The Shareholder Disqualification System under the Company Law: Legal Interpretation and Practical Application

Author: Li Heng

With the formal entry into force of the Company Law of the People's Republic of China (hereinafter referred to as the "new Company Law") on July 1, 2024, the shareholder disqualification system, as an important legal innovation, aims to strengthen the management of shareholders' capital contributions, maintain the adequacy of the company's capital, and protect the legitimate rights and interests of other shareholders, the company, and creditors. This article will, in light of the relevant provisions of the new Company Law, provide a detailed analysis of the legal basis, applicable conditions, specific operation procedures, and practical applications of the shareholder disqualification system, with the hope of offering useful reference for corporate governance.

I. Legal Basis of the Shareholder Disqualification System

A. Statutory Provisions

Article 51 of the new Company Law stipulates that after the establishment of a limited liability company, the board of directors shall verify the capital contributions of shareholders. If it is found that a shareholder fails to pay in full and on time the capital contributions as stipulated in the company's articles of association, the company shall issue a written notice of demand for payment of capital contributions to the shareholder. If the obligations specified in the preceding paragraph are not fulfilled in a timely manner, causing losses to the company, the directors responsible shall bear compensation liability.

Article 52 of the new Company Law stipulates that if a shareholder fails to pay the capital contributions by the due date as specified in the company's articles of association, the company may, when issuing a written notice of demand for payment of capital contributions, specify a grace period for payment of capital contributions. The grace period shall be not less than 60 days from the date of issuance of the notice of demand by the company. If, upon the expiration of the grace period, the shareholder still fails to fulfill the obligation of capital contribution, the company may, by resolution of the board of directors, issue a written notice of disqualification to the shareholder. The notice shall be issued in writing. As of the date of issuance of the notice, the shareholder loses the equity corresponding to the unpaid capital contributions. The equity lost in accordance with the provisions of the preceding paragraph shall be transferred in accordance with the law, or the registered capital shall be reduced accordingly and the equity shall be cancelled. If the equity is not transferred or cancelled within six months, the other shareholders of the company shall pay the corresponding capital contributions in full in proportion to their capital contributions. If a shareholder has an objection to the disqualification, the shareholder shall file a lawsuit with the people's court within 30 days from the date of receipt of the notice of disqualification.

B. Evolution of the System

In the sense of the company code, this article is a newly added provision. In terms of the evolution of the substantive rules, this article is an improvement of the "shareholder expulsion" system in Article 17 of the Interpretation of the Supreme People's Court on Several Issues Concerning the Application of the Company Law of the People's Republic of China (III). Article 17 of the Interpretation of the Supreme People's Court on Several Issues Concerning the Application of the Company Law of the People's Republic of China (III) states: "If a shareholder of a limited liability company fails to perform the obligation of capital contribution or withdraws all of his capital contributions, and after the company has urged him to pay or return the capital contributions, he still fails to pay or return the capital contributions within a reasonable period, and the company, by resolution of the shareholders' meeting, terminates the shareholder's qualification as a shareholder, and the shareholder requests to confirm that the termination is invalid, the people's court shall not support it. Under the circumstances specified in the preceding paragraph, when making a judgment, the people's court shall explain that the company shall promptly go through the legal procedures for reducing the registered capital, or other shareholders or a third party shall pay the corresponding capital contributions. Before the company goes through the legal procedures for reducing the registered capital or other shareholders or a third party pays the corresponding capital contributions, if the company's creditors request the relevant parties to bear corresponding liabilities in accordance with Article 13 or Article 14 of these Provisions, the people's court shall support it."

C. Comparison of the Systems

In terms of the substantive regulatory significance, this article is an improvement of the shareholder expulsion system for limited liability companies in Article 17 of the Interpretation of the Supreme People's Court on Several Issues Concerning the Application of the Company Law of the People's Republic of China (III), but the two systems are quite different. Before the promulgation of the new Company Law, there was often confusion in the practical field regarding the application of shareholder expulsion and shareholder disqualification. However, after the promulgation of the new Company Law, the differences between the two in terms of scope of application, applicable conditions, application procedures, and legal consequences have become clear. In terms of the scope of application, shareholder expulsion is only applicable to limited liability companies, while shareholder disqualification can be applied to both limited liability companies and joint - stock limited companies. In terms of applicable conditions, the triggering conditions for shareholder expulsion are "failure to perform the obligation of capital contribution or withdrawal of all capital contributions", which are relatively strict. The triggering condition for shareholder disqualification is "failure to pay the capital contributions by the due date as specified in the company's articles of association", which is relatively clear and broad. In terms of application procedures, shareholder expulsion does not stipulate the form of demand for payment. As long as the demand for payment is ineffective, the shareholders' meeting can make a resolution of expulsion. For shareholder disqualification, a written demand for payment is required. After the demand for payment is ineffective, the board of directors shall make a resolution of disqualification and the company shall issue a notice of disqualification to the shareholder in arrears. In terms of legal consequences, the legal consequences of shareholder expulsion are broader than those of shareholder disqualification. The result of shareholder expulsion is that the shareholder is removed from the company's membership. Shareholder disqualification only stipulates that the shareholder loses the equity corresponding to the unpaid capital contributions. If the shareholder still holds part of the paid - in equity, he will not face the consequence of being removed from the company's membership. That is, disqualification does not necessarily lead to expulsion.

II. Applicable Conditions and Procedural Development

A. Applicable Conditions

Failure to Perform the Obligation of Capital Contribution: The shareholder fails to pay the capital contributions by the due date as specified in the company's articles of association and still fails to fulfill the obligation of capital contribution within the grace period after the company issues a written notice of demand for payment.

Written Demand for Payment: The company issues a written notice of demand for payment of capital contributions to the shareholder who fails to perform the obligation of capital contribution. The notice of demand shall specify a grace period for payment of capital contributions, and the grace period shall be not less than 60 days from the date of issuance of the notice of demand by the company.

Resolution of the Board of Directors: After the expiration of the grace period, if the shareholder still fails to perform the obligation of capital contribution, the board of directors of the company shall hold a meeting to resolve on the shareholder losing the equity corresponding to the unpaid capital contributions.

Written Notice of Disqualification: After the company makes a resolution through the board of directors, it shall issue a written notice of disqualification to the shareholder. The notice shall take effect as of the date of issuance.

B. Procedural Development

III. Handling after Shareholder Disqualification

A. Substantive Handling

Equity Transfer or Capital Reduction: The equity lost by the disqualified shareholder shall be transferred in accordance with the law, or the registered capital shall be reduced accordingly and the equity shall be cancelled. If the equity is not transferred or cancelled within six months, the other shareholders of the company shall pay the corresponding capital contributions in full in proportion to their capital contributions.

Right of Objection: If a disqualified shareholder has an objection to the disqualification, the shareholder shall file a lawsuit with the people's court within 30 days from the date of receipt of the notice of disqualification.

B. Procedural Handling

There are two situations after the shareholder receives the notice of disqualification: The first situation is that if the shareholder has no objection, the disqualification takes effect immediately, and the shareholder loses the equity. The second situation is that if the shareholder has an objection, the shareholder shall file a lawsuit within 30 days from the date of receipt of the notice, and the court shall confirm the validity of the resolution of disqualification. The court's judgment is also divided into two types: ① If the judgment negates the validity of the resolution, the shareholder's equity remains, but the obligation of capital contribution shall continue to be fulfilled. ② If the judgment confirms the validity of the resolution of disqualification, the shareholder loses the equity as of the date of receipt of the notice.

IV. Several Practical Issues of Shareholder Disqualification

A. Recusal of Interested Directors from Voting

In the voting procedure for the board of directors to decide whether to issue a notice of disqualification, if the shareholder with defective capital contribution is himself a director, or if the shareholder can control the members of the board of directors, the interested directors shall recuse themselves from voting. If the number of remaining directors is less than the minimum legal number (i.e., 3) after the recusal of interested directors, the matter shall be submitted to the shareholders' meeting for consideration. In the resolution of the shareholders' meeting, the shareholder who has been urged to make capital contributions shall also recuse himself from voting.

B. The Obligation of Capital Contribution of the Disqualified Shareholder Still Exists before the Completion of the Capital Reduction and Change Registration

For the company's creditors before the completion of the capital reduction and change registration due to shareholder disqualification, the obligation of capital contribution of the disqualified shareholder still exists. The company's creditors have the right to require the disqualified shareholder to bear supplementary compensation liability for the part of the company's debts that cannot be repaid, according to the amount of unpaid capital contributions. According to the relevant provisions of the Company Law, after the shareholder is disqualified, his obligation of capital contribution remains valid before the completion of the capital reduction and change registration. Specifically, Articles 32 and 34 of the Company Law point out that the change of registered capital must be registered before it can be opposed to a bona fide counterparty. In addition, Article 17 of the Interpretation of the Supreme People's Court on Several Issues Concerning the Application of the Company Law of the People's Republic of China (III) (2020 Amendment) stipulates that "if a shareholder of a limited liability company fails to perform the obligation of capital contribution or withdraws all of his capital contributions, and after the company has urged him to pay or return the capital contributions, he still fails to pay or return the capital contributions within a reasonable period, and the company, by resolution of the shareholders' meeting, terminates the shareholder's qualification as a shareholder, and the shareholder requests to confirm that the termination is invalid, the people's court shall not support it. Under the circumstances specified in the preceding paragraph, when making a judgment, the people's court shall explain that the company shall promptly go through the legal procedures for reducing the registered capital, or other shareholders or a third party shall pay the corresponding capital contributions. Before the company goes through the legal procedures for reducing the registered capital or other shareholders or a third party pays the corresponding capital contributions, if the company's creditors request the relevant parties to bear corresponding liabilities in accordance with Article 13 or Article 14 of these Provisions, the people's court shall support it."

The current problem is that after the implementation of the new Company Law, the supporting judicial interpretation has not been issued, and the original interpretation is still valid, so its applicability needs to be further clarified. To sum up, before the completion of the capital reduction and change registration, the company's creditors can require the disqualified shareholder to bear supplementary compensation liability for the unpaid part to protect the legitimate rights and interests of the creditors.

C. Disqualification Does Not Exempt the Liability for Damages to the Company

If losses are caused to the company due to failure to pay the capital contributions in full and on time, the liability for damages to the company cannot be exempted even if the shareholder is disqualified. Specifically, Article 49 of the Company Law stipulates that "shareholders shall pay in full and on time the capital contributions subscribed by each of them as specified in the company's articles of association. … If a shareholder fails to pay the capital contributions in full and on time, in addition to paying the full amount to the company, the shareholder shall also bear compensation liability for the losses caused to the company." According to this article, based on the legal nature of the liability for damages, whether the shareholder is disqualified or not, he shall bear compensation liability for the losses caused to the company, and the liability shall not be exempted due to disqualification.

V. Caution: Prevent Shareholders from Taking Flight

Reflection shows that if a shareholder is urged to be disqualified, does it mean that the shareholder has achieved a targeted capital reduction (a special form of non - proportionate capital reduction)? Further thinking reveals that this system may be abused by some controlling shareholders. They may use the name of disqualification to evade huge capital contribution obligations and even shift the capital contribution responsibility to other minority shareholders. If these minority shareholders have no ability to contribute capital themselves, or are actually "vests" of the controlling shareholders, holding shares on their behalf, the moral risk of abusing disqualification will be even more serious. Through disqualification, these controlling shareholders may successfully avoid many restrictions on shareholders' capital contribution responsibilities in the law, such as the original shareholder's capital contribution responsibility in Article 88 of the Company Law regarding the transfer of shares within the unexpired capital contribution period. This phenomenon deserves high attention.

Conclusion

The new Company Law has made relatively clear provisions on the shareholder disqualification system, further improving the corporate governance structure and protecting the legitimate rights and interests of the company and other shareholders. However, there are still some unclear mechanisms in the specific implementation process, as well as the need to be vigilant against "shareholders taking flight", which need to be further clarified and optimized in subsequent practical operations, legislation, and judicial practice. It is hoped that this article can provide useful reference for corporate governance and promote the shareholder disqualification system to play a greater role in practical applications.

References

Liu Xinhui, et al.: "Research on the Shareholder Disqualification Mechanism under the New Company Law and Its Legal Application", published in Zhong Lun Vision.

Li Jianwei: Commentary on the Company Law, Law Press, 2024, p. 218.

Li Jianwei: Commentary on the Company Law, Law Press, 2024, p. 223.