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Legal Issues Related to the Reorganization of a Limited Liability Company into a Joint Stock Limited

Date:2020-05-11 18:37:49

Chinese laws and regulations require that for a company to list on any of the three national stock exchanges, i.e. the Shanghai Stock Exchange, Shenzhen Stock Exchange, or the National Equities Exchange and Quotations (hereinafter: “NEEQ”), it meet two requirements: (1) it must be a Joint Stock Limited Company (hereinafter: “JSLC”); and (2) it must have an operating history of three years (two years for the NEEQ).

As compared to a JSLC, it is easier to setup a limited liability company (hereinafter: “LLC”) and the reporting requirements are much less onerous. As a result, many companies prefer to establish themselves as LLCs. However, if they later decide to list their company on one of the three national exchanges, they must reorganize their company as a JSLC (hereinafter: “reorganization”).

Such reorganizations are quite common, but the procedure for doing them in practice diverges from the theoretical understanding of how the procedure should work. This paper discusses: (1) how the procedure works in practice and its background; (2) the theoretical debate surrounding the nature of reorganization; (3) the author’s view of reorganizations; and (4) how to amend the procedure so as to match the theoretical understanding of the nature of reorganizations.

I.    Reorganizations in Practice

As reflected in documents released by the three national stock exchanges, reorganizations generally require the following steps.

1.    Audit and Valuation

•    Determine a date for the audit and valuation.
•    Hire institution(s) to conduct the audit and valuation.
•    The institution(s) review the LLC and issue audit and valuation reports.

2.    Shareholders’ Meeting

•    Convene a meeting of the LLC’s shareholders.
•    The shareholders pass a resolution to convert the LLC into a JSLC by converting the entire original book value of its audited net assets.

3.    Promoter’s Agreement

•    The shareholders of the LLC execute a promoters’ agreement that contains terms pertaining to the name, address, business cope, [mode of establishment], asset investments, proportion of ownership, and rights and liabilities of the promoters.
•    As a result, the shareholders become promoters of the JSLC.

4.    Verify Capital Contributions

•    Hire an accounting firm to verify the capital contributions and issue capital verification certificate.

5.    Founding Meeting

•    Convene a founding meeting, deliberate on and pass a resolution confirming the articles of association and the rules of procedure of the JSLC and elect new board members, supervisors, etc.
 
6.    Registration

•    Go through the registration formalities to alter the registration particulars.

II.    Background to the Current Reorganization Process

Companies follow the procedure described in Part I is because it was required by the Company Law of the People’s Republic of China (2004) (hereinafter: “2004 Company Law”). Article 98 of the 2004 Company Law states:

A limited liability company that is reorganized into a joint-stock limited company shall meet the requirements stipulated herein and shall go through the procedures stipulated herein.

The “procedures stipulated herein” refer to the procedures for setting up a new JSLC.

Nonetheless, it is not clear why a founding meeting (step 5 above) is necessary. The Company Law creates two methods for the formation of a JSLC: (1) by promotion; and (2) by public offering. Founding meetings are only necessary when establishing a JSLC via public offering which reorganizations are not. The author believes that founding meetings are nevertheless convened because of regulations given by the China Securities Regulatory Commission which requires lawyers to comment on whether or not the procedures and matters discussed at the founding meeting are were in accordance with the law, regulations, and regulatory documents. As such, financial intermediaries have combined the procedures for establishing a JSLC through public offering and promotion.

III.    Views on the Nature of Reorganizations

Experience shows that, in practice, companies that wish to list on the national stock exchanges follow the procedure described in Part I. However, the theoretical debate about the procedure for reorganization centers on the question of whether or not the JSLC that results is a continuation of the LLC or an entirely new entity.

Article 9, ¶2 of the Administrative Measures for Initial Public Offerings and Listing of Stocks states that:

Where any limited liability company is converted into a joint stock limited company by converting the entire original book value of its net assets, the relevant term for its business operations may be calculated as of the date on which the limited company [is][was] established.

The use of the word “may” indicates that the JSLC might, or might not, be a continuation of the LLC.

As evidence that the JSLC is a new company, one could look at Article 22 of the Administrative Provisions on the Registration of the Registered Capital of Companies (Order of the State Administration for Industry and Commerce of the People's Republic of China [2005] No.22, expired) which states that:

If … a limited company is changed into a JSLC, the total amount of paid-in equity converted shall  be  no more  than the  amount of net  assets of  the  company. The  net assets of a … limited company shall be subject to the assessment-based pricing of a capital assessment institution that has the qualification for making assessments, and shall be verified by a capital verification institution.

Verification by a capital verification institution is generally only required for either the setup of a new company or the change in the registered capital of a company. In this case, even though the amount of registered capital may not be changing, the capital verification procedure is still required, indicating that the reorganization is being treated as the setup of a new company.

Nonetheless, the author believes that when a reorganization occurs as a result of a resolution of the Board of Shareholders (as specified in Article 37(9) of the Company Law of the People’s Republic of China (2013) (hereinafter: “2013 Company Law”)), the resulting JSLC is a continuation of the LLC for the following reasons:

1.    The 2013 Company Law only has two ways to create a new JSLC: (1) promotion; and (2) public offering. A reorganization is neither of these.

2.    Article 9, which discusses the conversion of LLCs into JSLCs (and vice-versa) stipulates that “the claims and debts of the company prior to the conversion shall be succeeded by the company after the conversion.” If the JSLC were a new company, it would not make sense for it to take on the LLC’s claims and debts.

3.    A JSLC established through reorganization is required to go through the procedure for amendment rather than incorporation.

IV.    Recent Changes in the Law Regarding Reorganization

Recent changes in Company Law and Administrative Provisions on the Registration of the Registered Capital of Companies also supports the author’s interpretation that the JSLC that results from a reorganization is a continuation of the prior LLC.

1.    The 2005 amendment to the Company Law removed the requirement that an LLC converting to a JSLC must both meet the requirements of a JSLC and go through the procedures stipulated in the Company Law. Instead, Article 9 of the Company Law of the People’s Republic of China (2005) (“2005 Company Law”), only the requirements must be met.

2.    The 2014 amendments to the Administrative Provisions on the Registration of  the Registered Capital of Companies removed the requirement in the prior version that, when an LLC is being converted to a JSLC, “[t]he net assets of a former … limited company shall be subject to the assessment-based pricing of a capital assessment institution that has the qualification for making assessments, and shall be verified by a capital verification institution.” As discussed in section III above, the verification procedure is necessary for the establishment of a new company or a change in registered capital.

3.    The amendment to the Circular on Releasing Specification for Registration Material of Domestic Enterprises and Standardization of Registration Files with the State Administration for Industry and Commerce also removed the need for a capital verification report.

The second and third amendments discussed above were made in reaction to the 2013 amendment to the Company Law which removed the need for capital verification reports except for JSLCs being established through public offering. However, in the 2005 amendments for the company law already removed the need for JSLCs being established through reorganization to follow the procedures laid out for creating a new JSLC.

V.    Proposals for Modification

As argued above, a reorganization is the transformation of a company, not the creation of a new one. In addition, the relevant laws and regulations have been amended. As such, the procedure for reorganization should be revised as follows:

1.    Audit

    •    Determine a date for the audit.
    •    Hire institution(s) to conduct the audit.
    •    The institution(s) review the LLC and issue audit reports.

2.    Shareholders’ Meeting (same as step 2 above)

•    Convene a meeting of the LLC’s shareholders.
•    The shareholders pass a resolution to convert the LLC into a JSLC by converting the entire original book value of its audited net assets.

3.    Convene a shareholders’ meeting (not a founding meeting), deliberate on and pass a resolution confirming the articles of association and the rules of procedure of the JSLC and elect new board members, supervisors, etc. (corresponding to, but not the same as, step 5 above)

4.    Go through the registration formalities to alter the registration particulars (same as step 6 above).


Documents released by the NEEQ show that some companies have tried to simplify the procedure or reorganization. For example, Shandong Wantong Hydraulic Co., Ltd (hereinafter: “Shandong Wantong”) released a document entitled “Additional Legal Submissions about Shandong Wantong Hydraulic Co., Ltd Applying for Listing on NEEQ to Transfer its Stocks in Public” related to their listing on the NEEQ. This document shows that during the process of listing, the NEEQ requested that Shandong Wantong provide a valuation report. The financial intermediary replied that, under the new regulations, a valuation report is no longer necessary. The NEEQ accepted this and allowed Shandong Wantong to list without this report.

As can be seen from the case above, companies have had some success in simplifying the procedure for reorganization. However, the old procedures persist. In the example above, the company merely simplified the procedure of valuation and even this led to a request by the NEEQ. Had a company failed to execute a promoters’ agreement or convene a founding meeting, the company would have faced considerable pressure. Thus, prudent financial intermediaries will recommend that the company fully comply with the procedure laid out in the first part of this article.

In order to truly simplify the procedures for reorganization and reduce the costs of entering capital markets, the China Securities Regulatory Commission must issue documents describing a new, simplified, procedure. Only then can companies and financial intermediaries reduce the costs of entering capital markets.
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