Mortgage of Cooperative Joint Venture Assets Without Board Approval

When the pharmaceutical company failed to repay the loan, the bank sued both the pharmaceutical company and Company A, seeking repayment of the loan plus interest from the proceeds of the sale of the mortgaged building.

The provincial level High People's Court held that the consent signed by the three Hong Kong directors in the absence of a properly convened board meeting did not meet the requirements of IR Articles 28 and 29 for a valid board resolution. Accordingly, the mortgage agreement was invalid.

On appeal, the Supreme People's Court (SPC) noted that according to Article 50 of the PRC Contract Law (中华人民共和国合同法), a contract concluded by a legal representative in excess of his authority will be valid unless the other party knows or should have known that the legal representative was acting in excess of his authority. The Court found that although Zheng had exceeded his authority in entering into the mortgage agreement, the bank had reason to believe Zheng was authorized to enter into the agreement based on the certificate of title and the consent of the three directors.

The SPC reasoned that the requirements of Articles 28 and 29 are internal company matters regarding the structure of the company and the allocation of authority. A company cannot rely on the failure to comply with such requirements to defeat the claims of an unsuspecting bank. Moreover, in this case, the mortgage was properly registered. Accordingly, the Court held that the mortgage agreement was valid and ordered the sale of the building with the proceeds to be paid to the bank on a priority basis.

Assessment

This case involves apparent authority, a new concept formally introduced by the 1999 PRC Contract Law (中华人民共和国合同法). Having failed to meet the requirements of IR Articles 28 and 29, Zheng clearly did not have the actual authority to mortgage the Company's assets. However, did the bank reasonably believe that Zheng had authority to enter into the agreement? More specifically, should the bank be obligated at least to try to verify Zheng had the necessary authority by requiring him to produce a board resolution that, on its face, meets the requirements of Articles 28 and 29?

In practice, PRC courts often reason that an agreement between a company and a third party that requires board approval ought still be considered valid, even if such approval is not obtained. This is because such approvals are internal matters and the third party has no obligation to investigate or conduct due diligence.

However, in this case, the board approval requirement is not simply an internal matter that was decided by the parties themselves. Rather, it is a statutory obligation imposed by the State Council on co-operative joint ventures to protect the party that is in the minority and does not appoint the chairperson. Moreover, in this case, the bank, a sophisticated party that can be expected to know the requirements for cooperative joint ventures to mortgage their assets, could have easily ascertained the number of directors required for a duly authorized meeting by simply examining Company A's articles of association. The bank could protect itself further by including a representation and warranty in the mortgage agreement stating that the Company has obtained all necessary corporate approvals to enter into the agreement and will indemnify the bank in full if it has not.

Such a contractual right for indemnification would not give the bank a priority right to the proceeds of the sale of the building if the Company were insolvent and could not otherwise repay the loan. Thus, the bank would still have an incentive to do the minimal due diligence required to review the Company's articles of association and board meeting minutes. The result is that there would be fewer disputes of this sort and more protection for the minority partner in co-operative joint ventures, thereby achieving the State Council's purpose in enacting IR Articles 28 and 29.

By Shirley Xu and Feng Jinwei
Yiwen Law Firm,
Beijing