I. New Corporate Officer Liabilities under the China Company Law
We start our analysis by giving three examples of corporate officer liability under the new law.
1. Fiduciary duty specified in Art. 180
In China company law, fiduciary duty refers to the duties of loyalty and diligence. The Art. 180 provides that directors, supervisors, and senior officers owe a duty of loyalty to the company and shall take efforts to avoid conflicts between their personal interests and the interests of the company, and shall not use their power and privileges in the company to seek improper benefits for themselves and others.
The other part of fiduciary duty is the duty of diligence, which means that directors, supervisors, and senior officers owe a duty of diligence to the company. When performing their duties, they should exercise the usual and reasonable care that a manager should have for the benefit of company.
2. Losses caused to others by managers specified in Art.191
When directors or senior officers perform their duties and cause losses to others, the company should be first liable for damage compensation. But for the director or senior officers who have intent or gross negligence in causing such losses, they personally shall also be held responsible.
3. Joint liability from the controlling person instructing executives in Art.192
In cases where a controlling shareholder, or actual control person we normally called, of a company instructs its senior officer to engage in actions that are harmful to the interests of the company or its other shareholders, both the controlling shareholder and the senior officer involved shall bear joint and several liabilities.
II. Litigation Risks under the New China Company Law
1. Breaching director or executive officer’s fiduciary duties
There are multiple ways that plaintiffs can bring lawsuits against corporate executives for breaching their fiduciary duties:
(1) direct lawsuits brought by a company itself against corporate officers;
(2) shareholder derivative lawsuit brought by shareholders on behalf of a company or its board of directors/board of supervisors; and
(3) litigations initiated by third parties.
For example, under Article 211 of new Company Law, if a company distributes profits to shareholder(s) in violation of the law, and causes losses to the company, the shareholder(s) and the responsible executives shall be liable for losses.
In corporate business reality, other than being a defendant itself, management team will also need to respond to the litigations against their company, subsidiaries and even parent companies and their ultimate shareholders.
2. Piercing corporate’s veil and parent company’s liability
“Piercing corporate veil” means in China Company Law, in order to seek remediation, plaintiffs can skip a defendant company by denying its limited liability, or by denying its legal personality as an entity, and bring the case against its shareholders. It is about a liability that is going to be passed to the parent company. In China company law, this liability can also be passed to executive officers of the parent company or those of its other subsidiaries.
Take a recent case as an example. The Supreme People's Court discussed in its opinion that in conditions where a subsidiary is no longer in a position to operate independently and be self-supporting, and when the parent company causes a harmful situation and abuses its rights to damage the interests of its subsidiary, the parent company shall be jointly liable for the debts of its subsidiary.
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(1) The common features of Piercing cases
The Circular of the Supreme People's Court on Issuing the Summaries of the National Conference for the Work of Courts in the Trial of Civil and Commercial Cases
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summarized the common features of similar cases, to which Piercing the Corporate Veil can be applied. The common reasons include parent company and subsidiary personality confusion, excessive dominance and control by parent company, and significant capital shortage at the subsidiary level.
The new Company Law also adds a horizontal direction of such piercing, which means legal personality denial for the same level subsidiaries under a same shareholder control if, for example, one company transfers capital or profits from one subsidiary to another in order to avoid the debt of the first subsidiary.
At the vertical direction, from top to down, another Article 189(4) of new Company Law allows shareholders of a parent company to bring a shareholder derivative lawsuit against the senior managers within its wholly owned subsidiary.
(2) A defense strategy: the principle of business judgment
The new Company Law adds a specific interpretation for the duty of diligence, which says that the directors and officers shall act as reasonable business persons. This is the principle of business judgment. Senior management team can leverage evidence of how a reasonable business person makes a decision in similar situation to support their defense. It’s necessary to add that the reasonable judgement principle should not be measured purely by business performance results. It is not a result-driven logic. The principle shall be applied in the actual dispute context. It will need to take efforts by looking into the actual decision-making process and restore a comprehensive picture of the process, including whether the business decision is made in line with the AOA and the company charter, whether it is within the officer’s delegation scope, and other relevant factors.
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The principle offers a defense strategy. But it also leaves room for Chinese courts. The judges have their discretion when determining if an officer's business judgment is reasonable. Therefore, in actual litigations, the burden of proof will be on companies and on their officers. The senior management team needs to keep sufficient records showing how a business decision is made. Executives should stay away from any indicators of non-diligence or insufficient diligence, for examples, excessive controls by parent company, losses of independence at the subsidiary level.
III. Scenarios of Executive Liabilities
Getting into scenarios of what might actually be happening in the MNCs can provide a better understanding of how executives should perform their duties of loyalty and diligence.
1. Parent company’s interfering in subsidiary’s business operation
In another Supreme People's Court case, the appellate court held that the interests of a wholly-owned subsidiary and its parent company are clearly aligned, therefore the fiduciary duty should be naturally extended to the subsidiary. When the parent company’s executive officer improperly seeks business opportunities of the subsidiary and harms the subsidiary's interests, the executive officer should be liable for damages.
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The case indicates that parent companies should think deep how the management team in their headquarters interacts with people in their subsidiaries. Corporate officers need to avoid intervening the daily operation of their subsidiaries.
2. Appointment of Legal Representatives
In MNC context, when companies such as a manufacturing plant needs to name a legal representative but there are no suitable candidates, companies often find an alternative as a temporary solution. But if the temporary candidate is incapable of the manager position, the actual operation process may leave evidence that the local legal rep does not have the ability to operate on its own and in fact it is the parent company that actually makes the decisions. The MNC will run the risk of personality mixing and loss of corporate independence.
Article 11 of new Company Law clearly stipulates that the consequence of a legal representative's behavior shall be borne by the company. Even if there is evidence that the company's bylaw or shareholders' meeting has set up limitations that the legal representative can only act in certain scope, those limitations will not be taken as excuses when it comes to external counterparts who don't know such limits and act in good faith when dealing with the company.
So, if the legal representative acts improperly and causes damage while doing their job, the company may have to take the hit. There are not only symbolic functions of legal rep, but also real meaningful impacts as being a legal rep.
3. Response to government investigations
When facing a government investigation, how managers respond to it is quite important. It can bring similar questions when a MNC has a flat management structure and it is just so easy to confuse investigators that a parent company is doing things that its subsidiary is supposed to do, leaving impression or evidence of mixed legal personality.
When a MNC has too complex organizational structure and legal entities’ behaviors under its headquarter are intertwined, it is often critical to differentiate the actual legal entities and their responsible management team who can be really responsible for responding to external authorities.
IV. Mitigate Executive Liabilities through Corporate Compliance
From the scenarios just discussed above, we can summarize a few suggestions on good corporate governance and compliance practices.
(1) Pay attention to local corporate governance mechanism and, to a certain degree, maintain local subsidiary’s independence. Parent company should refrain from intervening subsidiaries’ daily operations. Maintain an effective local management team and keep its autonomy. Legal Rep in Chinese legal context is the key. We suggest never trying to manipulate the Legal Rep. For MNCs with flat management structure or small size companies, this consideration is especially important.
(2) To maintain independence, we suggest setting up specific rules for communication between parent company and subsidiaries. This is what we call the code of communication. Managers should maintain alerts on the content of the communications and the way by which headquarter managers communicate with people at the subsidiary level. This can be applied to internal reports, business discussions through emails, memos, PPTs and recorded phones.
(3) Maintain a balanced governance process. When interacting with authorities and third parties for legal and compliance matters, trust and rely on chief legal officers/GCs to handle the legal matters in a professional way. Business leaders should refrain from directly handling such legal matters.
(4) A strong compliance culture and internal control program with attention to details and processes is still a must-have. It includes, for examples, proper record keeping of managers’ decision-making process, effective management of whistleblowing program, compliance awareness and culture.
V. Conclusion
The new Company Law and judicial cases have sent a clear message to the industry about the importance of good governance and strong compliance program. We believe it will change the overall landscape of China company law.
It should be noticed in many situations beyond fiduciary duty that corporate officers are held responsible for corporate wrongdoings. This involves several other laws such as anti-competition; export control, on which recently China MOFCOM issued a new regulation of dual-use items; Anti-money laundering law that was just revised; even national security matters. All the rules should raise attention for corporate managers.
