Corporate Governance under the New Company Law (Part 1): Fiduciary Duties and Minority Shareholder Protection

The Anglo-American corporate governance models, with their emphasis on shareholder protection, influenced recent reform efforts around the globe. In France, economic deregulation and losses resulting from opaque managerial initiatives placed corporate governance squarely into the national reform debate. French companies unwound their concentrated cross-shareholdings to attract Anglo-American institutional investors, which in turn were able to assert successful demands for further shareholder protection. The Asian financial crisis precipitated a renewed focus on governance shortcomings in certain Asian economies and underscored the need to develop advanced and resilient capital markets. For instance, Malaysia responded to the crisis with reforms of its capital markets regulatory framework and a comprehensive corporate governance code promoting best practices in the qualifications of board members and the relationships among the board, managers and shareholders. Companies listed on the Kuala Lumpur Stock Exchange are required to disclose the extent of their compliance with the code.

With much of the global economy focused on corporate governance, commentators and academics assessed the role of corporate governance practices in firms' ability to attract external financing. Investors' legal protections are now widely regarded as an important factor in the development of capital markets.¹ A growing body of closely related research indicates higher valuations for companies governed by principles favorable to investors.²

Corporate governance reform in China

China emerged from the Asian financial crisis relatively unscathed. Its tight capital controls, large foreign currency reserves and illiquid foreign investment insulated China from the external shocks that roiled many of the region's economies. However, the government acknowledged the potential benefits from increased capital mobility; in 2003, the Central Committee announced a plan to achieve gradual capital account convertibility "provided that risks can be effectively guarded off." In light of the weaknesses in its banking sector, China is approaching capital account flexibility cautiously. Meanwhile, China continues to implement reforms in pursuit of restructuring and large-scale privatization of state-owned enterprises (SOEs) to relieve the country of the fiscal drain caused by much of the state sector. China also continues to develop its financial sector institutions. The establishment of transparent governance structures that promote investor protection and effective dissemination of information is regarded as a pre-condition to the successful implementation of these inter-connected policy prerogatives.

In a speech delivered in 2002, Zhou Xiaochuan, the then Chairman of the China Securities Regulatory Commission (CSRC), commented that "foreign research proves that the better investor protection in a country or region, the better developed the capital market in that country or region, and the stronger its capability to resist financial risks." That year, the CSRC issued the Code of Corporate Governance for Listed Companies in China (Listed Companies Code), in an attempt to improve corporate governance behavior by guiding the evolution of best practices in such areas as information disclosure and the supervision of management. However, the Listed Companies Code was inconsistently enforced and it was not enough to regain momentum in the equity markets. The new Company Law promotes many of the principles articulated by the Listed Companies Code, including protections for minority shareholders and shareholders' right to seek civil remedies. These principles are now mandatory for listed and unlisted companies, and the requirements have received further clarification.

Impact of the new Company Law

The legal relationship between investors and management of Chinese companies is profoundly affected by the New Company Law.³ Chinese and foreign investors must understand the tools they now wield to impact decision-making. Controlling shareholders must be doubly aware; under certain circumstances, they might now be subjected to civil actions by minority shareholders. Chinese directors, officers and managers appear to face the prospect of much greater liabilities, particularly civil liabilities in shareholder lawsuits, for their missteps under the New Company Law. Not only are the rules and duties governing management's actions much more clearly articulated but they are also much broader. Foreign directors on the boards of Chinese companies are no less susceptible to the new civil liabilities than Chinese directors.

Foreign-invested enterprises (FIEs) are also impacted. Although laws regulating FIEs prevail over conflicting provisions of the New Company Law, the New Company Law applies to FIEs for matters that are not addressed in FIE laws.⁴ FIE laws are currently silent on the imposition of fiduciary duties on directors and senior officers and the restriction of abuses by controlling shareholders; presumably, the New Company Law will govern FIEs on these matters. The parent company of an FIE will often appoint a foreigner as the legal representative of the FIE. It is frequently the case that most of the duties performed by the foreigner on the FIE's behalf are conducted through a local Chinese person granted the power of attorney. Under the New Company Law, the actions of this local person might give rise to civil liabilities for the foreigner. Furthermore, the New Company Law governs companies with foreign investment, which are nevertheless regulated as Chinese domestic companies, such as subsidiaries of FIEs.

Tension between investors and management

During the period of the 'pure' planned Chinese economy, the legal regime for corporate governance was largely irrelevant. As the central plan plays a decreasingly important role in the allocation of Chinese labour and investment capital, the importance of constructing a productivity-optimizing corporate governance regime increases. In most corporate governance systems, ultimate control of a corporation lies in the hands of the largest shareholders or creditors. Individuals with management expertise are necessary to control and oversee the firm's activities where it is not desirable or efficient for investors to control the firm directly. However, managers' interests typically do not align perfectly with investors' objectives, which, broadly stated, include maximizing the value of the business and the ability to receive a return of capital and profits from the enterprise. The agency problem is the inability of investors to control managers' actions through perfect contracts.⁵

The old PRC Company Law (Old Company Law)(中华人民共和国公司法) acted as an impediment to China's economic reform imperatives. With its weak shareholder protection and lack of a civil enforcement mechanism, it preserved a relationship-based business culture marked by prevalent self-dealing. China experienced its own series of high-profile corporate scandals in recent years, which underscored shareholders' vulnerability to value expropriation by management and controlling shareholders. Sanjiu Pharmaceutical Company was reportedly China's largest pharmaceutical group. In 2001, it was discovered that a group of its major shareholders and their business partners had managed to expropriate 96% of the company's net assets. In another scandal, conglomerate Guangxia (Yinchuan) Industry falsified financial statements for several years, inflating its net profits by Rmb745 million (US$93.6 million). More recently, executives of Guangdong Kelon Electrical Holdings, one of China's largest appliance manufacturers, were found to have embezzled money from the company and inflated sales through transactions with affiliates controlled by the former chairman.

Awareness of the production inefficiencies and retardation of investment that can result from the agency problem appears to have driven many of the reforms under the New Company Law. For example, Chinese companies are now better able to structure managers' compensation to help align their interests more closely with those of investors by introducing equity incentive schemes. In many countries, managers are paid bonuses in the form of the company's shares so that they also become owners, thus serving to align their interests with the interests of the company's investors. The New Company Law enables Chinese managers to sell shares they own in companies for which they currently work, after one year has passed since the shares were listed on a national exchange.⁶ In contrast, under the Old Company Law, an absolute prohibition was placed on management's ability to divest its shares while in the service of the company. However, a company cannot always sufficiently limit management self-dealing and profit-taking with incentive compensation, as such contracts are often poorly structured. Furthermore, compensation that would perfectly align the interests of managers and investors is too expensive to be tenable in all cases. Therefore, it is important for investors to possess additional protection, such as the powerful fiduciary duties of managers and controlling shareholders seen in a number of corporate governance systems.

Fiduciary duties as a partial solution

The New Company Law unveils a framework of management duties resembling common law fiduciary duties. The Chinese concept of fiduciary duties, if further developed by its enforcement and elaboration, will undoubtedly be shaped by unique characteristics of the Chinese economy and Chinese institutions. Nevertheless, a brief analysis of fiduciary duties of corporate managers in the United States clarifies some of the issues that may be confronted in the Chinese context. Since the Chinese framework appears to be patterned on common law concepts, an understanding of the application and enforcement of American fiduciary duties may shed some light on the future path of the Chinese duties.

Under the Anglo-American common law, a fiduciary is any person who undertakes to assist a beneficiary who places complete confidence and trust in the fiduciary to exercise control over the beneficiary's property or affairs. The concept has its genesis in the English courts of equity. In the United States, managers, directors and controlling shareholders are bound by fiduciary duties of loyalty and care to protect the interests of the corporation and to act in the best interests of its shareholders.⁷ These fiduciary duties are enforceable primarily through shareholder-initiated lawsuits.

The duty of loyalty is at issue where a fiduciary has a personal financial stake in a transaction different from the common interests of the company's shareholders. It typically requires officers and directors to try to advance the company's and its shareholders' best interests in good faith and not to consider or represent other interests.⁸ The duty of care is among the more controversial issues in the corporate law of American states. It requires management to exercise the care that an ordinary and prudent person in a like position would exercise under similar circumstances. However, the business judgement rule prevents strict enforcement of the duty of care, qualifying it with a "presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company."⁹ Disinterested directors of American companies are presumed to have exercised due care in exercising their authority as long as their efforts were undertaken in good faith.

Fiduciary duties under the New Company Law

For the first time, the New Company Law expressly commits directors, supervisors and senior officers of Chinese companies to uphold "duties of loyalty and diligence" (忠实义务和劝勉义务) to their companies.¹⁰ Also, shareholders have been granted a private enforcement mechanism against management indiscretions. This is a significant departure from the Old Company Law's almost exclusive reliance on "sanctions imposed by the company" and administrative and criminal liabilities to enforce the requirement that directors, supervisors and managers protect the interests and benefits of the company "with loyalty and honesty," which was a hollow concept as its scope and application were left silent in the Old Company Law.

In this regard, the Chinese corporate governance regime appears to be steering toward the common law system, with privately enforceable fiduciary duties that primarily protect shareholders. Unlike the laws of most American states, however, the New Company Law does not explicitly impose fiduciary duties on controlling shareholders. It is unclear whether this omission is for policy reasons, as the state is still the controlling shareholder in most Chinese companies. Regardless, the express provision of open-ended, enforceable fiduciary duties for management is an important step. The New Company Law offers a number of shareholder protections that have the potential to be further developed into fiduciary duties for controlling shareholders and may prove especially favorable to minority shareholders in practice.

Article 149 of the New Company Law provides some guidance with respect to the Chinese government's intentions regarding the new duties, particularly the duty of loyalty, by specifically prohibiting the following actions by directors and senior officers:¹¹

(i) misappropriating any company funds;

(ii) depositing company funds in bank accounts opened in their own names or in the names of others;

(iii) lending company funds directly to others or pledging company assets as security for the debts of others, in violation of the company's articles of association or without approval by shareholders or by the board of directors;

(iv) entering into any contract or transaction with the company in violation of the company's articles of association or without approval by the shareholders;

(v) taking advantage of their positions to obtain for their own benefit or the benefit of others any business opportunities belonging to the company, or engaging in the same type of business as the company for their own account or for the account of others without approval by the shareholders;

(vi) accepting commissions on transactions between others and the company and keeping such commissions as their own;

(vii) disclosing any company secrets without authorization, and

(viii) committing any other act that is in violation of their duty of loyalty to the company.

The proscribed activities in Article 149 limit managers' diversion of company profits in a manner similar to important common law fiduciary duty concepts. For example, item (v) of Article 149 introduces the main concept behind the common law doctrine of corporate opportunities, which prohibits directors and officers of American companies from engaging in business in competition with the company. In California, among other American jurisdictions, this doctrine is more clearly articulated, and perhaps narrower, than in the New Company Law. Under California law, the prohibition is not violated unless, inter alia, the opportunity is in the company's line of activity, the company could have utilized the opportunity, and the company is financially able to undertake the opportunity.¹² It may be difficult for Chinese directors and senior officers to determine which opportunities "belong to the company." More importantly, Chinese shareholders now possess considerable discretion to prevent directors and senior officers from engaging independently in productive business activities, although the company does not truly desire or is unable to pursue such activities itself.

In the common law, management's self-dealing with the company is generally not allowed absent approval by directors or shareholders who do not have a personal stake in a transaction different from the interests common to the company's shareholders. Item (iv) of Article 149 limits management self-dealing. Self-dealing limitations are also covered elsewhere in the New Company Law. For example, Article 125 forbids interested directors of listed companies from voting on resolutions involving enterprises with which they have an affiliation. Article 149 does not specifically address certain fiduciary concepts found in the American common law, such as managers' provision of false information to shareholders. However, item (viii) serves as a catch-all provision, apparently signalling the Chinese government's willingness to apply the duty of loyalty extensively.

The broad language of Article 21 further limits management's actions in conflict with company interests. This provision renders directors, supervisors and senior officers liable for any losses the company suffers when he or she takes advantage of any 'affiliation relationship' to damage the company's interests. An 'affiliation relationship' is the relationship between the manager and a third party the manager controls, directly or indirectly, or any other relationship the manager has, which may lead to the transfer of any company interests.¹³

Article 150 holds directors, supervisors and senior officers liable for any losses they cause to the company by violating any laws, administrative regulations or the company's articles of association while acting on the company's behalf. Article 153 allows shareholders to bring directors and senior officers before the people's courts when they cause losses to the shareholders by acting in this way. The distinction is vague and may arguably be artificial in certain circumstances, since losses to the company are ultimately suffered by shareholders as the company owners. However, the provision exists in the New Company Law to distinguish between shareholder direct and derivative lawsuits.¹⁴

Articles 150 and 153 serve at least two important purposes in the Chinese fiduciary duties framework. Firstly, they provide one of the most fundamental components of common law fiduciary duties by binding management to the company's governing documents. Article 113 expands this requirement by holding directors of companies limited by shares liable for material losses to the company caused by resolutions they pass in violation of shareholder resolutions. Secondly, they fold other laws and administrative regulations into the civil enforcement framework of the New Company Law.

Fiduciary duties under the PRC Securities Law

The new PRC Securities Law (Securities Law)¹⁵ supplements the fiduciary duties of Chinese listed company management with, inter alia, liabilities for misrepresentations and insider trading.¹⁶ The civil cause of action for misrepresentation is expanded by the Securities Law to include directors, officers and senior managers who misrepresent information about the company in any information disclosure materials, including annual and interim reports.¹⁷ Another development in the Securities Law requires directors, supervisors and senior managers of listed companies to guarantee the authenticity, accuracy and integrity of the information the company discloses.¹⁸ Listed company management might find these new disclosure provisions troublesome, particularly following a merger or an acquisition giving rise to the possibility of undisclosed liabilities. The result may be increased diligence and accounting costs. Also, the Securities Law establishes civil liabilities for directors, supervisors and senior officers of a listed company who harm investors by trading securities of the company.¹⁹ Articles 150 and 153 allow certain violations of the misrepresentation and insider trading provisions of the Securities Law to fall within the New Company Law's civil enforcement framework. Violations may also fall within the catch-all provision of Article 149.

Civil liabilities for breach of fiduciary duties

Together, Articles 21, 148, 149 and 150 of the New Company Law theoretically provide a basis for holding managers liable for company losses caused by any of their actions in violation of the duties of loyalty and diligence. However, despite the examples enumerated in Article 149, Chinese management's duties remain quite vague and may be difficult for the courts to interpret. In American jurisprudence, fiduciary duties are judge-made principles, invented and refined in judicial decisions spanning more than a century. The states have codified these duties in their commercial laws. For instance, the New York Business Corporation Law requires a director to perform his duties "in good faith and with that degree of care which an ordinarily prudent person in a like position would use under similar circumstances."²⁰ This broad statement is comparable to the statement in Article 149. However, in the American legal system, judges faced with disputes regarding managers' duties are guided by principles enunciated in prior decisions based on particular fact patterns. Chinese judges have no such guidance at the outset. Until the duties are clarified, Chinese company management may be wise to take extra precautions.

The New Company Law fails to specify the extent of fiduciaries' liabilities. Article 149 provides that the company is entitled to any gains made by a director or senior officer who commits any of the proscribed actions in violation of his duties to the company. This is similar to the common law concept that a disloyal fiduciary may not profit from his breach. Consequently, at common law, a fiduciary's personal gain resulting from a fiduciary breach must be surrendered.²¹ There is little additional guidance provided by the New Company Law with respect to the damages that might be assessed on managers who violate their duties. If a director, supervisor or senior officer violates laws (including, presumably, Article 148), administrative regulations or the company's articles of association, Article 150 holds such manager liable for 'compensation' for losses caused to the company.²² Article 21 similarly holds offending managers liable for 'compensation' for losses suffered by the company.²³

Whereas the bounds and form of civil compensation under the New Company Law are mostly unspecified, damages principles are quite developed in the American context. In American cases involving breach of fiduciary duties, damages awards are typically grounded on restitutionary principles, based on restoring the aggrieved parties to the positions they would have held had the duty not been violated. Where issues of loyalty are involved, penalties are sometimes assessed to discourage disloyal behavior. American courts exercise significant discretion in designating remedies. Two of the primary remedial options are: (i) undoing the transaction (also known as rescission) and (ii) money damages. It remains to be seen how the 'compensation' referred to in Articles 150 and 21 will manifest, if at all.

No deference to business judgement

Perhaps the most important common law concept absent from the New Company Law's framework for fiduciary duties is the business judgement rule, which eliminates directors' liability for their erroneous acts or omissions involving a question of business judgement, absent a showing of fraud, conflict of interest or bad faith.²⁴ The business judgement rule is critical in the understanding of directors' duties and liabilities under the common law. Without the business judgement rule, the duty of care gives rise to the prospect of second-guessing by courts, with the benefit of hindsight, of any board decision that yields less than optimal results. The New Company Law can be seen as providing no specific guidance with respect to management's adherence to the duty of diligence.²⁵ Presumably, managers are simply expected to exercise their authority with diligence. Furthermore, there is certainly no presumption of propriety accorded to business decisions in the New Company Law. The result may be unduly burdensome and costly efforts by Chinese directors, supervisors and senior officers, to ensure that a court would adjudicate ex post that they had exercised sufficient diligence before taking actions. Moreover, management may be less likely to take rational risks on behalf of Chinese companies.

Indemnification for management's civil liabilities

In common law jurisdictions, fiduciary duties typically go hand in hand with statutory indemnification rights for management, to induce qualified individuals to serve in these positions in the face of potential personal liability. Generally, these rights may be mandatory or permissive, and they define the scope of indemnification that may be provided by the company. The New Company Law provides no direct statutory basis for companies to indemnify directors, managers and senior officers from their potential civil liabilities in connection with their fiduciary duties. Therefore, under the new corporate governance regime, it is of great importance for management to seek indemnification from these liabilities in their employment contracts and in the company's articles of association. Chinese companies must carefully formulate management indemnification policies that distinguish among different types of breach of fiduciary duties. For example, the company may decide to indemnify a director for his or her breach of the duty of diligence but not for any breach of the duty of loyalty, nor any acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.

Director and officer indemnification may still be a new concept to Chinese companies. In practice, Chinese companies tend to be unwilling to include such indemnity provisions in their articles of association or employment agreements. With the increased risk of civil lawsuits, directors and officers of Chinese companies are likely to pay more attention to the availability of personal liability indemnification and heavily negotiate such provisions. It may be advisable to incorporate such provisions in the company's articles of association as a general policy of the company. Chinese companies should be aware of the director and officer liability insurance (D&O Insurance) products available to the Chinese market. Foreign companies may need to re-examine the validity and adequacy of the global D&O Insurance they obtain for directors and officers of their Chinese subsidiaries, and determine whether local D&O Insurance will be needed.

Protecting minority shareholders

The ability to sue management for violations of their fiduciary duties provides vital but incomplete protection for shareholders. The New Company Law introduces several new provisions to protect further the interests of shareholders, especially strengthening the rights of minority shareholders. Chinese controlling shareholders are typically able to appoint and remove board members. Minority shareholders are often precluded from attaining this power by the costs implicit in amassing or coordinating a sufficiently large shareholding position. Therefore, minority shareholders often have little or no power over management. They may also be powerless against the self-interested actions of the controlling shareholders. Controlling shareholders' self-dealing is a prevalent problem in China. Chinese controlling shareholders often cause the company to enter into transactions or agreements with other businesses owned or controlled by the shareholder on terms that effectively divert profits from the company.

Restraining controlling shareholders

Under the New Company Law, one of the important minority shareholder protections is introduced in Article 21 (described earlier as a restraint on management's actions in conflict with the interests of the company), which may help to curb controlling shareholders' self-dealing. Article 21 is also applicable to 'controlling shareholders' and 'de facto controlling persons',²⁶ rendering them liable to pay 'compensation' for any loss the company suffers as a result of their taking advantage of any 'affiliation relationship'.²⁷ 'Controlling shareholder' refers to a shareholder whose capital contribution or equity accounts for more than 50% of the total capital contributions or equity of a company, or a shareholder whose capital contribution or equity accounts for less than 50% but who holds sufficient voting rights to have a significant influence on shareholder resolutions. The test for determining whether a shareholder is subject to Article 21 resembles the test for determining whether the shareholder of a Delaware corporation owes fiduciary duties to minority shareholders and the corporation.²⁸

The New Company Law provides additional causes of action that might be used by minority shareholders against controlling shareholders. If a shareholder abuses his or her rights and causes losses to any other shareholder, the abusing shareholder must compensate the other shareholder for such loss.²⁹ Furthermore, shareholders may bring lawsuits against any person, including controlling shareholders, who encroaches upon the lawful rights and interests of the company and causes losses to the company.³⁰ However, the New Company Law does not mention what acts might constitute an encroachment upon the rights and interests of a company, nor acts that would be regarded as abuse of a shareholder's rights.

Participation in the decision-making process

The New Company Law also makes it easier for minority shareholders to participate in companies' decision-making processes. The threshold for shareholders of limited liability companies to request the convening of an interim shareholders' meeting is lowered. Shareholders collectively holding 10% of the voting rights may request a meeting, down from 25% under the Old Company Law.³¹ For companies limited by shares, shareholders individually or collectively holding 10% of the voting rights can request to convene an interim shareholders' meeting.³² Shareholders individually or collectively holding 3% (previously, 5%) or more of a company's shares may submit shareholder proposals to shareholders' meetings through the board of directors.³³ Furthermore, the New Company Law continues to confer upon shareholders the authority to decide the matters reserved to shareholders under the Old Company Law,³⁴ including the authority to elect and replace directors and supervisors. Companies limited by shares are now allowed to provide for cumulative voting in the articles of association. Alternatively, the shareholders may adopt cumulative voting by resolution. Cumulative voting grants each share the same number of votes as that of the directors or supervisors to be elected at a shareholders' general meeting, to be allocated freely among the candidates at the discretion of the shareholders.³⁵ The foregoing provisions give minority shareholders a greater opportunity to oust the management of a company limited by shares.

Minority shareholders' strengthened controls over the corporate decision-making process are also reflected in the expansion of corporate matters that require shareholder approval. For example, a company's decision to provide security for its shareholders or its de facto controlling person is now required to be approved at shareholders' meetings by a majority of the voting rights held by disinterested shareholders.³⁶ Approval at a shareholders' general meeting by the shareholders who hold more than two-thirds of the voting rights, represented at such meeting, is now required if a listed company plans to acquire or sell major assets over a one-year period, the aggregate value of which exceeds 30% of the value of the firm's total assets, or the company plans to provide security over a one-year period of a value exceeding 30% of the value of its total assets.³⁷ These new provisions help to ensure that minority shareholders have influence over major corporate matters.

Access to information

The New Company Law further facilitates minority shareholders' participation in the corporate decision-making process by improving their access to information. Shareholders now have the right to access and make copies of not only the minutes of shareholders' meetings and company financial statements, but also the resolutions of the board of directors and the board of supervisors.³⁸ Directors, supervisors and senior officers must attend shareholder meetings upon request by shareholders and answer inquiries from the shareholders.³⁹ Moreover, shareholders of limited liability companies may examine the company's accounting books, in addition to the financial statements.⁴⁰ This access is important because some accounting anomalies may be reflected in the accounting records rather than the company's financial statements. Furthermore, shareholders of a company limited by shares have the right to be informed on a regular basis of remunerations to the company's directors, supervisors and senior officers.⁴¹

Shareholders' exit strategy

Another concern for minority shareholders in an unlisted company is the exit strategy. The controlling shareholders may try to prevent minority shareholders from realizing the value of their investments by withholding dividends or forcing the minority shareholders out of the business on unfavorable terms. Article 75 addresses this concern by providing an exit right for equity holders of limited liability companies, although it may go too far in stripping limited liability company managers of their discretion to retain and reinvest earnings. Shareholders of a limited liability company who vote against any of the following may require the company to buy back their equity interests at a reasonable price:⁴²

(i) the company's resolution not to distribute profits to its shareholders for five consecutive years despite the company being profitable for those five years;

(ii) a merger or split of the company or transfer of the major assets of the company, or

(iii) renewal of the company's operation term after its expiration or events triggering dissolution.

Article 75 does not provide a valuation method for the equity interests. In practice, it may be difficult to determine the value of a close corporation. Therefore, it may be hard to reach equity repurchase agreements on terms mutually satisfactory to minority shareholders and the company. This problem may be exacerbated if the company has insufficient capital to buy back the equity interests without taking a loan. If the parties fail to reach an agreement, the shareholders may initiate legal proceedings in the people's court.

The New Company Law confers an additional exit strategy for shareholders. Minority shareholders with more than 10% of the voting rights of all shareholders may petition the people's court to dissolve a company experiencing difficulties in its business operations, where the continued existence of the company will cause serious losses to the shareholders' interests.⁴³

Contractual arrangements

In addition to statutory safeguards, minority shareholders are granted additional flexibility to protect their interests through contractual arrangements. The New Company Law leaves a variety of corporate matters to be determined by companies' articles of association. This indicates a new policy in favour of self-governance by the stakeholders of a firm. Minority shareholders may take advantage of this by negotiating additional protections, such as reserving additional functions and powers to the shareholders, in the company's articles of association, joint venture contracts or shareholders' agreements. This new flexibility may enable some companies to attract investment despite investors' perceptions of shortcomings in components of the state's governance apparatus.

Challenging times ahead

The New Company Law embraces minority shareholder protections and fiduciary duties at a time when the domestic capital markets are stagnant and much of the state sector remains an encumbrance on the economy. There is a sense that despite the government's tremendously successful economic and legal reforms in recent years, the old governance system restrained further progress in these essential reform areas. Indeed, the New Company Law's rules governing the investor-management relationship are already serving as a platform for the introduction of further corporate governance reform measures. For example, the State-owned Assets Supervision and Administration Commission recently issued the Implementing Opinions on Further Regulating Restructure of State-Owned Enterprises, partially lifting the suspension of management buy-outs of large SOEs and listed SOEs. The process had been suspended in part because of abuses of the weak corporate governance system. Also, the CSRC recently published the Rules for Shareholders Meetings of Listed Companies, which, among other things, further facilitate minority shareholders' ability to call shareholders' meetings.

The New Company Law will have an immediate impact on the various stakeholders of Chinese companies. Even provisions with apparent ambiguities and defects lay the legal basis for creative and aggressive use by practitioners in response to market demands and thus open the door for greater long-term social and economic consequences than perhaps the legislators envisioned. However, the real impact of this new corporate governance regime will depend on the manner of its implementation and enforcement by the government. This may be a particular challenge for China considering the state's difficulties in enforcing related corporate governance legislation, the inexperience of all parties with civil enforcement, the lack of judicial expertise in corporate governance matters and the prevalence of state intervention in the judicial process.

Endnotes

1 See, for example, La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R., 1997, Legal Determinants of External Finance, Journal of Finance, 52, 1131-50.

2 See, for example, Bebchuk, L., Cohen, A. and Ferrell, A., 2005, What Matters in Corporate Governance?, Working Paper, Harvard Law School; Gompers, P., Ishii, J. and Metrick, A., 2003, Corporate Governance and Equity Prices, The Quarterly Journal of Economics 118, 107-155; La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R., 2002, Investor Protection and Corporate Valuation, Journal of Finance 60, 1147-70.

3 Additional stakeholders are also affected. For instance, Article 20 of the New Company Law allows injured creditors to pierce the corporate veil to gain recourse to the assets of shareholders who abuse the corporate form. Article 52 strengthens the representation of employees on supervisory boards.

4 Article 218 ibid.

5 Jensen, M. and Meckling, W., 1976, Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, Journal of Financial Economics 3,
305-360.

6 Article 142 of the New Company Law. This development is particularly significant in light of the incentive compensation legislation issued this year. The State-owned Assets Supervision and Administration Commission and Ministry of Finance recently issued the Administrative Measures on Stock Incentives by State-controlled Listed Companies (Offshore) (Trial), which became effective on March 1 2006. Also, the CSRC issued the Measures for the Administration of the Equity Incentives of Listed Companies (Trial Implementation), effective from January 6 2006. Please refer to pages 25 and 36 in this issue of China Law & Practice for a detailed discussion of these incentive compensation measures and a full translation of the legislation.

7 In the United States, each state has created its own unique body of law defining fiduciary duties, although the broad contours of the duties have tended to converge across state lines.

8 See, for example, Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983); Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986).

9 Citron v. Fairchild Camera & Instrument Corp., 569 A.2d 53, 64 (Del. 1989).

10 Article 148 of the New Company Law. Article 217 defines 'senior officer' as the manager, deputy manager or chief financial officer of a company, the secretary of the board of directors of a listed company, or any other person specified in the articles of association of a company.

11 Article 149 ibid. It is unclear why the new Company Law specifically confers the duties of loyalty and diligence on Chinese supervisors but does not hold supervisors to the limitations of Article 149. Perhaps this is a recognition of the greater opportunities directors and officers may possess to take advantage of their authority to the detriment of the corporation.

12 9 Witkin Sum. Cal. Law Corp § 91.

13 Article 217 of the New Company Law.

14 Articles 153 and 152 ibid, which establish procedures for shareholder derivative lawsuits against management and other persons triggered, inter alia, by the acts described in Article 150, will be discussed in the next issue of China Law & Practice.

15 Simultaneous with the announcement of the New Company Law, the government announced a sweeping reform of the PRC Securities Law (Amended).

16 Under the common law, misrepresentations made by the company to shareholders have, under certain circumstances, been treated as breaches of managers' fiduciary duties. The common law holds managers to a duty of disclosure that derives from a manager's duty to communicate honestly with shareholders about corporate affairs. Some common law courts have also held insider trading by managers to be a breach of their fiduciary duty because insider information is a type of corporate property that managers are unauthorized to use for their own benefit.

17 Article 69 of the Securities Law.

18 Article 68 ibid.

19 Article 76 ibid.

20 New York Business Corporation Law (BCL) § 717. Officers of New York corporations owe the same statutory fiduciary duty. BCL § 715.

21 Bomarko, Inc. v. Int'l. Telecharge, Inc., 794 A.2d 1161, 1188 (Del. 1999).

22 Article 150 of the New Company Law.

23 Article 21 ibid.

24 See, for example, In re Croton River Club, Inc., 52 F.3d 41, 45 (2d Cir. 1995). The duty of care is most often considered in the context of approval by the board of directors. However, some courts have extended the business judgement rule to actions taken by officers.

25 The prohibited activities in Article 149 are designed to encourage managers' loyalty to the company. They do not address the care and diligence with which managers perform their functions.

26 Article 217 of the New Company Law defines 'de facto controlling person' as any person who is not a shareholder of a company but has de facto control of the company by means of investment relationships, agreements or any other arrangements.

27 The state's controlling interests in any two or more enterprises do not give rise to an 'affiliation relationship' between them.

28 Under Delaware law, a shareholder who owns at least 50% of a corporation's outstanding voting stock is deemed to have control as a legal matter and is therefore considered a fiduciary, Kahn v. Lynch, 638 A.2d 1110, 1113-14 (Del. 1994), but even a shareholder holding less than 50% of the vote is considered a fiduciary where there is a dominating relationship resulting in de facto control. See ibid at 1114; Citron v. Fairchild, 569 A.2d at 70.

29 Article 20 of the New Company Law.

30 Article 152 ibid.

31 Article 40 ibid.

32 Article 101 ibid.

33 Article 103 ibid.

34 Articles 38 and 100 ibid.

35 Article 106 ibid.

36 Article 16 ibid.

37 Article 122 ibid.

38 Articles 34 and 98 ibid.

39 Article 151 ibid.

40 Article 34 ibid.

41 Article 117 ibid.

42 Article 75 ibid.

43 Article 183 ibid.