JC Master Research | Typical Cases in the Corporate Equity Change Phase — Equity Transfer Disputes 3

First-instance judgment: The court ruled that Yang must pay Liu liquidated damages in the amount of RMB 1.5 million within ten days from the date this judgment takes effect, and dismissed Liu’s remaining claims. Both Liu and Yang dissatisfied with the ruling, filed appeals.

Second-instance judgment: The appeal is dismissed, and the original judgment is afofficeed.

The court’s final judgment holds that the principal issues in this case are threefold: first, whether Mr. Yang breached the non‑compete obligation stipulated in the Share Transfer Agreement; second, whether Mr. Yang is required to pay liquidated damages to Ms. Liu, and if so, whether the amount of such damages should be adjusted; and third, whether the water purification company bears liability for breach of contract.
 

I. Mr. Yang breached the non-competition obligation stipulated in the Share Transfer Agreement.

 

From the perspective of the specific content of the non-competition obligation, According to the non‑compete clause in the Share Transfer Agreement, during the applicable non‑compete period, Mr. Yang is obligated not to manufacture or operate any patent‑protected technologies and products owned by Mr. Liu and his enterprises; not to manufacture or operate fiber‑bundle filtration technologies and products; and not to engage in any conduct that would harm the interests of Mr. Liu and his enterprises. In light of the plain meaning of the contract, its underlying purpose, and the principle of good faith, the aforementioned contractual provisions may be construed as follows: Given that the subject matter of the Share Transfer Agreement is the equity interest in an environmental engineering company, the term “enterprise” in the clause should be understood to refer exclusively to that environmental engineering company. Accordingly, the obligation to “not manufacture or operate patent‑protected technologies and products owned by Mr. Liu and his enterprises” means that Mr. Liu and the environmental engineering company may not manufacture or operate any patent‑protected technologies and products already in their possession at the time the Share Transfer Agreement was executed. The additional stipulations—“not to manufacture or operate general fiber‑bundle filtration technologies and products, and not to engage in any conduct that would harm the interests of Mr. Liu and his enterprises”—constitute further clarification of this provision and serve to emphasize the associated obligations. In sum, the scope of Mr. Yang’s non‑compete obligations is as follows: (1) he shall not manufacture or operate any patent‑protected technologies and products already owned by Mr. Liu and the environmental engineering company at the time the Share Transfer Agreement was signed; and (2) he shall not manufacture or operate generic fiber‑bundle filtration technologies and products.
 

From the perspective of the commencement date for the performance of this non-competition obligation, Pursuant to the non‑compete clause of the Share Transfer Agreement, Mr. Yang shall commence performance of his non‑compete obligations upon completion of the share transfer transaction. With respect to the conditions for the completion of the equity transfer transaction, the relevant milestone shall be deemed to have been reached upon Liu and Yang’s application to the company registration authority for registration of the change in equity interests. The reasons are as follows: First, viewed from the purpose of the contract, Liu and Yang entered into the Share Transfer Agreement with the aim of transferring equity interests; accordingly, the equity‑transfer provisions constitute the principal terms and primary obligations under the contract, while the non‑competition clause represents a secondary term and ancillary obligation, subordinate to Yang’s duty to transfer his equity. Thus, Yang’s obligation to transfer his equity and the non‑competition obligation attached thereto must be performed concurrently. Second, Yang’s voluntary assumption of the non‑competition obligation serves as an essential foundation for the conclusion and performance of the Share Transfer Agreement between Liu and Yang. The underlying intent was to safeguard Liu’s and the environmental engineering company’s trade secrets and competitive interests by restricting Yang’s right to work and the commercial competitiveness of the enterprise he leads. From the moment Yang transferred his equity to Liu, the environmental engineering company’s trade secrets and competitive interests were exposed; therefore, Yang should have begun to perform his non‑competition obligation from that very date. Third, in light of the nature of the non‑competition obligation, it is a negative obligation: so long as Yang refrains from actively engaging in competitive activities, the obligation is fulfilled. Conversely, if Yang were to actively pursue competitive conduct, the trade secrets and competitive interests of Liu and the environmental engineering company would suffer irreparable harm, thereby undermining the very basis upon which the parties entered into the Share Transfer Agreement—without any possibility of remedy. Accordingly, Yang should have commenced performance of his non‑competition obligation from the date he transferred his equity. Furthermore, considering the actual circumstances of performance, given that Liu had already paid the vast majority of the equity‑transfer consideration, Yang voluntarily cooperated with Liu in filing an application with the corporate registration authority to effect the registration of the equity change. This demonstrates that the equity‑transfer payments made by Liu were sufficient to secure the realization of the substantial portion of Yang’s contractual rights; thus, Yang voluntarily undertook to perform his contractual obligations through such actual performance, starting from that point. Finally, with respect to the specific timing, the day on which Liu and Yang filed their application with the corporate registration authority to register the equity change—the day they reached agreement on the registration and proceeded to implement it—marks the point at which the equity change should, at least between Liu and Yang, be deemed complete. Although, prior to the corporate registration authority’s approval of the registration, the equity change does not yet produce external legal effects—that is, it cannot be invoked against bona fide third parties—it nonetheless acquires internal legal force between Liu and Yang, requiring Yang to begin performing his non‑competition obligation from the date he submitted the application for equity‑change registration.
 

From the perspective of the term for fulfilling the non-competition obligation, With respect to the obligations concerning the patented technologies and products already owned by Liu and the environmental engineering company at the time of the execution of the Share Transfer Agreement, Yang shall be prohibited for life from manufacturing or engaging in the business of such technologies and products. As for generic fiber‑bundle filtration technologies and products, the duration of Yang’s non‑compete obligation shall not exceed two years. In this case, Liu and Yang did not expressly specify in the non‑compete clause of the Share Transfer Agreement the termination date of Yang’s non‑compete obligation. At trial, both parties unanimously conofficeed that, at the time of executing the Share Transfer Agreement, their mutual understanding was that the non‑compete period would extend for life. With respect to Mr. Yang’s obligation not to manufacture or market the patented technologies and products that Mr. Liu and the Environmental Engineering Company already possessed at the time of the execution of the Share Transfer Agreement, since Mr. Liu and the Environmental Engineering Company retain the right to dispose of their own patented technologies and products, prohibiting Mr. Yang from manufacturing or marketing such technologies and products constitutes a legitimate exercise of their lawful rights and does not amount to an undue restriction on Mr. Yang’s rights. Accordingly, the parties’ agreement that this non‑compete obligation shall remain in effect for life does not contravene any mandatory legal provisions and is therefore valid. With respect to Mr. Yang, the obligation not to manufacture or operate general‑purpose fiber‑bundle filtration technologies and products. According to Article 24, Paragraph 2 of the Labor Contract Law of the People’s Republic of China (hereinafter referred to as the “Labor Contract Law”), upon termination or dissolution of a labor contract, an employee who is bound by a confidentiality obligation may not, within a non‑compete period exceeding two years, take employment with another employer engaged in the production or operation of similar products or the conduct of similar business that competes with the original employer, nor may such employee independently establish or operate a business engaged in the production or operation of similar products or the conduct of similar business. This provision constitutes a mandatory rule of binding effect. In the present case, although Yang and Liu were both shareholders of the environmental engineering company at the time of signing the Share Transfer Agreement, and thus enjoyed equal status, the non‑compete clause restricts Yang’s right to work; a lifetime non‑compete period would infringe upon Yang’s fundamental right to subsistence and would also undermine the development of market competition and the advancement of science and technology. Accordingly, the Labor Contract Law’s limitation on the non‑compete period to no more than two years should likewise be applied by analogy to this case. Furthermore, considering the nature of Yang’s non‑compete obligation, the non‑compete clause in the Share Transfer Agreement is a unilateral, gratuitous contractual provision: Liu did not provide any consideration in exchange for Yang’s non‑compete obligation. Therefore, it is inappropriate to impose an excessively stringent duty of care on Yang, and limiting the non‑compete period is indeed necessary. In summary, the period during which Mr. Yang is obligated to observe the non‑compete restriction is as follows: (1) From January 31, 2008—namely, the date on which he filed with the company registration authority for registration of the equity transfer—Mr. Yang shall not manufacture or engage in the business of any patented technologies or products already owned by Mr. Liu and the environmental engineering company at the time the Share Transfer Agreement was executed; (2) From January 31, 2008, through January 30, 2010, Mr. Yang shall not manufacture or engage in the business of generic fiber‑bundle filtration technologies or products.
 

From the perspective of how non-compete obligations are fulfilled, Whether it is Mr. Yang personally or the enterprises he leads or is affiliated with, as long as there is a breach of the non‑compete clause in the Share Transfer Agreement, Mr. Yang shall bear the corresponding liability for breach of contract. In this case, the non‑compete clause of the Share Transfer Agreement stipulates that Mr. Yang—both “in his personal capacity and through the enterprises he leads or is affiliated with”—is obligated to observe the non‑compete restriction. On its face, this provision appears to define the parties bound by the obligation; however, in accordance with the principle of privity of contract, a contract generally does not impose obligations on persons outside the contracting parties. Therefore, considering the plain meaning of the contract, its purpose, and the principle of good faith, the aforementioned wording should be construed as an agreement regarding the manner of conduct: namely, Mr. Yang may neither engage in competitive activities himself nor through any enterprise he leads or is affiliated with. Taking into account the facts of the entire case and the relationship between Mr. Yang and the water‑purification company, it is established that Mr. Yang became the controlling shareholder of the water‑purification company through an increase in capital and acquisition of shares. Accordingly, from the date of that capital increase, the water‑purification company can be deemed to have become an enterprise led by or affiliated with Mr. Yang. Furthermore, examining the projects in which the water‑purification company participated in bidding, both successful bids were secured during the period when Mr. Yang was subject to the non‑compete restriction and when he held controlling interest in the water‑purification company. In sum, it is beyond doubt that Mr. Yang’s participation in bidding and winning contracts in the name of the water‑purification company constituted a violation of the non‑compete obligation set forth in the Share Transfer Agreement.
 

II. Yang shall pay Liu liquidated damages; however, the amount of such liquidated damages shall be adjusted.

Given that Mr. Yang’s conduct has already breached the non‑compete obligation stipulated in the Share Transfer Agreement, he is duly liable for corresponding breach of contract. Accordingly, Mr. Yang should pay liquidated damages to Ms. Liu in accordance with the non‑compete clause of the Share Transfer Agreement. Where the agreed liquidated damages are excessively higher than the actual losses incurred, the parties may request the people’s court or an arbitration institution to reduce them appropriately. If a party contends that the agreed liquidated damages are excessive and seeks a reasonable reduction, the people’s court shall, on the basis of the actual losses and taking into account such comprehensive factors as the performance of the contract, the degree of fault of the parties, and the expected benefits, assess the matter in light of the principles of fairness and good faith and render a decision. The premise for a party to seek a reduction in liquidated damages is that the amount is unreasonably high in relation to the actual losses; as the breaching party, Mr. Yang bears the burden of proving that the liquidated damages were excessively high, while Ms. Liu, as the non‑breaching party, must likewise furnish relevant evidence to demonstrate that the agreed liquidated damages are reasonable. In this case, Neither Liu nor Yang was able to furnish sufficient and credible evidence in support of their respective claims. Accordingly, the court, relying on the existing evidence and taking into account all the established facts as well as the prevailing level of development in the relevant industry, applied the principles of fairness and good faith. Based on the mutually agreed-upon liquidated damages of RMB 2 million, the amount is appropriately reduced, and the liquidated damages are set at RMB 1.5 million.
 

III. The water purification company shall not be liable for breach of contract.
 

The water purification company is not a party to the Share Transfer Agreement, and there is no contractual relationship of rights and obligations between Mr. Liu and the water purification company, pursuant to… The principle of relativity of contracts The non‑compete clause in the Share Transfer Agreement is enforceable only against Mr. Yang and does not bind the Water Purification Company; accordingly, the Water Purification Company is not required to comply with the non‑compete obligation nor bear any liability for breach of contract.

The Civil Code of the People’s Republic of China (This case is governed by Articles 62 and 140 of the General Provisions of the Civil Law of the People’s Republic of China, which came into effect on August 27, 2009.)
 

Article 119 A contract duly concluded in accordance with the law is legally binding on the parties.
 

Article 143 A civil legal act is valid if it meets the following conditions:
 

(1) The actor possesses the corresponding civil capacity for conduct;
 

(2) The expression of intent is genuine;
 

(3) It shall not violate the mandatory provisions of laws and administrative regulations, nor contravene public order and good morals.
 

Article 148 Civil juristic acts may be subject to conditions, except where their nature precludes such conditions. A civil juristic act subject to a condition precedent shall become effective upon the fulfillment of that condition. A civil juristic act subject to a condition subsequent shall cease to be effective upon the fulfillment of that condition.
 

Article 509 The parties shall perform their respective obligations in full in accordance with the agreement.
 

The parties shall abide by the principle of good faith and, in accordance with the nature and purpose of the contract and prevailing trade practices, perform obligations such as notification, assistance, and confidentiality.
 

In the course of performing the contract, the parties shall avoid wasting resources, polluting the environment, and damaging the ecosystem.
 

Article 585 The parties may agree that, in the event of a breach by one party, the breaching party shall pay the other party a specified amount of liquidated damages, or they may agree on a method for calculating the amount of compensation for losses arising from the breach.
 

If the agreed‑upon liquidated damages are lower than the actual losses incurred, the people’s court or the arbitration institution may, upon request of a party, increase them; if the agreed‑upon liquidated damages are excessively higher than the actual losses, the people’s court or the arbitration institution may, upon request of a party, reduce them appropriately.
 

Where the parties have agreed on a liquidated damages clause for delayed performance, the defaulting party, after paying the liquidated damages, shall still perform the obligation.
 

Interpretation of the Supreme People’s Court on Several Issues Concerning the Application of the General Provisions of the Contract Section of the Civil Code of the People’s Republic of China (This case is governed by Article 29 of the Interpretation (II) of the Supreme People’s Court on Several Issues Concerning the Application of the Contract Law of the People’s Republic of China, which came into effect in 2009 (Fa Shi [2009] No. 5).)
 

Article 65 Where a party contends that the agreed‑upon liquidated damages are excessively higher than the losses caused by the breach and requests an appropriate reduction, the people’s court shall, on the basis of the losses specified in Article 584 of the Civil Code, take into account such factors as the parties to the contract, the type of transaction, the performance of the contract, the degree of fault of the parties, and the context of performance, and render its decision in accordance with the principles of fairness and good faith.
 

Where the agreed liquidated damages exceed 30 percent of the actual losses, the people’s court will generally deem them to be excessively higher than the losses incurred.

 

Where a party who has maliciously breached the contract seeks a reduction in liquidated damages, the people’s court will generally not grant such request.

 

The Labor Contract Law of the People’s Republic of China
 

Article 24 [Scope and Duration of Non-Compete Restrictions] The persons subject to non‑compete restrictions are limited to the employer’s senior management, senior technical personnel, and other individuals who have a duty of confidentiality. The scope, geographic area, and duration of the non‑compete restriction shall be agreed upon by the employer and the employee, and such agreement must not violate applicable laws or regulations.

 

After the termination or dissolution of the labor contract, the non‑compete period during which the persons specified in the preceding paragraph may be employed by another employer engaged in the production or operation of similar products or the conduct of similar business, or may themselves establish an enterprise to produce or operate such products or engage in such business, shall not exceed two years.