Professional Interpretation

Abstract: Related transactions are widely existing in market economy. According to the principles of market economy, all transactions between enterprises should be conducted in market competition. In the related transaction, there are various correlations between two parties, and the transaction is not conducted under the conditions of fully public competition, which, objectively, may bring about good or bad influence to the enterprise. Taking "LETV Crisis" as an example, Corporate Business Team of Beijing Docvit Law Firm interprets the relevant provisions of company's related transactions and analyzes legal risks existing in related transactions for your reference.

I. LETV fell into arrears, capital crisis attracting attention again

Recently, the news from Internet revealed that LETV owed Jiangsu Branch of China Mobile's RMB14.2625 million IDC, the resource rental fee, which could not be repaid in time, or the flow port might be turned off. The document called "the Report on Jiangsu Branch of China Mobile Turning off IDC Resources of LETV shows Letv is one of TOP55 key Internet customers regulated by group enterprise company, currently leasing 30 cabinets and 290G bandwidth of Jiangsu company in Nanjing, Suzhou and Wuxi. Since July 2016, LETV has been owing rental fee of IDC resources, as of May 2017, the total amount of fee in arrears in Jiangsu is RMB 14.2625 million yuan, has seriously harmed the interests of the company. Since April 2017, Group Client Dept. of Jiangsu Branch will collect long-term overdue bills of LETV, at the end of April, together with Company Office and Strategic and Legal Affairs Dept., sent an official letter to LETV, but LETV itself is in a predicament with cash flow strains, can’t keep payment commitments all the times.

Since capital chain rupture happened, Letv arrears problem has been disclosed for a few times, and Letv 2016 Annual Report, which attracted much attention previously, to a certain extent, seems to have shown its capital problem.

On April 19, le.com released 2016 Annual Report, then, the Shenzhen Stock Exchange sent le.com an inquiry letter about the annual report, involving accounts receivable, prepaid accounts and related transactions, prediction of future earnings and cash flow, etc., among which, related transactions is one of major concerns of Shenzhen Stock Exchange. The data of 2016 Annual Report of le.com shows that its related transactions increased greatly and top 5 customers are all its affiliated parties, in 2016, the sales volume with affiliated parties accounted for more than half of full-year revenue. That is to say, more than half of the revenue of le.com in 2016 came from related transactions.

As shown from the public information, three main characteristics of related transaction of Letv are: many affiliated enterprises, big amount of related transactions, various types of related transactions.

1. Many affiliated enterprises. The transactions between listed companies and related parties are related transactions. The affiliated parties may be the controlling shareholders and their relatives, or they may be enterprises related to listed companies, such as subsidiaries, grandson companies, joint venture enterprises, etc. According to the 2016 Annual Report, there are at least 90 affiliated enterprises in Letv (see picture below).

2. Big amount of related transactions. According to verification opinions of Zhongde Securities on related transactions of Letv, in 2016, the trading amount of Letv as a buyer is 7.498 billion, the trading amount of Letv as a seller is 12.868 billion, the total amount of affiliated transactions exceeds 20 billion. In addition, as shown from the report, in the revenue of 21.987 billion in 2016, accounts receivable are 8.686 billion. The accounts receivable from affiliated parties are 3.798 billion yuan. In other words, at least 17% of the profit of Letv in 2016 came from the "asset transfer" between the enterprises within the group, from left hand to the right hand.

3. Various types of related transactions. The related transactions of Letv basically cover the types of related transactions, including but not limited to: (1) buy or sell goods or other assets; (2) provide or receive services; (3) the lease; (4) guaranty (5) borrow money from each other.

II. Interpretation of relevant provisions of related transactions

Related transactions generally refer to transactions that are carried out between different main bodies with investment or contractual relationships, also referred to as related-party transactions. A company's related transactions are an economic activity. The normal related transaction can stabilize the business, spread the operation risk and benefit the company's development; But, in practice, controlling company makes use of affiliated relations and controlling position to force subordinate company to transact with itself or other affiliated parties, and therefore harms the interests of subordinate companies and minority shareholders. Regarding this, corporate laws of all countries have the relevant complex or simple provisions of related transaction, adjust affiliated relation, protect the interests of subordinate companies and minority shareholders.

In civil law countries, there are more detailed rules on personnel control, accounting principles and financial control of the company, and the court can make decisions in accordance with the provisions of the law. In Anglo-American law system countries, because of the high discretion of the judge and the law-making function, the decision can usually be made by the judge according to the actual circumstances of the case, so the latter’s control of related transactions is shown in the case law.

With the development of economy, the scale-up of company and the increasingly complex internal structure of company, related transactions in our country is gradually increasing; Especially in larger companies and listed companies, it happens more. Some of the company's major shareholders, actual controller and managers, through related transactions with the company, embezzle company capital, provide guaranty for themselves or affiliated parties, by manipulating trading conditions, transfer company’s profits to affiliated parties, severely harms the interests of company, minority shareholders and creditors.

As to the definition of affiliated relations and affiliated parties, definition standards required by regulation are different in accordance with different laws and regulations. For example, the accounting standard focuses on financial accounting and post-disclosure to reflect the financial information of a complete accounting entity; Tax rules focus on determining transfer pricing and accounting income tax to avoid harming state taxation; The rules of securities focus on decision-making process and prior disclosure, in order to prevent the related transactions from harming the interests of listed companies and medium and small shareholders. The relevant provisions of related transactions are interpreted mainly from accounting, tax law and corporate law as follows.

 (I) Identification of affiliated parties in the financial accounting system

Article 3 of the Accounting Standards for Enterprises No. 36 - Affiliated Party Disclosure stipulates, if one party controls, jointly controls the other party or exerts significant influence on the other party, and two parties or more than two parties are controlled, jointly controlled or exerted significant influence by one party, affiliated parties come into being.

The control here refers to the right to determine the financial and business policies of an enterprise and to obtain profits from the operation of the enterprise. A significant influence refers to the power to participate in decision-making on the financial and operational policies of an enterprise, but it does not determine these policies.

The ways to participate in decision-making mainly include: send representatives to the board of directors or similar organizations, who participate in the policy-making process, exchange managers, etc. The act of transferring resources, services or obligations between the above affiliated parties, whether or not to collect the price, is regarded as a related transaction.

In terms of accounting standards, if one party controls, jointly controls the other party or exerts significant influence on the other party, and two parties or more than two parties are controlled, jointly controlled or exerted significant influence by one party, affiliated parties come into being. As per accounting, if the shareholding ratio reaches 20% - 50%, it is regarded as exerting significant influence, if it is more than 50%, it is regarded as control. So basically as long as the controlling shareholder control or jointly control more than 20% of the shares of other companies, it is affiliated party.

 (II) Identification of affiliated parties in the tax law

Article 41 of Enterprise Income Tax Law stipulates, the businesses between the enterprise and its affiliated parties are not in conformity with the principle of independent transaction and reduce taxable revenue or income of the enterprise or its affiliated parties, the tax authority shall have the right to adjust according to the reasonable method. When the enterprise and its affiliated parties jointly developing or accepting intangible assets, or jointly providing or accepting labor services, the cost incurred shall be apportioned when calculating the taxable income in accordance with the principle of independent transaction.

Article 109 of the Implementation Regulations of Enterprise Income Tax Law stipulated, affiliated parties mentioned in Article 41 of Enterprise Income Tax Law refers to enterprises, other organizations or individuals which have one of the following affiliated relations with enterprise : 1. have direct or indirect control relation in capital, operation, purchase and sales; 2. Directly or indirectly controlled by the same third party; 3. Other relations that are associated with interest.

 (III) Identification of affiliated relation in the corporate law

Item IV of Article 216 of the "company law" stipulates, affiliated relation refers to the relation between controlling shareholders, actual controllers, directors, supervisors and senior management personnel and the enterprise they directly or indirectly control, and other relation which may lead to transfer of corporate interests. However, the state holding enterprises don’t have affiliated relations between them because their shares are controlled by the state.

According to the regulations of the corporate law, affiliated parties refer to the controlling shareholders, actual controllers, directors, supervisors and senior management personnel controlling the enterprise directly or indirectly.

Article 21 of the Corporate Law stipulates that the controlling shareholders, actual controllers, directors, supervisors and senior management personnel of the company shall not use their affiliated relations to harm the interests of the company. If the violation of the preceding article causes losses to the company, they shall be liable for compensation.

The above regulations reflect the basic attitude of our corporate law on related transactions, that is to prohibit improper related transactions. Such provision on related transactions in Corporate Law is a realistic choice made for the system after measuring the rationality and harmfulness that may exist in transactions, especially under the condition of growing unfair related transactions.

Article 125 of "Corporate Law" stipulates, if directors of listed company have affiliated relation with the enterprises which are involved in the resolution of board of directors, the directors shall not exercise their voting rights for the resolution, nor shall exercise their voting rights on behalf of other directors. Such specific operational provisions provide effective regulatory tools to prevent improper related transactions.

In addition to the above regulations on related transactions and affiliated relations, the regulations of corporate law on shareholder lawsuits, shareholder representative lawsuits, cumulative voting system, independent director system, the provisions on guaranty of the shareholders and actual controllers, etc., also can help adjust improper related transactions of company.

 III. Legal risk analysis of company related transactions

 (I) Identification of illegal related transactions

In the cases involving related transactions in the people's court, how to determine the illegal related transaction is the entry point and key of the trial involving related transaction cases. Article 21 of the corporate law stipulates: "the controlling shareholders, actual controllers, directors, supervisors and senior managers of the company shall not use their affiliated relations to harm the interests of the company." The regulation establishes the legal basis and the principle of regulating related transactions, outlines the boundaries between legal related transactions and illegal related transaction, namely "harm the interests of the company" is a fundamental standard of illegal related transaction.

In practice, illegal related transactions harm not only the interests of the company, but also those of minority shareholders and those of creditors, which fall into the category of illegal related transaction. In judicial practice, it is possible to judge whether the related transactions are lawful or not based on the following aspects:

1. The procedural requirements to judge whether the related transaction violates legal provision. Procedural requirements are legal requirements for the behavior process of related transaction, in order to restrict the illegal behavior in related transactions, the process conditions for behavior process of related transactions in all countries are provided, i.e., the disclosure and approval system of related transactions.

Although full disclosure of information is the key to secure justice and fairness of related transactions, to disclose or not is not necessarily associated with whether the related transactions, in essence, are fair and just or not, that is to say, even failure to fulfill the disclosure obligations in related transactions, it shall not necessarily causes invalidity of related transaction behavior; Approval system of related transaction is different from disclosure system, the corporate law in all countries stipulates approval of related transactions, i.e., related transaction behavior of the company needs to be approved especially, after being approved by meeting of shareholders and the board of directors, related transactions can be implemented and have the force of law, otherwise become nullified.

2. Whether the related transaction behavior violates the provisions of laws and administrative regulations. If related transaction itself violates the prohibitive or mandatory regulation of laws and administrative rules and regulations, it obviously belongs to illegal related transactions, for example, company directors and senior managers enter into a contract with the company or conduct transactions, in violation of the provisions of the company's articles of association or without the consent of the shareholders' committee, general meeting of shareholders, .

3. Whether the motivation for related transaction is justified. Motivation is the idea of motivating a person to engage in some kind of behavior. The thought is ideology, although it is not easy to grasp, can be judged according to the behavior of affiliated party. This is actually the standard of good faith and malice in civil law. Related transactions actually involve the interests of the affiliated parties. In the event of a transaction, it is inevitable that there will be a case of a person violating the transaction obligations. In judicial practice, ought to judge the legitimacy of related transactions according to whether the purpose of affiliated party transaction behavior is proper, whether motivation for transaction is to manipulate market, transfer profits or property, present false statements, evade tax.

Whether related transaction itself violates the rules. The so-called violation of regular transactions, i.e., based on business trading habits the transaction conditions are clearly improper. How to determine whether trading behavior is an unconventional trading activity? In judicial practice, how to evaluate the market price, what procedure you need to perform, if there is no fair and scientific evaluation mechanism, both parties themselves determine an intermediary institution to assess the results they need, it is bound to harm the interests of the company and the creditors. Therefore, the people's court should refer to the market trading practice and refer to the appraisal opinions of professional audit and evaluation bodies. In the event whether related transaction itself violates the rules, the court judges whether the trading behavior of associated traders bring to the company real or obvious possible loss based on transaction structure. The obvious possible losses shall be paid particular attention.

 (II)  Risk prevention measures for related transactions of company

Related transactions have long been widespread in many companies. In order to avoid risks, companies shall pay attention to the following points in related transactions:

1. Authenticity of related transactions. True related transactions refer to the fact that there is a motivation for real transaction, which is consistent with business practices. The false related transaction not only deviates from the interests of company, but also often hides the violating and illegal factors. For example, some companies make up nonexistent transactions to transfer income and apportionment expenses, or settle interest charges through mutual funds. Once discovered, the company faces penalties and the company's credit is affected. Therefore, companies shall pay attention to the authenticity of related transactions.

2. Focus on the disclosure of related transactions. The existence of related transactions is not the focus of attention, and the timely, in-depth, complete and accurate disclosure of related transactions has become the focus of public investors' attention and the focus of the supervision department. Only by insisting on the principle of focusing on disclosure instead of existence, the company can make the company run more robustly.

3. The necessity and fairness of related transactions. The necessary related transactions are indispensable for the existence and development of the company, such as: comprehensive service agreement, purchase or lease agreement replied on by the main business, etc. This kind of related transaction is also the related transaction making company go forward, meanwhile, also the fairness of the related transaction shall be considered.

4. Focus on protecting the interests of small and medium shareholders in related transactions. In practice, related transactions occur between new and old controlling shareholders and their affiliated parties. Although the controlling shareholders are not different from other shareholders in the quality of rights, it is only the difference in quantity, their rights are superior to those of ordinary shareholders. Related transactions tend to harm the interests of small and medium shareholders, if this problem can’t be dealt with well, it will arouse dissatisfaction of small and medium shareholders, may ensnare the company in litigation, will affect the company's reputation, and hinder to the development of the company.

IV. Summary and reflection

The company's related transactions are inevitable, in general, the company can reasonably make full use of related transactions to bring benefits to the enterprise. Therefore, legal related transactions become an important means for high unification of economy, convenience and efficiency. But related transactions are a double-edged sword for companies. In the long run, the consequences of related transactions will also have an adverse impact on the company, and there are many legal risks. Companies should be cautious in dealing with related transactions so as not to swamp the company.