A Discussion on How to Prevent Corporate Deadlock via Design of Articles of Association
By Li Huirong
The most classic sentence in theoretical and practical circles of company law must be “unless otherwise provided in the articles of association of the company”, which is also a magic weapon for shareholders to manage their company in an effective and flexible way by reaching agreements among themselves through the articles of association. Then can the sentence of “otherwise provided in the articles of association” be used to prevent circumstances of “corporate deadlock”, a shared headache of shareholders and directors in operating a company? This article attempts to make a general discussion on this issue from three aspects: the definition and typical types of corporate deadlock, its causes and the key points of designing the articles of association to prevent corporate deadlock.
I. Definition and Typical Types of Corporate Deadlock
1. Definition of Corporate Deadlock
Corporate deadlock normally refers to a situation of stalemate caused by intensified conflict among shareholders and directors during existence and operation of a company. Because of corporate deadlock, the shareholders’ meeting, the board of directors and other organs of the company are unable to make decisions pursuant to statutory procedures, making normal operation of the company impossible or even paralyzing the company. Corporate deadlock mostly happens in limited liability companies, especially those with a smaller number of shareholders holding similar percentages of shares, where it becomes impossible to make decisions pursuant to applicable provisions of the company law, bringing the decision-making process into a standstill.
2. Typical types of corporate deadlock
It is generally believed that corporate deadlock has two categories, namely shareholder deadlock and director deadlock: (1) Shareholder deadlock refers to a situation where, due to severe disagreement among shareholders, effective decisions on corporate operation fail to be reached during two consecutive shareholders’ meetings and such failure may cause substantial damage to the company; (2) Director deadlock refers to a situation where, due to severe disagreement among directors, effective decisions on corporate operation fail to be reached during two consecutive board meetings and such failure may cause substantial damage to the company. There is also another special type of corporate deadlock, namely a director deadlock caused by shareholder deadlock, meaning that when a director’s term of office expires, severe disagreement among shareholders makes it impossible to select a successive director during two consecutive shareholders’ meetings and as a result, the number of directors at the board is insufficient for making operation decisions.
II. Analysis on the causes of corporate deadlock
Per practical experience, corporate deadlock has the following common causes:
1. Unreasonable design of the equity structure of the company
Normally in a limited liability company with a smaller number of shareholders, each shareholder holds a balanced or even identical amount of shares, such as the common structure of 50%:50% or 1/3 for each. Under this kind of equity structure, if no separation design or special provision is made concerning the shareholding ratio and the voting power ratio, during operation of the company, when shareholders cannot reach a consensus on the philosophy and strategy of operation, and, because limited liability companies have natural characters of incorporation by humans, when initial trust among shareholders when setting up the company collapses and their relationship goes into a deadlock, neither party, with the shares held by it, is able to secure an effective decision made in accordance with their will. As a result, operation of the company will fall into an ongoing stalemate.
2. Unreasonable design of the voting mechanism of shareholders/directors
If the articles of association provide that a resolution of the shareholders’ meeting or board of directors can only be passed by unanimous consensus of all shareholders or directors, or confer the one-vote veto power on an individual shareholder or director (the so-called “article that is unable to make but enough to break”; the one-vote veto power vested in an individual director is a controversial issue in practice), the company may fall into a deadlock if a resolution cannot be passed due to failure to reach unanimous consensus or an individual shareholder/director’s exercise of his/her one-vote veto power.
3. The loss of contact or missing of a shareholder/director
It may happen in practice that, due to various reasons, a shareholder or director is unaccounted for, missing or not heard of for a long time. As a result, a normal shareholders’ meeting or board meeting cannot be convened and no resolution of the company can be formed, leading the company into a deadlock.
4. Moral hazard of shareholders and directors
In practice, corporate deadlock may be caused by moral hazards where the official seal is withheld by a major shareholder or director without permission due to divergent interests or other reasons, or a shareholder or general manager takes along the company’s business license without authorization and disappears, etc..
Although it seems that corporate deadlock is a result of the dysfunction of a company’s decision-making mechanism caused by dispute or conflict among shareholders or directors, the crux of corporate deadlock lies in the company’s institutional system. While the existing company law has provided effective protection of shareholders’ rights and interests as well as the company’s interests, it also brings certain risks and challenges to company operation. These factors are fundamental causes of corporate deadlock. The institutional arrangement in the existing company law and the closure of the institutional structure of companies are the hotbed for corporate deadlock.
III. Key points of designing the articles of association to prevent corporate deadlock
Corporate deadlock not only causes huge damages to a company and its shareholders, but is also against the original aspiration of shareholders when setting up the company in the first place. Even though the law has offered judicial remedies after the occurrence of corporate deadlock, the damages caused by corporate deadlock are irreparable. Therefore, shareholders are advised to take preventive measures against corporate deadlock as early as establishment of the company. The articles of association constitute a corporate contract among shareholders when the company is established, and thus has a contractual nature. The Chinese company law allows a relatively large room of autonomy for shareholders when formulating the articles of association. Given that, shareholders should make full use of such autonomous power based on their own circumstances when formulating the articles of association and strive to avoid corporate deadlock through scientific and reasonable design of the voting system and the company’s governance structure. From a practical perspective, the following clauses may be placed in the articles of association to prevent corporate deadlock:
1. Design a diversified voting mechanism according to the circumstance of the company
According to the company law, major resolutions of the company should be passed by shareholders representing a majority of votes, while especially significant resolutions such as amending the articles of association and adding or reducing the company’s registered capital should be implemented after being passed by shareholders representing at least two thirds of the voting rights, and decisions on general operation matters should be voted by the board of directors and be passed by directors representing a majority of votes. When there is fierce conflict or dispute among shareholders or directors who hold utterly confrontational attitude against each other, it is likely that neither party will be able to secure such majority or two thirds of votes. As a result, it is almost impossible to have a resolution passed and a corporate deadlock is thus formed. Below are some common types of voting system, the core of which is to separate the shareholding ratio and the voting system rather than keeping them united with each other, so as to break the unitary structure where shareholders enjoy voting rights corresponding to their portions of shares. Founders or shareholders of companies may select among these types in combination with the practical situations of their companies and themselves.
A. The mechanism of voting rights restriction. This means that the articles of association provide that the number of a shareholder’s voting rights should be reduced when its/his portion of shares reaches a certain level. This mechanism puts restrictions on the controlling shareholder’s voting rights to prevent it/him from infringing minority shareholders’ legitimate rights and interests by taking advantage of the capital majority decision-making system.
B The special voting mechanism for specific matters/significant matters, meaning that certain matters to be voted by the shareholders’ meeting will be passed only if certain shareholders are among those who consent such matters, which replaces the simple voting mechanism prescribed by the company law requiring majority votes or two thirds absolute majority votes. This will to some extent avoid the situation where minority shareholders’ lawful rights and interests are at risk during decision making for major or significant matters. For example, the articles of association may provide that in the event of asset disposal involving an amount of over RMB 5 million, the resolution can only be implemented after being passed by shareholders that include a certain shareholder and represent a majority of votes.
C. The mechanism of recusal of voting rights. The system of recusal of shareholders’ voting rights, also called the voting right exclusion system, means that during the voting process at a shareholders’ meeting, the shareholder(s) with special interests in the voted matter should be recused and should not exercise his/their voting rights on such matter on his/their own or represented by others. The system of recusal of directors’ voting rights means that during the voting process at a board meeting, the director(s) with special interests in the voted matter should be recused and should not exercise his/their voting rights. Specific and clear provisions should be included in the articles of association on matters such as related-party transaction, provision of guarantee for shareholders and directors and self-dealing with the company.
Extension: Circumstances where shareholders’ voting rights should be restricted or recused as set forth in the Company Law
A. Where a company provides a guaranty for a shareholder or actual controller of the company, a resolution shall be passed by the shareholders’ meeting, and such shareholder or actual controller shall not participate in voting on the resolution (see Article 16 of the Company Law).
B. Where a director or senior officer conducts self-dealing with the company or takes advantage of his/her position to compete with the company in the same trade, he/she shall first obtain the consent of the shareholders’ meeting or the general meeting of shareholders, and such director shall not participate in voting on the consent (see Article 148 of the Company Law).
C. A shareholder who fails to fulfill his/its capital contribution duty or unlawfully withdraws his/its capital contribution does not have any voting right on the resolution concerning his/its expulsion.
Related statutory provisions: Article 42 (exercise of the shareholder’s voting right) and Article 43 (methods of deliberation and voting procedures of the shareholders’ meeting) of the Company Law, etc.
2. Reasonable assignment of the power of control over the company
Where a company has two shareholders, the company’s articles of association may provide that if one party serves as the chairman of the board, the other party may designate a majority of directors; where the two parties have an equal number of directors, an intermediary agency may be retained to designate independent directors; or, in a company without the board of directors, if one party serves as the executive director, the other party may act as the general manager, and the articles of association may specify that the executive director does not have the authority to retain or dismiss the general manager.
Related statutory provisions: Article 42 (exercise of a shareholder’s voting right), Article 103 (a shareholder’s voting right) and Article 104 (decision making power of the general meeting of shareholders on significant matters) of the Company Law, etc.
3. Set the final say mechanism
The articles of association may give the chairman of the board the authority to make the final decision when a voting deadlock occurs. It may also provide that when a voting deadlock occurs at the board meeting, the matter concerned may be referred to the shareholders’ meeting for voting, etc.. Such final say mechanism can be used to alleviate deadlock at the board of directors.
Related statutory provisions: Article 37 (function and power of the shareholders’ meeting), Article 103 (a shareholder’s voting right), Article 46 (function and power of the board of directors of a limited liability company), Article 108 (function and power of the board of directors of a company limited by shares) of the Company Law, etc..
4. Specify causes of dissolution of the company
Article 43 of the Company Law provides that, “Unless otherwise provided in the law, methods of deliberation and voting procedures of the shareholders' meeting shall be specified by the company's articles of association. Any resolution made at the shareholders' meeting on any revision to the company's articles of association, any increase or reduction of its registered capital, or any combination, division, dissolution or transformation of the company must be passed by shareholders representing two thirds or more of the voting rights.” When a dissolution resolution cannot be passed at the shareholders’ meeting, agreed dissolution appears to be very important. Shareholders may specify other causes of dissolution in the articles of association in addition to the statutory causes. When any of the circumstances happens, the company will be dissolved. Such practice may, to a large extent, solve a dissolution deadlock by avoiding the situation where the only way out is an individual shareholder’s filing of a corporate dissolution lawsuit with the court.
Related statutory provisions: Article 43 (methods of deliberation and voting procedures of the shareholders’ meeting), Article 180 (causes of corporate dissolution) and Article 182 (petition the court to dissolve the company) of the Company Law, and Article 1 (circumstances where a corporate dissolution lawsuit may be filed) of the Interpretations II of the Company Law
5. Specify the mechanism of a shareholder’s withdrawal from the company under special circumstances
Article 71 of the Company Law sets out the procedure and conditions of stock rights transfer in a limited liability company, which seems to have provided two ways to shareholders of a limited liability company to withdraw from the company via stock right transfer: transferring stock rights to other shareholders of the company without limitation; or transferring the stock rights to any person other than the shareholders of the company after obtaining consent of other shareholders of the company. However, because limited liability companies have relatively strong characters of incorporation by humans and establishment of the companies is based on mutual trust among shareholders, and because stock rights in limited liability companies are not transferred in an open trading market like that of companies limited by shares, the difficulty of stock right transfer in limited liability companies has virtually increased. Therefore, in most cases in practice, persons other than the shareholders of a limited liability company are normally unwilling to join the company through stock right transfer, so such stock right transfer can only be done among shareholders within the company. However, under a corporate deadlock, such internal transfer route is blocked, directly making it impossible for shareholders to withdraw from the company through transfer of their stock rights, which continues the deadlock situation.
If it is agreed in the articles of association in advance that, in special circumstances or a corporate deadlock, minority shareholders have the right to request the controlling shareholder to purchase stock rights concerned at an agreed or reasonable price, or solve conflict among shareholders through the company’s repurchase of one shareholder’s stock right and reduction of capital, thus providing clear and operable routes for shareholders to withdraw from the company under a corporate deadlock. Such agreement belongs to autonomy of will among shareholders, and is binding to all shareholders and the company as soon as incorporated in the articles of association. Such agreement forms a legal relationship of expected transfer or repurchase of shares among shareholders and the company. Once certain conditions are met, qualified shareholders will be entitled to requesting other shareholders or the company to purchase its shares according to agreed conditions, so that shareholders who no longer intend to participate in operation of the company can withdraw smoothly and the company will continue to exist.
Related legal provisions: Article 71 of the Company Law (conditions and procedures of transfer of stock rights in a limited liability company) and Article 16 of the Interpretations (IV) of the Company Law (limitation on the exercise of the preemptive right when a natural person shareholder is changed due to the inheritance relationship)
To sum up, in the context of the Chinese company law which intends to release regulation and respect the autonomy of companies, setting out clear agreement of voluntary clauses in the articles of association can supplement and amend default rules preinstalled by the company law; from a practical perspective of the company, reasonably setting out the rights and obligations of shareholders and directors in the articles of association can to some extent effectively avoid corporate deadlock; or, when a corporate deadlock happens, specific mechanisms as agreed in the articles of association can be triggered to provide institutional support for the company to walk out of deadlock.
As Hamilton the jurist once said, “Without agreement, no remedy for a deadlock can be fully satisfying”. When it comes to corporate deadlock, it is necessary to “nip in the bud”: reasonably design the voting system and the company’s governance structure by actively using the voluntary clauses of the articles of association, which is the best way to prevent corporate deadlock.
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