could result in manifestly unfair consequences. Therefore, Hongri Company and Jiang Yang argue that the reasonable period to assert their preemptive rights has already lapsed.

Case InsightsFor Investors: When investors choose to invest in a target company through capital increase, it is important to pay attention to the provisions regarding preemptive rights of existing shareholders in the target company's articles of association. It is crucial to ensure that the project company notifies the original shareholders in accordance with the legal regulations and provisions of the company's articles of association and obtains written declarations from the original shareholders waiving their preemptive rights as a prerequisite for the payment of the capital increase funds. Otherwise, the capital increase may be deemed invalid due to a violation of mandatory provisions of laws and regulations.For Original Shareholders: If the preemptive rights of original shareholders are infringed upon, it is important to promptly seek legal remedies to protect their rights. Failing to take legal action in a timely manner may result in the argument that the reasonable period for asserting preemptive rights has lapsed.

Disputes over Liquidation PreferenceOverview of priority liquidation preference Liquidation preference does not have a specific legal definition but in practice, it generally refers to the right of an investor, after investing in the equity of a target company, to receive priority in the distribution of liquidation proceeds in accordance with the agreed-upon formula in the event of the target company's liquidation. Furthermore, if there are remaining assets in the target company, the investor may also have the right, as stipulated, to continue participating in the distribution of the remaining assets based on their proportionate shareholding.

Liquidation preference clause can be described as follows:In the event of the target company being liquidated, terminated, dissolved, or declared bankrupt in accordance with applicable laws, after the payment of liquidation expenses and the repayment of the target company's debts in the order of priority specified by the applicable laws, the remaining assets shall be distributed according to the following scheme:

First, the investor shall be paid an amount equal to one times their original purchase price plus any accrued dividends and declared but unpaid dividends. Afterward, the remaining assets shall be distributed to the investor and the original shareholders in proportion to their respective shareholdings.

According to Article 186, paragraph 2 of the Company Law: "After separately paying liquidation expenses, employee wages, social insurance premiums, statutory compensation, settling tax debts, and repaying company debts, the remaining property shall be distributed among the shareholders of a limited liability company in proportion to their capital contributions, and among the shareholders of a joint-stock limited company in proportion to their shareholdings."

In judicial practice, when property is distributed among shareholders based on the "liquidation preference" clause, which pertains to the remaining assets of the target company after the payment of liquidation expenses in accordance with legal requirements, courts generally tend to recognize the validity of the "liquidation preference" clause. This means that shareholders can determine the distribution among themselves, as long as it does not violate mandatory provisions of law and does not harm the legitimate interests of the target company's creditors or third parties.

Typical case [2] Issue:  Under the circumstance of "Equity as Debt", can investors have the right to priority in liquidation distribution over all shareholders as creditors (non-shareholders)?On June 21, 2011, Xinhua Trust signed the "Huzhou Kaixuan International Community Equity Investment Collective Fund Trust Plan Cooperation Agreement" with Gangcheng Real Estate, Ji Asheng, and Ding Linde. The agreement stipulated that: （1）Xinhua Trust would provide a trust fund not exceeding 250 million RMB to Gangcheng Real Estate in the form of "equity investment." A portion of the funds would be used to acquire an 80% equity stake in Gangcheng Real Estate, and the proceeds from the equity transfer would be entirely utilized for project construction.（2）The financing period for this transaction was fixed at 1.5 years, 2 years, and 2.5 years.（3）Gangcheng Real Estate was obligated to repay the trust fund to Xinhua Trust and make payments for trust income, trust fees, custody fees, and lump-sum fees. The credit enhancement measures included:（1）Gangcheng Real Estate provides land as charge; (2) Ji Asheng and Ding Linde pledge their equity as collateral; (3) Ji Asheng provides joint liability guarantees. After the contract was signed, Xinhua Trust disbursed a total of 224.78 million RMB (including 80.78 million RMB from capital reserves) to Gangcheng Real Estate's account as trust funds. However, as of the maturity date of the trust plan, Gangcheng Real Estate had only made partial payments of trust income and had not fulfilled its obligations to repay the principal and income as agreed.

On August 4, 2015, the Intermediate People's Court of Huzhou City ruled to accept the bankruptcy liquidation dispute case involving Gangcheng Real Estate. Xinhua Trust filed a claim within the statutory period as a creditor to the administrator. However, the administrator considered Xinhua Trust's claim to be related to an equity investment relationship with Gangcheng Real Estate and therefore refused to recognize it as a valid debt claim.

The People's Court of Wuxing District, Huzhou City [3] believes that:

Firstly, in the issue of de facto shareholders, it is necessary to distinguish between internal and external relationships. Disputes over equity rights arising from internal relationships can be based on agreements between the parties, whether they are dormant shareholders or real debts of real shareholders; However, internal agreements are not applicable to external relations. According to Article 32, Paragraph 3 of the Company Law of the People's Republic of China,  "A company shall register with the registration authority the names or titles of shareholders and their subscribed capital. Any changes to the registered items shall be subject to registration. Any actions taken without registration or change registration shall not be effective against any third party." Therefore, third parties are not bound by internal agreements between the parties but rely on the publicized information provided by the parties to establish their trust.

In this case, it is not a typical dispute regarding a loan contract or a share transfer, but rather a litigation derived from the bankruptcy liquidation of Gangcheng Real Estate. The outcome of this case involves the interests of all creditors in the bankruptcy liquidation of Gangcheng Real Estate. Therefore, the principle of corporate appearance should be applied. In other words, all creditors of Gangcheng Real Estate, relative to the parties involved in this case, are considered third parties. They have a reasonable basis to rely on the shareholder information recorded in Gangcheng Real Estate's shareholder register and the information publicly disclosed by the regulatory authorities, which includes Xinhua Trust's status as the holder of an 80% equity stake in Gangcheng Real Estate.

As can be seen from the above cases, investors are not be able to claim the priority of liquidation and distribution over all shareholders based on their substantive creditor status under the condition of equity as debt.

Case insights

For investors, it is advisable to include a priority liquidation clause in the investment agreement and preferably establish commercial arbitration which respects the autonomy of the parties as the dispute resolution method. Additionally, if the intention of the investing party is to pursue a creditor's investment, caution should be exercised when employing the ‘equity as debt’ investment approach. Prior to investment, thorough due diligence should be conducted to have a comprehensive understanding of the target company's liabilities and repayment capacity; In the drafting of the investment agreement, emphasis should be placed on the "debt" aspect to avoid being characterized as a "pure equity investment"; In terms of post-investment monitoring, attention should be given to the target company's performance and fulfillment capabilities to avoid asserting rights only at the time of the target company's bankruptcy liquidation.For the target company, when describing the priority liquidation clause in investment agreements or other relevant documents, it is advisable to set higher standards for triggering the priority liquidation right and avoid using fallback clauses. Additionally, it is recommended to minimize the preferred liquidation rate for the investing party.

references

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[1] (2010) Min Ti Zi No. 48.

[2] (2016) Zhejiang 0502 Minchu No. 1671.

[3] The second-instance of this case was concluded through mediation, and the relevant civil mediation documents were not publicly disclosed.