Equity Investment Dispute Questions and Answers (I): Resolving Conflicts between a Shareholders' Agreement and the Articles of Association

Authors: Dong LIU丨Wei ZHANG丨Hanwei QI丨Neng QIAN

Introduction

In the field of equity investment, high returns go hand in hand with high risks.  From the decision-making at the investment stage, to the details of post-investment management, and further to the choice of exit path, the choice of strategy at each stage may have a disruptive impact on both investment security and returns.

As a team that has long been deeply engaged in the field of corporate dispute resolution, Han Kun's dispute resolution team has accompanied investors to participate in business negotiations, helped resolve differences in post-investment management, and assisted in overcoming exit-related deadlocks.  Through our many years of practical experience, we have found that, despite differences among the investment projects and the portfolio companies, the confusion, pain points, and risks investors encounter in their equity investments tend to have many commonalities.

Han Kun's dispute resolution team has been exploring and practicing these topics consistently over the years to address issues such as predicting risks in advance and how to break disputes when they arise.  Based on our years of practical experience and industry observations, we are launching this series of articles, presented in a Q&A format, to address key risks and solutions, with a view to providing useful reference for the investor community.

This article is the first of a series of Q&As about equity investment disputes.  In practice, all the shareholders of a portfolio company (and, in some cases, the portfolio company itself) usually sign a shareholders' agreement, which stipulates, among other things, the rights and obligations of the parties to the agreement and the corporate governance arrangements.  The articles of association, as the "constitutional" document of the portfolio company, also governs corporate governance issues.  When a shareholders' agreement exists with the articles of association, conflicting provisions and related disputes easily arise.  This article focuses on the following four questions and introduces the differences between shareholders' agreements and articles of association.  Our focus is on the applicable rules and practical considerations where conflicts arise between the two documents.

1.  What is a shareholders' agreement? What is the purpose of executing a shareholders' agreement?

2.  What is a company's articles of association? What is the difference between the articles of association and a shareholders' agreement?

3.  How do judicial authorities typically handle conflicts between a shareholders' agreement and the articles of association?

4.  How can potential conflicts between a shareholders' agreement and the articles of association be prevented in advance or remedied after they arise?

What is a shareholders' agreement? What's the purpose of executing a shareholders' agreement?

A shareholders' agreement refers to an agreement concluded between the shareholders, or between the shareholders and the company, with respect to the allocation and exercise of internal corporate powers, the management of the affairs of the company, and the rights and obligations among the shareholders.

Generally, shareholders' agreements can be divided into shareholders' agreements signed by some shareholders and shareholders' agreements jointly signed by all shareholders (the invested company may also be a signatory).  The former generally stipulates the special rights and obligations among shareholders, while the latter can not only stipulate the relationship among shareholders, but also, under certain conditions, make special arrangements for corporate governance to be binding on the company under specific conditions (the shareholder agreements mentioned in this article refer to the latter).

For example:

1.  For matters of a limited liability company that require resolution of the shareholders' meeting, all shareholders may adopt such resolution by executing a shareholders' agreement, instead of convening a shareholders' meeting (Article 59 of the Company Law);

2.  In the case of a small limited liability company or a limited liability company with a small number of shareholders, the shareholders' agreement may provide that the company shall have no supervisor (Article 83 of the Company Law);

3.  Unless otherwise agreed by all shareholders, a limited liability company's profits shall be distributed in proportion to shareholders' paid-in capital contributions under the Company Law (Article 210 of the Company Law);

4.  When a limited liability company reduces its registered capital under the Company Law, the amount of capital contribution of each of its shareholders shall be reduced on a pro rata basis, unless otherwise agreed upon by all shareholders (Article 224 of the Company Law);

5.  Unless otherwise agreed by all shareholders, when a limited liability company increases its registered capital under the Company Law, its shareholders shall have the preemptive right to subscribe for additional capital in proportion to their respective paid-in capital contributions under the same conditions (Article 227 of the Company Law).

In addition to the matters expressly provided for under applicable law, shareholders' agreements commonly include, in practice, other corporate governance–related provisions, such as requiring certain business decisions to be submitted to the shareholders' meeting or the board of directors for approval (for example, transactions exceeding a specified monetary threshold), and granting certain shareholders veto rights in respect of specified matters.

What are a company's articles of association? How do they differ from a shareholders' agreement?

The articles of association are a necessary document that a company formulates in accordance with laws and regulations to clarify the basic rights and obligations of all parties involved in the company's legal relationship (including the company, shareholders, directors, supervisors and senior managers) and the basic rules of corporate governance.  According to the Understanding and Application of the Company Law of the People's Republic of China compiled by the Second Civil Tribunal of the Supreme People's Court, a company's articles of association must be formalized, legalized, authentic, and open^[1].

The key differences between a shareholders' agreement and the articles of association are as follows:

1.  Different legal basis.  The articles of association must be formulated in accordance with the law, whereas a shareholders' agreement is signed upon the option of shareholders independently, and is not a mandatory document for the company.

2.  Different legal effect.  The articles of association of the company is the "charter of the company", which is binding on the company, its shareholders, directors, supervisors and senior managers.  By contrast, the shareholders' agreement is generally only effective between and among the parties to the agreement, and binds the company under specific circumstances (see Question 1 above).

3.  Different emphasis.  The articles of association focuses more on the overall governance framework of the company, while a shareholders' agreement focuses more on the detailed arrangements with respect to shareholders' rights and obligations.

4.  Different rules on amendment.  Amending the articles of association requires a major resolution to be adopted at the shareholders' meeting and, under the Company Law, must be adopted by a majority vote (2/3 or more of the voting rights) of the shareholders' meeting.  By contrast, for a shareholders' agreement, an amendment may be made only with the unanimous consent of all the parties to the agreement.

It is thus clear that there are similarities between the articles of association and the shareholders' agreement, and their functions can overlap to some extent.  However, based on the above differences, investors should decide whether to execute a shareholders' agreement based on their actual circumstances.  For example, although the articles of association of the company serve as the "charter of the company", the fact that the articles of association can be amended by a majority vote means that the provisions of a shareholders' agreement offer greater stability.  Therefore, in practice, investors often prefer to sign a shareholders' agreement to specify various special investor rights in corporate governance.

How does the judiciary usually handle conflicts between a shareholders' agreement and the articles of association?

Generally, a shareholders' agreement only stipulates the rights and obligations among the shareholders and the internal governance issues of the company, while the articles of association must also set out the company's registered capital, business scope, and other registration matters.  Therefore, according to the principle of "differentiation between internal and external relations", when the affairs of a third party outside the agreement are involved, the shareholders' agreement generally cannot be binding or enforced by any third party other than the parties signing the agreement, but subject to the articles of association and registration of the company.

In judicial practice, the more common and important question is how to resolve the conflict between the shareholders' agreement and the articles of association concerning the internal affairs of the company.  Currently, the laws and regulations do not clearly provide uniform rules on the application of the conflict between the shareholders' agreement and the articles of association.  In practice, courts tylically undertake a holistic assessment to determine which of the two documents better reflects the true intentions of the parties.  The common consideration for making such judgments include:

Firstly, judging by the chronological order, i.e., the latest formed or revised shareholders' agreement or the Articles of Association shall prevail.  For example, in Case (2024) Yu 0106 Min Chu No.3307, with respect to the shareholders' dispute on the time limit for capital contribution, the court upheld the plaintiff's claim that the shareholders being sued must complete their capital contributions within the time limit specified in the shareholders' agreement, for the reasons that such shareholders' agreement was formed after the articles of association.

Secondly, order of precedence provisions in shareholders' agreements have been deemed valid and enforceable, such as "in the case of any inconsistency between the shareholders' agreement and the articles of association, the shareholders' agreement shall prevail".  For example, in Case (2025) Yu Min Shen No.956, the court held that "the shareholders agreed that the clauses in the Cooperative Development Agreement were the preferential provisions, and this provision was not against the mandatory provisions of laws and regulations and was binding on the shareholders".

Thirdly, in addition to the above-mentioned general rules, the judiciary may comprehensively analyze other factors.  For example, (i) whether the shareholders had actually complied with the shareholders' agreement or with the articles of association before the dispute arose; (ii) whether the articles of association were a template document executed solely for the purpose of corporate registration; (iii) whether any subsequent amendments to the articles of association, made after the execution of the shareholders' agreement, relate to any matters in dispute; and (iv) whether such amendments to the articles of association were unanimously approved by all the shareholders.

How can potential conflicts between a shareholders' agreement and the articles of association be prevented in advance or remedied after they arise?

In practice, there is no uniform judicial standard for resolving conflicts between a shareholders' agreement and a company's articles of association in relation to internal corporate governance matters.  Therefore, investors should understand the coordination relationship and the potential conflicts between the two documents, and seek to protect their own rights and interests by means of preventive measures and post-conflict remedies.

• From the perspective of prevention, we suggest that investors take the following measures:

1.  Key rights provisions should be stipulated in both the shareholders' agreement and the articles of association to avoid any conflict between the two documents.  If any provisions are not appropriate to be reflected in the articles of association submitted to the registration authority for filing, investors may consider separately preparing a short-form articles of association for registration purposes, which is then followed by the signing of a detailed articles of association that stipulates key rights provisions.

2.  Set the priority clauses in the case of any conflict between the shareholders' agreement and the articles of association.  In order to maintain the stability of the provisions regarding the rights of the investors as stipulated in the shareholders' agreement and avoid other shareholders from jeopardizing its rights through amendment to the articles of association, priority clauses may be expressly specified in the shareholders' agreement;

3.  Amend the shareholders' agreement and the articles of association in parallel.  This is recommended so that the provisions of both documents remain consistent.

• From the perspective of post-conflict remedies, if a dispute arises as to the applicability of a shareholders' agreement or the articles of association, we suggest that investors analyze and strive for the applicable provisions in their favor from the following perspectives:

1.  Confirm the specific provisions of both the shareholders' agreement and the articles of association with respect to the specific matters arising from disputes, and consider which set of provisions better serves their interests;

2.  Confirm the sequence of the execution of the shareholders' agreement and the articles of association;

3.  Confirm whether the shareholders' agreement has any preferential provisions;

4.  Confirm whether, prior to the dispute, the parties have actually performed their obligations in accordance with the shareholders' agreement or the articles of association;

5.  Analyze and demonstrate comprehensively that the shareholders' agreement or the articles of association should have priority in resolving the dispute by considering the timing of execution and amendment, the relevant provisions, the parties' performance, and the true intentions of the parties.

[1] See the Understanding and Application of the Company Law of the People's Republic of China (Part One), compiled by the Second Civil Division of the Supreme People's Court, pp. 13 – 14.