Corporate Governance under the New Company Law (Part 2): Shareholder Lawsuits and Enforcement

Insufficiency of public enforcement

China has relied too heavily on administrative and criminal actions to police corporate governance matters. Public enforcement resources are insufficient to identify and prosecute most violators. Furthermore, enforcement efforts by government agencies, such as the China Securities Regulatory Commission (CSRC) and the State Administration for Industry and Commerce, may be susceptible to political influence, local protectionism and other forms of corruption, and similar problems. To make matters worse, administrative and criminal penalties in China have not been severe enough to deter bad corporate governance practices in Chinese companies. The government is often reluctant to impose heavy administrative penalties on offenders for fear of negatively impacting the company's performance and criminal prosecution is only invoked in particularly serious circumstances. Potential violators may rationally choose to run afoul of the laws because the illicit gains they foresee are larger than the likely penalties.

Deterrent effect of private enforcement

Private enforcement mechanisms such as shareholder lawsuits serve the dual purpose of deterring potential wrongdoers and compensating injured investors. Shareholder civil lawsuits may provide a more effective deterrent to corporate governance-related violations than public enforcement measures. Investors are often in a better position to know when and to what extent their interests have been harmed, and they are motivated to seek compensation for the harms they suffer. Also, in the context of shareholder lawsuits, measurement of the damages owed to investors will often be more reflective of the actual losses suffered by the company and the investors than the penalties administered in public enforcement actions. Thus, the threat of shareholder lawsuits under the New Company Law should render management and controlling shareholders less likely to seek illicit gains by violating corporate governance provisions. Together, public and private enforcement may significantly advance compliance with corporate governance laws in China.

Early shareholder lawsuits

Before the issuance of the New Company Law, government policies generally did not favour private enforcement of corporate governance matters. However, the prior PRC Company Law (Old Company Law)(中华人民共和国公司法) recognized the separation of ownership from the management of Chinese companies, ensuring that aggrieved parties would eventually demand judicial intervention to resolve disputes. The nascent Chinese capital markets provided particularly fertile ground for a litigation culture by creating a shareholding class in China with clear economic interests and often no direct influence over management. Increased disclosure requirements and visible share prices are important tools for shareholder lawsuits, especially in the Chinese civil enforcement system, which has underdeveloped evidence and fact discovery rules.

The first reported shareholder lawsuit against a listed company in China was initiated by an individual shareholder against Hongguang Industrial Co. In June 1998, a Shanghai investor purchased 1,800 shares of the company's stock for Rmb15,745 (US$1,902). Four months later, she sold these shares for a loss of Rmb3,137. When she later heard about an investigation of the company by the CSRC, she filed a claim asserting that she had sustained losses by relying on misrepresentations in the prospectus and other company communications. Though the CSRC fined the company for its misrepresentations, a Shanghai court dismissed the investor's case. The court stated that there was no proof that her losses were directly caused by the company's misrepresentations and added that the CSRC should decide such matters.

In 2001, the Supreme People's Court (SPC) issued a circular stating that Chinese courts were ill-equipped to hear shareholder securities law suits.² Nevertheless, shareholders continued to bring claims to the courts. In January 2002, the SPC responded to investors' demands with a circular (2002 Circular)³ that allowed people's courts to accept lawsuits from aggrieved shareholders against listed companies for misrepresentations in disclosure materials. This announcement marked an important commitment to the development of Chinese civil litigation. In January 2002, the Haerbing Intermediate People's Court formally accepted a civil misrepresentation case brought by three shareholders against Daqing Lianyi Petrochemical Shareholding Co. (Daqing Case). This case was reportedly the first shareholder civil remedies action accepted by a people's court.

On January 9 2003, the SPC issued the Several Provisions for Trial of Civil Compensation Cases Arising from False Representation in the Securities Market (2003 Judicial Interpretations) to replace the 2002 Circular. The 2003 Judicial Interpretations provided rules for the courts when trying civil compensation cases involving fraudulent disclosures by listed companies, thus rendering shareholder litigation more practicable in China. Slowly, Chinese courts have begun to render decisions in shareholder lawsuits against listed companies. For instance, in the final judgement rendered in the Daqing Case in December 2004, the court for the first time elaborated on the concept of the systemic risk of the securities market, an important contribution to the determination of loss causation in securities misrepresentation cases in China.⁴ Shareholder lawsuits appear to be gradually gaining viability as an enforcement tool. The development process gained momentum with the passage of the New Company Law.

Civil liabilities under the New Company Law

Under the Old Company Law, where shareholders were conferred certain rights, those rights were provided mainly without any mention of civil remedies. Articles 20, 21 and 149 of the New Company Law introduce new rules governing the relationships among investors and management, accompanied by civil liabilities.⁵ Private enforcement is deeply affected by this development because provisions setting out statutory civil liabilities are arguably sufficient to establish the right to bring civil lawsuits when those provisions are violated.

The New Company Law provides that controlling shareholders must pay 'compensation' for losses they cause to the company by abusing their shareholder rights⁶ or utilizing any relationships they may have to expropriate company interests.⁷ Directors, supervisors, officers and anyone else who exercises control over the company must likewise pay 'compensation' for any damage they cause to the company's interests by taking advantage of their affiliations.⁸ In addition, the company is entitled to any gains made by a director or senior officer who commits any of the actions proscribed by
Article 149 in violation of his or her duty of loyalty to the company.

The New Company Law also maintains a provision contained in similar form in the Old Company Law. Directors, supervisors and senior officers are 'liable for compensation' for losses they cause to the company by violating any laws, administrative regulations or the company's articles of association in the performance of their official duties.⁹

Civil remedies under the Securities Law

Prior to its amendment, the PRC Securities Law ((中华人民共和国証券法))provided civil liability only for misrepresentations made in securities issuance and trading.¹⁰ The amended PRC Securities Law (Securities Law), which became effective on January 1 2006, specifies civil remedies for a number of additional violations, including matters involving corporate governance. For example, Article 76 of the Securities Law provides civil remedies for insider trading.

Right to compel compliance

Private enforcement of the New Company Law is bolstered by several provisions providing shareholders with the right to seek court intervention to compel compliance with certain corporate governance matters. For example, if a shareholder's right to examine a limited liability company's accounting books is denied by the company, the shareholder can petition the people's court to require the company to provide access.¹¹ Shareholders may also petition the people's court to revoke any shareholder or board resolution that violates the company's articles of association or that was passed at an improperly convened meeting or using an improper voting method.¹²

Further, Articles 75 and 183 of the New Company Law confer exit rights upon shareholders under certain circumstances, with a role for intervention by the people's court. If the shareholder and the limited liability company cannot reach the equity repurchase agreement contemplated by Article 75, the shareholder may initiate legal proceedings. Article 183 allows shareholders with more than 10% of the voting rights of all shareholders to petition the people's court to dissolve a company experiencing difficulties in its business operations, where the continued existence of the company would cause serious loss to the shareholders.

Introducing derivative lawsuits

For the first time, Article 152 of the New Company Law establishes statutory derivative lawsuits under Chinese law.¹³ A shareholder derivative lawsuit is an assertion of a company claim initiated by one or more shareholders to prevent or remedy injury to the company. It is a tool for the protection of companies' shareholders, especially minority shareholders. Under Article 152, certain shareholders may "directly initiate legal proceedings in the people's court in their own name for the benefit of the company" (为了公司的利益以自己的名义直接向人民法院提起诉讼), as opposed to direct lawsuits, which are brought by shareholders on their own behalf.¹⁴

Under Article 152, the commission of any act described in Article 150 gives rise to certain shareholders' right to bring a derivative lawsuit. Shareholders may initiate a derivative lawsuit against a company's director, senior officer or supervisor, who violates any laws or administrative regulations or the company's articles of association, in the performance of his or her official duties, causing losses to the company. Article 152 also allows certain shareholders to initiate derivative lawsuits against any person who encroaches upon the lawful rights and interests of the company, thus causing losses to the company.

Distinguishing between derivative and direct lawsuits

Whether a shareholder initiates a derivative lawsuit under
Article 152 of the New Company Law or a direct lawsuit under Article 153 will depend on the impact of the alleged injury. Article 152 allows certain shareholders to bring derivative lawsuits in their own name for the benefit of the company in certain circumstances where a director, senior officer, supervisor or other person causes losses to the company. By contrast, Article 153 enables shareholders to bring direct lawsuits against a company's director or senior officer who violates any provision of laws, administrative regulations or the company's articles of association and causes losses to the shareholders. However, determining whether the harm is suffered by shareholders or the company is not always a straightforward exercise.

American jurisdictions, which have well-developed laws governing derivative actions, have established a variety of approaches to distinguish between derivative and direct actions. The general rule appears to be that if the injury was suffered directly by the company and indirectly by the shareholders through the diminution of the value of their shares, the appropriate action will be a derivative lawsuit. For example, in the United States, the following are generally actionable only as derivative suits:

i. breaches of fiduciary duties;

ii. waste of corporate assets;

iii. excessive management compensation;

iv. usurpation of corporate opportunities, and

v. self-dealing.

If the injury is suffered directly by the shareholders of American companies, the shareholders should bring a direct lawsuit. Where the shareholder's injury is unique to the shareholder alone, and is not suffered by the other shareholders, the shareholder can sue directly as an individual. The following generally proceed as direct actions in the United States:

i. lawsuits claiming the deprivation of shareholders' voting rights, preemptive rights, or rights to inspect the company's books and records;

ii. lawsuits seeking a declaration of dividends, and

iii. lawsuits alleging that the directors or officers fraudulently induced the shareholder to sell stock.

The New Company Law provides very limited guidance with respect to the causes of action that should proceed as derivative actions. Gains made by directors or senior officers who commit any of the acts described in Article 149 "shall belong to the company." This provision indicates that breaches of fiduciary duties are likely to be treated as derivative actions under the New Company Law. Since the New Company Law provides no additional clues, and China's case precedents are too limited to distinguish the other fact patterns that may arise in the context of derivative and direct shareholder actions, the distinctions developed in the American context can be a useful reference for China's judiciary in the near-term. As long as the distinction between company and shareholder harms remains ambiguous, the possibility exists that shareholders will seek to avoid the onerous procedural restrictions of Article 152 by petitioning the court to classify actions that should be derivative in nature as direct actions.

Characterizing a lawsuit as direct or derivative will naturally affect the payment of any recovery proceeds. Although Article 152 does not explicitly direct the payment of the recovery proceeds, it can reasonably be inferred that any recovery in derivative actions will be paid to the company because the shareholders will be seeking compensation for corporate injuries. According to the practice in most jurisdictions, all recovery in a derivative action is generally paid to the company, while recovery in a direct action is paid to the plaintiff shareholder, or the class on behalf of which the shareholder brings the direct lawsuit.¹⁵

Procedures for derivative lawsuits

Article 152 of the New Company Law provides basic procedures for shareholder derivative lawsuits. This is an important development in Chinese law. Shareholders possessed the legal right to bring certain lawsuits prior to passage of the New Company Law, but shareholders' enforcement efforts were often halted by procedural gaps under the laws. Chinese courts faced with procedural gaps often refuse to accept a case. Therefore, statutory derivative and direct lawsuits procedures make private enforcement efforts more feasible.

Derivative lawsuits represent a temporary usurpation by shareholders of the decision-making power of the board of directors. They also give rise to the possibility of groundless 'strike suits' by minority shareholders with the intention to compel settlement offers. Due to the potential for abuse, derivative lawsuits are usually accompanied by onerous procedural hurdles. The New Company Law is no exception. It introduces barriers to shareholders who seek to sue on the company's behalf. Unfortunately, certain aspects of the procedures are underdeveloped.

On April 28 2006, the SPC issued the Provisions on Several Issues concerning the Application of the PRC Company Law (1) (Company Law Interpretations),¹⁶ which address certain procedural issues regarding the application of the New Company Law to civil lawsuits and clarify certain issues related to the standing requirement for shareholders who seek to initiate derivate lawsuits. Prior to the issuance of the Company Law Interpretations, the SPC announced that its interpretations of the New Company Law will be issued in several instalments. It is possible that the SPC's forthcoming interpretations (Forthcoming Interpretations) will further address the vague or missing components of the derivative lawsuits procedures.

Defendants in derivative actions

The New Company Law allows shareholder derivative lawsuits against a company's directors, senior officers or supervisors, as well as any other persons who encroach upon the lawful rights and interests of the company.¹⁷ The law does not specify that controlling shareholders may be subject to derivative suits. In most American jurisdictions, minority shareholders may initiate derivative actions against controlling shareholders. On the face of the law, a controlling shareholder who violates the rights and interests of a Chinese company, causing losses to the company, may be subjected to a derivative lawsuit pursuant to Article 152.

From a deterrence perspective, the ability to bring civil lawsuits against controlling shareholders is favourable. However, derivative lawsuits against controlling shareholders often do not make perfect sense, because damages in a derivative lawsuit are typically awarded to the company and thus provide value to all of the shareholders (including the offending shareholder).¹⁸

Role of the company in derivative lawsuits

The New Company Law and the PRC Civil Procedure Law (Civil Procedure Law)(中华人民共和国民事诉讼法)¹⁹ do not specify the role of the company in a derivative lawsuit. In American jurisdictions, the company is usually named as a nominal defendant in derivative lawsuits for procedural purposes. However, this concept may cause confusion in the context of Chinese law. Under the Civil Procedure Law, a plaintiff must have a specific claim against the defendant.²⁰ However, in a derivative lawsuit, the shareholder plaintiff represents the interests of the company.

In some civil law countries, such as Japan, the company is named as a plaintiff in the derivative action, but not as a defendant.²¹ From a Chinese law perspective, this may be a practical solution. However, it seems illogical to place a company unwillingly into the role of a plaintiff. Another approach is to name the company as a third party either with or without an independent right of claim. Either characterization may be ill-fitting for the company. Of the two choices, it seems more appropriate to place the company in the role of a third party without an independent claim, because a third party with an independent right of action may join the litigation only by voluntary application.²² If the board of directors or board of supervisors, as the case may be, rejects a shareholder demand to bring a company lawsuit, it is difficult to imagine the company voluntarily submitting an application to join the litigation. It remains to be seen whether this omission in the procedural rules will be addressed in the Forthcoming Interpretations.

Standing requirement for shareholder plaintiffs

In terms of the standing requirement, Article 152 distinguishes limited liability companies from companies limited by shares. For companies limited by shares, the shareholder plaintiffs have standing to bring derivative lawsuits only if they have held, individually or collectively, at least 1% of the shares of the company for at least 180 consecutive days.²³ The standing requirement limits the possibilities for opportunistic acquisitions of shares in order to bring speculative litigation. This standing requirement in the New Company Law is adopted from the uninterrupted six-month ownership period requirement in Japanese law.²⁴ However, the Chinese law adds the more restrictive 1% shareholding requirement. Although the New Company Law allows the plaintiffs' shareholdings to be calculated in the aggregate to meet the 1% minimum shareholding requirement,²⁵ in practice this may not make much difference because of the difficulties for shareholders to coordinate collective action.

For equity holders of limited liability companies, there is no shareholding threshold, no length of shareholding requirement, nor any requirement with respect to the timing of the share acquisition. These omissions are probably based on the fact that the relatively small number of shares outstanding and the lack of a public market for the equity of limited liability companies already serve the purpose of minimizing strike suits.

Demand requirement

The demand requirement is an important procedural hurdle for shareholder derivative lawsuits. Under Article 152, shareholders who seek to initiate derivative lawsuits must first issue a demand to the company's board of supervisors²⁶ to bring the lawsuit against directors or senior officers, or issue a demand to the board of directors²⁷ to cause the company to sue the offending supervisors. Derivative lawsuits against any other person are also subject to the demand requirement, but Article 152 does not specify whether the demand must be made to the board of directors or the board of supervisors.

Only if the board of supervisors or the board of directors, as the case may be, refuses to initiate the lawsuit, or fails to bring a lawsuit within 30 days after receiving the demand, can the demanding shareholders bring a derivative action on the company's behalf. The 30-day waiting period may be waived in situations where the company will suffer irreparable losses if the derivative lawsuit is not initiated immediately.

In the United States, shareholders are permitted to sue without a prior demand on the board when such a demand would be futile because the alleged wrongdoers control the board. Article 152 provides no such exception to the demand requirement. If the Forthcoming Interpretations do not provide such an exception, potential shareholder plaintiffs may waste significant time waiting for the directors to reject the demand, perhaps losing the opportunity to obtain a remedy in a timely manner.

It is unclear what principles the Chinese courts will follow in deciding whether to permit a derivative action to proceed once it has been rejected by the board of directors or supervisory board. When such a demand is rejected in the United States, the court must determine whether the board's determination is entitled to deference as a 'business judgement'. In many instances, the court will not allow a judicial review of the merits of the board's decision, but rather will defer to the business judgement of the disinterested directors and dismiss the action.²⁸ China does not yet have express legal doctrine similar to the 'business judgement rule'.

Statute of limitations

The New Company Law does not provide a statute of limitations for derivate lawsuits. Therefore, under the PRC Civil Law General Principles, since the right of action for derivative suits originally belongs to the company and shareholders only exercise such right derivatively on behalf of the company, the applicable statute of limitations should run for two years from the date when the company knows or should have reason to know of the harm done.²⁹ However, shareholders, especially minority shareholders, often do not immediately become aware of the harm done to the company. In many cases, only the management of the company has first-hand knowledge of the occurrence of such losses. Since the management may themselves become defendants in shareholder lawsuits, they may allow the statute of limitations to lapse without taking any legal action. Therefore, deciding the statute of limitations for shareholder derivative lawsuits based on knowledge of the company would be unfair to plaintiff shareholders.

Some American jurisdictions have adopted special statute of limitations rules for shareholder derivative lawsuits. For example, Delaware courts have held that where a shareholder derivative suit alleges that corporate fiduciaries have engaged in: (i) fraud or fraudulent concealment, or (ii) actionable self-dealing, the statute of limitations begins to run from the time the plaintiff shareholder, or shareholders of the company generally, discovered or should have discovered the basis for the claims in the exercise of reasonable diligence.³⁰ It may be advisable for Chinese law to borrow from this experience and establish a special statute of limitations rule suitable to the features of shareholder derivative lawsuits.

Litigation expenses

Article 152 of the New Company Law does not require plaintiffs to post security for litigation expenses nor the company to reimburse prevailing shareholder plaintiffs' litigation expenses. In the American derivative lawsuit system, these two rules are sometimes utilized to strike a balance between discouraging frivolous lawsuits and promoting bona fide derivative actions. The 'security for expenses' rule is generally regarded as having a chilling effect on strike suits, while the reimbursement of plaintiffs' litigation expenses promotes litigation activity.

The New Company Law only mentions the requirement of security for litigation expenses in Article 22, which deals with shareholder lawsuits against void or voidable resolutions of shareholders' meetings or meetings of the board of directors. There is no inference that this mechanism will also apply to lawsuits under Article 152. A number of jurisdictions in the United States have adopted security for expenses statutes.³¹ Chinese law should perhaps adopt a discretionary security for expenses rule to equip the courts with a tool to discourage frivolous lawsuits. If China adopts such a rule, it should consider whether the merits of a dispute should be taken into consideration in requesting security.

As for reimbursement of expenses, it is advisable to allow prevailing shareholders to be reimbursed by the company for their litigation expenses, including reasonable lawyers' fees. This rule would work as an incentive for shareholders to bring meritorious derivative lawsuits and would foster fairness in the legal system. Prevailing shareholders should be compensated for the costs they bear to confer a benefit on the company.

Filing fees

Under the current Chinese law, filing fees for initiating a derivative lawsuit will be calculated on a sliding scale according to the amount in controversy.³² Before the commencement of any litigation, the plaintiff must generally pay the filing fee to the court. Filing fees calculated under the current rule may sometimes be prohibitively expensive and thus discourage shareholders from bringing a derivative lawsuit. For instance, if the amount in controversy is more than Rmb500,000 (US$62,500) but less than Rmb1,000,000, the filing fee will be 1% of the amount in controversy. Although reduction or waiver of filing fees is allowed, plaintiffs' lawyers rarely seek reduction or waiver of the fees because they fear resulting negative bias from the court. It is advisable for Chinese law to provide preferential treatment to plaintiffs in derivative actions with respect to the filing fee requirement, to make derivative lawsuits more affordable and thus more practicable.

Settlement or compromise

There is currently no special statutory guidance for settlement of a derivative lawsuit in China. Generally, settlements of civil actions in China are not subject to court approval. However, settlement without a court's supervision may cause abuse of the derivative lawsuit system. If settlement of derivative lawsuits is allowed without judicial review, plaintiffs' lawyers may be motivated by the prospect of receiving a percentage of the recovery amount to settle a case prematurely or to trade some of the merits of the plaintiffs' claims. On the other side of the settlement, corporate wrongdoers may be motivated to reach a settlement with plaintiff shareholders, because amounts paid in settlement may be covered by directors' and officers' liability insurance while any judgement for losses caused by management's wrongdoing is probably not. Therefore, courts should play an active role in approving settlements of derivative lawsuits. In the United States, derivative lawsuits will not be dismissed or compromised without the approval of the court.

No preclusive effect of prior litigation

Currently, there is no clearly established claim preclusion rule or issue preclusion rule under Chinese law. The common law rule of res judicata, otherwise known as claim preclusion, prevents the parties to an action or their privies from re-litigating issues that were or could have been raised in a prior action that was subject to a final judgement on the merits. Under the common law concept of collateral estoppel, also known as issue preclusion, once a court has decided an issue of fact or law necessary to its judgement, that decision may preclude re-litigation of the issue in a suit on a different cause of action involving one or more of the parties to the first action. Claim preclusion and issue preclusion promote the final determination of disputes, prevent the disruptive effects of multiple lawsuits and conserve judicial resources. Without such rules, the New Company Law's derivative lawsuit mechanism might open the door to a multiplicity of lawsuits and inconsistent judgements. Therefore, it is advisable for China to adopt clear rules modelled on the claim and issue preclusion rules from the common law.

Class action and Chinese joint action

With the introduction of Article 153, the New Company Law provides a clear basis for shareholders to bring direct lawsuits against directors and senior officers under certain circumstances. As discussed earlier, a number of additional provisions in the New Company Law and the Securities Law increase the likelihood that shareholder lawsuits will develop into a viable enforcement and compensation mechanism. Shareholders and lawyers in China will increasingly be confronted with circumstances under which joint legal action by numerous shareholder plaintiffs would be advantageous.

In some foreign jurisdictions, notably the United States and Brazil, direct lawsuits with numerous plaintiffs or defendants are allowed to proceed in the form of class action. The class action is a procedural device by which one party, or a group of parties, may sue as representatives of a larger class. Often, many of the class members are unknown. The policies supporting class action are similar to the policies behind derivative lawsuits. The class action is a device intended to conserve judicial resources and lessen the burden on defendants who might otherwise face a multiplicity of similar lawsuits. Class actions can also help avoid inconsistent adjudications, protect the interests of absent class members, and mobilize private litigants whose individual injuries might be too small to justify the expense of individual action. By stimulating private litigation, class actions can aid law enforcement efforts.

Chinese law currently provides basic joint action procedures for cases where one of the parties is numerous but certain³³ and for joint actions where the persons comprising one of the parties are numerous but uncertain at the commencement of the action.³⁴ The latter type of joint action could potentially serve a similar function to American-style class action.

Legal elements of US class actions

The United States legal system is widely regarded as possessing some of the world's most sophisticated class action laws. Under American procedures, there are typically four common prerequisites to a class action:³⁵

i. the class is so numerous that joinder of all of the members individually would be impracticable;

ii. there must be questions of law or fact common to the members of the class;

iii. the claims of the representative parties must be typical of the claims and defenses of the class as a whole, and

iv. the representative parties must be able to fairly and adequately protect the interests of the class.

American class actions are similar to derivative actions in that both require notice to potential claimants and an opportunity for them to participate in the litigation. Also, both types of litigation require the court to determine the fairness of settlements or compromises.

China's ambivalence to class action

Class action has been strongly advocated by the CSRC and legal experts in China, and lawyers have attempted to circumvent procedural hurdles to bring class action-type lawsuits. In 2002, a CSRC assistant chairman, Jesse Wang Jianxi, stated, "We must fully employ legal and administrative measures to punish behavior in breach of law and regulation and in violation of minority shareholder interests. ... We should introduce class action lawsuits. We should enable shareholders to seek compensation through civil lawsuits." However, this statement was made shortly after the SPC banned the use of 'class action' in securities-related misrepresentation cases.³⁶ These conflicting messages may indicate inconsistent opinions within the government about how quickly and how far China should proceed in the advancement of shareholder litigation.

Chinese joint action with unknown class members

Article 55 of the Civil Procedure Law regulates joint action where "the subject matter of the action is of the same category and one party is numerous and of an uncertain number upon commencement of the lawsuit" (诉讼标的是同一种类, 当事人一方人数众多在起诉时人数尚未确定的). Theoretically, this type of joint litigation is allowed as a procedural device for shareholder lawsuits other than securities-related misrepresentation cases. There are no direct legal impediments to using the Article 55 joint action for shareholder claims triggered by most violations of the New Company Law. However, the people's courts have preferred the more restrictive joint actions with a fixed number of plaintiffs and individual actions. The courts' resistance to allowing joint actions to proceed with unknown class members is probably due to the gaps and ambiguities presented by Article 55 of the Civil Procedure Law. Without clear guidance from the statute, people's courts would be forced to exercise considerable discretion to determine important elements of the proceedings.

Public notice

Article 55 provides that the people's court may issue a public notice stating the particulars and claims of the case and informing claimants to file at the people's court within a fixed period of time to join the action.³⁷ The statute provides no guidance with respect to the form or manner of the notice.

Litigation representatives

Claimants who file at the people's court within the specified period may select two to five representatives from among themselves to engage in litigation. If the claimants fail to agree upon representatives, the people's court may facilitate negotiations among the claimants to select representatives, or the court may designate the representatives unilaterally.³⁸

Article 55 further provides that litigation under that provision is binding on the represented parties. However, the litigation representatives must secure prior consent from the class members to change or waive any claims or reach a compromise with the opposing party. The law does not indicate the consequences of a failure to obtain such consent.

Application of judgement

The judgements or orders rendered by the people's court in an Article 55 joint action will be effective for all of the claimants who filed at the court to join the action. The same judgements or orders will also bind claimants who did not participate in the joint action but instead instituted independent legal proceedings at any time prior to the expiration of the statute of limitations. It is unclear whether these claimants who bring independent actions will be barred from bringing their claims entirely; whether some of the issues from the joint action will be precluded from re-litigation in the independent actions; or whether these claimants are expected to share in the recovery proceeds from the joint action. Potential claimants who fail to file before the expiration of the statute of limitations forfeit their claims and do not participate in the judgement. By contrast, in an American class action, the judgement is binding on all class members unless they affirmatively opt out.

Opening the door for shareholder lawsuits

The emphasis on protection of shareholders' rights through civil enforcement is one of the most important developments in the New Company Law. However, the inadequate institutional setting for private enforcement will not change overnight. In China, shareholders' rights are often recognized on paper but easily compromised in reality. Inadequacies exist at every stage in the enforcement process. In the Daqing Case, it took almost three years for the case to be accepted by the court and for the court to render a final judgement in the joint action. More than a year has passed since the judgement and the shareholders have yet to receive payment owing to them. Enforcement of the judgement is currently before the SPC, after a series of appeals by a third party whose identity has not been disclosed to the public.

In addition to well-developed laws, effective civil enforcement requires the government's determination to enforce the rules and proper incentives for stakeholders to wield the lawsuit tools. Private lawsuits in China are hindered by lawyers' difficulties in collecting fees and the 'loser pays' rule. Shareholder lawsuit activity is also stifled by problems in the general environment for civil lawsuits, such as underdeveloped evidence rules and the lack of any pre-trial discovery procedures. The absence of a jury trial may be another barrier to effective shareholder litigation in China.

The New Company Law has already opened the door for shareholders to enforce their rights and there have been positive developments in practice since its issuance. For example, 22 law firms across 12 provinces in China recently formed a lawyers group to represent shareholders of Guangdong Kelon Electrical Holdings. The shareholders claim to have suffered losses as a result of the company's executives embezzling funds and inflating sales through transactions with companies controlled by the former chairman. The lawyers have expressed that they might initiate derivative lawsuits on behalf of the company. Their approach is obviously fuelled by the New Company Law.

The Chinese civil enforcement framework has thus far developed in a piecemeal, gradual fashion that may have masked some of the dramatic changes that have already taken place. The fledgling capital markets and burgeoning private business sectors are founded on legal principles that allow persons with no prior relationship to interact to create wealth. In China, a market for legal services has developed with the private economy and the seeds of a legal-minded culture may already have been planted. With each new commitment to private law, its further development appears increasingly inevitable. As lines blur between public and private, it will be interesting to witness the extent to which the bureaucracy might be subjected to the laws.

Endnotes

1 For an analysis of shareholder protection introduced by the New Company Law, see Corporate Governance under the New Company Law (Part 1): Fiduciary Duties and Minority Shareholder Protection, China Law & Practice, Vol. 20, No. 3, pg 17.

2 Circular on Temporary Dismissal of Securities-related Civil Remedies Cases, issued by the SPC on September 21 2001. The circular stated, in relevant part: "Judicial remedies to illegal securities activities such as insider trading, fraud and market manipulation are new issues worth people's courts' attention and research. However, people's courts are not yet ready to accept and hear these types of cases because of legislative and judicial limitations. Therefore, for the time being, people's courts will not accept civil remedies cases with respect to illegal securities acts."3

Circular on Acceptance of Securities-related Civil Remedies Cases with respect to Misrepresentation, issued by the SPC on January 15 2002.

4 Although case precedents do not have binding force in China, judgements in shareholder lawsuits are expected to provide guidance for similar subsequent cases.

5 Article 113 of the New Company Law further expands civil liabilities for non-compliance with corporate governance rules. Under the Old Company Law, a director of a company limited by shares only bore liability for any resolutions he or she approved which violated laws, administrative regulations or the company's articles of association. Article 113 adds a requirement for directors of companies limited by shares to compensate the company if he or she took part in approving a board resolution that violates a shareholder resolution and causes losses to the company.

6 Article 20 ibid.

7 Article 21 ibid.

8 Article 21 ibid.

9 Article 150 ibid.

10 Article 63 of the PRC Securities Law, issued by National People's Congress (NPC) on December 29 1998 and effective on July 1 1999.

11 Article 34 of the New Company Law.

12 Article 22 ibid. Additionally, Article 22 provides that any resolutions of shareholders' meetings or the resolutions of the board of directors in violation of laws or administrative regulation are null and void. This creates an implied private right of action for shareholders to bring lawsuits to petition the court to declare such resolution invalid.

13 In 2003, the Jiangsu High People's Court and the Shanghai High People's Court both promulgated interpretations establishing rules for derivative lawsuits in their respective jurisdictions.

14 Article 153 of the New Company Law provides the procedural counterpart to Article 152, specifying the grounds for assertion of a direct shareholder lawsuit against directors or senior officers.

15 Courts in some foreign jurisdictions award direct payment of recovery proceeds to minority shareholders in derivative actions. Also, some courts permit the minority shareholders to sue oppressive controlling persons directly, even though the dispute is based on harm to the company. This is typically allowed only in the context of a closely held company.

16 Please refer to page 35 in this issue of China Law & Practice for a full translation of the Company Law Interpretations.

17 Article 152 of the New Comapany Law.

18 Generally, another drawback to derivative lawsuits is that the controlling person against whom the action is brought often retains his or her controlling position after the lawsuit and thereby retains a measure of control over any compensation he or she may have paid to the company.

19 The Civil Procedure Law was issued by the NPC in 1991.

20 Article 108(3) of the Civil Procedure Law.

21 Based on the circumstances, the Japanese court may determine that the company will not participate in the action.

22 Article 56(1) of the Civil Procedure Law.

23 Article 4 of the Company Law Interpretations.

24 Article 267(1) of the Commercial Code of Japan.

25 Article 4 of the Company Law Interpretations.

26 If a limited liability company has not established a board of supervisors, the shareholders must make the demand to the company's supervisors.

27 If a limited liability company has not established a board of directors, the shareholders must make the demand to the company's executive director.

28 The business judgement rule encompasses decisions whether to initiate, or refrain from, litigation. It presumes a board's decision was made by disinterested directors who acted on an informed basis, in good faith and in the honest belief the decision was in the company's best interest. Its protection can be claimed when disinterested directors fulfilled their duty to inform themselves of all material data reasonably available to them and then acted with due care.

29 Articles 135 and 137 of the Civil Procedure Law.

30 See, for example, Kahn v. Seaboard Corp., 625 A.2d 269, 276-277 (Del.
Ch. 1993).

31 Such statutes are often circumvented by plaintiffs' lawyers in practice.

32 Article 107 of the Civil Procedure Law; Article 5(4) of the Provisions Regarding Collection of Litigation Fees by People's Courts, issued by the SPC on
July 12 1989.

33 Articles 53 and 54 of the Civil Procedure Law establish joint action where a numerous party elects representatives to litigate the claims.

34 Articles 53 and 55 ibid.

35 See, for example, Rule 23 of the Federal Rules of Civil Procedure.

36 Article 4 of the 2002 Circular.

37 The SPC's Interpretation of Civil Procedure Law (CPL Interpretation), issued in 1992, provides that the notice period will depend upon the circumstances of the case but will not be less than 30 days.

38 Article 55 of the Civil Procedure Law; Article 61 of the CPL Interpretation.