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I. Concept of Nominee Equity Holding

What is nominee shareholding? Take "Huang and Luo v. S Paper & Plastic Co., Ltd. (Case of Dispute over Confirmation of Shareholder Qualification)", one of the typical cases of nominee shareholding disputes released by Shanghai No. 2 Intermediate People's Court, as an example:

In 2012, S Paper & Plastic Co., Ltd. was established with a registered capital of RMB 5 million, among which Huang Mou subscribed a capital contribution of RMB 1 million, holding a 20% shareholding ratio of the company. In the same year, Luo Mou and Huang Mou signed a Power of Attorney, which stipulated that the 20% equity interest of S Paper & Plastic Co., Ltd. held under the name of Huang Mou is actually owned by Luo Mou, and Luo Mou entrusts Huang Mou to handle all relevant matters concerning the aforesaid equity with full authority. It was also agreed that in the event of transfer, deregistration of S Paper & Plastic Co., Ltd. or any other circumstance affecting the normal operation of the company, Huang Mou shall return all the aforesaid equity to Luo Mou in full and withdraw from S Paper & Plastic Co., Ltd. Subsequently, due to the poor market performance of S Paper & Plastic Co., Ltd., Huang Mou and Luo Mou filed a lawsuit with the people's court, requesting to confirm that Luo Mou is the de facto shareholder holding 20% of the equity interest of S Paper & Plastic Co., Ltd., and that S Paper & Plastic Co., Ltd. shall complete the industrial and commercial registration alteration procedures for Luo Mou.

Nominee shareholding, also referred to as entrusted shareholding, anonymous investment or capital contribution under a false name, is a shareholding mode whereby an actual capital contributor concludes an agreement with another person, and the latter exercises shareholders' rights and performs shareholders' obligations on behalf of the actual capital contributor in its own name.

As can be seen from the case, nominee shareholding involves dormant shareholders and nominal shareholders. A dormant shareholder (Luo in the case), i.e. the actual capital contributor, refers to an investor who entrusts another party to hold equity on his behalf. A nominal shareholder (Huang in the case) refers to a natural person or legal person that is recorded in the company's articles of association, shareholders' register and industrial and commercial registration, makes no actual capital contribution, and exercises shareholders' rights as entrusted by the actual capital contributor.

II. Legal Risks of Nominee Shareholding

For reasons including sustaining the stability of a company's shareholding structure, facilitating management to boost efficiency, and circumventing certain restrictions, nominee shareholding is highly prevalent in practice. Nevertheless, nominee shareholding per se carries inherent risks. Where the agreement on the relevant rights and obligations between the undisclosed shareholder and the nominal shareholder is ambiguous, or no such agreement has been concluded, the risks will be significantly aggravated.

1. Risks Concerning the Legal Validity of Nominee Equity Holding

Looking back on the typical cases set out at the beginning of the text, the *Letter of Entrustment* signed by Luo Mou and Huang Mou is essentially an entrusted shareholding agreement between a dormant shareholder and a nominal shareholder. Is this agreement valid?

Pursuant to Article 24 of the *Provisions of the Supreme People's Court on Several Issues concerning the Application of the Company Law of the People's Republic of China (III)* (hereinafter referred to as "Interpretation III of the Company Law"), it is stipulated that: "Where an actual contributor and a nominal contributor of a limited liability company conclude a contract which stipulates that the actual contributor shall make capital contributions and enjoy investment rights and interests, and the nominal contributor shall act as the nominal shareholder, in case of a dispute between the actual contributor and the nominal shareholder over the validity of the aforesaid contract, the people's court shall affirm the contract as valid provided that there is no circumstance of invalidity as prescribed by law."

It can be seen therefrom that nominee shareholding can be recognized by law only under certain conditions, namely that it must not violate the mandatory provisions of the laws of China. Otherwise, even if a relevant agreement exists, it runs the risk of being held invalid. In the event that the agreement is held invalid, not only will the actual investor fail to achieve its investment purpose, but such invalidity is also highly likely to give rise to a series of disputes.

2. Legal Risks to Be Borne by Undisclosed Shareholders

(1) Risk of Potential Obstacles to Obtaining Registration as a Shareholder

In a nominee shareholding relationship, the nominee shareholder exercises the rights and performs the obligations of a corporate shareholder on behalf of the actual shareholder, while the actual shareholder remains the genuine shareholder of the company. However, where the actual shareholder intends to be registered as a shareholder of record, certain conditions shall be satisfied. Pursuant to the typical case published by the Shanghai No. 2 Intermediate People's Court, *Zhao v. ZL Technology Co., Ltd., with Zhao Jinmou and Yang as Third Parties (Dispute over Confirmation of Shareholder Qualification)*:

Zhao Mou is the actual capital contributor of 40% of the equity of ZL Technology Co., Ltd., and such proportion of equity is held on his behalf by Zhao Jinmou, a third party. Pursuant to the entrusted equity holding agreement concluded between Zhao Mou and Zhao Jinmou, Zhao Mou filed a lawsuit with the people's court, asserting that he is the actual capital contributor of the aforesaid proportion of equity and requesting ZL Technology Co., Ltd. to complete the aforementioned equity alteration registration formalities with the company registration authority.

During the trial of this case, Zhao Jinmou confirmed that Zhao was the actual capital contributor of the equity representing the said proportion. Other shareholders of ZL Technology Co., Ltd. explicitly stated during the court hearing that they did not consent to Zhao being admitted as a shareholder of the company, and ZL Technology Co., Ltd. also refused to handle the formalities for shareholder alteration registration. The court did not uphold Zhao's litigation claims. Pursuant to the provisions of Judicial Interpretation III of the Company Law of the People's Republic of China, where a dormant shareholder intends to be altered and registered as a nominal shareholder, consent from more than half of the other shareholders of the company shall be obtained. If the aforementioned conditions for becoming a registered shareholder cannot be met, even if the equity nominee agreement is rescinded, the nominee-held equity shall remain registered under the name of the nominal shareholder, and the shareholder rights and interests of the dormant shareholder after the rescission of the agreement will also face the risk of no longer being bound by the original equity nominee agreement.

(2) Risk of Legal Obstacles to the Exercise of Shareholder Rights

The nominee shareholding agreement shall only be valid as between the dormant shareholder and the nominee shareholder, and shall be null and void with respect to the company, other shareholders and third parties. Accordingly, the actual shareholder rights of the dormant shareholder can only be realized through the nominee shareholder. In the event that the nominee shareholder fails to cooperate, the dormant shareholder may incur damages.

(3) Risks of transfer or pledge of nominee-held equity

Pursuant to the typical case of *Song v. Wang and Li: Dispute over Claim for Confirmation of Invalidity of Equity Transfer Contract* issued by the Shanghai No. 2 Intermediate People's Court:

Wang is a registered shareholder of a trading company, holding 24% of the equity interest therein. The capital contribution agreement executed by and between Song and Wang expressly stipulates that the equity interest held by Wang is actually funded by Song. Subsequently, without the consent of Song, Wang entered into an equity transfer agreement with Li, transferring the aforesaid 24% equity interest of the company to the bona fide Li. Other shareholders of the company have no objection to the transfer, and the relevant industrial and commercial alteration registration formalities have been completed accordingly.

Song filed a lawsuit with the court on the ground that he was the actual capital contributor of the said 24% equity interest, claiming that the equity transfer agreement between Wang and Li is void. The court finally dismissed Song's litigation claims. Accordingly, where a nominee shareholder makes unauthorized disposition of the equity interest held on behalf of the actual contributor, including transferring or pledging the aforesaid equity interest to a third party, and such third party meets the conditions for being a bona fide third party, the bona fide third party shall be protected in priority over the holder of the undisclosed equity interest.

(4) Risks of equity interests held under nominee arrangement being frozen or enforced due to the nominal shareholder

Where a nominal shareholder is added as a person subject to enforcement pursuant to an application arising out of his or her personal cases, the equity held under a nominee holding arrangement will very likely be classified as property subject to enforcement. Under such circumstances, the de facto shareholder shall not be entitled to oppose the enforcement on the basis of the equity nominee holding agreement.

3. Legal Risks to Be Borne by Nominee Shareholders

(1) The risk of bearing legal liability

As a nominee shareholder is registered on the company's register of members and in its commercial registration filings, the nominee shareholder shall generally bear liability when problems arise, and may pursue recourse against the actual shareholder pursuant to the nominee equity holding agreement after it has assumed such liability. Reference is made to another leading case published by the Shanghai No. 2 Intermediate People's Court: *Cai v. B Construction Co., Ltd. and Fang (Dispute over Sales Contract)*:

B Construction Co., Ltd. entered into an agreement with S Engineering Co., Ltd., a third party not involved in the present case, under which each party shall contribute RMB 1,000,000 for the proposed establishment of T Environmental Protection Co., Ltd. Separately, B Construction Co., Ltd. concluded an investment agreement with Mr. Fang, which stipulates that 50% of the RMB 1,000,000 capital contribution to be made by B Construction Co., Ltd. to T Environmental Protection Co., Ltd., namely RMB 500,000, shall be actually borne by Mr. Fang; Mr. Fang shall participate in corporate governance in the name of B Construction Co., Ltd. and be entitled to surplus distribution. Following the execution of the aforesaid agreement, Mr. Fang failed to fulfill his actual capital contribution obligation. After the establishment of T Environmental Protection Co., Ltd., as it was incapable of paying its external contractual payments, the creditor Mr. Cai initiated a lawsuit, demanding that B Construction Co., Ltd. assume liability for the debts owed by T Environmental Protection Co., Ltd. to Mr. Cai within the scope of its unpaid capital contributions.

In this case, Company B Construction pleaded that the equity involved was actually held by Fang, who shall be liable for making capital contribution and bearing relevant liabilities. The court of first instance, after trial, rendered a judgment that Company B Construction shall bear supplementary compensation liability for the debts owed by Company T Environmental Protection to Cai within the scope of the principal of RMB 500,000 of its unpaid capital contribution and the accrued interest thereon. After the judgment was pronounced, Company B Construction was dissatisfied with the judgment and filed an appeal. The court of second instance rendered a judgment dismissing the appeal and affirming the original judgment. It can be seen from this case that where the shares held by a nominal shareholder involve defective capital contribution (i.e. the dormant shareholder fails to make actual capital contribution or withdraws the capital contribution), the company's creditors may, based on the shareholder information registered with the industrial and commercial authority, require the nominal shareholder to assume repayment liability for the company's debts within the scope of the defective capital contribution. Where a nominal shareholder raises a defense on the ground that it is only a nominee holder and has no obligation to make capital contribution, such defense will hardly be upheld by the court.

(2) Risk of potential difficulty in exiting the company

While dormant shareholders face difficulties in having their shareholder status formally registered, nominee shareholders are also subject to restrictions on exiting the company. Where a nominee shareholder intends to terminate the shareholding entrustment agreement and exit the company, such action shall likewise be subject to the consent of more than half of the other shareholders.

III. Opinions and Suggestions

1. Conclude and perfect the equity entrustment agreement

As key evidence, the Equity Entrustment Agreement often plays a decisive role in disputes over equity entrustment. On the basis of concluding a written agreement, the more comprehensive the terms of the agreement are, the more conducive it is to mitigating risks. For example, to protect the rights of actual investors, methods for exercising shareholder rights and other relevant matters are usually explicitly specified in the agreement. In addition, detailed liability for breach of contract may be stipulated in the agreement to prevent acts damaging the interests of actual investors, including abuse of shareholder rights, neglect to exercise shareholder rights, or unauthorized disposal of the entrusted equity by the nominee shareholder. Explicit provisions on the ownership of property rights and interests may also be set out in the agreement to avoid subsequent disputes.

2. Disclose to other shareholders of the company and obtain their consent.

To avoid difficulties encountered when dormant shareholders become registered shareholders or when nominal shareholders exit, relevant information may be disclosed to other shareholders in advance, and written evidence signed and confirmed by such shareholders shall be obtained. For example, other shareholders may be required to sign for confirmation on the shareholding entrustment agreement to indicate that they have knowledge of and consent to the aforesaid arrangement.

3. Handling of Equity Pledge

To prevent the equity held by a nominal shareholder on behalf of the actual contributor (dormant shareholder) from being classified as the property of the nominal shareholder subject to enforcement, the nominal shareholder may pledge the aforesaid equity to the actual contributor or a third party designated by the actual contributor, and complete the industrial and commercial registration formalities for the equity pledge.

4. A third party may be appointed to serve as a director, supervisor or senior manager to participate in the operation of the company.

A dormant shareholder may appoint a third party it trusts to serve as a director, supervisor or senior executive of the company, so as to facilitate its understanding of the company's operation. Where the nominee shareholder commits any act impairing the legitimate interests of the dormant shareholder, the dormant shareholder may be notified of such act in a timely manner. Under certain circumstances, directors and supervisors may also directly initiate litigation to safeguard the relevant rights and interests.

Note: All cases cited herein are sourced from the *White Paper on the Trial of Nominee Shareholding Dispute Cases (2012-2016)* issued by the Shanghai No. 2 Intermediate People's Court.