Chinese court adopts narrow interpretation of public policy exception when enforcing HKIAC awards

Bar & Bench

By Arthur Ma & Joanna Du

In the fourth article under the HKIAC series, Arthur Ma & Joanna Du examine the interpretation of laws with respect to arbitral awards by Chinese courts.

In a recent court ruling, a Chinese court enforced two awards issued by the Hong Kong International Arbitration Centre (“HKIAC”) despite claims that enforcing the awards would violate China’s public policy. The court ruling immediately attracted heated discussion because it is the first time a Chinese court has considered a variable interest entity (“VIE”), valuation adjustment mechanism (“VAM”) and the public policy exception in one ruling.

This case is also another demonstration of the excellent track record of enforcement of HKIAC awards in China.

The Fujian Across Express Case

On 5 November 2014, the Fuzhou Intermediate People’s Court (“Fuzhou Court”) handed down a civil ruling in Fujian Across Express Information Technology Co., Ltd and others v China MediaExpress Holdings, Inc. (“Fujian Across Express Case”)[1], confirming the enforceability of two HKIAC awards in mainland China under the Arrangements on the Mutual Enforcement of Arbitral Awards between the Mainland and the Hong Kong Special Administrative Region (“Arrangement”).

The two HKIAC awards

Zheng Cheng, Ouwen Lin and Qingpin Lin were the three shareholders of China MediaExpress Holdings, Inc. (“China MediaExpress”). Cheng was also the legal representative of Fujian Across Express Information Technology Co., Ltd (“Across”) and Fujian Fenzhong Media Co., Ltd (“Fenzhong”). In 2009, China MediaExpress went public in the United States via reverse takeover and subsequently entered into a Share Purchase Agreement (“SPA”) and Investors’ Rights Agreement (“IRA”) with Starr Investments Cayman II Inc (“Starr”).

Under the SPA, Starr purchased: (1) 1,000,000 convertible preference shares in consideration of US$30,000,000, and (2) 1,545,455 ordinary share warrants in consideration of US$6.47 per share. Under the SPA, where certain events were triggered, Starr could request China MediaExpress, its subsidiaries and shareholders to buy back Starr’s shares or to assume liability for the compensation. In the absence of these events, Starr would only be entitled to the rights as a China MediaExpress’s shareholder.

Following the transaction, Starr learned Cheng and others were involved in improper and illegal secret dealings that violated the SPA and IRA. To protect its interest, Starr commenced arbitration before HKIAC against Cheng, Across, Fenzhong and China MediaExpress.

On 19 December 2012, the arbitral tribunal rendered two arbitral awards (HKIAC/A11030 and HKIAC/A11098), ordering Cheng, Across, Fenzhong and China MediaExpress to compensate Starr for losses under the SPA and IRA, and to pay legal costs and interest.

Enforcement of the two HKIAC awards

Starr subsequently applied to the Fuzhou Court, as the competent court under PRC law, for enforcement of the awards under the Arrangement.

Cheng, Across and Fenzhong (“Applicants”) submitted that the HKIAC awards seriously violated the “public interest of the Mainland”. First, they contended that the VIE structure adopted by the parties in the underlying transactions, is prohibited by the mandatory provisions of Chinese law[2]. Second, they claimed that the SPA was a VAM arrangement which infringed the interests of China MediaExpress, its creditors and other shareholders. Third, the Applicants argued that the arbitration agreement applied US law with the purpose of sidestepping the mandatory provisions of the relevant Chinese laws. Based on these grounds, the Applicants requested the Fuzhou Court reject Starr’s application for recognition and enforcement of the awards.

In response to these contentions, Starr argued that enforcing the HKIAC awards would not violate the “public interest of the Mainland”. Specifically, Starr argued that the wording of Article 7 of the Arrangement indicates that the Court should only examine whether the consequence of enforcement would violate the “public interest of the Mainland”, not whether the applicable law issue in the substantive legal dispute would violate “public interest of the Mainland”.

On this premise enforcement of the HKIAC awards would compel the Applicants to compensate the losses incurred by Starr under the SPA and IRA which would encourage parties to abide by their contractual obligations. Starr then sought to distinguish public interest from the mandatory rules applicable in the Mainland; when considering whether enforcement of a Hong Kong award would violate the “public interest of the Mainland”, the correct reference was the basic legal system of China and the fundamental interest of the society.

Fuzhou Court’s Ruling

After reviewing both sides’ arguments, the Fuzhou Court ruled in favour of Starr and rejected the Applicants’ request for non-enforcement. In particular, the Fuzhou Court ruled that:

First, both HKIAC awards ordered the Applicants to compensate Starr for its loss arising out of the Applicants’ breach of the SPA and IRA, rather than ordering the Applicants to continue to perform the SPA or IRA. Therefore enforcing the HKIAC awards would encourage people to abide by the agreements they have entered into, uphold the spirit of contract law and serve the purpose of safeguarding the public interest.

Second, as the Supreme People’s Court (“SPC”) has directed in a previous case, violations of certain regulations concerning VIE and VAM do not necessarily constitute a violation of the “public interest of the Mainland”.

Public Policy as a Ground to Refuse Enforcement of Foreign Awards in China

The Arrangement which was drafted by the SPC in 1999 takes note of the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (“New York Convention”)[3] in relation to the non-enforcement of arbitral awards made in Hong Kong. In particular, pursuant to Article 7 of Section 3, if a Mainland Chinese court believes that enforcing a Hong Kong arbitral award would violate “public interest of the Mainland”, the court may refuse to enforce such award.

Notably, following China’s accession to the New York Convention, the SPC has been holding a very tight line in interpreting the “public policy” exception. On numerous occasions, the Chinese courts have affirmed that a mere breach of mandatory provisions of Chinese laws or regulations do not amount to a violation of the public policy of China.[4] In a previous case, the SPC stated that “the issue of public policy shall only be restricted to the circumstances where recognising the arbitral award will violate Chinese basic legal system and damage Chinese basic social interest“.[5]

The legal status of VIE under Chinese Law

As the Applicant contended in the Fujian Across Express Case, the VIE structure adopted in the parties’ underlying transactions is prohibited by the mandatory provisions of Chinese law.

A VIE arrangement refers to a business structure which typically involves an onshore wholly foreign-owned enterprise (“WFOE”) or foreign-invested enterprise (“FIE”) owned by overseas investors (and sometimes mainland China founders). The WFOE or FIE in turn controls a domestic company which holds the necessary licence to operate in China in certain foreign restricted or prohibited sectors. The WFOE or FIE’s control is usually through contractual arrangement rather than share ownership.

The VIE structure is a creative commercial device welcomed by many institutional foreign investors and local founders, however its legality under PRC law is unclear. It is popular among foreign investors because it can be used to bypass China’s stringent rules on foreign ownership in certain protected sectors. It also enables domestic companies to list overseas on international capital markets., for example, was listed in the NASDAQ in 2010 and is a well known as the pioneer of the VIE structure. Despite this, the VIE structure has, until very recently,[6] never received official recognition, arguably due to its controversial nature circumventing (a) China’s regulations on foreign investment in certain restricted or prohibited sectors; and (b) the required approvals from the relevant government authorities in China.

The legal status of VAM under Chinese law

Compared with VIE, VAM is only more problematic as such a commonly used investment tool for private equity houses has been announced illegal under certain circumstances by the Chinese courts since 2012.

VAM is the mechanism that incentivises investment by mitigating against the uncertainties and risks associated with the investee company’s financial performance. A typical VAM provides that, if the investee company meets (or fails to meet) certain financial targets within an agreed period following the investment, the investee company’s valuation will be adjusted accordingly. For example, it is usually agreed that should the investee company fail to meet the agreed financial targets, the investors would be compensated by either additional shares or cash.

As with VIE, the legality of VAM under PRC law remained unclear until the case Haifu v Shiheng, Wisdom Asia and Lu Bo (2012) Min Ti Zi No. 11. The case concerned a capital increase agreement (“Capital Increase Agreement”) entered into by Haifu Investment Co., Ltd (“Haifu”), Gansu Zhongxing Zinc Co., Ltd (which later changed its name to Shiheng Non-Ferrous Resources Recycle Co., Ltd) (“Shiheng”), Wisdom Asia Limited (“Wisdom Asia”) and Lu Bo. According to the Capital Increase Agreement, Haifu would invest RMB20 million in Shiheng to subscribe for its capital increase. Section 7(2) of the Capital Increase Agreement provided for a VAM arrangement that, if Shiheng’s net profit in 2008 was to fall below RMB30 million, Haifu would be entitled to request compensation from Shiheng; if Shiheng was unable to provide compensation, Haifu would be entitled to request that compensation from Widsom Asia.

In the first and second instances, the courts denied the legality of the VAM arrangement in the Capital Increase Agreement. In retrial, the SPC ruled that (a) the VAM arrangement as a matter between the original shareholders and the investors shall be valid and enforceable; and (b) the VAM arrangement as a matter between the investee company and the investors shall be invalid and unenforceable. The SPC’s ruling provides some comfort to investors which are hesitant of VAM’s legal status in China.

Significance of the Fuzhou Court Ruling

The Fuzhou Court’s ruling in the Fujian Across Express Case is significant. First, it ruled that when examining a “violation of public interest of the Mainland” claim brought under the Arrangement, the court should look at the effect or consequence of the enforcement instead of the content or substantive issues in the award. Second and more importantly, the ruling clarified that “public interest of the Mainland” or “public policy” in China is by no means equivalent to the mandatory provisions of Chinese laws or regulations. Therefore, a violation of government regulations does not necessarily equate to a violation of the “public interest” or “public policy” of the Mainland.

On a broader view, the Fujian Across Express Case once again demonstrates the Chinese courts’ commitment to enforcing arbitral awards under the Arrangement, which has resulted in the excellent record of enforcement of Hong Kong and HKIAC awards in China.

Arthur Ma
Arthur Ma
Joanna Du
Joanna Du

Arthur Ma is a Partner at DaHui Lawyers, and  Joanna Du  is an Associate  at Herbert Smith Freehills)

[1] (2014) Rong Zhi Jian Zi No.51
[2] In particular, the Applicants submitted that the VIE arrangement violates: (1) Provisions on the Administration of Foreign-Invested Telecommunications Enterprises issued by the State Council on 10 September 2008, (2) Circular on Intensifying the Administration of Foreign Investment in Value-added Telecommunications Services issued by the Ministry of Information Industry (the now Ministry of Industry and Information Technology) on 13 July 2006, and (3) Provisions of the Ministry of Commerce on the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors issued by the Ministry of Commerce on 25 August 2011.
[4] Refer to the Reply of the SPC on Request for Instructions on Application of ED&F (Hong Kong) Co., Ltd for Recognition and Enforcement of the Arbitral Award of London Sugar Association [2003] Min Si Ta Zi No.3; Reply to Request for Instructions regarding Haikou Intermediate People’s Court’s Refusal to Recognise and Enforce the Arbitral Award of the Stockholm Chamber of Commerce issued by the Supreme People’s Court on 13 July 2005
[5] Refer to the SPC’s Reply to the Request for Instructions on Non-Recognition of No.07-11 (Tokyo) Arbitral Award of the Japan Commercial Arbitration Association on 29 June 2010.
[6] It should be noted that on 19 January 2015, the Ministry of Commerce published the draft PRC Foreign Investment Law for public comment. The draft for the very first time addressed the VIE structure in writing and introduced options for dealing with VIEs. Although the Foreign Investment Law has yet to be finalised and various issues still remain to be resolved, it at least evidences China’s determination to put the VIE under the realm of legal regulation.
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