The phrase “during the performance of an investment agreement” in this article means the process of a legal and valid investment agreement being made between an investor and a proposed invested entity (such as a company) and being performed until a circumstance occurs where the agreement shall be terminated under law or this agreement. To facilitate discussion, the “investor” is assumed “not to be a shareholder”. Legal issues connected with future investment by shareholders will be discussed in another article.

What process should a company follow to increase its registered capital during the performance of an investment agreement? Does the company need to obtain prior approval of the investor? What would happen if the company or its shareholders increase its registered capital without knowledge or approval of the investor who is not a shareholder?

This article does not discuss cases in which a well-designed investment agreement is made considering the possibility that shares in the proposed invested entity may change during the performance of the investment agreement and includes clauses governing this change. This article only discusses cases in which an investment agreement is made without considering this possibility at all.

Actually, share changes in a proposed invested company that might arise during the performance of an investment agreement include not only “capital increase” but also capital reduction, share transfer, etc. Why does this article only discuss “capital increase”?

Generally, investment, especially a premium capital increase is based on the investor’s acknowledgement of the value and prospect of the proposed invested company, but a key employee’s act of selling their shares or reducing the registered capital will certainly depreciate its value. If this act is done before the investment agreement is made, it is uncertain if the proposed investment could be achieved. Even an inexperienced lawyer could think of Article Ninety Four of the Contract Law (1999), based on which the investment agreement should be canceled and the company or its shareholders should be responsible for their breach of contract. In case of a “capital increase”, the situation is more complicated and varies in different cases.  

In case of a “capital increase” by external parties at a price lower than agreed in the applicable investment agreement, it can be assumed that the assessment of the quality of the target company is not accurate. The way of dealing with this case is similar to that mentioned in the previous paragraph and will not be further discussed. If an “anti-dilution” clause is contained in the investment agreement, the investor can cause that clause to apply.

What if the price of a capital increase by external parties is higher than that agreed in the applicable investment agreement? In this case the share structure changes at the time of signing the investment agreement. The original shareholder’s shareholding percentage is diluted and the investor’s share percentage under the investment agreement cannot be realized. If the capital increase occurred after completion of the performance of the investment agreement, the investor could exercise their right of first refusal pursuant to Article Thirty Four of the Company Law (2018). However, in this case they are not given an opportunity to exercise this right. Similarly, in case of a capital increase by the original shareholder, the investor’s right would be damaged and the investor can reasonably require that the investment agreement be canceled pursuant to Article Ninety Four of the Contract Law (1999) and the company or its shareholders take the responsibility for breach.

The real problem is that in case of a capital increase by the equal percentage by the original shareholder, the amount of the registered capital subscribed by the original shareholder would increase, which would impose more obligation on the company, and seemingly could not cause the investor’s right to be damaged, let alone causing the investment agreement to be canceled. I had this problem when dealing with a case last year. For the sake of confidentiality, some information relating to the case is omitted.  

The investor A and the game company B (with the registered capital of RMB 1,000,000 yuan) and its shareholders C, D, E, etc. signed a Capital Increase Agreement on November 15th 2016, under which A contributed RMB 4,500,000 yuan and subscribed the increased capital of Company B of RMB 111,100 yuan equal to 10% of the registered capital (of RMB 111,100 yuan) after the capital increase. The investment should be paid in two installments. The first installment of RMB 2,250,000 yuan should be paid before November 30th 2016 and the final installment of RMB 2,250,000 yuan should be paid before February 28th 2017. It was agreed to carry out procedures of the change of registration of the administration of industry and commerce after the investment funds were fully paid. A paid the first installment as agreed. In January 2017 the board of shareholders of Company B made the resolution for a capital increase from RMB 1,000,000 yuan to RMB 10,000,000 yuan (the increased capital was not paid in) and carried out procedures of the change of registration of the administration of industry and commerce. A knew the capital increase after its completion, believed that it was inappropriate and required that the Capital Increase Agreement should be canceled, Company B and its shareholders should refund the paid investment funds of RMB 2,250,000 yuan and additionally Company B should pay a breach penalty of RMB 450,000 yuan. As Company B and its shareholders did not meet Company B’s requirement, A sued them.

The proceedings lasted for about two years mainly because the appeal court remanded the case as the court of first instance failed to record the process of dealing with the defendant’s counterclaim. During the proceedings the two sides comprehensively argued against each other. One of the defendants changed his lawyer for four times. The key issue of this case was whether the capital increase by Company B in January 2017 was a “material breach”.

The plaintiff (A) claimed firmly that the capital increase from RMB 1,000,000 yuan to RMB 10,000,000 yuan by Company B in January 2017 made it impossible for A to meet the purpose of the Capital Increase Agreement and therefore was a material breach. Main reasons for this claim are as follows.

a. According to the Capital Increase Agreement, A agreed to contribute RMB 4,500,000 yuan and subscribe the increased capital of RMB 111,100 yuan. The figure 10% was was only the result of calculation based on the registered capital subscribed by A for the capital increase by Company B. The amount of RMB 111,100 yuan agreed to contribute thereunder was in legal force. If A subscribed RMB 111,100 yuan under the Capital Increase Agreement, its shareholding percentage would be 11.11/1011.11 equal to about 1% after Company B increased its registered capital to RMB 10,000,000 yuan, much less than the original objective A intended to meet when signing the Capital Increase Agreement.

b. A should subscribe RMB 1,111,100 yuan capital in order to keep its capital contribution at 10% after the registered capital of Company B increased to RMB 10,000,000 yuan. According to the Capital Increase Agreement, A only subscribed RMB 111,100 yuan of the total amount of RMB 4,500,000 yuan, with the rest (RMB 4,388,900 yuan) paid into the capital reserve shared by all shareholders, not exclusively owned by A. Therefore, A had to pay at least RMB 1,000,000 yuan in order to keep its capital contribution at 10%, against A’s original intention.

c. The parties could increase the amount of capital subscribed by A from RMB 111,100 yuan to 1,111,100 yuan to meet the expectation to hold 10% shares by amending the Capital Increase Agreement, but the court could not order the parties to make this amendment and this amendment could only be made by the parties involved reaching an agreement. This action could only address the issue of A’s shareholding percentage, which however was not all the original objectives and core interests at the time of A signing the Capital Increase Agreement.

First, the increased capital of Company B was subscribed by the original shareholder but not paid in. After March 2014, legal restrictions on the payment date of capital contributions are lifted. Shareholders of Company B agreed that the subscribed capital would be paid in decades of years later. As a result, the company’s financial status did not improve with this capital increase and liabilities owed to the company by its shareholders increased. If there are new investors in the future, upon a premium capital increase, they usually require the original shareholders to pay all their capital contributions. This would be easier to achieve when the registered capital of the company was RMB 1,000,000 yuan and RMB 1,111,100 yuan. If the original shareholder could not pay the registered capital of RMB 10,000,000 yuan, future investment would be greatly affected, against the interests of A as an investor.

Second, an increase in registered capital is accompanied by higher business risks. A company with registered capital of RMB 10,000,000 yuan can participate in a transaction that a company with registered capital of RMB 1,000,000 yuan cannot. However, if the first company remains in the same financial status as a company with registered capital of RMB 1,000,000 yuan, the company and its creditors would be in a risky and uncertain situation that would also be against its shareholders and potential shareholders. Look at the example case. Shareholders of Company B increased its registered capital to RMB 10,000,000 yuan for the purpose of obtaining a license to publish games by itself. However, it had to pay a high cost to publish games by itself. To control costs effectively the company could entrust an agent to publish games on its behalf and give the agent a share of revenue. Despite less profits, this would be a safer solution for the business that had just been started, which accorded with A’s expectation for its investment in Company B. In other words, an investor who agreed to subscribe an amount of RMB 111,100 yuan for a capital increase by a company with registered capital of RMB 1,000,000 might not agree to subscribe an amount of RMB 1,111,100 yuan for a capital increase by a company with registered capital of RMB 10,000,000.     

Third, Company B and its shareholders did not increase its registered capital to RMB 10,000,000 yuan during their performance of the Capital Increase Agreement. Upon completion of the performance of the Capital Increase Agreement, the company had its registered capital of RMB 1,111,100 yuan, of which the capital of RMB 111,100 yuan contributed by A was paid in and the rest capital contributed by A was paid into the capital reserve which could be used for share increase. When the company increased its registered capital to RMB 10,000,000 yuan, A subscribed RMB 111,110 yuan for the capital increase to RMB 4,500,000 yuan to keep its shareholding percentage at 10% as set out in the Capital Increase Agreement and the amount paid into the capital reserve would be RMB 3,388,900 yuan. The difference is as large as more than RMB one million yuan, against A’s expectation.  

At first, the defendant and its lawyer did not know well about finance, accounting and company laws and believed that registered capital was just a figure and there was no real difference between registered capital of RMB 1,000,000 yuan and that of RMB 10,000,000 yuan and therefore all they needed to do was to promise before the court to let A hold 10% shares. As all lawyers appointed by the defendant had the same opinion on this key issue, our client won in the first trial and the first and final phases of retrial.

The proceedings lasted for about two years. Lawyers appointed by the defendant in different phases of the case defend against the plaintiff’s claim in different ways that could not completely accord with each other and will not be discussed in this article because none of them hit the point. One of the defendant’s lawyer’s opinions was unreasonable but worth discussion.

Lawyers representing one of the defendants for a period of the proceedings stated that A had held 10% of shares in Company B upon signing the capital increase agreement before completing procedures of the change of registration of the administration of industry and commerce. Accordingly, when Company B increased its registered capital in January 2017, A’s capital contribution to Company B “increased” to keep its shareholding percentage at 10%.

This opinion is worth discussion not because it was a powerful argument against the plaintiff at the trial, but purely because it relates to a point that we often fail to give enough attention to.

We usually believe that a “change” is not made until completion of procedures of the “change of registration of the administration of industry and commerce”. This belief is generally accepted but against law. Article 32.2 of the Company Law (2018) states that “in case of any change of registered matters, procedures of the change of registration should be carried out and no opposition to any third party is allowed before completion of procedures of registration or the change of registration”. According to Chinese company laws, procedures of “incorporation” of a general limited liability company accord with the “opposition principle”, not “validity principle”, based on which non-completion of procedures of the change of registration of the administration of industry and commerce did not mean that A couldn’t have been a shareholder of Company B. It was also not appropriate to believe that as long as the Capital Increase Agreement was entered into, A was a shareholder of Company B. In my opinion, when deciding if A was a shareholder of Company B, at least the following factors should be considered.

a. Was the investment mutually agreed?

b. Was the agreed investment carried out?

c. Were conditions for the closing of a share transaction met? Was the transaction closed?

If the Capital Increase Agreement amounted to a unanimous agreement between the parties to make the investment, it could be assumed that the investment had been mutually agreed.

However, the investment under the Capital Increase Agreement did not fully made. According to the Capital Increase Agreement, the investment fund should be paid in two equal parts, RMB 2,250,000 yuan each, the first part to be paid before November 30th 2016 and the second part to be paid before February 28th 2017. A paid the first part but did not pay the second one. Based on this it could be concluded that the investment was not fully made. Additionally, the Capital Increase Agreement stated that “the investor A shall be obligated to make the investment, provided that (a) the result of the due diligence investigation is acceptable to the investor and (b) the investor’s decision making committee for the investment has given approval for the investment”. These clauses are included in many investment agreements mainly to protect the investors’ interests and are practically useful, at least in this case.

During the trial, we argued that the payment date of the first part of the investment funds came shortly after the execution date of the Capital Increase Agreement so that it was impossible to complete a due diligence investigation between the two dates, but to facilitate the running of Company B, A agreed to pay part of the funds first and carry out the due diligence investigation at an appropriate time later to confirm the intent of investment. The defendant insisted that A’s act of having paid the first part of the investment funds should be deemed as having completed the due diligence investigation and having issued the resolution made by the decision making committee for the investment, but gave no proof that A had carried out the due diligence investigation and issued the resolution made by the decision making committee for the investment before paying the first part of the investment funds. We submitted to the court proof that A carried out the due diligence investigation in 2017, but the decision making committee for the investment disapproved of the investigation result and decided not to make the investment. “Satisfactory completion of the due diligence investigation” and “approval of the decision making committee for the investment” could not be deduced from the act of having paid RMB 2,250,000 yuan, or otherwise the above clause was meaningless. No agreement or law required that A must approve the due diligence investigation as long as it paid the first part of the funds. Therefore, the investment agreed in the Capital Increase Agreement was not carried out and the amount paid should be refunded.

The Capital Increase Agreement did not specify the closing of the share transaction but only specified the date of the change of registration of the administration of industry and commerce. The closing of the share transaction could only be construed as “completion of the change of registration of the administration of industry and commerce”. If the agreement included a provision stating that the closing of the share transaction shall be completed by Company B issuing the Shareholders’ Register to which A shall be added, A would be a shareholder of Company B, whether the change of registration of the administration of industry and commerce was completed or not. There was no such provision in the agreement, actually.

If A was a shareholder of Company B in November 2016, the resolution for the capital increase made in January 2017 without being unanimously agreed by all shareholders or being discussed in a meeting would not have been “established” pursuant to Article Five of the Legal Interpretation (IV) of the Company Law. To seek a remedy shareholders of Company B should sue the company by claiming that the resolution was not established, canceled the change registered with the administration of industry and commerce, changed its registered capital to RMB 1,000,000 yuan and then ask for further performance of the Capital Increase Agreement. Unfortunately, the defendant’s lawyer could not prove that A had become a shareholder of Company B, and it was not appropriate to claim this point of view during the proceedings for cancellation of the Capital Increase Agreement.    

To sum up, proposed invested companies should make greatest possible efforts to avoid changes in their shares, including capital increase or reduction and share transfer. If the investment agreement is performed for a long time or needs to be modified in an emergency, it would be advisable to obtain prior written approval of the investor. Good lawyers sometimes include relevant clauses in the investment agreement to avoid unnecessary disputes.

The Contract Law and the Company Law are quite different as they were made by different authorities. Lawyers who want to practise in company law litigation cases need to have a good knowledge of at least the Company Law and four legal interpretations. Experience in litigation cases heard in No.1 Civil Court is not applicable in all circumstances. Lawyers who deal with company law litigation cases by relying only on experience in civil law and contract law litigation cases or do not know financial and accounting basics are irresponsible for their clients and themselves.