Company Law Revision Draft of China: Major changes concerning company’s management personnel

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published on 14 April 2022 | reading time approx. 6 minutes

by Christina Gigler and Xiaolan Zhao

         
Besides the key changes in the company capital regime as mentioned in our previous article, the “Revision Draft” of the Company Law makes further amendments with regards to company’s organ structure, responsibilities and liabilities of company’s management personnel. Directors, supervisors and senior management personnel bear greater and clearer responsibilities.

  

   

 

Creation of audit committee under board of directors

Under the current Company Law, the main organizational structure of a company consists of shareholders' meeting, board of directors (BoD)/executive director and board of supervisors (BoS)/supervisor(s) (hereinafter collectively referred to as the BoD and BoS). Among them, BoD and BoS participate in corporate governance parallelly, forming a dualistic governance model. In practice however, for many companies, BoS is unwilling or unable to implement their supervisory function. One reason for this might be that BoS is usually nominated by the majority shareholders and therefore represent the interests of them. When the interests of the controlling shareholders are in conflict with those of the company, BoS may have a tendency to remain silent. Another reason may lie in the lack of substantial supervisory power. Based on the current Company Law, BoS has the right of raising dismissal proposal against directors and senior managers who violate laws or administrative regulations, not the right of direct dismissal.

 

The Revision Draft seeks a solution to this problem and for the first time creates the audit committee composed of directors under the BoD, which shall be responsible for supervising the finance and accounting of the company. In addition, the audit committee shall exercise further duties as prescribed in the articles of association. Such duties of audit committee may lead to an overlap with those of supervisors or can replace them to a certain degree.

 

For limited liability companies with audit committee, supervisor is not required anymore. For companies limited by shares, in order not to set up BoS or appoint supervisors, more than half of its members in audit committee shall be non-executive directors and no audit committee member may assume the position of the company's manager or financial principal. It should be noted particularly that "executive director" here has not the same definition as the "executive director" under current Company Law for limited liability companies without BoD. In the Revision Draft, "executive director" becomes an exclusive concept for companies limited by shares, i.e. only companies limited by shares have "executive director" and "non-executive director".

 

No upper limit in number of directors and unified requirement of employees' representatives in the board of directors

In the current Company Law, BoD of limited liability companies comprises of three to 13 members, while BoD of companies limited by shares can have five to 19 members. The Revision Draft removes above restriction and stipulates that BoD shall consist of three members or more, regardless of the legal form of company.

 

Also, based on the Revision Draft, limited liability companies of a relatively small scale can have one director or manager, which might have a rather small impact in practice, as already now limited liability companies with relatively few shareholders or of a relatively small scale may appoint one executive director instead of establishing a BoD, who can also serve as General Manager.

 

In addition, under the current Company Law, only wholly state-owned companies with limited liability are required to have employees' representative in their BoD. In order to guarantee the participation of employees in the management, the Revision Draft stipulates that all limited liability companies with 300 employees or more shall have at least one employees' representative in the BoD, that is democratically elected by employees, irrespective of whether the company is state-owned or not. We assume that many investors would not be pleased by this change.

It is for the moment not yet clear, whether this provision also implies that limited liability companies with more than 300 employees shall establish BoD.

 

Clear definition of the duty of loyalty and diligence

In 2021, the Kangmei Pharmaceuticals case with its 2.46-billion-yuan verdict shocked the Chinese securities market. 13 directors and supervisors were held responsible for financial fraud and thus bore respectively 5% to 100% jointly and severally liable for damages in the event of any shortfall, triggering a wave of resignations of independent directors of listed companies. Following the Securities Law revision, which was adopted prior to the Kangmei Pharmaceuticals case , responsibilities and obligations of directors, supervisors as well as senior management personnel (hereafter referred to as the "Management") are more clearly defined in the Revision Draft.

 

The current Company Law stipulates that the Management shall comply with the provisions of laws and administrative regulations and the articles of association of the company and bear duty of loyalty and diligence towards the company. However, it lacks further definition of what is loyalty and what is diligence. Although it is not rare in the judicial practice, that the Management has been held legally liable for violating this article, there are no unified rules in judgement whether to separate the liability for loyalty and diligence or how to apply them in practice.

 

The Revision Draft defines for the first time duty of loyalty and duty of diligence in two separate paragraphs. Duty of loyalty indicates that the Management may not seek improper benefits by taking advantage of their positions, while duty of diligence emphasizes that the Management shall perform their duties with the reasonable care normally expected for managers for the best interests of the company. It can be seen that the duty of loyalty is rather a passive obligation while duty of diligence is more an active obligation. Under duty of loyalty, the Management is no longer exempted from liability for not knowing, not participating, having questioned, or being non-professional, and might be held responsible for defaulting performance or non-performance in fulfilling their obligations.

 

In addition, the subject of the duty of loyalty in the current Company Law are only directors and senior management personnel. The Revision Draft includes supervisors into the subject thereof, which unifies the responsibility of all the Management.

 

Compensation liabilities of directors, supervisors and senior management personnel

In our previous article on major changes concerning company capital, we have introduced the significant changes regarding the company's capital and the corresponding responsibilities to be borne by shareholders. With regard to the preservation of the company's capital, the Revision Draft also clarifies the responsibilities of the Management as well as their compensation liabilities in event of capital contribution default, surreptitious capital withdrawal, illegal profit distribution, illegal capital reduction and illegal financial support for the acquisition of company shares by others.

 

The Revision Draft stipulates that where the Management shall be liable for compensation, where they know or should have known that a shareholder at the time of establishment failed to make its capital contribution, but fails to take any necessary measures, which causes any loss to the company.

 

The main differences from the current legal situation are:

  • the compensation liability is expanded from director and senior management personnel to all the management, ensuring supervisor to fulfill his supervisory obligation.
  • the Revision Draft requires the Management to "taking necessary measures" in addition to duty of loyalty and diligence, which may include assisting the company in capital contribution verification, sending written reminders or even notices of share deprivation to defaulting shareholders.
  •  tightening Management's responsibility by expanding the duty of indemnify in event of capital withdrawal from "conduct assistance" – in sense of duty of loyalty to "know or should have known" - in sense of duty of diligence.

 

For illegal profit distribution, illegal capital reduction and providing financial support for the acquisition of company shares by others in violation of the regulations, the Revision Draft strengthens the responsibility of the Management by stipulating that the Management who is responsible for causing losses in said situations to the company shall be liable for compensation. However, there is no further explanation regarding in what situation they shall be held "responsible". We believe it should at least include duty of loyalty and diligence. That is, the Management may neither actively assist any illegal acts, nor remain passive and deliberately ignore the illegal situation.

 

At the end, the Revision Draft adds a catch-all compensation clause to the third party which stipulates that in event of any damage to others caused by a director or senior manager intentionally or due to gross negligence while performing his/her duties, he/she shall bear joint liability with the company.

 

Restrictions on affiliated transactions

On the basis of current Company Law, the Revision Draft clarifies the reporting and resolution requirements for affiliated transactions of the Management and expands the scope of affiliated parties. Fulfilling certain prerequisites, affiliated transactions are allowed.

  • Legal procedure

Where the Management intends to conclude a contract or conduct a transaction with the company directly or indirectly, they shall report the relevant matters to the BoD or the shareholders' meeting, for which a resolution of the BoD or the shareholders' meeting shall be made according to the articles of association.

  • Abstention from Voting

The affiliated directors may not participate in the voting, and their voting right may not be counted into the total number of votes, when the BoD makes a resolution.

  • Definition of affiliated parties

Affiliated parties includes the Management, their close relatives, enterprises directly or indirectly controlled by the management or by the close relatives thereof as well as any affiliated party having any other related relationship with the management.

 

Non-competition

The current Company Law stipulates that "a director or senior manager shall not without the consent of the shareholders' meeting or the shareholders' general meeting, take advantage of the position to seek business opportunities belonging to the company for himself or others". The Revision Draft again expands the subject from "director or senior manager" to all the management and provides three exceptional situations, namely:

  • (I) where business opportunity has been reported to the BoD or the shareholders' meeting, and a resolution has been made by the BoD or the shareholders' meeting;
  • (II) where business opportunity has been reported to the BoD or the shareholders' meeting, but the BoD or the shareholders' meeting explicitly rejects such business opportunity; or
  • (III) where, according to the laws, administrative regulations or the articles of association, the company cannot take advantage of such business opportunity.

 

Outlook

This Revision Draft shows the legislator's intention to reinforce the duties and responsibilities of directors, supervisors and senior management personnel in corporate governance. If such revisions are finally adopted in the Company Law, it is recommendable for companies to prepare or update management rules for the management, by clarifying criteria for compliance on the one hand, and preparing the basis for claiming compensation in the event of damage to the company or its shareholders caused by the management due to breaches of duty on the other hand.

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