Rumors abound that China discriminates against foreign investors through its regulatory and legal system. Whether claims about unfair court decisions or unfairly strict regulators, there is a perception that China treats foreign investors unfairly. Fortunately, China’s Congress created a legal loophole in its laws that allows legal circumvention of discriminatory laws or practices, something that was previously considered illegal. The legal circumvention technique is to lawfully obtain a false regulatory designation that your company is Chinese-owned. While this approach is totally legal, the cost of a compliance violation is catastrophic: you will lose ownership of the entire company.
In this article, we’ll go over the nature of the legal authority that permits a foreign company to hide its foreign ownership status, before discussing the compliance requirements the law imposes for this approach.
Contents
Legal authority for discrimination circumvention
Legal authority for discrimination circumvention
The legal authority for using false designations to avoid discrimination from China’s enforcement officials derives from the recent Foreign Investment Act. This is a complex law, and we recommend you get a quick overview of China’s foreign investment laws at our FAQ and see comprehensive regulations and government guidance here.
Chinese law is different from other jurisdictions in that all companies must be qualified as being either a Chinese-owned entity or a foreign-owned entity. Thanks to deliberate legal loopholes, the confusing part is that this qualification is mostly fictional: any Chinese company can qualify as foreign-owned, and any foreign company can qualify as Chinese-owned.
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The circumvention method is introduced by obscure Supreme Court rules to the 2020 Foreign Investment Act which officially sanction using Chinese nominee shareholder contracts to establish a fictional ownership structure, which may be legally declared to the Ministry of Commerce to obtain the desired Foreign/Chinese status. Why is this immense rule in an obscure court rule and not in the Congressional legislation? Chinese legislators apparently needed a way to avoid the ire of angry nationalists who already stirred up a firestorm over the Act.
Notwithstanding a qualification as a Chinese-owned entity, de facto foreign-owned entities still need to comply with special rules governing foreign-owned entities. This creates a whole host of special compliance risks that a foreign-owned entity with a typical nationality designation would typically not have difficulty with.
Loss of ownership rights can result from access exceptions violations.
Evading discrimination by China’s regulatory enforcement officers by using a Chinese-owned qualification requires strict compliance with the Foreign Investment Access Exceptions List, and a business owner risks losing all ownership rights in their company if operations are not in compliance while identified as a Chinese company. The reasons for that are incredibly technical and will be illustrated with prior case precedents, and the rule can be found in the Foreign Investment Act’s Supreme Court Rules §15. (see CBL’s translation)
The rules allow for using a nominee shareholder agreement to nominally qualify as a Chinese-owned company and require courts to enforce those agreements in the foreign owner’s interest — unless the agreement is in violation of applicable law, which in court precedents means the Foreign Investment Access Exceptions List. In that case, you lose everything.
The current court rules derive from a previous leading case, Supreme Court Appeal No. 37 (2017). A nominee shareholder contract provided that the company Huaixin and its shareholders agreed that Zhang Xiulan, a German citizen, may be admitted as a shareholder to contribute capital to the company. As a shareholder, they participated in meetings and voted. The company’s principal line of business is real estate development, which did not fall under China’s investment access exceptions. Therefore, Zhang Xiulan’s shareholding was legal, despite their foreign citizenship.
Cases following the China Foreign Investment Act’s passage have imposed catastrophic non-compliance penalties when hiding foreign identities to avoid discrimination. In Supreme Court Appeal No. 6561 (2021) under the Foreign Investment Act, a Taiwanese investor executed a share assignment agreement for shares in a company operating in an industry that falls under the Exceptions List. Consequently, the Court held the nominee shareholding agreement unenforceable and the investor was deprived of all ownership in the company without compensation.
From these opinions, we can see that nominee shareholding is not permitted if involving an industry listed in the Exceptions List. A nominee shareholding agreement will be invalidated as an illegal contract. Foreign businesses in China get into a lot of trouble in these cases, such as when Shanghai police raided Bain & Company for violations. (BBC). How does a famous business consulting firm get in legal trouble for such basic mistakes?
A lot of these companies received legal advice and auditing from law firms where the English quality was so bad as to be misleading, resulting in non-compliant business practices. You can avoid those problems by having red flag assessments and legal memoranda translated into English by professional legal translators. Avoid relying on poorly trained internal staff or LSP freelancers when making risky decisions of this nature.
Other legal risks exist when attempting to avoid potential discrimination against foreign investors in China. Complex foreign exchange rules apply when investing in a foreign-owned entity, and failure to follow them could result in entire investment agreements being invalidated.
In a Shanghai court case, a Partnership Contract described a lawful manner for investors to invest in a partnership; however, the relevant foreign exchange transaction information showing the lawful investment could not be found, apparently due to an attempt to circumvent foreign exchange requirements applicable to foreigners. On these grounds, the court invalidated the foreign owner’s interest in the partnership.
A nominee shareholder in a foreign-owned entity can attain a declaration of its interest in an entity if three conditions are met:
(1) The beneficial owner lawfully makes an investment;
(2) Other shareholders recognize the investment;
(3) The foreign investment regulator approves of the arrangement.
Thus, the entity should ensure that its equity structure conforms to these three conditions.
Recall that foreign exchange regulation noncompliance can result in the foreign investor’s participation not being recognized. Therefore, ensure that foreign exchange compliance is always achieved when contributing capital.
Other shareholders should sign an acknowledgment of the nominee shareholder. In the 2020 case Zhang Feng v. Cheng Fengming, the beneficial owner prevailed over a nominee shareholder who alleged the agreement was ineffective, with the key evidence being that the other shareholders signed a statement recognizing the nominee agreement.
Red flag assessments are needed to ensure investment access exceptions list compliance.
Ensure that the company is not operating in an industry governed by the Exceptions List. In the 2019 Shanghai case 0115-cv-6248, a foreign national beneficial owner petitioned to be directly substituted as an equity owner in Niu Xinda LLC based on a nominee agreement. The court specifically found that the company’s business operations did not fall under the Exceptions List, and held that the defendant has standing to be directly substituted as the plaintiff in this case.
This case shows courts will treat the foreign beneficial owner of shares as the actual shareholder. Another defensive tactic is to grant a security interest in the nominee shares to a third party. The Supreme Court’s rules provide that a pledge in the nominee shares for a foreign investor shall be given effect even if not subsequently recorded.
Establish clear contract terms governing the return of the investment and any investment gains. The Rules, at §18(a), address when the nominee agreement is invalidated but the shares are worth more than the amount invested. In this case, the parties shall be awarded a fair partition of the equity.
This approach was used in a persuasive Shanghai civil judgment precedent, Gong v. Sugiura 74-cv-585 (2018). In this case, Gong was a nominee shareholder for Japanese investor Sugiura and refused to return the shares on the grounds that the agreement is ineffective. The court believed that Sugiura should receive most of the gains from the income because he bore most of the risks. Gong Yin was entitled to a portion of the gains because he invested significant effort in facilitating the investment and carrying on effective trustee work. Ultimately, the court awarded 70% of the investment gains to Sugiura and the remainder to Gong Yin.
We can see from this case how Shanghai courts will weigh the equities in arriving at a fair decision in the absence of a contract, but in this case, it does look like the foreign investor got the short end of the stick. Nonetheless, 30% of investment gains is still many times higher than the management fees that typical investors would consider accepting; therefore, the nominee agreement should explicitly define these numbers.
Potential personal liability and consequences for compliance failures.
Liquidation proceeding joint and several liability could be imposed, leading to an exit ban. Under Chinese corporate law, both beneficial owner and nominee shareholder liability can arise during liquidation proceedings or for acts and omissions prior to liquidation. Chinese courts are generally unwilling to excuse either party from liquidation liability regardless of what the nominee agreement provides. For veil-piercing purposes, the bad acts of one party can result in joint liability with the other party. For a foreign party merely attempting to avoid discrimination, that can mean an exit ban.
In Civil Appeal No. 2509 (2015), the Supreme Court held in a persuasive authority that parties are entitled to reasonably rely on the apparent ownership of the shares by the nominee shareholder, and that the contractual relationship with a beneficial owner does not run to those third parties.
The Court reasoned that nominee shareholders are legally the owners of the shares and are the liable party to creditors. A second point of reasoning is the beneficial owner does not undertake liability directly to the creditors. Thus, beneficial owner liability could, in theory, be avoided by making prior agreements with creditors, although this rarely happens in practice.
Statutory and regulatory law provides an extensive number of compliance requirements for companies, and failure to follow those compliance requirements extends to individual shareholders. Some of these requirements extend to debtor-creditor law as well. Unlike the United States and Europe, China has no personal bankruptcy law, therefore these liabilities can follow the individual until they are settled.
For foreign persons, this most notably means exit bans, which are very common in business disputes. Evidence for this was reported in an article in the MIT Sloan’s Business Review. Actions against individuals don’t stop at exit bans; under the social credit system, individuals can be prohibited from using transport systems or payment apps, and have earnings garnished. Courts have an expansive legal basis to approve such enforcement actions on beneficial owners.
Conclusion
Nominee shareholder agreements are explicitly considered by China’s Foreign Investment Act and are an encouraged way for foreign investors to get peace of mind about risks that their investments may be discriminated against. Nonetheless, there are significant compliance risks associated with using nominee agreements both from a corporate law perspective and for compliance with China’s foreign investment law.
FURTHER READING
Get authoritative insights about Chinese foreign investment law from official government guidance in translation:
For a general overview of this topic, see also CBL’s Foreign Investment FAQ.