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Cross-shareholding is a relatively common phenomenon, also referred to as reciprocal shareholding, mutual shareholding or mutual equity participation. It refers to an economic phenomenon or organizational form in which two or more companies hold equity interests in each other for specific purposes, thus forming a status where each party acts as an investor of the other. For example, both Company A and Company B have independent legal person status. Company A holds 20% of the equity interests of Company B, while Company B holds 15% of the equity interests of Company A, which constitutes the most basic form of cross-shareholding. Another form is that Company A holds equity interests in Company B, Company B holds equity interests in Company C, and Company C in turn holds equity interests in Company A. All other forms of cross-shareholding are mostly extensions and variations of the two basic forms above.

I. Classification of Cross-Shareholding

(I) Taking whether a parent-subsidiary relationship is constituted as the criterion

1. Cross-shareholding between parent and subsidiary companies: Where one of the companies with mutual equity participation can exercise actual control over the other, a controlling and controlled relationship is thus formed between the aforesaid mutually equity-participating companies, that is, Company A and Company B may act as the parent company and subsidiary company of each other.

2. Cross-shareholding Formed by Pure Mutual Investment: Where no controlling relationship is formed between two cross-shareholding companies, the cross-shareholding concerned is only established through mutual investment. This situation is relatively common in practice, such as the cross-shareholding between Suning and Alibaba. In the market, for the purposes of industrial synergy and strategic cooperation, market entities will bind the interest relationship between the two parties by way of cross-equity ownership. The degree of internal control over cross-shareholding between parent and subsidiary companies is far higher than that over cross-shareholding between companies without a parent-subsidiary relationship.

3. Cross-shareholding under Unilateral Control: This situation mostly occurs in the capital market, and sometimes such cross-shareholding is passively formed as a result of mergers, acquisitions and reorganizations. For example, where a listed company becomes the controlling shareholder of a certain company through mergers, acquisitions and reorganizations, the subsidiary of the aforesaid company in turn holds a small stake in the listed company. Under such circumstances, the China Securities Regulatory Commission (CSRC) will primarily consider whether it will produce adverse effects on the governance of the listed company. Generally, the subsidiary will waive the voting rights attached to the shares of the listed company it holds.

(II) Taking whether shares are directly held as the criterion

1. Direct Type: Direct cross-shareholding refers to a situation where two companies hold shares in each other. For instance, Party A holds 30% of the equity interest in Party B, and Party B holds 20% of the equity interest in Party A.

2. Indirect Type: The simplest form of indirect cross-shareholding refers to the scenario where Company A holds shares in Company B, Company B holds shares in Company C, and Company C in turn holds shares in Company A, thus forming a circular shareholding structure. Compared with the direct type, the degree of control achieved through indirect shareholding is relatively lower than that of direct shareholding.

II. Causes for the Formation of Cross-Shareholding

1. Active cross-shareholding: refers to the circumstance where equity participating companies mutually hold shares in each other on the basis of specific motives, such as mutual shareholding for the purpose of strategic cooperation.

2. Passive Cross-Shareholding: Refers to the circumstance where a company has no motive to conduct cross-shareholding on its own, and acquires shares of another party for other reasons. For example, Company A holds shares of Company B, while Company B is a shareholder of Company C. Where Company C absorbs and merges Company A, Company C shall enjoy all rights and interests of the former Company A, including the shares of Company B held thereby. At this point, a mutual shareholding relationship is formed between Company C and Company B.

III. Positive Effects of Cross-Shareholding

1. Complementary Advantages and Coordinated Development Through cross-shareholding, enterprises can achieve complementary advantages and coordinated development in the aspects of technology, personnel, sales and innovation. Especially for upstream and downstream enterprises, cross-shareholding can effectively facilitate cooperation in capital, raw materials, technology and market. It can also generate horizontal effects, including scale expansion, efficiency improvement, competitiveness enhancement, etc. For example, an investment company with capital channels and a technology company with technological strengths can realize coordinated development through cross-shareholding; alternatively, an Internet company with market resources and a supplier with goods sources can realize online and offline business cooperation by virtue of cross-shareholding.

2. Stable Operation For highly cyclical industries, cross-shareholding can also fulfill the purpose of dispersing operational risks. Although ordinary diversified operation can also achieve the goal of risk diversification, the advantage of risk diversification through cross-shareholding lies in that it requires no actual capital expenditure. The most typical practice is that both parties realize their respective diversified operations by means of share swap, so as to mitigate risks arising from industry cyclicality. Accordingly, cross-shareholding is similar to an insurance mechanism, which protects enterprises from general commercial risks and industry cyclical risks.

3. Strengthen interconnections and achieve development with less capital. A parent company may strengthen mutual connections by means of cross-shareholding among various subsidiaries within the enterprise group as well as cross-shareholding between the parent company and its subsidiaries, so that the holding company or the actual controller can control the entire group company with a smaller amount of capital.

4. Stabilize the equity structure to prevent hostile takeovers. After cross-shareholding, a special alliance relationship is formed as parties hold shares in each other, which strengthens the operational authority of the company's management. In the event of a takeover in the external open market, such stable alliance can effectively block hostile takeovers.

Cross-shareholding first originated from the Yowa Real Estate Company incident in Japan. In 1952, the company fell victim to a hostile takeover, which triggered internal structural adjustment of the Mitsubishi Group. In 1953, following the amendment of Japan's Anti-Monopoly Act, subsidiaries under the Mitsubishi Group began to implement cross-shareholding out of the need to prevent takeovers from the secondary market. Since then, cross-shareholding has been widely applied in Japan as an anti-takeover strategy. In the 1950s, Japanese enterprises also used cross-shareholding as a strategy to maintain close relations with banks for capital acquisition.

IV. Relevant Legal Provisions

The current Company Law of the People's Republic of China and its supporting judicial interpretations contain no special provisions governing cross-shareholding. Prior to the promulgation of the Company Law, certain regulatory documents once included provisions relating to cross-shareholding.

It is stipulated in the 1992 Interim Provisions of Shenzhen Municipality on Companies Limited by Shares that: Where a company holds more than 10% of the shares of another enterprise, the latter shall not purchase the shares of the former; where a company holds more than 50% of the shares of another enterprise, the former is the parent company and the latter is the subsidiary company, and a subsidiary company shall be strictly prohibited from subscribing for the shares of its parent company; where an enterprise acquires more than 10% of the total shares of a company, the former shall notify the latter within 10 days.

The *Standard Opinions on Companies Limited by Shares* issued by the State Commission for Economic Restructuring in 1992 stipulates that: Where a company holds 10% or more of the shares of another enterprise, the latter shall not purchase the shares of the former.

Article 40 of the *Interim Provisions of the Hainan Special Economic Zone on Companies Limited by Shares* (1992) provides that: When a company acquires more than 10% of the shares of another company, it shall notify the other company. If it fails to give such notification, the voting rights attached to its excess shareholdings in the other company shall be suspended. Where companies hold cross-shareholdings exceeding the proportion specified in the preceding paragraph, the company that notifies the other party later than the other company shall be deemed to have failed to give notification, the voting rights attached to its excess shareholdings in the other company shall be suspended, and such excess shareholdings shall be disposed of within six months.

However, following the promulgation of the Company Law of the People's Republic of China in 1993, all such documents have ceased to be effective. The 1993 version of the Company Law imposed a restriction on the total amount of a company's external investment, stipulating that such amount shall not exceed 50% of the company's net assets. This provision was deleted when the Company Law was revised in 2005, which has resulted in a regulatory void over the issue of cross-shareholding in China's current statutory-level normative documents. Of course, this does not mean that cross-shareholding is not subject to any legal restrictions. As a type of equity structure arrangement, cross-shareholding shall still be regulated if such arrangement materially violates the provisions or principles of the Company Law and harms the interests of other shareholders or creditors.

At the legislative level of departmental rules, Article 10 of the *Trial Provisions on the Establishment of Subsidiaries by Securities Companies* (revised by the China Securities Regulatory Commission (CSRC) pursuant to the *Decision of the China Securities Regulatory Commission on Amending the Trial Provisions on the Establishment of Subsidiaries by Securities Companies* issued on October 11, 2012) stipulates that: "A subsidiary shall not, directly or indirectly, hold the equities or shares of its controlling shareholder or other subsidiaries controlled by the same securities company, or invest in its controlling shareholder or other subsidiaries controlled by the same securities company by any other means." However, as the aforesaid provision only applies to securities companies, it does not cover investment companies, other companies and listed companies that are in urgent need of regulation.

On April 30, 2019, the Shanghai Stock Exchange and the Shenzhen Stock Exchange revised the *Rules Governing the Listing of Stocks* once again merely five months after the previous revision. Notably, among the key focuses of this revision, relevant provisions concerning cross-shareholding of listed companies were formulated.

Notice on Amending Relevant Provisions of the *Rules Governing the Listing of Stocks on Shenzhen Stock Exchange* and the *Rules Governing the Listing of Stocks on the ChiNext Market of Shenzhen Stock Exchange* Article 3: One paragraph is added as Paragraph 2 to Article 11.8.4 of the *Listing Rules* and Article 11.8.5 of the *ChiNext Listing Rules* respectively, which provides that: "A controlling subsidiary of a listed company shall not acquire shares issued by the said listed company. Where it holds such shares due to special reasons, it shall eliminate such circumstance within one year. Prior to the elimination of such circumstance, the controlling subsidiary of the listed company shall not exercise the voting rights attached to the shares it holds."

Notice on Amending the Rules Governing the Listing of Stocks on the Shanghai Stock Exchange, Article 3: One additional paragraph shall be inserted as Paragraph 2 of Article 11.9.5, which reads: "A controlling subsidiary of a listed company shall not acquire shares issued by the said listed company. Where it does hold such shares due to special reasons, it shall eliminate such situation in accordance with law within one year. Prior to the elimination of the aforesaid situation, the relevant subsidiary shall not exercise the voting rights corresponding to the shares it holds."

The Shenzhen Stock Exchange (SZSE) stated that, "It is explicitly stipulated that listed companies shall not form cross-shareholdings. Given that cross-shareholdings may lead to problems such as overstatement of assets and unclear equity structure, in accordance with the current regulatory provisions and regulatory practices of China, this revision explicitly stipulates that the controlling subsidiaries of a listed company shall not acquire shares issued by the listed company. It also requires that cross-shareholdings formed due to special reasons such as judicial transfer and passive holding shall be eliminated within one year, and no voting rights shall be exercised before the elimination of such cross-shareholdings."

Accordingly, as evidenced by IPO cases of certain companies and merger, acquisition and restructuring cases of listed companies, cross-shareholding is an issue to which regulatory authorities pay relatively high attention. When regulatory authorities raise concerns in this regard, listed companies shall generally explain the impact of cross-shareholding on the corporate governance of listed companies and propose relevant solutions. However, small-proportion cross-shareholding is permitted on condition that the voting rights attached thereto are waived, or such cross-shareholding shall be eliminated within a specified period of time.

In conclusion, it can be seen that at present, the Company Law of China has no specific restrictive or prohibitive provisions on cross-shareholding. While regulations are imposed on entities in special sectors such as listed companies and subsidiaries of securities companies, such regulations are not universally applicable. The cross-shareholding acts of ordinary limited liability companies do not violate the prohibitive provisions of the *Company Law of the People's Republic of China* and other relevant laws and regulations.

V. Potential Legal Issues Arising from Cross-shareholding

1. Falsely inflating paid-in capital and ambiguous capital contribution obligations

Cross-shareholding between companies will lead to fictitious capital increase. This is because each flow of funds between cross-shareholding companies will result in a simultaneous increase in the capital amount of both enterprises, while in fact, the funds only circulate back and forth between the companies without any substantial increase in capital. For example, Company A invests RMB 1 million in Company B and thus holds shares of Company B, and Company B also invests RMB 1 million in Company A. On the face of it, the capital has increased, but in essence, this sum of funds is only circulated once before being returned, and does not give rise to any actual increase in capital.

What if the registered capital of both companies has not been fully paid in? No capital flow occurs throughout the entire process. When it comes to the enforcement of capital contribution obligations, the recovery of the RMB 1 million registered capital payable by Company A is required of Company B, while the recovery of the registered capital payable by Company B is in turn required of Company A, leaving the entire RMB 1 million of liability capital completely unrecoverable.

2. Infringe upon the legitimate rights and interests of other shareholders

Cross-shareholding leads to an increase in the number of a company's shareholders. However, since the capital involved in such cross-shareholding is fictitious, it will cause a proportional decrease in the shareholding proportion of other shareholders, thereby impairing the rights of other shareholders.

3. Disruption of the Corporate Governance Structure

In the case of cross-shareholding between a parent company and its subsidiary, if the parent company intends to convene a shareholders' meeting, how shall the subsidiary, as the controlling shareholder of the parent company, form its independent expression of intent? Under normal circumstances, the decision shall be made by the shareholders of the subsidiary in accordance with the Company Law of China and the articles of association of the subsidiary. However, the shareholder of the subsidiary is the parent company itself, which ultimately results in a situation where the shareholder cannot express its intent independently. Therefore, listed companies require that voting rights be waived in the case of cross-shareholding.

4. Risks Arising from Confusion of Corporate Personality

An important criterion for determining confusion of corporate personalities between companies is to examine whether there exists confusion of personnel, confusion of business operations and confusion of property. The core of the aforesaid criteria is confusion of property, as the independent property of a company serves as the foundation for its independent assumption of liabilities. Cross-shareholding is also a common form or phenomenon. Where each subject of cross-shareholding holds independently owned property, has clear property relations, and is able to bear its civil obligations with its corporate property, no confusion of corporate personalities shall be affirmed. However, where the property relations between cross-shareholding companies are unclear, the independent property of each company is hardly distinguishable, and the interests of the companies' creditors are impaired, there is a risk that such companies may be determined to have confusion of corporate personalities.

Pursuant to the *Minutes of the 9th National Working Conference on Civil and Commercial Trials of People's Courts*, acts of abusing the company's independent status and shareholders' limited liability that give rise to disregard of corporate personality mainly fall into three categories: first, intermingling of corporate and shareholder personalities; second, excessive domination and control; third, significant undercapitalization. The most fundamental criterion for determining the intermingling of personalities is whether the company has independent will and independent property. Where intermingling of personalities occurs, the following forms of intermixture are usually present concurrently: intermingling of the company's business operations with those of its shareholders; intermingling of the company's personnel with that of its shareholders, especially intermingling of financial staff; intermingling of the company's domicile with that of its shareholders. When trying cases, the People's Courts shall focus on examining whether the intermingling of personalities is constituted. It is not required that other forms of intermixture exist at the same time, as such other forms of intermixture usually only serve as corroborating evidence for the finding of intermingling of personalities.

In the event of mutual shareholding between companies, part of the shares held by one party in the other party may very likely be the property contributed by the other party to the former as capital. Where the aforesaid shareholding reaches the level of a controlling interest, it may appear that the two are mutually independent enterprises on the surface, but they have actually been integrated into a single entity, thus resulting in confusion of the legal personalities of the company and its shareholders.

Judicial cases involving cross-shareholding are not common. In practice, they are often used to prove "piercing the corporate veil", that is, to prove that the existence of cross-shareholding relationship constitutes confusion of corporate personality, and then with reference to the provisions of Articles 10 and 11 of the *Minutes of the National Courts' Symposium on Civil and Commercial Adjudication* issued by the Supreme People's Court and the spirit of Guiding Case No. 15 of the Supreme People's Court, shareholders shall be required to bear joint and several liability or supplementary liability.

For example, the Guangdong High People's Court also held in its Ruling (2019) Yue Min Shen No. 5237 that: "The aforesaid companies have such indicative factors as mutual lending, mutual leasing of business premises, identical shareholders, cross-appointment of senior executives, cross-shareholding among shareholders, and kinship among shareholders. On this basis, it is not improper for the court of second instance to affirm the claim of Li Xianbin et al. that confusion of legal personality exists among the aforesaid companies as a result of commingling of finances and affiliation."

Therefore, although cross-shareholding among ordinary limited liability companies does not violate the provisions of laws, when such companies face litigation initiated by creditors, there is a risk that the people's court will ascertain the existence of confusion of corporate personality and thus order them to bear joint and several liability or supplementary liability. This point deserves full attention in judicial practice.

VI. Comments and Suggestions

In practice, cross-shareholding, as an instrument, may generate both positive effects and adverse impacts. However, it is not inherently absolutely right or wrong, and its effect hinges on specific operations. How can we mitigate the problems arising therefrom while ensuring the realization of the objectives of cross-shareholding?

1. The proportion of cross-shareholding shall not be excessively high. Where the proportion is relatively high, the mutual influence and control between companies will be correspondingly greater, which will significantly affect the corporate governance structure. Therefore, it is recommended that the aforesaid proportion be maintained at a relatively low level.

2. In terms of corporate governance, the impact may also be reduced by means of waiving voting rights.

3. With respect to the protection of shareholders' rights and interests, the capital contribution obligations of all parties shall be explicitly specified, including the time limit for capital contribution, method of capital contribution, liability for breach of contract for failure to fulfill capital contribution obligations upon expiration of the time limit, remedies and other relevant matters, so as to ensure the performance of the aforesaid capital contribution obligations. For minority shareholders of companies with cross-shareholdings, the basic rights they are entitled to as shareholders shall be protected as far as possible.

4. Avoid confusion of juridical person personality. Identity in such aspects as office addresses and financial personnel shall be avoided as far as possible. All companies shall maintain clear accounts, conduct reasonable related-party transactions at fair prices, and achieve financial independence.

In conclusion, cross-shareholding is a relatively complex legal system. In its application, full play shall be given to its positive effects, while legal issues and risks arising therefrom shall be avoided or mitigated.