Strengthening the Regulation of Affiliated Transactions

Article 20 of the Company Law only lays out the general principles for affiliated transactions of companies, specifying that an affiliated party that has taken advantage of its affiliation and prejudiced the company's interests will be liable for compensation. Unfortunately, Article 20 does not specify the criteria for assessment. In practice, the court would mainly assess the affiliated transaction based on procedural matters (for example, identification of affiliation, information disclosure and negotiation of the affiliated transaction), as well as substantive matters such as the fairness of the transaction. However, due to the complexity of affiliated transactions and the shortfall in legislation, some courts might find it difficult or impossible to determine whether an affiliated transaction is fair from both the procedural and substantive perspectives. In particular, some courts would only look at the procedural matters; the defendant would then mount its defense on the grounds that the transaction has obtained approval from the shareholders' meeting. In reality, a company is usually controlled by its major shareholder or de facto controller whose opinions in respect of the company's management strategies are decisive. It is difficult to conclude whether a transaction is fair based only on procedural considerations.

2 . It is difficult for a shareholder to file a shareholder representative lawsuit on the grounds of "prejudicing the company's interests"

The third paragraph of Article 151 of the Company Law specifies that if a third party infringes upon the lawful rights and interests of a company causing the company to incur a loss, a qualified shareholder may institute legal proceedings in a people's court. However, the term "third party" could have different interpretations and it is not clear whether the term includes the controlling shareholder or the de facto controller who carried out the affiliated transaction. Therefore, in practice, it can be very difficult for a shareholder to institute a shareholder representative lawsuit under Article 151.

The Wolters Kluwer database records 55 precedent cases at first instance that feature "affiliated transactions" and "shareholder representative litigation" as keywords. Among these cases, 14 prosecution claims were rejected; only six cases were accepted by the court with "dispute over compensation liability of an affiliated transaction" as the cause of action; and four cases involved a shareholder's request to rescind the contract or determine that the contract was invalid. Clearly shareholder representative suits are instituted in respect of affiliated transactions in only limited circumstances. This may be because shareholders face certain difficulties in filing such representative actions. Moreover, in practice, there are few shareholder representative cases involving the validity of affiliated transaction contracts where determining the contract as invalid or rescinding the contract could protect the company's interests.

II . The regulation of affiliated transactions under Judicial Interpretation V

Articles 1 and 2 of Judicial Interpretation V improve the regulation of affiliated transactions of companies in two aspects: (1) clarifying that liability for compensation relating to unfair affiliated transactions cannot be avoided by complying with statutory procedures; and (2) denying the validity of relevant affiliated transaction contracts.

In a court dispute over compensation liability relating to affiliated transactions, the related party often raises a defense on the basis that the transaction complied with legal procedures. Article 1 of Judicial Interpretation V emphasizes that liability of affiliated transactions cannot be avoided by complying with legal procedures, in order to safeguard the rights and interests of small and medium investors and to provide the right of relief to affected companies.

Judicial Interpretation V clearly states that even though a transaction is procedurally legal, a company may seek to claim damages from the controlling shareholder or other such affiliated parties if the transaction is unfair and harms the company's interests. At the same time, Judicial Interpretation V extends its scope of application to shareholder representative lawsuits. Where a company chooses not to file a case when a contract is invalid or can be rescinded, an eligible shareholder may request a court determination that the contract is invalid, or apply for rescission of that contract in accordance with law.

III . Further improvement of the assessment criteria for affiliated transactions is needed

The promulgation of Judicial Interpretation V has not yet entirely removed the difficulties relating to the trial of unfair affiliated transaction disputes, although it will, to a certain extent, regulate such transactions. Further improvement to relevant regulations is still needed.

1 . The test for determining an affiliated transaction has not been standardized

In a trial of an affiliated transaction dispute, the court would first determine whether the transaction is an affiliated transaction before deciding whether the transaction was fair. In relation to the first step, there is no clear definition in the Company Law of an affiliated transaction. When applying Judicial Interpretation V, the court would therefore consider the interpretation of "affiliated transaction" found in other provisions. Under the current legal framework, legal documents such as Accounting Guidelines No. 36, Company Law, Measures for the Administration of Information Disclosure by Listed Companies (上市公司信息披露管理办法) and Shanghai Stock Exchange, Implementing Guidelines on Affiliated Transactions of Listed Companies (上海证券交易所上市公司关联交易实施指引) all mention the determination of an affiliated transaction. Nevertheless, these tests found in these sources are different as the regulatory focuses of different departments are not the same. In practice, therefore, the parties may each request application of their own legally valid test to prove whether the transaction in question is an affiliated transaction. This creates judicial uncertainty as to which test the court will adopt.

2 . The uncertainty in burden of proof

Judicial Interpretation V has not shifted the burden of proof to the defendant regarding the "harms to the company's interests made by the affiliated transaction". The Civil Procedure Law (民事诉讼法) specifies that the burden of proof lies with the party who raises an allegation. Therefore, the plaintiff shoulders the burden of proving the unfairness of an affiliated transaction as well as harms to a company's interests. However, since small and medium shareholders are not parties involved in the affiliated transaction, it will be difficult for them to adduce specific and complete evidence. This makes the existing principle of burden of proof unfavorable to small and medium shareholders who wish to safeguard a company's interests through litigation.

3 . The substantive review criteria for affiliated transactions have not been determined

After the promulgation of Judicial Interpretation V, courts will further emphasize the substantive review criteria of affiliated transactions. However, the interpretation does not clarify what those criteria comprise. According to the press conference held regarding Judicial Interpretation V, the core value of an affiliated transaction is fairness. As discussed earlier, even where a transaction is procedurally legal, a company can claim for damages if the transaction violates the principle of fairness and harms the interests of the company. In addition, the test for fairness regarding affiliated transactions is not standardized; this can be observed in the Company Law, Accounting Standards No.36 and provisions of the China Securities Regulatory Commission (such as the Guidance for the Governance of Listed Companies). It is common practice to consider whether a transaction is fair based on the fairness of the cost of the transaction. However, such test is difficult to apply in a non-competitive market. Since the current criteria for substantive assessment of affiliated transactions have not been unified, further interpretation and clarification are needed from judges in individual cases.