Professional Interpretation

Prelude: Persons hold equity for actual investors, also known as equity entrustment. it refers to the actual investors and others agree to hold the equity in the name of the latter. Equity entrustment is very common in practice, the dispute settlement team of Docvit Firm explore the reasons behind such phenomena through systemic analysis, and the recognition of such entrustment from the perspective of legislation and jurisdiction to provide reference for enterprises.

The Reasons for the Equity Entrustment

Part of the reasons for the equity entrustment is that the law prohibits certain specific profession staff being shareholders of enterprises, such as "Civil Servant Law", " Police Law of PRC", "Securities Law" and so on, in addition, China's law clearly stipulates that foreign capital is restricted or prohibited in certain industries, that is to say, foreign individuals or foreign legal entities cannot enter certain industries and become shareholders.

It is also partially due to that the Company Law provides for the protection of minority shareholders' interests and the cap on the number of shareholders. To circumvent these statues, then the equity will be concentrated its ownership in the hands of one or a few individuals instead of more actual shareholders. It may also be that, to reduce the frequent shareholding changes caused by resignation of staff or improve the efficiency of decision-making, thus the staff shareholder’s equity entrusted by the company management as a result. Equity entrustment appearing on the stock market may mainly be evasion of the sales restriction period of shares and requirements of the voting procedures of associated transactions. And equity entrustment exists may also be that actual investors want to keep unknown and anonymous. Sometimes it even becomes a concealed form of benefit transfer, such as bribery.

It is possible that the nominal shareholder on the behalf of the actual investor may either be an individual or the entity.

At first glance, the equity entrustment and the property trust may seem similar. Article 2 of the Trust Law of PRC stipulates Trust refers to the act in which the trustor, entrusts the certain property rights to the trustee based on his trust in the trustee, according to the intentions of the trustor, for the benefit of the beneficiary or for a specific purpose, to conduct management or disposal. The difference between the two is that equity entrustment is not only the property right, but also with the character of the shareholder's personality. Equity entrustment involves two parties, the nominal shareholder and the actual shareholder. The trust may involve three parties, trustor, trustees, and beneficiaries. In addition, equity entrustment is generally hidden and the Trust is open. The trust relationship can be directly governed by the Trust law, and the equity entrustment can only be adjusted by rules and provisions of civil law.

Recognition of Equity Entrustment from Legislation Perspective

Generally speaking, parties to the Equity Entrustment Agreement will determine their rights and obligations of both parties in the agreement. Article 25 of Provisions of Supreme People's Court on Several Issues Concerning the Application of the Company Law of the PRCIIIis a clearer stipulation on such agreements until now, which stipulates that "the actual investor of a limited liability company signs a contract with a nominal investor, they agree that the actual investor shall enjoy the investment interests while nominal investor is just the shell of real investor, and if dispute arising from the validity of the contract between two parties, in the absence of circumstances stipulated under Article 52 of the Contract Law, the people's court shall hold the contract valid. The actual investor and the nominal shareholder as stipulated in the preceding paragraph have disputes over the entitlement of investment interests and the actual contributors claim rights on the ground that they actually fulfill the capital contribution obligations, the people's court shall support his/her claim. The nominal shareholder denies the rights of the actual investor with the excuse of his/her name recorded in the register of shareholders of the company and be registered in the company registration house, he/she will not be supported by the court. The actual contributor asks the company to change the shareholder and issue the capital certificate, his/her name stated in the register of shareholders, recorded in the articles of association of the company and registered with the company registration authority, unless with the consent of more than half of the other shareholders of the company, the people's court shall not support. "

In addition, the Supreme People's Court also confirmed in the form of communiqué the following guidelines for referees: (1) In the case that there is an equity entrustment relationship with the target company's equity, the "hidden shareholders" require their nomination, and their nominal shareholders and other shareholders agree such request, it will be supported by the court (Wang Cheng and FuYang, Anhui HuaFangHeTai Real Estate Development Co., Ltd. shareholder qualification confirmation dispute); (2) the creditors of nominal shareholders apply for compulsory enforcement of the equity, the anonymous shareholder requiring the cessation of enforcement on the ground that he/she is actual obligee, the court will not support (Harbin National Grain Exchange Center and Branch of Sci&Tec Co., Ltd. of the Harbin Bank enforcement dispute).

Article 14 to Article 20 of the Provisions of the Supreme People's Court on Several Issues concerning the Trial of Disputes Concerning Foreign-Funded Enterprises provide more detailed rules on the adjudication of equity entrustment in the field of foreign investment.

In addition, the equity entrustment agreement is also a type of agreement, so it is also subject to the provisions of Article 52 concerning the invalid contract of the Contract Law.

In the field of securities, Article 13 of the Measures for the Administration of Initial Public Offering and Listing stipulates provides the issuer's shareholding is clear-defined. There are no major ownership disputes over the title hood of the issuer’s shares as held by its controlling shareholders, or by the shareholders under the control of its controlling shareholders of the actual controller. Article 1 of Chapter II of the "Business Rules for the Share Transfer System of the National SMEs" stipulates that enterprises applying for listing in the national share transfer system must have "a clear shareholding structure and lawful compliance with the issuance and transfer of shares. Many comments therefore incline to conclude that the equity entrustment is forbidden in this area, but the author believes that the terms "clear-defined equity" are not accurate and therefore do not show that regulators negative attitude to equity entrustment.

Judicial Determination of Equity Entrustment

Generally, the actual investor and the nominal shareholder will sign an agreement to clarify the rights and obligations of both parties. How does the law recognize such agreement and once the actual investor, the nominal shareholder and the target company have disputes arising from the agreement, how can the court decide?

There are thousands of cases that appear in the case database if you search the key word " equity entrustment." Examining these cases, we can see that the court will generally support the validity of the equity entrustment agreement and the property rights of the anonymous shareholders. Meanwhile, equity entrustment has close connection with the shares transfer, shareholders’ status confirmation, etc.

Among them, a case, where BoZhi Capital Fund Co., Ltd. (hereinafter referred to as BoZhi Company) and HongYuan Holding Group Co., Ltd. (HongYuanCompany) are two parties of the dispute, which is trialed by the Beijing Higher People's Court of First Instance and the Supreme People's Court for the second instance. BoZhi Company filed suit against HongYuan Company many times because there is a key premise of the dispute between the two parties, that is, the validity of the equity entrustment agreement. The basic facts of the case are as follows: In 2005, BoZhi Company and HongYuan Company signed the Entrusted Investment and Custody Agreement, which stipulates that HongYuan Company hold 9% equity of Xinhua Life Insurance on behalf of BoZhi Company. Based on this, BoZhi Company will make a payment to HongYuan as consideration. Later BoZhi companies and HongYuan companies have dispute on profit of equity investment. In the trial of the case, the court investigated the validity of the "Entrusted Investment and Custody Agreement" signed by BoZhi Company and HongYuan Company and the ownership of 9% of Xinhua Life Insurance equity.

BoZhi has received the support of the Higher People's Court in the first instance and the Supreme People's Court negative decision in the second instance. In the final judgment of the Supreme People's Court, it states that although the above agreements are based on the true intentions of both parties, while ownership of equity should be determined according to lawful investment and cannot be freely agreed upon by the parties. Therefore, although the parties agree that the relationship is the relationship of equity entrustment in the agreement, it cannot be concluded as so and the relationship between the two parties should be deemed as the contract of investment entrustment. The Supreme People's Court further argue that although HongYuan Company was entrusted by BoZhi to invest Xinhua Life Insurance, however, HongYuan Company did not invest in the name of BoZhi, nor registered the equity involved in the BoZhicompany's name, but to Invest and register of the equity involved in its own name, and the investment has not only been approved by the China Insurance Regulatory Commission, HongYuan also participated in the management of Xinhua Life Insurance in its name, fulfilled the obligations of shareholders and exercised the right of the shareholders, therefore, it cannot be considered that the equity involved are owned by BoZhi, it shall be deemed to be enjoyed by the HongYuan Company

Frankly speaking, the opinion of the Supreme People's Court is a surprise. As a hidden shareholder in this case, BoZhi did not violate the restrictive provisions on the equity of foreign capital entering the insurance company under the laws of our country. The agreement itself also did not violate the provisions of the Contract Law. In fact, The Supreme People's Court also considered the agreement true and effective, but it completely denied the principle of "the free intention of the parties" and held that ownership should not be freely agreed upon by the parties. As for the further discussion, that HongYuan Company invested, registered equity and participate the management of the target company with its own name, to fulfill the obligations of shareholders and to exercise the rights of shareholder, all are exactly the strong proof to prove that HongYuan Company perform his duties of nominal shareholder, and it is the proper way of equity entrustment. However, in the Supreme People's Court’s opinion it has become the proof of HongYuan company being the owner of the equity involved, and come to conclusion that HongYuan company should enjoy equity. It is difficult to understand. As for the Supreme People's Court's ending, "the question of equity ownership and entrusted investment is a two-tiered legal relationship. The former is formed by legal investment and the latter is formed by the contractual conduct between the parties." It is more beyond the reasonable sense. Equity entrustment and investment entrustment has the similarity while of their own properties. In this case, BoZhi established the behavior of the equity investment by signing equity entrustment agreement, it is valid and binding. The supreme law's decision on the case is hard to justify. The writer presumes that the decision of this case is perhaps affected by the target company, which is a listed company, if BoZhi Company be supported, then it will affect the people’s reliance to rules of transparency of listed companies, it equivalently to recognize the equity entrustment can exist in the securities field?

Risk of Equity Entrustment

In fact, from the above example，can be seen that the equity entrustment is at a significant risk. HongYuan Company swallowed the equity transfer proceeds by using capital increase and transfer of equity, etc, however, BoZhi Company’s rights has been disclaimed because HongYuan Company did not act according to instructions of the hidden shareholder. In general, both parties have risks in equity entrustment as follows:

Risks for actual investor: It is hard for the actual investor to establish his/her shareholder identity, although the judicial interpretation affirms the validity of the agreement, the investment rights and interests are not the same as the shareholders' rights and interests, the investment rights and interests can only be claimed to the nominal shareholders, but not directly to the target company. There are some limitations. According to the interpretation of the Company Law, only half or more than that of the shareholders of the Company agree that the actual investor may request the court to change the shareholder, issue a capital contribution certificate, record it in the register of shareholders and request the company registration authority to handle with registration.

Risk of Nominal shareholders encroach on the actual investor's interests, generally in the equity entrustment, the actual investors are behind the scenes, and the nominal shareholders exercise their rights on behalf of the real investor. Facing all kinds of temptations, it is quite possible that the nominal shareholders will infringe on the actual investors’ interests. For example: Nominal shareholders do not give asset returns to real investors, abuse shareholder rights (major decisions are not negotiated), dispose of equity at his own discretion (as in the above example).

There are also risks for nominal shareholder, should the actual investor fail to fulfill its contribution obligation, if the creditor claims, the nominal shareholder needs to undertake the obligation of repaying the contribution and cannot refuse to assume the liability on the ground that he/she is not the actual investor. Therefore, the nominal shareholders should clearly learn about the actual investor's identity and correctly judge whether the latter meets the legal conditions of becoming a shareholder, whether the company operation is compliant with the laws and the rules, etc., to avoid being a "white glove" in which others engage in illegal business.

In summary, from the above analysis, it can be seen that the effectiveness of the equity entrustment agreement is generally recognized by law; the property rights of the actual investors are generally supported by the court; the actual investors decide to be nominated on the registrar should follow the certain procedures; there are risks for both party to equity entrustment agreement.