Tag:securities-and-capital-markets-advisory-services-for-listed-companies,corporate-mergers-and-acquisitions-corporate-governance
The legal system of companies constitutes a fundamental part of the socialist legal system. The current Company Law of the People’s Republic of China (PRC) (the “current Company Law”) was enacted in 1993. Since its inception, it has undergone amendments to certain articles in 1999 and 2004, a comprehensive revision in 2005, and important amendments to the basic system of companies in 2013 and 2018. Throughout the three decades following its promulgation and implementation, the Company Law has played a crucial role in establishing and improving the modern corporate system in China, contributing to the sustained and healthy development of the socialist market economy.
The Company Law as revised by the Standing Committee of the National People’s Congress (NPC) on 29 December 2023 (the “new Company Law”) introduces substantial additions and amendments to about 70 articles, building upon the existing 218 articles in 13 chapters of the current Company Law. The restructuring of corporate governance rules stands out as a prominent feature of the new Company Law.
I. Returning the legal representative to the legal status of “representative”
As the basic civil law of the PRC, the General Principles of the Civil Law established the legal representative system for the first time in 1986. Article 38 of those General Principles provides, “In accordance with law or the articles of association of the legal person, the responsible person who acts on behalf of the legal person in exercising its functions and powers shall be its legal representative.” Pursuant to such provision, the representative of a legal person is only the legal representative who may only be the responsible person who acts on behalf of the legal person in exercising its functions and powers. Article 7 of the PRC Law on Industrial Enterprises Owned by the Whole People, adopted by the NPC in 1988, provides, “The enterprise implements a factory director (manager) responsibility system.” Article 45 of that Law provides that the factory director is the legal representative of the enterprise. Article 13 of the current Company Law provides that the legal representative of a company shall be the chairperson of the board of directors (BoD), an executive director, or a manager in accordance with its articles of association (AOA), and shall be registered in accordance with law. It can be observed from the above provisions that the legal representative system in China underscores that the legal representative of a company should be its “leader”.
The PRC Civil Code, effective as of 1 January 2021, amended the legal representative system. Article 61 of the Civil Code specifies that the person with the responsibility of representing a legal person in conducting civil activities in accordance with law or the legal person’s AOA is the legal representative of the legal person. The new Company Law draws on such provision of the Civil Code. Article 10 of the new Company Law states that the legal representative of a company shall, in accordance with its AOA, be the director or manager who performs corporate affairs on behalf of the company. The new Company Law delegates that the legal representative may be the person as agreed upon in the AOA. In other words, the AOA may stipulate that any one or more directors or managers authorized by the BoD may act as the legal representative of the company. It is no longer mandatory to designate the chairperson of the BoD, the executive director or the manager as the legal representative, giving autonomy and more flexibility to the company.
The legal representative system restructured by the new Company Law allows legal representative to return to its legal attribute as a “representative” while diminishing the “official-centric” mindset within the business entity.
II. Introducing a one-tier corporate governance structure
In both British and American countries, a one-tier corporate governance structure is adopted, featuring corporate governance bodies consisting of a shareholders’ meeting and a BoD. The BoD has both operational and supervisory responsibilities. A company may have independent directors but not necessarily a separate board of supervisors (BoS). In contrast, Germany and other continental law countries adhere to a two-tier corporate governance structure, involving shareholders’ meeting, BoS and BoD. The BoD lacks independent directors. The BoS, as a superior body to the BoD, have powers such as appointing and dismissing directors, determining compensation, making significant decisions, and exercising supervisory authority.
Since the enactment of the Company Law in 1993, China has followed the traditional two-tier corporate governance structure under the continental legal system. For listed companies, China has also incorporated the independent director system from British and American legal systems. The new Company Law introduces an alternative one-tier corporate governance structure, marking a significant highlight in the latest revision.
Article 69 of the new Company Law provides that a limited liability company (LLC) may, in accordance with its AOA, set up an audit committee, composed of directors, on its BoD to exercise the powers and functions of a BoS as provided for in the new Company Law, without having a BoS or supervisor. Employee representatives of the members of the LLC’s BoD may also serve as members of the audit committee. Article 121 of the new Company Law provides that a joint stock limited company (JSLC) may, in accordance with its AOA, set up an audit committee, composed of directors, on its BoD to exercise the powers and functions of a BoS as provided for in the new Company Law, without having a BoS or supervisor. The audit committee shall have three or more members, a majority of whom shall not hold positions in the JSLC other than that of a director and shall not have any relationship with the JSLC that may affect their independent and objective judgement.
The new Company Law empowers companies to autonomously choose in the AOA their corporate governance structure, be it one-tier, two-tier, or hybrid. If a company chooses a hybrid structure, it will have a shareholders’ meeting, a BoD, a BoS (or supervisor), and an audit committee. It is important to note that if a company has both an audit committee and a BoS or supervisor, the respective functions of these two supervisory bodies should be defined in its AOA to optimise their supervisory roles.
The introduction of the one-tier structure in the new Company Law enhances the diversity of corporate governance models. This change is of great significance for market players to design their own governance structure in line with their development needs.
III. Simplifying governance structure for companies of smaller scale and with smaller number of members
Firstly, the BoS (or supervisor) is no longer compulsory. Introducing a one-tier corporate governance structure, the new Company Law regulates the establishment of a BoS (or supervisor) as an arbitrary norm. In accordance with Article 83 of the new Company Law, a LLC of smaller scale or with smaller number of shareholders may opt not to set up any BoS and have one supervisor to exercise the functions and powers of the BoS as provided by this law. With the unanimous consent from all shareholders, the LLC may also decide not to appoint a supervisor. Article 133 further specifies that a JSLC of smaller scale or with smaller number of shareholders has the option not to establish any BoS and instead appoint one supervisor to exercise the functions and powers of the BoS outlined by this law. This suggests that, with unanimous consent from shareholders, LLCs of smaller scale or with smaller number of shareholders may no longer be required to institute supervisory bodies such as the BoS. In the case of JSLCs, however, without an established audit committee, at least one supervisor must be appointed.
Secondly, the formation of the BoD is simplified for non-listed JSLCs. The new Company Law honours market practices by extending the arbitrary BoD requirement for LLCs under the current Company Law to JSLCs. Article 126 of the new Company Law stipulates that a JSLC of smaller scale or with smaller number of shareholders has the option not to establish a BoD and instead appoint one director to exercise the functions and powers of the BoD outlined by this law.
The new rules stated in the above two paragraphs also align with corporate practices. In the case of LLCs or JSLCs of smaller scale or with smaller number of shareholders, shareholders typically serve as decision-makers and operational managers, with ownership and operational control often residing with a single individual. This reduces the need for supervisory bodies such as the BoS (supervisor), or BoD, minimising agency costs and demonstrating respect for the autonomy of the company. However, regarding the threshold for defining smaller scale or smaller number of shareholders, the author believes that these quantifiable standards can be left to shareholders to determine based on the specific governance needs of the company.
IV. Establishing an audit committee
Drawing inspiration from corporate governance practices of the Anglo-American legal system and incorporating insights from the relevant practices of Chinese listed companies, the new Company Law introduces a substantial institutional innovation through the establishment of an audit committee.
The audit committee system in China originates with the issuance of the Corporate Governance Guidelines for Listed Companies by the China Securities Regulatory Commission (CSRC) in 2002, marking a pioneering introduction of audit committees in listed companies. The General Office of the State Council subsequently issued the Guiding Opinions on Further Improving the Corporate Governance Structure of State-Owned Enterprises in 2017. This document proposed the creation of specialised committees, including nomination committee, compensation and assessment committee, and audit committee, within the BoD of state-owned enterprises (SOEs) to provide consultation for decision-making; the compensation and assessment committee and the audit committee shall be composed of external directors. On 7 April 2023, the General Office of the State Council issued the Opinions on the Reform of the Independent Director System of Listed Companies, stipulating that the BoD of a listed company shall establish an audit committee whose members are all non-executive directors, on which independent directors are the majority. The audit committee shall have the duties to examine the company’s financial information and the disclosure, and supervise and assess internal and external audits and internal control, among others. Material matters, such as financial accounting reports and disclosures, require approval from the audit committee before submission to the BoD for review. Paragraph 1, Article 26 of the Measures for the Administration of Independent Directors of Listed Companies, issued by the CSRC on 1 August 2023 and implemented as of 4 September 2023, provide that “The audit committee of the board of directors of a listed company shall be responsible for reviewing the financial information of the company and the disclosure thereof and supervising and assessing the internal and external audits and internal control. The following matters shall be submitted to the board of directors for deliberation with the approval of a majority of all members of the audit committee: (1) disclosing financial accounting reports, financial information in periodical reports, and internal control evaluation reports; (2) hiring or dismissing the accounting firm providing audit services for the listed company; (3) hiring or dismissing the person in charge of financial affairs of the listed company; (4) modifying accounting policies or accounting estimates, or correcting material accounting errors due to reasons other than changes in accounting standards; and (5) other matters prescribed by laws, administrative regulations, rules of the CSRC, or bylaws of the company.”
The audit committee system is formally introduced and applied to LLCs by law for the first time. This signifies the legislature’s endeavour to apply the within the domain of LLCs. In accordance with Articles 69 and 121 of the new Company Law, whether for an LLC or for a JSLC, the audit committee is designed to exercise the functions and powers of the BoS when the company does not have a BoS (or supervisor). Article 176 of the new Company Law stipulates that for a wholly state-owned company, no BoS or supervisor is required if the company establishes an audit committee, composed of directors, on its BoD to exercise the functions and powers of the BoS.
Therefore, if a company establishes a BoS (or supervisor), the functions and powers of the audit committee should be specified in the AOA. Its fundamental functions and powers should align with the relevant regulations set forth by the General Office of the State Council and the CSRC. If a company has an audit committee but no BoS (or supervisor), the audit committee will exercise the functions and powers of the BoS.
V. Strengthening mechanisms to constrain controlling shareholder and actual controller
When it comes to exercising control over a company, there are generally two forms: (1) shareholder control, involving the supervision and restriction of company managers through shareholders’ meeting, and (2) internal management control, where directors, officers or other members of the management independent of shareholders possess actual control over the company. In practice, control may also lie with shareholders other than controlling ones, or even non-shareholding individuals, legal persons, or other organisations - thus serving as the actual controllers of the company.
If controlling shareholders, actual controllers, or any other persons who actually control the company exercise directorial powers, they are considered as “shadow directors” and are obligated to assume corresponding duties even if they do not hold directorial positions. The Minutes of the National Courts’ Civil and Commercial Trial Work Conference of the Supreme People’s Court (SPC) also state that “If a controlling shareholder or actual controller controls more than one subsidiary or affiliate and abuses its control to cause the subsidiaries or affiliates to have blurred property boundaries and financial confusion, transfer interests between them, be deprived of separate personality, degenerate into tools for the controlling shareholder to evade debts, operate illegally, and even violate the law and commit crimes, the legal personality of the subsidiaries or affiliates may be disregarded, taking into account the facts of the case so as to order joint and several liability to be assumed.”
A significant highlight of the new Company Law is the integration of insights from judicial practices, strengthening the obligations of controlling shareholders and actual controllers. As outlined in Article 23 of the new Company Law, if shareholders abuse the company’s independent status as a legal person and the limited liability of shareholders, evade debts and seriously damage the interests of the company’s creditors, they shall bear joint and several liabilities for the company’s debts. If a shareholder uses two or more companies under his/her control to carry out the acts specified in the preceding sentence, each company shall bear joint and several liabilities for the debts of any company. Article 192 of the new Company Law specifies that if controlling shareholders and actual controllers instruct directors and officers to engage in behaviour detrimental to the interests of the company or shareholders, controlling shareholders and actual controllers shall be jointly and severally liable with directors and officers.
Moreover, Paragraph 3, Article 180 of the new Company Law stipulates that if controlling shareholders or actual controllers of a company do not serve as directors but actually execute company affairs, the preceding two paragraphs shall apply. In other words, the new Company Law extends the duties of loyalty and diligence owed by directors, supervisors, and officers to the company to controlling shareholders and actual controllers.
The new rules stated in the above two paragraphs integrate shareholders and actual controllers into corporate governance, aiming to safeguard the rights of stakeholders in the company.
VI. Defining the duty of diligence for the first time
Article 147 of the current Company Law stipulates that directors, supervisors and officers shall comply with laws, administrative regulations and the AOA and bear duties of loyalty and diligence towards the company. Article 148 enumerates eight prohibited acts related to the duty of loyalty of directors and senior managers. The current Company Law, however, does not provide a definition of the duty of diligence.
In judicial practice, there are many cases on the duty of diligence of directors, supervisors, and officers. For example, in the dispute between Shandong Lawrance Textile Co., Ltd. and Ahmed Gaber Sobhy Ismail over liability for damaging corporate interests, the SPC stated in its civil ruling: “Duty of diligence means that a senior executive, when performing his or her duties, shall exercise the care of a good manager and the reasonable care of an ordinary prudent person for the best interests of the company… The current Company Law only provides for the duty of diligence of officers in principle, without describing the specific circumstances that constitute a violation of this duty. Throughout the judicial practice of the Company Law, the exercise of the reasonable care that an ordinary prudent person should exercise in similar situations is a proven standard gradually established for the duty of diligence. Business transaction practices are ever changing in the market. The requirement for correctness of every business decision may make officers overly cautious or even hesitant to move forward. This would further result in a delay or loss of business opportunities and a reduced operational efficiency, ultimately detrimental to achieving the interests of the company and shareholders. In particular, without conflict of interest between officers and the company or any other breach of the duty of loyalty, officers’ performance of operation and management duties in accordance with laws and the AOA shall be recognised and protected by law.”
The standard established for the duty of diligence in the above SPC case is ultimately incorporated in the new Company Law. Paragraph 2, Article 180 of the new Company Law provides that the directors, supervisors and officers have a duty of diligence to the company. When performing their duties, they shall exercise the reasonable care that a manager should generally exercise for the best interests of the company.
The definition of the duty of diligence in the new Company Law will undergo further scrutiny in judicial practice.
VII. Further strengthening the democratic management system with the employee representative congress as the basic form
The employee (representative) congress is the fundamental form of democratic management in an enterprise, playing an irreplaceable role in safeguarding the democratic rights of employees, protecting their legitimate interests, building harmonious labour relations, and promoting the healthy development of the enterprise. In accordance with Paragraph 2, Article 18 of the current Company Law, companies shall implement democratic management through employee representative congress or other means in accordance with the Constitution and relevant laws.
The new Company Law has further institutionalised the participation of employee representatives in corporate governance. For instance, as stipulated in Paragraph 1, Article 68 of the new Company Law, the BoD of a LLC shall have three or more members, who may include employee representatives. Where a LLC has 300 or more employees, its BoD shall include employee representatives unless a BoS has been established in accordance with law and has employee representatives. The employee representatives on the BoD shall be democratically elected by employees through the employee representative congress, employee congress or otherwise. Article 120 of the new Company Law stipulates that employee representatives of the members of the JSLC’s BoD may serve as members of the audit committee.
Under the current Company Law, a wholly state-owned company or a LLC established by two or more SOEs or other state-owned investors shall have employee representatives as director. As required by the new rules stated in the above paragraph, it is a mandatory for a LLC with 300 or more employees to have employee representatives on the BoD to participate in corporate governance. This requirement may be exempted if the LLC has established an audit committee in place of the BoS (or supervisor) or if the BoS has no (or the supervisor is not an) employee representatives.
This requirement further enhances the participation of employee representatives in corporate governance as an effective means of democratic management.
VIII. Simplifying the decision-making process of state-funded enterprises and elevating compliance management to a statutory framework
The Central Committee for Comprehensively Deepening Reform deliberated the 2020-2022 action plan for SOE reform at its 14th session on 30 June 2020, officially kicking off the reform of SOEs in the following three years. In October 2020, the State Council issued the Opinions on Further Improving the Quality of Listed Companies, forming the top-level design and institutional arrangements in this aspect. The report to the 20th National Congress of the Communist Party of China also proposes to “deepen reform of state-owned capital and state-owned enterprises (SOEs); accelerate efforts to improve the layout of the state-owned sector and adjust its structure; work to see state-owned capital and enterprises get stronger, do better, and grow bigger; and enhance the core competitiveness of SOEs”. The new Company Law, following the trend of SOE reform, simplifies the decision-making process for SOEs in the face of market competition in order to reduce their agency costs. Article 172 of the new Company Law stipulates that a wholly state-owned company does not have a shareholders’ meeting, and the body performing the duties of capital contributors exercises functions and powers of the shareholders’ meeting. Such body may authorise the BoD to exercise certain functions and powers of the shareholders’ meeting, provided that the formulation and amendment to the AOA, merger, division, dissolution, application for bankruptcy, increase or decrease of registered capital, and distribution of profits must be determined by such body.
Article 66 of the current Company Law requires that merger, division, dissolution and application for bankruptcy of a wholly state-owned company shall be subject to the examination of the supervision and administration authority and the approval of the people’s government at the same level. Article 172 of the new Company Law directly amends the requirement. Specifically, the new rule confers the power to decide on such major matters upon the body performing the duties of capital contributors, and removes the requirement for the approval of the people’s government. In a word, the management and capital contributors are empowered to decide on all matters of state-funded enterprises. The amendment simplifies the decision-making amid market changes, reducing the agency costs of such enterprises.
The State-owned Assets Supervision and Administration Commission (SASAC) under the State Council issued the Guidelines for the Compliance Management of Central Enterprises (for Trial Implementation) in 2018, and the Measures for the Compliance Management of Central Enterprises effective as of 1 October 2022. Guided by the SASAC, local SASAC offices have facilitated compliance management of SOEs within their respective jurisdictions. Article 177 of the new Company Law stipulates that a state-funded company shall, in accordance with law, establish and improve internal supervision, management and risk control systems to strengthen internal compliance management.
The new rule stated in the above paragraph elevate compliance management from a requirement of ministerial regulations to that of a statute, indicating a new era of compliance management for SOEs.
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