In 1995, Company A and Company B established Company C by way of a joint venture (JV). In the beginning, the two parties jointly framed the Articles of Association which provided that the Board of Directors consisted of five directors of which three were to be appointed by Party A and two by Party B. The Chairman of the Board and the General Manager were to be elected and appointed by the Board.

After the establishment of the JV, conflict between the two shareholders was constant, with disagreements often regarding business policy and profit allocation.

In July 2005, the employment contract of the JV’s Chairman, who was also the General Manager, expired. In order to elect a new Chairman and General Manager, the two directors appointed by Company B recommended a Board meeting. However, the three directors from Company A refused to attend the Board meeting, resulting in the JV entering a stage with no legal representative and no General Manager. As the JV could no longer operate effectively, both the company and the shareholders suffered grave losses. In September 2007, Company B asked the court to terminate its joint equity relationship with Party A and to deregister and liquidate the JV.

This is a typical case whereby shareholder discord results in corporate deadlock. It is not uncommon in small limited liability companies (LLCs) having a small number of shareholders and an imperfect shareholders’ board. Below is a discussion on certain provisions of the Company Law and Judicial Interpretations of the Company Law (II) and a brief analysis of how to handle this kind of corporate deadlock.

I. Definition of Corporate Deadlock

Corporate Deadlock refers to when the existence and operation of the company is in a state of stagnation because of intense conflict between shareholders or directors, so that the Shareholders’ Meetings or the Board of Directors cannot make decisions following proper legal procedures and the company cannot operate normally, becoming paralysed.

The Company Law and Provisions of the Supreme People’s Court on the Application of the Company Law (II) (“Judicial Interpretations of the Company Law (II)”), which became effective on May 19, 2008, provide that Corporate Deadlock refers to the situation “where any company meets any serious difficulty in its operations or management so that the interests of the shareholders would face heavy losses if it continued to exist and it cannot be solved by any other means.”

A company generally falls to into ade adlock in two cases:i ) majority shareholders control the company so that the Shareholder Meeting stops functioning and the interests of minority shareholders are damaged; or ii) the shareholders are balanced in strength so that no party is able to effectively control the company and the company cannot operate normally.

II. Tackling Corporate Deadlock

Article 183 of the Company Law allows shareholders to ask “the people's court to dissolve the company.” The key points and components of a plea for dissolution are as follows:

1. The company meets some serious difficulty in its operations or management.

Article 1 of the Judicial Interpretations of the Company Law (II) enumerates four types of company deadlock: i) the company cannot hold meetings of shareholders for two or more consecutive years; ii) valid resolutions cannot be made in meetings of shareholders for two or more consecutive years because voting shareholders cannot reach statutory proportion or the proportion provided in the articles of association of the company; iii) the directors of the company are in conflict for a long time, which cannot be resolved through a meeting of shareholders; or iv) the company has some other kind of serious difficulties in its operation and management. Of these, the first two types are serious difficulties or deadlock in form and thereby easily recognized; whereas the third type is a substantive deadlock.

These types of deadlock are more related to company management than to finance. The judicial interpretation specifies that, “where any shareholders file a lawsuit to dissolve the company on the grounds that their rights and interests, such as the right to information, claims for profit distribution, have been harmed, or the company is in debt and its assets are insufficient to pay off all debts, or the business license has been revoked but liquidation has not been conducted yet, the people's court shall not accept the lawsuit.” This means that serious difficulties in company operations or management are intentionally considered to be separate from financial difficulties.

2. Shareholders’ interests face heavy losses if the company continues to exist.

Heavy losses are relative to slight or normal losses, judged at the court’s discretion. Continued existence refers to the future state of affairs if the court did not dissolve the company, and making a judgment on probabilities increases the difficulty of interpreting this vague expression. In addition, “the interests of shareholders” rather than “the interests of the company” is used.

As previously discussed, the Court does not accept lawsuits filed on the grounds that shareholders’ rights and interests have been harmed, or the company is in debt and its assets are insufficient to pay off all debts. This means that harm to shareholders’ interests cannot be a cause of action when requesting the court to dissolve the company. Therefore, the author believes that heavy losses of shareholder interests in this regard refers to the overall harm to shareholder rights and interests, or future, potential, indirect losses affecting all shareholders rather than current, concrete, individual losses already occurring. Moreover, if the shareholder losses can be remedied individually, the plea for dissolution is not applicable. A shareholder can only ask the Court to dissolve the company when losses threaten the company’s existence and are not able to be ascribed to any individual grievance.

3. The deadlock cannot be resolved byany other means.

The aim of this point is to prevent maliciously litigating a deadlock case for the improper dissolution of a company. The author believes that “no other means” is not a precondition to file a case and this point should not be overly stressed before filing the case. In the course of the litigation, the exhaustion doctrine applies. In other words, it is acceptable to file the case if other remedies “have been employed” rather than “have been exhausted”.

4. The Court shall attach priority tomeditation.

The author bel ieves that “other means” includes court mediation. It is not a question of prudence or other considerations, but a necessary procedure in handling deadlock cases. The court should mediate in line with this principle. Note: this newsletter is intended to be a general guide only and should not be taken, or relied on, as professional legal advice. Please contact us for any further information or advice in regard to the above information.

5. Plaintiff should be eligible.

The Company Law and Judicial Interpretations of the Company Law (II) provide that any shareholders, separately or jointly, holding ten percent or more of the shareholder's voting rights of a company may file a lawsuit to dissolve the company. It should be noted that the “ten percent” refers to the shareholder's voting rights, not the capital contribution shares or stock. Moreover, the law makes no distinction between an LLC and a joint stock company. In addition, where any other shareholders or interested parties apply to participate in the litigation as a coplaintiff or a third party, the people's court shall give permission.

6. The eligible defendant is the company.

Judicial Interpretations of the Company Law (II) provides that “where the plaintiff files a lawsuit simultaneously against any other shareholders, the people's court shall advise the plaintiff to amend the other shareholders as third parties; if the plaintiff insists on making no change, the people's court shall reject the lawsuit.”

7. The effect of the court decision.

A judgment on a lawsuit regarding company dissolution rendered by the people's court shall be legally binding on all shareholders of the company, including those who waived their right to appear in the lawsuit.

8. Liquidation after the conclusion of thecase.

Judicial Interpretations of the CompanyLaw ( II ) provides that “where any shareholders file a lawsuit to dissolve a company and also apply to the people's court for liquidation of the company, the people's court shall not accept the application for liquidation.” However, if no liquidation group is formed within the time limit upon the occurrence of causes for dissolution, the creditors may ask the Court to designate relevant persons to form a liquidation group. Where creditors have not applied for liquidation, shareholders of the company may apply to the Court to designate a liquidation group for liquidation of the company.

9. Ne bis in idem.

Where any shareholders file a lawsuit for company dissolution based on the same facts and grounds as an earlier lawsuit for dissolution already rejected by the people's court, the people's court shall not accept the lawsuit.

III. Preventing corporate deadlock

The corporate deadlock issue is not the same as that of company dissolution provided in Article 183 of the Company Law. Filing a case for dissolving companies in which the parties can no longer operate effectively due to deadlock is but one of the measures available. In theory there are many alternative remedies, including giving minority shareholders the right to buy back shares and improving the capital withdrawal regime.

The author holds that since corporate deadl o ck r e sul t s mainl y from unreasonable shareholding structures or unreasonable modes of operating shareholder or directors’ meetings or voting procedures, deadlocks can be prevented by better drafted Articles of Association. Improvements in this regard may include properly allocating voting rights to shareholders, establishing a voting right withdrawal regime, giving the Chairman of the Board the right to make a final decision in cases of a voting deadlock, or requesting the Board of Directors to refer matters to the General Shareholder Meeting in cases of voting deadlock, and making prior arrangement for capital withdrawal (e.g. conditions for assignment of shares and deduction of registered capital).

By Liu Junhong, Lifang & Partners