Redressing the Rights of Shareholders in Corporate Fraud

In China's relatively brief corporate history, corporate fraud has been a recurring feature. The recent high-profile arrest of Gu Chujun, the former chairman of Guangdong Kelon, on charges of embezzlement, has again focused attention on the need to improve corporate governance and legal protection for minority shareholders. Kelon's shareholders recently launched lawsuits against the company and Gu in the hope of recovering compensation for the losses they have suffered as a result of his alleged fraud.

Shareholder class actions of this kind are rare in China and the chances of shareholders recovering compensation are slim. Indeed, as discussed in this article, China's nascent corporate law and undeveloped judicial system lack adequate remedies for effective shareholder redress.

Ousting the Management

According to thePRC Company Law(中华人民共和国公司法), shareholders are entitled to request an interim shareholders' meeting to seek the removal of suspect directors. Indeed, this is what Yan Yiming, a PRC lawyer well-known for advocating shareholder rights and himself a small shareholder in Kelon, attempted to do prior to the decision by the board of Kelon to remove Gu as chairman. Certain minimum shareholding thresholds must be met before an interim meeting can be requested. In the case of a limited liability company, shareholders holding more than a quarter of voting rights may make such a request, whereas in a joint stock company, the support of shareholders holding at least 10% of the issued shares is necessary. These thresholds may in practice be difficult to achieve, particularly in listed companies where non-tradable state and legal person shares typically account for as much as two-thirds of total share capital.

A further complication is that according to the PRC Company Law(中华人民共和国公司法), only company directors have the right to convene a shareholders' meeting. In many other jurisdictions, shareholders may apply to the court to mandate an interim meeting should company directors fail to respond to shareholder demands within a specified time-period. Since shareholders in Chinese companies lack this right, the scheduling and agendas of general meetings are often set at the will of board members and controlling shareholders. This apparent conflict of interest has often served to deprive minority shareholders of an effective mechanism to participate in companies' decision-making process and monitor behaviour of management.

Judicial Recourse

If minority shareholders cannot defend their interests through shareholders' meetings, then perhaps recourse may be sought through judicial proceedings? Yet there are few legal provisions governing the exercise of this right in China. According to Article 111 of the PRC Company Law(中华人民共和国公司法), shareholders are entitled to bring a suit to the People's Court to enjoin the execution of resolutions of a shareholders' meeting or board meeting deeming actions which are illegal or have violated the legitimate interests of shareholders. This provision, however, does not empower shareholders or the company to seek compensation from the responsible directors or officers.

Article 118 of the PRC Company Law(中华人民共和国公司法) stipulates that directors participating in the adoption of resolutions that are proven illegal shall be liable to the company for the damages caused. Chapter 10 of the law further imposes liabilities upon directors and officers who have committed the respective malpractices and confers the company the right to recover damages from them. However, any legal action to be taken by the company against the relevant persons under these provisions would presumably require the endorsement of the board which, if controlled by the fraudulent majority, would unlikely be willing to support such action.

Right of Exit

A further notable right of minority shareholders in other jurisdictions is the ability to exit a company when they consider that the interests of the controlling majority are severely out of line with those of their own. With this in mind, the National People's Congress proposed in late August 2005 amendments to the existing PRC Company Law to provide certain exit rights for minority shareholders. These include the right of shareholders to apply for the company's dissolution with a People's Court, so long as they successfully prove that the company is experiencing serious problems and its continuing operations will incur substantial and irreparable losses. However, under the proposed revision, an endorsement from at least 10% of the company's voting shares is required to file an application. It may therefore be difficult for the minority shareholders, who are often highly discrete and uncoordinated, to act collectively to make such an application.

The proposed revisions to the PRC Company Law(中华人民共和国公司法) also contemplate the right for a shareholder to be bought out at a fair price by the company, where the company has been consistently profitable but has failed to distribute its profits to the shareholders. Where an agreement cannot be reached between the shareholder and the company regarding the share sale, the shareholder may commence proceedings with a People's Court to seek redress.

Conclusion

Improving corporate governance is crucial to the creation of an attractive investment environment. China, like most other developing economies, still has a long way to go in achieving these goals. However, the recent debate on reforming the PRC Company Law(中华人民共和国公司法) as well as the growing public awareness of the need to improve minority shareholder protection in light of the Kelon saga and other corporate scandals, are an encouraging start in creating better corporate governance in the country.