China introduces statutory derivative action

Author: | Published: 1 Jul 2005
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A draft amendment to China's Company Law was proposed to the Standing Committee of the National People's Congress (NPC) in February 2005. This proposed amendment concerns 12 defects in the existing Company Law. One of the proposals is for rules governing shareholder action, including shareholder's direct action and shareholder's derivative action. Such rules do not yet exist in Chinese law.

In recent years, more and more disputes between controlling shareholders and minority shareholders in listed companies have been reported in China. In these disputes, shareholders often find it difficult to institute legal action when a controlling shareholder infringes the company's interests. In some China-foreign joint venture companies, the Chinese or foreign investors also face this predicament.

In 2003, some High People's Courts in China introduced derivative action, setting up rules for trials concerning disputes among company shareholders. Shanghai High People's Court promulgated its Opinion on Some Issues in Trials for Legal Actions Related to Company Disputes (No 1) (the Shanghai Court interpretation), in which, for the first time, derivative action was introduced to China. Jiangsu High People's Court, almost at the same time, promulgated its Opinion on Some Issues in Trials for Legal Actions Applied with Company Law (Provisional Rules) (the Jiangsu Court interpretation). The Jiangsu Court interpretation set up the rules for shareholder(s) representative action, which has the same common-law definition as derivative action.

In 2003, the Supreme People's Court publicized the first draft of Regulations on Some Issues Concerning Trials for Company Disputes (No 1), making them open for public comment (the Supreme Court interpretation). At the end of 2003, the Supreme People's Court revised the first draft based on the collected comments, and publicized the second draft of its interpretation. Both drafts of the Supreme Court interpretation established the rules for shareholder's derivative action, which is also called shareholder(s) representative action.

In Chinese legal practice, the Supreme People's Court often provides guidelines and comments on legislation drafted by the State Council of China and the NPC. Its comments are considered judicial interpretations of law. The Supreme People's Court interpretations will be applied in all lawsuit trials by each level of courts in China. However, the High People's Courts in different provinces, directly administered cities, and autonomous regions can make interpretations for the trials in their own jurisdictions. The interpretations from the High People's Courts cannot conflict with the interpretations of the Supreme People's Court.

Now that the amendment to the Company Law is drafted and proposed, it seems that the Supreme People's Court will not finalize its interpretation until NPC adopts the amendment. So, in practice, derivative action can only be successfully filed with the courts in Jiangsu or Shanghai. In other provinces or cities, derivative action might be filed and judged by the courts that are considering adopting the principles of derivative action mentioned in the proposed Supreme Court interpretation.

Rules of derivative action

There is no doubt that the Supreme People's Court and the local High People's Courts use common law for reference when they introduce derivative action. So most issues related to derivative action in the interpretations are the same as, or similar to, those in common law. The following issues are considered in the interpretations and/or the proposed amendments to the Company Law:

Requirement on plaintiffs

The interpretations from Jiangsu Court and Shanghai Court both require the plaintiff of a derivative action to meet the contemporaneous ownership rule, that is, the plaintiff must have been a shareholder at the time that the acts that are the subject of the lawsuit were committed.

The Jiangsu Court interpretation requires more of a plaintiff shareholder, specifying that "registered capital contributed by a plaintiff shareholder of a limited liability company shall be not less than 3% of the total registered capital of the company; shares held by a shareholder of a joint stock company (no matter it is a listed company or not) shall be not less than 1% of the total shares issued by the company and have been kept for no less than 6 months."

The Shanghai Court interpretation does not mention the minimum share requirement. Any shareholder may lodge derivative action regardless of its shareholding size.

The Supreme Court interpretation requires that a plaintiff shareholder of a limited liability company must hold at least 10% of the shares in that company; the minimum share requirement for a shareholder of a joint stock company is the same as the Jiangsu Court interpretation, but there is no holding term requirement.

The Jiangsu Court interpretation additionally requires that the alleged wrongdoing must have been committed after the plaintiff became a shareholder. The Supreme Court interpretation has the same requirement. There is also the continuing ownership rule in the Jiangsu Court interpretation and Supreme Court interpretation. The plaintiff must continue to own the shares in the company not only at the time of suit, but also right up until the moment of judgment.

The drafted amendment to the Company Law just specifies that a shareholder of a joint stock company, as a plaintiff of derivative action, must have held 1% or more of the shares in the company for at least 180 days. This requirement is not imposed on a plaintiff shareholder of limited liability company.

Although there is a minimum share requirement for the plaintiff shareholder, the attitude from the legislature and the courts toward this issue is not rigorous. This limitation is to prevent shareholders abusing their litigation rights or instituting suits without merit. The legislators say that the limitation is not grounded on antipathy to derivative action.

However, in China, 1% of issued capital shares in some large listed companies could mean hundreds of millions of shares, while in small listed companies would only be hundred of thousands of shares. A minimum share requirement based on a percentage will make it more difficult for shareholders of large companies to commence derivative action than for those in small companies. The legislature should consider replacing the share percentage requirement with the share sum requirement.

Demands on the board

The Jiangsu Court interpretation requires the plaintiff to make a demand on the board of directors and the board of supervisors of the company before commencing a derivative action; the plaintiff must demand that the board of directors and the board of supervisors bring a suit or take other corrective action to redress the wrongdoing. Only when the boards refuse or fail to act may the plaintiff commence the action. The demand would be excused if it were reasonably expected that the demand on the boards for bringing a suit would exceed the limitation of action.

The Supreme Court interpretation has a similar prerequisite to the Jiangsu Court interpretation. It specifies that the plaintiff must provide evidence proving it did demand that the company bring suit two months before it filed its suit and that the company failed to act. The exemptions from this prerequisite are: the property stake related to the action will be transacted or the period of limitation will expire; or any other urgent situation forcing the plaintiff to commence the immediate action.

The Shanghai Court interpretation has no such prerequisite, but specifies that the Court will consider the fact that the company could not take legal action itself because it was controlled by the wrongdoer. It appears that the Shanghai Court interpretation takes a different stance on this prerequisite than the other interpretations. The Shanghai High People's Court's opinion gives courts more liberty and efficiency because of its simplicity and convenience.

The drafted amendment to the Company Law also requires the demand on the board of directors or the board of supervisors of the company before filling the derivative action. However, the demand must be made on a cross basis: if the directors or high-level officers breach the duties stipulated in laws, a demand should be made on the board of supervisors; if the supervisors act wrongly, a demand should be made on the board of directors. It further specifies that, if the board of directors or the board of supervisors refuses or fails, within 30 days, to bring the lawsuit, the shareholder will have the right to begin the derivative action. Similar to the Supreme Court interpretation, the exemptions from the demand are also specified.

The draft amendment to the Company Law shares the Supreme Court interpretation's view on prerequisites to derivative action. The cross-basis demand requirement seems more comprehensive. However, usually, an appeal to the board of directors and the board of supervisors would be useless, for example, when the wrongdoers completely control the board of directors or the board of supervisors. The exemption from the prerequisite does not cover cases where a demand would be redundant. Another criticism points out that the cross-basis demand requirement would be a procedural obstacle to derivative action if both the directors and supervisors have done wrong to the company.

Defendants in derivative action

In accordance with the three interpretations, controlling shareholders, directors, supervisors, officers and/or counter parties committing the wrong transaction or behaviour could be aligned as defendants in a derivative action.

The Supreme Court interpretation defines controlling shareholders as the shareholders that are actively operating and managing the company, or materially influencing, based on the shares they hold or through other ways, the company's decisions on the issues concerning personnel, finance and operation.

The company could be aligned as a third party, but not as a defendant. A third party, pursuant to the Civil Procedure Law of China, is a party participating in a civil suit whose legal interests might be affected by the judgment. In a derivative action, the company, as a third party, would be deemed a nominal defendant, even though recovery runs exclusively in favour of the company. A third party in a derivative action has the right to file an appeal and apply to enforce a final judgment that is in its favour.

Security for expenses

In some common-law jurisdictions, a security-for-expenses statute applying to plaintiffs is included in statutory derivative action. In China, neither of the High Court interpretations provides such a provision.

The Supreme Court interpretation specifies that: "if the director, supervisor, manager or controlling shareholder of the company, aligned as defendant in the derivative action, provides evidence to prove that the suit lacks good faith and applies to require the plaintiff to give a security for expenses in connection with the action, the court shall approve the motion of security-for-expenses. The amount of the required security shall be equivalent to the expected reasonable expenses that the defendant may incur."

The purpose of security-for-expenses statutes undoubtedly is to deter so-called strike suits brought in the hope of securing a settlement profitable to the plaintiff shareholders. The provision in the Supreme Court interpretation distinguishes between strike suits and bona fide derivative action. It does not apply to all derivative action. However, it is difficult for the defendants to prove that the suit is brought mala fide. Because the recovery of a derivative action belongs to the company only, the plaintiff cannot derive any interests directly from the judgment of a derivative action. On the contrary, the plaintiff must pay the court's fee while filing the suit. It seems that the security-for-expenses statues would not be easily applied.

The security-for-expenses statute is a procedural question, so the proposed amendment to Company Law will not cover it.

Result of action

Both the Shanghai Court interpretation and the Jiangsu Court interpretation say: "In the case that an amicable settlement is proposed by the parties in the derivative action, such proposed settlement must not show harm to other shareholders or the company."

If the complaints claimed by the plaintiff are affirmed, a judgment will be entered to withdraw the related transaction, or order the wrongdoer, as well as the counterparties of the transaction, to recover the company's losses. The principle that a recovery in derivative action should be in favour of the company is confirmed both by the Shanghai Court interpretation and Jiangsu Court interpretation.

The Shanghai Court interpretation further specifies that, if the judgment is in favour of the defendant, the company must provide a reasonable compensation to the plaintiff. The Jiangsu Court interpretation considers that the reasonable expenses incurred for the action, such as attorneys' fees and travelling expenses, must be reimbursed by the company.

The Supreme Court interpretation further considers that an unsuccessful plaintiff must reimburse the defendant director, supervisor, manager or controlling shareholder of the company for their reasonable expenses caused by the action.

No res judicata effect of derivative action

The interpretations from the Supreme People's Court and High People's Courts do not mention the res judicata effect of the determination. When a derivative action is commenced, if other shareholders of the company claim for the same complaint, they can participate in the suit before the hearing begins. If the claims are not the same as the original ones, or if the other shareholders claim for other complainants, they will constitute another derivative action. These procedural provisions are specified in the Jiangsu Court interpretation and the Supreme Court interpretation.

Under common law, a determination of derivative suit on the merit is res judicata and precludes other derivative suits on the same claim; a determination of a dismissal of a derivative suit depends on the reason for the dismissal. The res judicata effect of the derivative action is efficient for court trial. However, in China, the lack of the res judicata effect means that the courts encounter serious problems in a number of cases. It seems that this practical rule needs to be added to statutory derivative action in China.

Trends in statutory derivative action

It is clear that derivative action rules must be added in the amendment to the Company Law. The NPC will adopt this amendment soon. However, the Company Law will simply specify some general principles of derivative action; most of the procedural issues will be interpreted by Supreme People's Court.

But company theory in China is different, in some aspects, than that in the common law countries, and some general principles of derivative action could not be directly transplanted in China. For example, a director's fiduciary duty is not nailed down in the Company Law. In most companies, the directors are appointed by shareholders. In this situation, the directors represent the shareholders and lose their fiduciary duties to the company. For the same reason, in a derivative action, to demand the board of directors to correct the wrongdoing is meaningless. So the rules of derivative action need to be amended from time to time to meet the real situation relating to China's company law system.

Because of the company legislation and practice in China, the judicial interpretation on derivative action will be much more important. In accordance with the proposed Supreme Court interpretation, the opinions are far from comprehensive and detailed. After NPC adopts the amendments to the Company Law, the Supreme People's Court will finalize and promulgate its interpretation. The rules of derivative action set up in the final Supreme Court Interpretation, together with those provided in the amendment to the Company Law, will be the whole statutory derivative action introduced in China. The two existing interpretations from the High People's Courts will be revised in accordance with the amendment to Company Law and the final Supreme Court interpretation.

Although the derivative action rules have been in China since 2003, no derivative suit case has yet been reported by the Supreme People's Court. Most of the shareholders' disputes relating to some listed companies are settled as shareholders' direct action. With the rising attention paid to the amendment to the Company Law and the rules of derivative action, it is believed that more and more derivative action will be brought. Those cases will help the legislature and courts develop and consummate the statutory derivative action.

A milestone

Although China has decided to introduce statutory derivative action, there is still a long way to go to construct a comprehensive and practicable procedural system for derivative action. But regardless of whether the statutory derivative action system in China is good enough or not, it is important for company system reform. It is also a milestone for the legal system relating to company law. Statutory derivative action will definitely be welcome among shareholders, especially minority shareholders, in China.

Author biographies

Zhu Hong Chao

Shanghai United Law Firm

Zhu Hong Chao is the managing partner of Shanghai United Law Firm. He earned his LLM (1996) and LLB (1982) from Fudan University. He has spent almost 20 years practising law in Shanghai, China.

Zhu's areas of specialty include corporation, securities and litigation. Zhu has actively represented a number of international and domestic clients and been involved in structuring, negotiation, document preparation and rendering legal opinion in many projects.

Zhu is the vice-chairman of All China Lawyers Association and Shanghai Lawyers Association and is also engaged as an arbitrator at Shanghai Arbitration Commission. He has written numerous books and articles on legal practice. His publications include: "The Law of Obligation of Taiwan," "The System and Practice of Chinese Lawyers," "The Manuscript of Lawyers," "Good Lawyers, Good Cases".

James GQ Chen

Shanghai United Law Firm

James Chen is a partner of Shanghai United Law Firm. He earned his LLB from Fudan University in 1996 and completed LLM course at Fudan University in 1999.

Chen's areas of specialty include investment, corporation and M&A. He is well recognized for his experience and skills in these areas. In the fields of investment and corporation, Chen has successfully advised a number of foreign companies on establishing joint ventures in China. Chen has also been actively involved in corporate reorganization and M&A of a large number of state-owned enterprises, collective-owned enterprises, private companies, foreign companies and foreign-invested companies.

Chen has spoken widely on specialist topics at local law schools and published a number of articles, including "IP Laws in International Investment," "Overview of Joint Venture Contracts," "Trade Secret Protection in China" and "Overview of China Trust Law".