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Directors' Duties in China Guangdong Xu, Tianshu Zhou, Bin Zeng and Jin Shi European Business Organization Law Review / Volume 14 / Issue 01 / March 2013, pp 57 - 95 DOI: 10.1017/S1566752912001048, Published online: 28 March 2013

Link to this article: http://journals.cambridge.org/abstract_S1566752912001048 How to cite this article: Guangdong Xu, Tianshu Zhou, Bin Zeng and Jin Shi (2013). Directors' Duties in China. European Business Organization Law Review, 14, pp 57-95 doi:10.1017/ S1566752912001048 Request Permissions : Click here

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European Business Organization Law Review 14: 57-95 © 2013 T.M.C.ASSER PRESS doi:10.1017/S1566752912001048

Directors’ Duties in China Guangdong Xu, Tianshu Zhou, Bin Zeng and Jin Shi ∗ .

1.

Introduction.............................................................................................. 58

2.

Fiduciary duties of directors under Chinese law...................................... 59

3. 3.1 3.2 3.3 3.4 3.5

The enforcement of directors’ duties by courts........................................ 63 Sources of data and cases......................................................................... 63 General pattern of cases........................................................................... 64 Lack of flexibility in judges’ decisions .................................................... 66 Innovations in implementing fiduciary duties ......................................... 69 Courts’ attitudes towards shareholder protection in listed companies ..... 73

4. 4.1 4.2 4.3 4.4 4.4.1 4.4.2 4.4.3

The role of the CSRC in public enforcement........................................... 77 China’s securities markets and the CSRC................................................ 77 Sources of data and cases......................................................................... 79 The basis for penalties ............................................................................. 80 Some regularities in the CSRC’s enforcement actions............................. 83 Who should be punished? ........................................................................ 83 Loyalty or diligence? ............................................................................... 84 External directors versus internal directors.............................................. 85

5.

Conclusion ............................................................................................... 87

Abstract This paper examines the development of the legal framework regarding fiduciary duties of directors in China. The concept of fiduciary duty was introduced by the 2005 revisions to China’s Corporate Law. The implementation of fiduciary duties in China has encountered considerable obstacles because of the inherent weakness of the legal system. The legal texts are simple, vague and rigid. In the enforcement process, formalised judgments have placed limitations on precedent creation, thus reducing the deterrent effect, and the judicial system has shown reluctance to intervene in matters related to directors’ duties in listed companies. There have been improvements, however. In a limited number of judicial decisions, courts have attempted to more clearly define the meaning of directors’ fiduciary duties. In the penalty decisions of the China Securities Regulatory Commission (CSRC), the duties of directors have been interpreted in a more sophisticated manner.

∗ Guangdong Xu is Associate Professor of Law and Economics at the Research Center for Law and Economics (RCLE) at China University of Political Science and Law (CUPL); Tianshu Zhou is Assistant Professor at the RCLE; Bin Zeng and Jin Shi are PhD candidates at the RCLE. We would like to thank Rainer Kulms and anonymous referees for their helpful comments.

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Keywords: fiduciary duties, China, corporate law, courts, securities authorities. 1.

INTRODUCTION

Since the late 1990s, a series of econometric studies conducted by four economists, La Porta, Lopez-de-Silanes, Shleifer and Vishny (LLSV), have embroiled the relationship between law and finance in controversy. One of LLSV’s key findings is that common law countries have more developed securities markets than civil law (continental law) countries. For example, in their 1997 publication,1 LLSV use the following three indicators to examine the development of securities markets in various countries: the ratio of stock market capitalisation to gross national product (GNP) in 1994, the ratio of the number of listed companies to the population in 1994, and the number of initial public offerings (IPOs) from mid-1995 to mid-1996. Using these three ratios as indicators, they find that common law countries have the most prosperous stock markets. LLSV indicate that a well-developed securities market is an outcome of effective legal protection for investors. The logic is simple. Investors are more willing to finance firms when they do not fear expropriation of company assets by corporate insiders, resulting in a flourishing financial market. Using a sample of 49 countries, they find that corporate law in common law countries offers shareholders the most protection, while corporate law in French civil law countries gives shareholders the least amount of protection. Corporate law in German and Scandinavian civil law offers shareholders protection in between that provided by common law jurisdictions and French civil law jurisdictions. LLSV identify an important policy issue: to develop an efficient securities market and contribute to a country’s economic development, should developing and transition countries systematically study and replicate the corporate laws in common law countries such as the United States or the United Kingdom? Even if LLSV’s conclusion about the superiority of corporate laws in common law countries holds true, it remains uncertain whether introducing such corporate laws in countries with a civil law tradition will produce the desired results. Studies of comparative law have revealed that transplanting legal systems is difficult, especially when the transplant takes place between countries with different legal traditions.2 Berkowitz, Pistor and Richard 3 find that the style of legal transplant plays a determining role in whether the law will be effective. If a law is transplanted mechanically, without considering the .

1 R. La Porta, F. Lopez-de-Silanes, A. Shleifer and R. Vishny, ‘Legal Determinants of External Finance’, 52 Journal of Finance (1997) p. 1131. 2 See H. Kanda and C.J. Milhaupt, ‘Re-examining Legal Transplants: The Director’s Fiduciary Duty in Japanese Corporate Law’, 51 American Journal of Comparative Law (2003) p. 887. 3 D. Berkowitz, K. Pistor and J. Richard, ‘Economic Development, Legality, and the Transplant Effect’, 47 European Economic Review (2003) p. 165.

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public’s familiarity with and acceptance of the imported ‘goods’ and without making appropriate adjustments to accommodate local conditions, a simple transplant can have devastating consequences. In this article, we examine such a case of legal transplant: the introduction of directors’ fiduciary duties in China’s Corporate Law. Fiduciary duty plays an important role in restricting managers’ opportunism; however, because of its broad and inclusive nature, fiduciary duty is a difficult concept to explain. In common law countries, its meaning has been continuously refined and enriched by precedential rulings by judges, thus becoming a workable principle in judicial practice. However, in a country with a civil law tradition, judges normally make judicial decisions following the strict letter of legislation, and the rich meaning of fiduciary duty is difficult to crystallise into a set of specific rules. It is therefore difficult to introduce the principle of fiduciary duty in civil law countries. In this paper, we examine the text of the Corporate Law in China, analyse the law enforcement outcomes, and present the problems and prospects related to directors’ fiduciary duties in China. We hope that this study will enrich the understanding of transplanted legal systems and, in particular, the applicability and vitality of fiduciary duties in civil law countries. The rest of the paper is organised as follows. The second section discusses legal provisions governing directors’ duties under China’s Corporate Law. The implementation of fiduciary duties by courts is analysed in the third section. The fourth section explores the public enforcement of fiduciary duties by regulators of the securities markets. The fifth section concludes. 2.

FIDUCIARY DUTIES OF DIRECTORS UNDER CHINESE LAW

Socialist China’s first unified Corporate Law was enacted in 1993. The main purpose of the legislation was to reform state-owned enterprises;4 directors’ duties were largely neglected. The Corporate Law did not prescribe a duty of loyalty for directors, and the directors’ duty of diligence (the equivalent of ‘duty of care’ under common law) was stipulated only in principle and without details. In 2005, China systematically revised its Corporate Law, including a common law-style classification of directors’ duties and bringing greater precision in the stipulation of the duty of loyalty and the duty of diligence. The revised Corporate Law dedicates an entire chapter (chapter 6) to the qualifications and obligations of the directors, supervisors and senior managers of a company; it defines the duties of a director more clearly, promoting director accountability. The most significant provision in this chapter is Article 148, which

4 See D.C. Clarke, ‘Corporate Governance in China: An Overview’, 14 China Economic Review (2003) p. 494.

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stipulates that ‘the directors, supervisors and senior executives of a company shall comply with the laws, administrative regulations and the articles of association of the company and bear the duties of loyalty and due diligence towards the company’.5 In addition to assigning duties to directors, the revised Corporate Law outlines these duties in Articles 148(2) and 149 by proscribing activities such as the acceptance of bribes, misappropriation of company funds, exploitation of company business opportunities, certain transactions with the company, competition with the company’s business, and disclosure of confidential information. Finally, the revised Corporate Law adds a catch-all provision (Article 149(8)) prohibiting all other acts that are inconsistent with directors’ duties. As Lee noted,6 ‘while it is not clear whether the intent of articles 148 and 149 of the revised company law is to import Anglo-American fiduciary concepts to China, it is at least arguable that those express stipulations could produce such effect’. The revised Corporate Law has spawned amendments to other laws and regulations that further enhance corporate governance. For example, in March 2006, the China Securities Regulatory Commission (CSRC) revised its Guidelines for Articles of Association of Listed Companies. Article 97 introduces a duty of loyalty, and Article 98 a duty of diligence. Compared with the revised Corporate Law, Article 98 of this regulation specifies that the duty of diligence includes treating all shareholders fairly and understanding the operations and management circumstances of the company. The introduction of directors’ fiduciary duties in China’s Corporate Law is a significant achievement. As corporate law and economics has shown, fiduciary duties can use sanctions effectively to deter directors and other senior managers from engaging in opportunistic behaviour, thereby reducing agency costs. In theory, directors’ duties and other governance mechanisms, such as shareholder voting rights, boards of directors, managerial compensation arrangements, the market for corporate control, and market intermediaries, constitute a system of corporate governance that can be relied upon to support the development of capital markets. Without legal provisions stipulating directors’ duties, there are loopholes in the system of corporate governance, which may lead to serious governance problems. Problems remain in the revised Corporate Law with respect to directors’ duties. First, certain provisions of the Corporate Law conflict with each other, leading to contradictions within the law.7 For example, according to Article 113(3), a director is liable only when a board resolution that he signs as a director causes serious

5 ‘Dongshi, jianshi, gaoji guanli ren yuan yingdang zunshou falv, xingzheng fagui, he gongsi zhangcheng, dui gongsi fuyou zhongshi yiwu he qinmian yiwu.’ 6 R. Lee, ‘Fiduciary Duty Without Equity: “Fiduciary Duties” of Directors under the Revised Company Law of the PRC’, 47 Virginia Journal of International Law (2007) p. 897, at pp. 908-909. 7 Y. Hu, ‘Bijiaofa shiye xia de jingying panduan guize: jianlun woguo dongshi yiwu de wanshan’ [Business Judgment Rules from the Perspective of Comparative Law: Improvement of the Duties of Chinese Directors], 2 Jianghuai Luntan [Jianghuai Forum] (2011) p. 107.

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losses to the company. However, Article 150 stipulates that, if the director violates the law, administrative regulations or the articles of association, and his actions result in company losses, he will be liable. Second, there is a lack of relevant regulations. For example, the revised Corporate Law stipulates that, during his employment with the company, a director shall not be self-employed or work for other companies that operate in a similar field. However, the law does not explicitly address proscribed activities after the director’s resignation. As another example, under the revised Corporate Law, any of the directors’ or senior managers’ incomes that are derived from proscribed activities must be returned to the company because the company has the right to income obtained by directors who have breached their duties. However, there is no specific regulation as to who may exercise the right to recover such income, how the right should be exercised, or the time frame within which the right can be exercised. In the absence of guidelines, parties may take advantage of legal loopholes to engage in opportunistic activities. Third, the provisions on the duties of directors, especially the duty of diligence, are overly simplistic, vague and lack workability.8 The relevant provisions of the Corporate Law contain only a brief description of the duty of diligence and lack detailed standards of review. Moreover, the law uses ‘duty of diligence’ to summarise the duties of three different parties – directors, supervisors and senior managers – without clarifying how the duty of diligence applies to each. Finally, the law places excessive emphasis on the duties of directors (and of supervisors and senior managers), providing few exceptions and exemptions. To some extent, these problems may reflect the difficulties of introducing fiduciary duties, a common law tool, in countries with a civil law tradition. As Clark 9 states, the ‘general fiduciary duty of loyalty is a residual concept that can include factual situations that no one has foreseen and categorized’. In other words, the principles of fiduciary duties may not be easily codified;10 their meaning is best specified by courts and developed in a large volume of case law over time. In common law countries, courts are therefore vested with great discretion in determin.

8 P. Luo, J. Li and Y. Zhao, ‘Woguo gongsi gaoguan qinmian yiwu zhi sifa cailiang de shizheng fenxi’ [An Empirical Analysis of Judicial Discretion on Duty of Diligence of Senior Managers in China], 3 Zhengquan Fayuan [Securities Law Review] (2010) p. 372. 9 R.C. Clark, Corporate Law (Boston, MA, Little, Brown & Company 1986), at p. 141. 10 See K. Pistor and C. Xu, ‘Fiduciary Duty in Transitional Civil Law Jurisdictions: Lessons from the Incomplete Law’, in C.J. Milhaupt, ed., Global Markets, Domestic Institutions: Corporate Law and Governance in a New Era of Cross-Border Deals (New York, Columbia University Press 2003) p. 77. They argue that attempts to codify fiduciary duties ‘will either leave out many actions or factual situations “no one has foreseen or categorized”, or will be phrased so broadly that the meaning can be understood only in the context of specific cases’. See also L.A. Hamermesh, ‘The Policy Foundations of Delaware Corporate Law’, 106 Columbia Law Review (2006) p. 1749, at p. 1777, who argues: ‘By their nature equitable and fact-bound, fiduciary duties resist, and may even suffer from, codification.’

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ing the boundaries of managers’ obligations to shareholders.11 While the fiduciary duties in common law countries have gradually become statute-based duties over time,12 case law continues to play an important role in legal development.13 More importantly, however, China’s legislation is vague. It has long been argued that laws and regulations in China are intentionally drafted in broad terms to allow for sufficient flexibility in implementation to meet the needs of diversified local conditions in a quickly changing environment.14 For this reason, certain drafting techniques, such as general principles, undefined terms, broadly worded discretion, omissions, and general catch-all phrases, are often employed to permit administrative discretion in interpretation. China’s legislation is so vague that Peerenboom 15 argues that ‘[v]irtually any PRC law may be cited as an example’. For instance, the equity joint venture was the most popular vehicle for foreign investment over the first two decades of China’s economic reform, and yet the Sino-Foreign Equity Joint Venture Law is only fifteen articles long. While the implementing regulations that were issued four years later filled in many of the gaps in the Equity Joint Venture Law, the Cooperative Joint Venture Law, consisting of a mere twenty-eight articles, was left to stand on its own for seven years until implementing regulations were finally issued. The 1979 Criminal Law was so lacking in detail that, when it was amended in 1997, the number of articles increased from 192 to 452. Poorly drafted legal provisions in China’s Corporate Law will inevitably lead judges to an awkward dilemma. These judges must either strictly follow the legal guidelines and therefore reject numerous cases that fall outside the reach of current .

11 See J.E. Fisch, ‘The Peculiar Role of the Delaware Courts in the Competition for Corporate Charters’, 68 University of Cincinnati Law Review (2000) p. 1061. He shows that in the United States – particularly in Delaware, which has been the dominant choice as state of incorporation for the largest US companies (almost half of the companies listed on the New York Stock Exchange and 60% of the Fortune 500 companies have chosen to incorporate in Delaware) – the applicable statutes provide almost no guidance on fiduciary principles, and the interpretation and application of fiduciary principles is derived primarily from judicial decisions. 12 For example, many states in the United States utilise statutes to define directors’ duty of care in corporate law. The provisions in most states are similar to or borrow from the American Bar Association’s (ABA) 1984 edition of the ‘Model Business Corporation Act’ (MBCA) § 8.30(a). 13 See Hamermesh, supra n. 10. He concludes that two principal agencies that develop Delaware corporate law, namely the Delaware judiciary and the Delaware General Assembly, ‘act symbiotically: the legislature crafts the broad, largely flexible framework for private ordering of corporate affairs in the knowledge that the judiciary will protect such flexibility while applying equitable principles of fiduciary duty to rein in particularly opportunistic behavior that defeats the legitimate expectations of other corporate participants’. 14 S. Lubman, ‘Bird in a Cage: Chinese Law Reform After Twenty Years’, 20 Northwestern Journal of International Law and Business (2000) p. 383. 15 R. Peerenboom, China’s Long March Toward Rule of Law (Cambridge, Cambridge University Press 2002) p. 251.

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legal rules, or they will be forced to fill in the gaps left by incomplete legal provisions by interpreting existing law more flexibly and more innovatively, which is a serious challenge to Chinese judges who are trained in the civil law tradition and are famous for their lack of professional competence.16 In addition to understanding the relevant provisions of formal laws and regulations, we must also know how they are implemented. As law and economics studies have shown, no law, no matter how elaborate, can be expected to affect people’s behaviour without effective enforcement.17 In general, legal enforcement can be divided into two categories. The first is private enforcement, which is initiated by private litigation, and the second is public enforcement, which relies on public authorities, such as the Securities and Exchange Commission (SEC) or tax collection agents.18 Therefore, we examine the enforcement of directors’ duties in China in terms of private versus public enforcement. 3.

THE ENFORCEMENT OF DIRECTORS’ DUTIES BY COURTS 19

3.1

Sources of data and cases

.

To obtain data from the court system, we performed a keyword search for ‘duty of loyalty’ and ‘duty of diligence’ under the directory ‘on the company, securities,

16 Prior to the 1995 Judges Law, there were no requirements to be a judge except that one be a cadre. Since 2002, however, all new judges in China have been required to hold bachelor degrees and to pass the national unified judicial exam. In 2005, for the first time, more than fifty per cent of Chinese judges had university degrees, which marks a sharp increase from 6.9 per cent in 1995. See B. Liebman, ‘China’s Courts: Restricted Reform’, 21 Columbia Journal of Asian Law (2007) p. 1. The low level of competence of the judiciary has resulted in many incorrectly decided cases. In 1999, the courts system supervised and reviewed 96,739 cases and corrected the judgment in 21,862 cases. See Peerenboom, supra n. 15. 17 See, for example, U. Bhattacharya and H. Daouk, ‘The World Price of Insider Trading’, 57 Journal of Finance (2002) p. 75. They find that the mere existence of insider trading regulations does not affect the cost of equity; however, insider trading enforcement is associated with a significant decrease in the cost of equity. 18 See S. Shavell, Foundations of Economic Analysis of Law (Cambridge, MA, Belknap Press of Harvard University Press 2004), ch. 25. For applications of this category to the study of capital markets, see R. La Porta, F. Lopez-de-Silanes and A. Shleifer, ‘What Works in Securities Law’, 61 Journal of Finance (2006) p. 1; and J.C. Coffee Jr, ‘Law and the Market: The Impact of Enforcement’, 156 University of Pennsylvania Law Review (2006) p. 229. 19 According to the Xianfa (Constitution) and the Renmin fayuan zuzhi fa (Law on the Organisation of People’s Courts), the people’s courts are judicial organs exercising judicial power on behalf of the state. People’s courts, according to Article 126 of the Xianfa, shall ‘in accordance with the law, exercise judicial power independently and are not subject to interference by administrative organs, public organizations or individuals’ (translation available at: ). However, they remain weak and have low status in the political system. See, for example, Peerenboom, supra n. 15.

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notes, and other civil disputes’ in the Beijing University judicial cases database.20 For duty of loyalty, we identified forty representative cases from 2006 to 2012 that were heard by courts under the Corporate Law of 2005. We further excluded cases in which one party appealed to a higher court, leaving us thirty-three cases (see Appendix A). For duty of diligence, we only found four cases during the same period, and in only one case did the court find for the plaintiff based on the duty of diligence.21 Therefore, we only focus on duty of loyalty cases in this paper. 3.2

General pattern of cases

From a quantitative perspective, cases in which directors are sued for breaching their fiduciary duties under the revised Corporate Law are few, and all concern There are four levels of courts in China: Zuigao renmin fayuan (Supreme People’s Court – SPC), Gaoji renmin fayuan (High People’s Courts – HPC), Zhongji renmin fayuan (Intermediate People’s Courts – IPC) and Jiceng renmin fayuan (Basic People’s Courts – BPC). The SPC is responsible for the interpretation of laws, administration of the judiciary, and adjudication, and also participates in certain legislative activities. HPCs are provincial-level courts in the capitals of provinces, IPCs are established in municipalities and prefectures, and BPCs in urban districts and rural counties. In principle, a typical civil trial process is as follows. After receiving qisuzhuang (statement of complaint) or koutou qisu (oral complaint), a court will first shencha (review) whether it meets the qisu tiaojian (requirements for acceptance). The court will shouli (accept) those cases that meet the requirements and buyu shouli (reject) those that fail to do so. The accepted cases will then shenli (be heard) in court. After fating diaocha (court investigation), juzheng zhizheng (evidence presentation), and fating bianlun (court debate), the court will finally reach panjue ( judgment), which will either zhichi (uphold) or bohui (dismiss) the claim of the plaintiff. In addition, the litigants in a case who want to challenge the judgment handed down by a court in the trial of first instance have the right to shangsu (appeal) the case to the next higher level court only once. The judgment at the second trial shall be final and cannot be appealed. For more details, see Zhonghua renmin gongheguo minshi susong fa (Civil Procedure Law of the People’s Republic of China, translation available at: ). 20 This is currently the most complete database of judicial cases in China. As of 21 November 2011, this database contained 410,896 records of all types of judicial rulings. Unfortunately, only authorised users can access the database via the internet and look up the cases that we cited in this paper. Available at: . 21 A similar distribution has been found in other empirical studies. For example, of 41 cases analysed by Luo et al., duty of loyalty cases accounted for 90%, duty of diligence cases for 6.3%, and cases regarding both duties for 3.7% of all cases. See Luo et al., supra n. 8. Similarly, Wang’s study, with a larger sample size, found that the number of disputes related to managers’ duty of loyalty was much higher than that related to the duty of diligence. Of 137 cases, there were only 5 in which the plaintiffs alleged that the managers had breached the duty of diligence or the duty of care, and only 3 where the court ruled that the defendants had breached the duty of diligence. See J. Wang, ‘Gongsi jingyingzhe zhongshi he qinmian yiwu susong yanjiu: yi 14 sheng he zhixiashi de 137 jian panjueshu wei yangben’ [A Study of Litigations on Duty of Loyalty and Duty of Diligence of Companies’ Managers – Based on 137 Judgments from 14 Provinces and Municipalities], 4 Beifang Faxue ( Northern Legal Science) (2011) p. 24. .

.

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closely held companies rather than publicly listed companies. This may be caused by imperfections in the law and lengthy judicial proceedings,22 which may result in uncertain litigation and lead to shareholders dropping their cases. Shareholders may also be unfamiliar with the concept of fiduciary duties and may therefore be reluctant to use it to protect their interests. Finally, most cases involving listed companies may have other means to address such matters, for instance, administrative penalties, which further reduce the scope of judicial power. A general pattern can be identified in the duty of loyalty cases. Most cases are related to a conflict of interest between directors (or senior managers) and their companies, such as appropriating company assets, establishing competing businesses, improperly benefiting third parties, and conducting related-party transactions without advance approval. These ‘conflict of interest’ cases account for nearly 88 per cent of all duty of loyalty cases; our sample contains only four cases that are not related to ‘conflict of interest’ and in these cases the director (or senior manager) either misused the company’s official seal or made business decisions that were not in the best interests of the company. Overall, there is no is no significant diversity between these cases (see Appendix A). It can be argued that this phenomenon is normal because the duty of loyalty is designed as a legal tool with a focus on conflict of interest between shareholders and directors (managers). As Anabtawi and Stout 23 argue, at the core of the duty of loyalty is a requirement that a corporate fiduciary (an officer or director) must act only in the best interests of the fiduciary’s beneficiary (the firm and its shareholders). In other words, the duty of loyalty requires managers to place the interests of the corporation and its shareholders above their own interests. Shareholders can then sue directors on the grounds of breach of the duty of loyalty (rather than other legal grounds) when their interests are harmed. Another plausible reason behind this pattern, we believe, is that Chinese judges prefer to limit their roles to the mechanical application of legal provisions, largely ruling out the possibility of interpreting the law in a more flexible manner. Directors’ activities that lead to a ‘conflict of interest’ are clearly listed in the law and are therefore more easily addressed by Chinese judges, who can directly apply the bright-line rules in their judgments, as opposed to other types of activities that may harm the interests of shareholders. In contrast, when a suit is filed by a shareholder on the basis of damage that is not explicitly proscribed in the Corporate Law, judges face the challenging task of extending the law’s application to new .

22 For example, according to the World Bank’s Doing Business, an annual report which presents quantitative indicators on business regulation and the protection of property rights for 183 economies, it takes 406 days and 34 procedures to resolve a commercial dispute through the courts in China. For more details, see . 23 I. Anabtawi and L. Stout, ‘Fiduciary Duties for Activist Shareholders’, 60 Stanford Law Review (2008) p. 1255.

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cases by interpreting existing law flexibly and innovatively. Given their limited competence,24 their bureaucrat-like incentive structure,25 and their limited power of legal interpretation,26 judges may be reluctant to accept cases in which they will be forced to go beyond the literal scope of legal provisions. The result is a selective bias in directors’ duties cases. This selective attitude of Chinese courts in deciding whether to take on a case has been confirmed by other studies. For example, courts accept a relatively small number of administrative cases, in spite of the fact that approximately 75 per cent of Chinese laws are administrative laws and regulations.27 As an extreme example, the Guangxi High People’s Court even issued a notice in 2004 listing thirteen categories of cases that courts in Guangxi will not accept.28 As generalised by Liebman, Chinese courts often address difficult or sensitive cases by inaction, and cases are refused or left unresolved.29 3.3

Lack of flexibility in judges’ decisions

The lack of flexibility in duty of loyalty cases prosecuted in Chinese courts can be further elucidated by exploring the details of the decisions rendered. In cases where the interests of shareholders and companies were obviously harmed, such as those involving directors embezzling company property or misappropriating company funds, the task faced by judges is simple, and they directly apply the legal pro-

See Peerenboom, supra n. 15, and Liebman, supra n. 16. See Y. Wang, ‘Sifa chengben yu sifa xiaolv: zhongguo fayuan de caizheng baozhang yu faguan jili’ [Judicial Cost and Judicial Efficiency: Fiscal Support and Incentives for Judges in China’s Courts], 4 Faxuejia [Legal Scholar] (2010) p. 132. He shows that in China’s judicial system, the income of judges is closely related to their positions within the hierarchy structure of China’s judiciary. In such an incentive system, the optimal strategy of judges is to maximise their income by getting promoted as quickly as possible and simultaneously trying to avoid mistakes in judgments as much as possible. See J. Ai, ‘Zhongguo faguan zuidahua shenmo’ [What Do Chinese Judges Maximise?], 3 Falv he Shehuikexue [Law and Social Science] (2007) p. 110. Obviously, fewer innovations mean fewer mistakes. 26 See Peerenboom, supra n. 15, at p. 317. He argues that a court in China is supposed to ‘limit its interpretation to that necessary to decide issues that have arisen, or arguably are likely to arise, in specific cases’. Moreover, the interpretative powers of courts ‘in theory are limited to clarifying laws without altering their original meaning or adding to their content’. In summary, ‘the power of courts to make law is much more limited than in a common-law precedent-based system’. 27 V. Hung, ‘China’s WTO Commitment on Independent Judicial Review: Impact on Legal and Political Reform’, 52 American Journal of Comparative Law (2004) p. 77. 28 See Liebman, supra n. 16. These include real estate disputes arising from government decisions or institutional reforms, claims brought by workers who were laid off because of corporate restructuring, and lawsuits resulting from a party’s failure to implement a government decision on property ownership or usage rights. 29 See Liebman, supra n. 16. 24 25

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hibitions in their judgments. For example, in a civil judgment based on Article 148 of the revised Corporate Law, the Beijing Second Intermediate People’s Court decreed: As executive director and legal representative of the Zhonghui Yachuang Company, Li Jia should obey the laws and the articles of association of the company. Nevertheless, Li Jia violated the duty of diligence and the duty of loyalty to the Zhonghui Yachuang Company by depositing the company’s funds in the Saiwo Online Company, a company directly controlled by Li Jia. He should therefore bear the corresponding liability.30

For cases regarding related transactions and non-competition, courts often examine whether the activity of directors is in line with the company’s articles of association and whether shareholders or the board of directors have approved the activity, thereby relieving them of the burden of substantially reviewing whether there is a conflict of interest. For example, in a judgment, the Zhejiang Zhuji City People’s Court ruled that because the defendant could not provide evidence to show that the transaction he had undertaken was in line with the company’s articles of association or that it had been approved by the shareholders’ meeting, the transaction was invalid.31 When cases fall outside of the scope of these approaches, courts often refuse to extend the legal application of the duty of loyalty by interpreting it more broadly. For example, in a case heard by the Beijing Second Intermediate People’s Court, Jishuntong, a transport company, sued its director on the basis of a breach of duty of loyalty. The plaintiff in this case claimed that, in 2009, the business of the company was completely stagnant, with no business turnover at all. Under such conditions, Mr Kang, the director of the company, had signed consulting contracts with a law firm and a human resource management company. According to the con-

30 Translated by the authors. See Beijing Second Intermediate People’s Court ([2011] erzhong min zhongzi No. 16710), available at: (however, as we have mentioned, only authorised users can access the database and look up cases). According to a notice issued by the SPC, the docket number of a case includes: li’an niandu (year of acceptance), zhizuo fayuan (court in charge), anjian xingzhi (characteristic of the case – civil versus criminal), shenpan chengxu de daizi (stage of trial – trial of first instance versus trial of second (final) instance), and anjian shunxu hao (serial number of the case). For more details, see L. Bao and Y. Liu, Fayuan susong wenshu geshi yangben [Sample Copies of Lawsuit Documents] (Beijing, Renmin chuban she [People’s Publishing House] 2009). Here ‘2011’ is the year of case acceptance; ‘erzhong’ refers to the Beijing Second Intermediate People’s Court; ‘min’ means that this is a civil case; ‘zhongzi’ stands for ‘trial of final instance’; and ‘16710’ is the serial number of the case. 31 Translated by the authors. See Zhejiang Zhuji City People’s Court ([2009] shaozhu shang chuzi No. 4057), available at: .

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tracts, Jishuntong was obliged to pay CNY 3,000 per year to the human resource company for human resource management services and CNY 15,000 per year to the law firm for legal services. The plaintiff claimed that, because the business of the company was in a deadlock situation, the consulting fees should not have been incurred and could easily have been avoided by Mr Kang. Mr Kang’s business judgment therefore directly caused the company a considerable loss. The court, however, dismissed this claim: In this case, Mr Kang was the managing director of the company. He signed consulting contracts with a human resource management firm and a law firm, and the company hence paid consulting fees to these two firms. As the managing director of the company, Mr Kang was obviously authorised to sign consulting contracts with other parties and make payments to these parties in accordance with these legally binding contracts. Mr Kang’s activities did not breach any law, administrative regulation or article of association of the company.32

It can be argued that the director’s decision in the Jishuntong case was unreasonable, even though no law, regulation or article of association of the company was breached. A decision to purchase third-party consulting services for a company whose business has been in stagnation can hardly be considered as commercially valid. The director should therefore have been judged to breach his duty to the company. However, as the judges in the Jishuntong case admitted, they were not empowered by law to review directors’ decisions substantively, no matter how unreasonable the decision appeared to be. After all, the only legal ground of judgment is the language of the law, regulations and the company’s articles of association; judges are not encouraged by the legal system to fill in gaps in legislation by using their discretion. Therefore, due to their restricted power of legal interpretation, their limited competence, and bureaucrat-like incentive structure, the role of Chinese judges in implementing fiduciary duties is limited to those cases where the current legal provisions can almost automatically apply. As generalised by Lee,33 judges in China are not trained to interpret legislation, and there is also a lack of a body of case law for Chinese judges to determine the content of fiduciary duty or display analysis interpreting the statutes. Even if they were to do so, Chinese judges tend to adopt a more restrictive approach…. Consequently, unless expressly proscribed, Chinese courts are more inclined to construe an alleged breach as not falling within the statute.

32 Translated by the authors. See Beijing Second Intermediate Court ([2011] erzhong min zhongzi No. 17136), available at: . 33 See Lee, supra n. 6, at p. 909.

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The problem with such a rigid approach to implementing fiduciary duties is that it may invite insiders to creatively structure unfair transactions to conform to the letter of the law, while substantially harming the interests of shareholders. By contrast, a more flexible manner of enforcing fiduciary duties, such as that operating in common law countries, which allows courts to assess the substantive terms of the entire transaction and decide whether these terms are fair to outside shareholders, rather than whether they conform to the letter of a statute, is more efficient in deterring opportunist activities conducted by directors and managers. The difference between China’s judicial practice and that in common law countries can be illustrated by the Halt Garage case.34 The fact pattern in Halt Garage is similar to that in Jishuntong. In Halt Garage, a company paid remuneration to a sick director who took no part in the business. After the company went into bankruptcy, the liquidator brought proceedings claiming the whole of the sick director’s remuneration. Lord Oliver held that ‘in the postulated circumstance of a wholly unreasonable payment, that might, no doubt, be prima facie evidence of fraud … the real test must, I think, be whether the transaction in question was a genuine exercise of power’.35 The liquidator’s claim was upheld. In this case, apparently, the business decision was not in breach of any law, regulation or the company’s articles of association. However, the court conducted a test of genuineness. A director’s unreasonable decision may therefore be judged in breach of his duty to act in the genuine belief that he is serving the best interests of the company. 3.4

Innovations in implementing fiduciary duties

As discussed, in most cases, laws, administrative regulations or the company’s articles of association are the only basis accepted by a Chinese court in determining whether the defendant has breached his duty. Courts therefore limit their roles to the mechanical application of legal provisions, and high levels of formalisation have become the most prominent feature of judgments related to directors’ duties. However, and fortunately, innovations can still be found. When faced with activities that may harm the interests of shareholders but are not explicitly proscribed in the revised Corporate Law, some courts have tried to interpret the law more innovatively, to a certain extent filling in the gaps left by legislation. Our sample contains at least four representative examples. In one case, a trading company sued one of its department managers because he was running a competing business and using the company’s confidential information. The judge’s decision in this case makes a great contribution to solving the

Re Halt Garage [1982] 3 All E.R. 1016. Ibid. See also L. Sealy and S. Worthington, Sealy’s Cases and Materials in Company Law, 9th edn. (Oxford, Oxford University Press 2010), at p. 273. 34 35

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legal problem of whether a company’s department manager should, as do the company’s ‘senior managers’, bear the duty of loyalty. The judge ruled as follows: To judge whether or not Mr Yu is a senior manager of the company, we should consider the scope of Mr Yu’s power as a department manager and also the importance and influence of his work. We should ask whether or not Mr Yu’s power includes substantially controlling the company’s business management or being authorised to make fundamental business decisions of the company or holding important confidential business information of the company. Based on the above information, we can conclude whether the duty of loyalty is applicable in this case.36

This case is an important example to show the capability and willingness of some Chinese judges to interpret the legislation more innovatively. The Corporate Law of 2005 has given a clear definition of senior managers, who include ‘the manager, deputy manager and the person in charge of the financial affairs of a company, and the secretary of a board of directors of a listed company and the other persons specified in a company’s articles of association’.37 Instead of following this stipulation mechanically, the court actively interpreted the law based on the factual evidence of the case in this instance. In another case, a court in Shanghai tried to clarify the duty of resigned directors, and thus tried to fill a gap in the current legal rules. In this case, Dekun Co. sued one of its former directors, Mr Huang, for breach of the duty of loyalty. Mr Huang was an executive director at Dekun Co., and team leader responsible for a PPT product from 2003 to 2005. In 2005, he resigned from Dekun Co. and incorporated a company with his friends to develop the same PPT product as that of Dekun Co. From July 2005 to November 2005, the net profit of the company owned by Mr Huang and his friends was CNY 3,869,806, and he received a dividend of CNY 1,934,903 as a major shareholder. Dekun Co. claimed that Mr Huang was in competition with the company to which he owed a duty of loyalty, and that he should therefore disgorge the profits to his former employer. However, in his defence Mr Huang stated that he had resigned from Dekun Co. in January 2005 before he earned any profit and that, as a result, he did not owe any duty to Dekun Co.

36 Translated by the authors. See Beijing First Intermediate Court ([2009] yizhong min zhongzi No. 13800), available at: . 37 See Article 217(1) of the Corporate Law, which stipulates that ‘gaoji guanli renyuan, shizhi gongsi de jingli, fujingli, caiwu fuzeren, shangshi gongsi dongshihui mishu he gongsi zhangcheng guiding de qita renyuan’.

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Despite the fact that the Corporate Law of 2005 is silent about whether the duty of loyalty should apply to former directors or senior managers who have resigned from their office, the Shanghai Intermediate Court upheld Dekun’s claim: Corporate directors or managers must not enter into any business which is in competition with their employer when they serve the company. Moreover, this duty should not be avoided even after they have resigned from their office. The reason is that the intangible assets (including information and connections with customers) which are controlled by the directors or senior managers will not be out of their reach just because of their resignation. During a certain period after the directors’ or managers’ resignation, the duty of loyalty is still applicable to them.38

A similar principle can be found in common law systems. In the Canadian Aero Service Ltd (Canaero) case, the president and vice-president of the plaintiff company (Canaero) were authorised to negotiate an aerial surveying and mapping contract with the government of Guyana on behalf of Canaero. However, they failed to make sufficient efforts to secure the contract for Canaero; instead, they resigned from Canaero and set up their own company, Terra. They then signed a contract with the government of Guyana in the name of Terra. In this case, Laskin J. ruled as follows: In my opinion, this ethic [strict ethic] disqualifies a director or senior officer from usurping for himself … a maturing business opportunity which his company is actively pursuing; he is also precluded from so acting even after his resignation where the resignation may fairly be said to be promoted or influenced by a wish to acquire for himself the opportunity sought by the company….39

Finally, an Intermediate Court in Wuhan went further, examining the ultimate purpose of fiduciary duties. In one case, the judge held the following opinion: The duty of loyalty and the duty of diligence are two important standards that can be relied on to judge whether executives damage their employers’ interests and whether they should undertake civil liability. It is necessary to control executives’ improper behaviour, while at the same time it should be noted that

38 Translated by the authors, see Shanghai Second Intermediate Court ([2008] hu erzhong minsan (shang) zhongzi No. 283), available at: . The Shanghai Second Intermediate Court reconfirmed this principle of a resigned director’s duty in a similar case, see Shanghai Second Intermediate Court ([2008] hu erzhong minsan (shang) zhongzi No. 29), available at: . 39 Canadian Aero Service Ltd v. O’Malley (n 244) 371, 382.

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any commercial decision may incur risk to some extent. If the law requires the executives to be responsible for any loss caused by their business decisions, a more harmful result will occur. Executives will then only adopt extremely safe business strategies, and companies will, accordingly, lose numerous profitable opportunities. In summary, when the duty of loyalty or the duty of diligence is applied, a balance between controlling the executives’ improper behaviour and facilitating business activities is called for.40

A surprising similarity can be found between this judgment and the economic justification for the ‘business judgment rule’ that is often used in the United States to insulate directors and officers from much of their potential liability. It can be argued that, despite the fact that there is no ‘business judgment rule’ in the revised Corporate Law, certain courts have inferred a similar standard. The business judgment rule is usually described as a legal presumption that the directors and officers of the corporation have exercised due care by acting on an informed basis, in good faith and in the honest belief that their actions are in the best interests of the corporation.41 Unless a plaintiff can produce persuasive evidence rebutting one of these three components – a generally difficult, if not impossible, task – corporate directors and officers are effectively immune from liability for breach of the duty of care.42 According to law and economic studies, the adoption of this rule reveals the difficulties faced by courts when trying to judge business decisions ex post. As Easterbrook and Fischel 43 argue, .

[t]o observe that things turned out poorly ex post, perhaps because of competitors’ reactions, or regulations, or changes in interest rates, or consumers’ fickleness, is not to know that the decision was wrong ex ante. Only after learning all of the possible outcomes, and the probability attached to each, could the court determine the wisdom of the decision at the time it was made … a court lacks the information to decide.

Given the complicated environment faced by firms and the importance of timely decision-making, many business decisions go unavoidably wrong. It is neither fair nor efficient to punish decision-makers (directors or managers) ex post for decisions that simply did not result in successful business, and fear of personal liability would cause corporate managers to be overly cautious, in addition to deterring

40 Translated by the authors, see Wuhan Intermediate Court ([2006] wu minshang chuzi No. 125), available at: . 41 Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). 42 Supra n. 23. at pp. 1262-1263. 43 F.H. Easterbrook and D.R. Fischel, The Economic Structure of Corporate Law (Cambridge, MA, Harvard University Press 1991), at p. 99.

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talented people from serving as directors. A ‘business judgment rule’ standard as a regulation is therefore desirable in order to avoid excessive legal restrictions on business operations. In general, there are few cases in which judges tried (or were forced) to interpret the law innovatively to cope with the problems they faced. More importantly, all these cases were heard in economically developed cities, such as Beijing, Shanghai and Wuhan.44 Beijing and Shanghai may be regarded as China’s ‘Delaware’ because they have the most effective courts for dealing with commercial disputes. It is therefore safe to say that the innovations in these cases reflect the quality of the high end of China’s judiciary but not that of judiciary practice in China as a whole. Another problem with such innovation is that the principle of fiduciary duty derives from a case-law environment in which judges enjoy considerable discretion in interpreting law, allowing them to protect the rights of shareholders without excessive interference in the business operations of companies. The development of fiduciary duties is therefore dependent upon the accumulation of precedent. In China, however, there is no such thing as a system of judicial precedent. Without such a system, judges who are in different areas (and/or time zones) but face similar cases may have to interpret the law from scratch, resulting in wasteful duplication of efforts; even worse, their interpretations may contradict one another, leading to even more inefficient outcomes, such as inconsistent judgments, legal uncertainty and weakening of the authority of the law. 3.5

Courts’ attitudes towards shareholder protection in listed companies

As we have shown, all fiduciary duty cases heard by courts in China are related to closely held companies rather than companies listed on a stock exchange. In other words, private litigation over fiduciary duties has not become an important force used by shareholders to protect their rights in China’s listed companies. There are several reasons that explain this phenomenon. The first is that the legal provisions on shareholders’ litigation in China’s Corporate Law (both the original and its revisions) are too vague to be used by shareholders in listed companies to protect their rights in practice. Before 2005, Article 111 of the Corporate Law of 1993 provided the only legal basis for shareholder litigation, stipulating that ‘where a resolution of the shareholders’ general meeting or of the board of directors violates the law or administrative regulations or infringes the 44 In fact, the majority of duty of loyalty cases we collected were heard by courts located in the eastern coastal area of China. More specifically, eleven cases were heard by Beijing courts. Shanghai courts heard eight cases and Zhejiang province courts seven. Three cases were filed before Guangdong province courts. Finally, the courts in the provinces of Shandong, Jiangsu, Hubei and Liaoning heard one case each. Additionally, nearly 90% of the cases were heard by intermediate or high courts, and only four by basic courts.

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lawful rights and interests of the shareholders, the shareholders concerned shall have the right to file a lawsuit before a people’s court demanding that such illegal or infringing action be stopped.’45 Shareholders were limited to injunctive relief rather than damages. Because of its inherent defects, Article 111 was rarely relied upon by courts to solve shareholders’ civil disputes; instead, courts simply rejected almost all private enforcement initiatives.46 While the Corporate Law of 2005 significantly strengthens shareholders’ power by requiring the wrongdoer to pay compensation and by introducing derivative suits, for example, it offers little procedural guidance, and courts not disposed to hear such cases will readily find justification for inaction.47 The second reason that explains the absence of litigation involving listed companies is that the revised Corporate Law imposes qualification limitations on shareholder litigation, requiring that, to file suit, plaintiffs must be shareholders of a listed company who ‘alone or together hold(s) more than 1% of the shares for more than 180 consecutive days’.48 A report issued by the China Securities Investor Protection Fund Corporation in 2009 shows that those investors whose investment duration is less than one month account for 44.22% of the surveyed investors, whereas investors with an average investment duration of more than half a year account for only 16.60%.49 In addition, 65% of surveyed investors invest less than CNY 100,000 in stocks, and more than 85% of these investors invest less than CNY 300,000. Yuan and Yang’s study 50 shows that the average shareholding of minority shareholders is less than 4,000 shares per person. In view of these practical obstacles, it is therefore difficult for minority shareholders to meet the legal requirement to be able to pursue shareholder litigation against listed companies. .

45 ‘Gudong dahui, dongshihui de jueyi weifan falv, xingzheng fagui, qinfan gudong hefa quanyi de, gudong youquan xiang renmin fayuan tiqi yaoqiu tingzhi gai weifa xingwei he qinhai xingwei de susong.’ 46 J. Wang, ‘Rule of Law and Rule of Officials: Shareholder Litigation and Anti-Dumping Investigation in China’, The Foundation for Law, Justice and Society, available at: . 47 D. Clarke, ‘The Ecology of Corporate Governance in China’, George Washington University Law School, Public Law and Legal Theory Working Paper No. 433, available at: . 48 See Article 152 of the Corporate Law, according to which a shareholder (or shareholders) is qualified to bring a lawsuit against the director(s) if he/she (they) ‘lianxu yibai bashi ri yishang dandu huozhe heji chiyou gongsi baifenzhiyi yishang gufen’. 49 ‘2009 nian touzizhe zonghe diaocha’ [A Survey of Investors in 2009], translated by the authors, available at: . 50 Z. Yuan and S. Yang, ‘Xianjin guli zhengce: falv baohu de jieguo haishi falv baohu de tidai-laizi woguo shangshi gongsi de zhengju’ [Cash Dividend Policy: A Consequence of Legal Protection or a Substitute for Legal Protection – Evidence from China’s Listed Companies], 5 Caimao Yanjiu [Research on Finance and Trade] (2006) p. 86.

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Third, the class action approach is not allowed under the current legal rules,51 which indicates that the legal tools available for protecting minority shareholder interests are limited. The failure to adopt a US-style class action mechanism is most likely political in nature. As clearly put by Hutchens,52 ‘the concentration of large numbers of aggrieved shareholders into an organized group triggers anxiety in a regime lacking popular legitimacy through suffrage’. Finally, most companies listed on China’s securities markets are reformed stateowned enterprises (SOEs) rather than truly private firms. China’s securities markets have been self-consciously designed to support the reform of SOEs, but not to allow private firms to raise capital.53 For example, a 2003 study concluded that approximately 84% of listed companies were directly or indirectly under state control, and a 2002 report found that, of the 1,015 controlling shareholders in the 1,175 listed companies studied, 77% could be considered organisations owned or controlled by the state.54 In addition, with respect to the ‘corporatised’ SOEs that dominate China’s securities markets, only approximately one third of such firms’ shares circulate on the public markets as so-called ‘liquid shares’ (liutong gu); the remainder of the shares generally stay in government hands, either directly as stateowned shares ( guoyou gu) or indirectly as legal-person shares (.faren gu).55 As the .

51 Z. Zhong, ‘Shilun woguo zhengquan minshi susong xingshi zhi wanshan lujing’ [A Tentative Study of Ways to Improve the Litigation Form of Securities Action in China], 2 Anhui Daxue Xuebao [Journal of Anhui University] (2006) p. 90. 52 W. Hutchens, ‘Private Securities Litigation in China: Material Disclosure about China’s Legal System’, 24 University of Pennsylvania Journal of International Economic Law (2003) p. 599, at p. 645. Hutchens further reports that, in a conversation with a professor from Yale School of Management who advocated adoption of a class action system, one Supreme People’s Court judge expressed anxiety regarding the political risks associated with creating groups of aggrieved investors. The judge regarded the class action system as ‘politically too dangerous’. 53 B. Naughton, The Chinese Economy: Transitions and Growth (Cambridge, MA, MIT Press 2007) p. 469. The most commonly used strategy to form a listed company is to have a promoter, usually a large SOE, ‘carve out’ all or a portion of its operating assets and contribute this into a joint stock company, which will then go public and become a listed company under a system of quota allocations administered by China’s securities authority, CSRC. See J. Qiu, ‘Corporate Governance in China: From the Protection of Minority Shareholders Perspective’, 2 Corporate Governance Law Review (2006) p. 311. Usually, the original SOE from which the listed company separated becomes the controlling shareholder of the listed company, and hence there is a firm relationship between a controlling shareholder and a listed company. This connection inevitably enables the controlling shareholder to effectively control the listed company. 54 Supra n. 47. 55 Supra n. 52. On 29 April 2005, CSRC initiated the non-tradable share reform with the promulgation of the Circular on Non-tradable Share Pilot Reform of Listed Companies. Following the positive results of the trial, a full-scale reform campaign was soon conducted among listed companies. The reform aimed to gradually eliminate the difference between the two types of shares and to balance the interests between the two categories of shareholders in a marketoriented way. This was achieved through negotiations between holders of non-tradable shares and tradable shares, with the former paying consideration to the latter in exchange for the floating

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dominant shareholder,56 the state can easily protect its interests through its power under the Corporate Law, such as by organising a general meeting of shareholders, nominating and appointing the chairman of the board, etc. Litigation is not a meaningful weapon for such a powerful controlling shareholder. When minority shareholders of China’s listed companies try to protect their rights through litigation, courts show extreme apathy.57 For example, in 2001, when investors filed suits against Yorkpoint Science and Technology and its management simultaneously in Beijing, Guangzhou and Shanghai, the Supreme People’s Court issued a notice 58 on 21 September 2001 directing all lower courts to temporarily stop accepting private securities lawsuits. Perhaps influenced by public opinion and social pressure, the Supreme People’s Court issued a second notice on 15 January 2002 stipulating that lower courts may accept private securities litigation based on allegations of false disclosure and material misrepresentation, subject to the condition that an administrative penalty had previously been imposed for the alleged fraud. However, the ban remains in place for private litigation based on other types of claims, such as insider trading and market manipulation. Finally, on 9 January 2003, the Supreme People’s Court issued the private securities litigation rules,59 which still limit private securities litigation to false disclosure claims and still require enabling government action as a precondition for the court to accept a private suit, except now the latter condition may be met by an administrative penalty or a criminal court ruling. Even after the issuance of the aforementioned rules, private securities litigation remains rare. Zhang’s study 60 shows that, through the end of 2007, lawsuits against listed companies that had administrative penalties imposed on them by the CSRC or the Ministry of Finance, or that had been subject to criminal sanctions by courts, .

.

rights of the originally non-tradable shares. As of 31 December 2007, 1298 listed companies, representing 98% of the total listed companies subject to the reform, had either imitated or completed the process of non-tradable share reform. See China Securities Regulatory Commission Annual Report 2007, available at: . 56 Naughton reports that the government directly owns the largest proportion of total stock, 46% at the end of 2001. See supra n. 53, at p. 470. 57 For a detailed discussion of this issue, see Z. Chen, ‘Capital Markets and Legal Development: The China Case’, 14 China Economic Review (2003) p. 451. 58 For more details on this notice, see K. Pistor and C. Xu, ‘Governing Stock Markets in Transition Economies: Lessons from China’, 7 American Law and Economics Review (2005) p. 184. 59 For a more extensive study on the rules, see Hutchens, supra n. 52. As generalised by Hutchens, the rules ‘seem to be a fragile weapon – plaintiffs must sue government-owned companies in government-controlled courts, the ability to leverage claims through class actions is limited, relief can only be sought for disclosure fraud, not insider trading or market manipulation, and some victims of disclosure fraud will be denied relief. In addition to this list of weaknesses, no private right to sue exists unless a division of the PRC government takes action to enable it’, supra n. 52, at p. 649. 60 T. Zhang, ‘Zhengquan minshi susong yu touzizhe baohu’ (Securities Litigation and Investor Protection), 11 Caizheng Yanjiu [Research on Finance] (2009) p. 58.

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numbered only 25. The companies sued for false disclosure account for a small percentage (less than 0.4%) of the companies listed on the Shanghai and Shenzhen Exchanges. The litigation period is relatively long, with an average duration of 2.5 years. Finally, even if the investors succeed in their lawsuit, the rewards are not substantial. Liebman and Milhaupt 61 report that, from 2001 to 2006, the total number of suit-eligible companies (as a result of CSRC administrative sanctions, criminal judgments, or Ministry of Finance sanctions) appears to have been approximately 130, whereas roughly twenty companies were sued in this period. In other words, although CSRC-sanctioned companies would appear to be easy targets for investor lawsuits, approximately 85% of the eligible target companies have not been sued. In addition, only a handful of cases have resulted in court judgments ordering compensation to plaintiffs. .

4.

THE ROLE OF THE CSRC IN PUBLIC ENFORCEMENT

4.1

China’s securities markets and the CSRC

Following their creation in 1990, China’s domestic stock exchanges, the Shanghai Stock Exchange (SHSE) and Shenzhen Stock Exchange (SZSE), grew quickly (if unsteadily).62 At the end of 2010, 2,063 companies were listed on the SHSE and SZSE combined, and total market capitalisation reached CNY 26.54 trillion, equivalent to 66.7% of GDP in fiscal year 2010.63 That same year, the SHSE was the sixth largest exchange in the world in terms of market capitalisation and the third largest in terms of value of shares traded.64 Following decades of development, however, the level of depth in the markets remains insubstantial. For example, the McKinsey Global Institute 65 reports that, in 2004, the total market capitalisation of all Chinese listed companies, including both .

61 B. Liebman and C. Milhaupt, ‘Reputational Sanctions in China’s Securities Market’, 108 Columbia Law Review (2008) p. 929. 62 The market continued its growth in most of the 1990s, reaching a peak at the end of 2000, then suffering a long decline that lasted for more than five years. The subsequent recovery finally led to another boom that culminated in 2007, followed by another bust. The bumpy development of stock markets seems to be at odds with China’s continuous and stable economic growth. For example, between mid-2001 and mid-2005, China’s GDP increased by more than 50 per cent, but total stock market capitalisation decreased by more than 50 per cent. 63 China Securities Regulatory Commission Annual Report 2010, available at: . 64 2010 World Federation of Exchanges Market Highlights, available at: . 65 Putting China’s Capital to Work: The Value of Financial System Reform, by McKinsey Global Institute, available at: .

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those listed domestically and those listed on the Hong Kong and other international exchanges, was only 33 per cent of GDP. However, roughly half of total market capitalisation (and two thirds of domestic market capitalisation) was represented by non-tradable shares owned by ‘legal persons’ or government entities. Excluding the value of these non-tradable shares left China with an equity depth of only 17 per cent of GDP, which was low compared with other countries. In fact, before 2006, the ratio between the market capitalisation of tradable shares and GDP in China had never been higher than 20 per cent.66 The primary regulatory agency of China’s capital markets is the CSRC. In 1998, China enacted its first Securities Law (revised in 2005), which gave the CSRC the power to regulate issuers, securities markets and market intermediaries. More specifically, according to Article 179 of the Securities Law, the functions performed by the CSRC can be divided into three parts, namely rule-formulating, supervising, and sanctioning. In terms of formulating rules, Article 179 stipulates that the CSRC ‘formulates the relevant rules and regulations on the supervision and administration of the securities market and exercises the power of examination or verification’.67 As for its supervisory role, the CSRC ‘carries out the supervision and administration of the issuance, listing, trading, registration, custody and settlement of securities’, and ‘carries out the supervision and administration of the securities activities of a securities issuer, listed company, stock exchange, securities company, securities registration and clearing institution, securities investment fund management company or securities trading service institution’.68 Finally, the CSRC is to ‘investigate into and punish any violation of any law or administrative regulation on the supervision and administration of the securities market’.69 Three main tools can be used by the CSRC to punish listed companies.70 First, for lesser infractions, the CSRC may issue reprimands called ‘correction orders’, in which a company or individual is told to correct certain behaviours. Second, the CSRC may issue more serious administrative sanctions that can take the form of formal warnings or fines. Fines for companies typically range from CNY 300,000 to 600,000; individuals are subject to fines ranging from CNY 30,000 to 300,000.71

66 China’s Securities and Futures Markets 2007, China Securities Regulatory Commission, available at: . 67 ‘Yifa zhiding youguan zhengquan shichang jiandu guanli de guizhang, guize, bing yifa xingshi shenpi huozhe hezhun quan.’ 68 ‘Yifa dui zhengquan de faxing, shangshi, jiaoyi, dengji, cunguan, jiesuan, jinxing jiandu guanli; yifa dui zhengquan faxingren, shangshi gongsi, zhengquan gongsi, zhengquan touzi jijin guanli gongsi, zhengquan fuwu jigou, zhengquan jiaoyisuo, zhengquan dengji jiesuo jigou de zhengquan yewu huodong, jinxing jiandu guanli.’ 69 ‘Yifa dui weifan zhengquan shichang jiandu guanli falv, xingzheng fagui de xingwei jinxing chachu.’ 70 See Liebman and Milhaupt, supra n. 61. 71 See Article 193 of the Securities Law.

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Third, individuals who commit serious violations may also be barred from participation in the securities markets and from serving as a senior manager or director of a listed company.72 According to a report 73 issued by the CSRC itself, from 2003 to 2007, it ‘investigated 736 cases, forwarded 104 cases for criminal charges and imposed sanctions on 212 cases involving 180 entities and 987 individuals. Some 165 executives and professionals were deprived of the right to practice in the securities market for extended periods’. The numbers do not look promising if the entire picture of China’s capital markets is taken into consideration. For example, Pistor and Xu 74 report that, in 2003, the number of punishment actions (11) was less than one per cent of the number of listed companies (1,278). In addition, the sanctions were often benign, with only 22% of all enforcement actions resulting in fines, as opposed to warnings or informal reprimands.75 In general, the CSRC is not an effective regulatory force, as many studies have noted. The foremost criticisms of the CSRC are its lack of expertise, its low level of resources (human and otherwise), its lack of independence from the state, and its susceptibility to political pressures.76 Clarke et al.77 have also shown that the CSRC’s investigative powers are severely circumscribed. For example, it may question executives of a listed company about a suspicious transaction, but not executives of the company on the other side of the transaction if the second company is not under the CSRC’s jurisdiction. .

.

4.2

Sources of data and cases

To obtain the data from regulatory agencies, we visited the CSRC’s website and used the keywords ‘director + duty of loyalty’ and ‘director + duty of diligence’ to search the related administrative penalty decisions.78 We identified 61 related cases.

See Article 233 of the Securities Law. China Capital Markets Development Report, China Securities Regulatory Commission, available at: . 74 Supra n. 58. 75 They therefore conclude that ‘formal law and law enforcement have played at best a marginal role in China’s market development’, supra n. 58, at p. 185. 76 G. Chen, M. Firth, D. Gao and O. Rui, ‘Is China’s Securities Regulatory Agency a Toothless Tiger? Evidence from Enforcement Actions’, 24 Journal of Accounting and Public Policy (2005) p. 451. 77 D. Clarke, P. Murrell and S. Whiting, ‘The Role of Law in China’s Economic Development’, in L. Brandt and T.G. Rawski, eds., China’s Great Economic Transformation (New York, Cambridge University Press 2008) p. 375. 78 Unfortunately, we cannot find an explanation for the docketing system of CSRC cases in public sources. It seems that a penalty decision will be allocated a number which indicates the year when the decision is made, as well as the time sequence of the case in that year. 72 73

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Cases with a repeated penalty decision and a reconsideration of a prior decision were omitted, leaving 34 cases (see Appendix B). 4.3

The basis for penalties

In those cases where the CSRC imposes penalties on directors of listed companies, it usually claims that ‘as a director of a listed company, he should perform his duties with loyalty and diligence’,79 and it holds directors accountable for not doing so. In reality, however, the CSRC’s punishments are based primarily on the Securities Law rather than on the revised Corporate Law.80 Because the central issue in most of these cases is information disclosure, the CSRC relies heavily on provisions in the Securities Law, such as Article 63, which stipulates: The information as disclosed by issuers and listed companies according to law shall be authentic, accurate and integrate and may not have any false record, misleading statement or major omission,81

Article 68, which requires that [t]he directors and senior managers of a listed company shall approve the periodic report of their company in written form. The board of supervisors of a listed company shall carry out an examination of the periodic report of the company as formulated by the board of directors and produce the relevant examination opinions in writing. The directors, supervisors and senior managers of a listed company shall guarantee the authenticity, accuracy and integrity of the information as disclosed by their listed company,82

and Article 193, which requires that [w]here an issuer, a listed company or any other obligor of information disclosure fails to disclose information according to the relevant provisions or where there is any false record, misleading or major omission in the information as disclosed, the securities regulatory body shall order it to be corrected, give a

Translated by the authors. The CSRC has only referred to the revised Corporate Law in a few cases, such as in the penalty decision on the Dongsheng Technology Company (CSRC [2010] No. 17) (available at: ). 81 ‘Faxingren, shangshi gongsi yifa pilu de xinxi, bixu zhenshi, zhunque, wanzheng, budeyou xujia jizai, wudaoxing chenshu, huozhe zhongda yilou.’ 82 ‘Shangshi gongsi dongshi, gaoji guanli renyuan yingdang dui gongsi dingqi baogao qianshu shumian queren yijian. shangshi gongsi jianshihui yingdang dui dongshihui bianzhi de gongsi dingqi baogao jinxing shenhe bing tichu shumian shenhe yijian. shangshi gongsi dongshi, jianshi, gaoji guanli renyuan yingdang baozheng shangshi gongsi suo pilu de xinxi zhenshi, zhunque, wanzheng.’ 79 80

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warning and impose a fine of 300,000 yuan up to 600,000 yuan. The person-incharge and any other person directly responsible shall be given a warning and imposed a fine of 30,000 yuan up to 300,000 yuan.83

A serious problem arises. The Securities Law, from which the enforcement power of the CSRC is derived, says nothing about the fiduciary duties of directors. By contrast, the Corporate Law, which specifies the fiduciary duties of directors, neither says anything about directors’ duties in information disclosure, nor empowers an administrative agency such as the CSRC to protect the interests of shareholders based on the fiduciary duties of directors. Fiduciary duties, then, can hardly be cited as a sound legal basis for the CSRC’s enforcement against directors who fail to disclose information, whereas such failure can still be punished according to the Securities Law without referring to the fiduciary duties. As empowered by the Securities Law, the CSRC ‘formulates the relevant rules and regulations on the supervision and administration of the securities market’, so it can be argued that the CSRC could solve the aforementioned problem by stipulating that failure to disclose information is a breach of the fiduciary duties of directors of listed companies, which, in turn, will be punished by the CSRC under its own rules and regulations. The CSRC does, in fact, impose fiduciary duties on directors of listed companies in its rules and regulations. For example, Article 33 of the Code of Corporate Governance for Listed Companies stipulates that ‘directors shall faithfully, honestly, and diligently perform their duties in the best interests of the company and all the shareholders’.84 Another CSRC regulation, the Guideline for Articles of Association of Listed Companies, requires all listed companies to specify in their articles of association that their directors bear the duty of loyalty and the duty of diligence. However, only the Guideline for Articles of Association of Listed Companies stipulates that ensuring that disclosed information is authentic, accurate and integrate is a component of the duty of diligence, but no rule or regulation elucidates what type of role the CSRC can play when such a duty is breached. In fact, the CSRC never referred to its rules or regulations in the punishment decisions we collected. It should not be surprising to find that the CSRC can punish directors in listed companies by referring to legal principles that are beyond the legal territory from which its enforcement power derives. It has long been argued that the legal system in China is marked by a strong pro-administration bias, and its legislation can be

83 ‘Faxingren, shangshi gongsi, huozhe qita xinxi pilu yiwuren wei anzhao guiding pilu xinxi, huozhe suo pilu de xinxi you xujia jizai, wudaoxing chenshu, huozhe zhongda yilou de, zeling gaizheng, jiyu jinggao, bing chuyi sanshi wanyuan yishang liushi wanyuan yixia de fakuan. dui zhijie fuze de zhuguan renyuan he qita zhijie zeren renyuan jiyu jinggao, bing chuyi san wanyuan yishang sanshi wanyuan yixia de fakuan.’ 84 ‘Dongshi ying genju gongsi he quanti gudong de zuida liyi, zhongshi, chengxin, qinmian de lvxing zhize.’

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argued to be intentionally designed to maximise the discretion of bureaucrats.85 In Lubman’s words, ‘agencies of the Chinese government are endowed with great discretion in interpreting laws, which raises complex and disorderly obstacles to legality not only for foreigners but for Chinese as well’.86 The CSRC is not an exception. For example, Clarke shows that the degree of the CSRC’s authority to regulate the securities markets is not clearly defined by law and the CSRC has interpreted its regulatory authority as broadly as possible.87 Broad bureaucratic discretion is not necessarily inefficient because it can enhance institutional adaptability to rapidly changing conditions. The CSRC has used its discretion to interpret fiduciary duties in a more flexible way, as we will show. Such discretion, however, is a double-edged sword. As Lubman 88 has cautioned, without institutional controls over decision-makers, officials may produce ad hoc decisions that are too easily detached from principles or accountability and that may be tainted by the interests of the rule-maker. The CSRC seems no exception to this prediction.89 Another problem with the excessive discretion of the CSRC is that its expanding power may crowd out investors’ reliance on and faith in the judicial system. Many studies have found that for the development of capital markets the enforcement of law through private litigation is at least as important as public enforcement of law that depends on the incentives, power and resources of public authorities such as the CSRC.90 The most serious problem related to the public enforcement of law is .

85 86

See supra nn. 14 and 15. S. Lubman, ‘Looking for Law in China’, 20 Columbia Journal of Asian Law (2006) p. 1, at

p. 41. 87 See supra n. 47. For example, according to Article 11 of the Securities Law (before it was revised in 2005), the CSRC is empowered to require the submission of whatever documents it deems relevant, without any apparent limitation. In practice, the CSRC even attempts to exercise censorship over the financial press. In general, Clarke concludes that ‘Chinese administrative agencies simply do not act according to a model of legally defined subject matter competence. The CSRC has such power as it can successfully assert. The main limitations on its authority are probably better understood as political, not legal’, supra n. 47, at p. 36. See also C. Shi, ‘Protecting Investors in China Through Multiple Regulatory Mechanisms and Effective Enforcement’, 24 Arizona Journal of International and Comparative Law (2007) p. 451. Shi shows that, compared with China, the securities markets’ regulatory bodies in the United States, the United Kingdom and Australia intervene less when regulating stock exchanges and listed companies. 88 See supra n. 86, at p. 46. See also Peerenboom, supra n. 15, at p. 251. Peerenboom argues that the outcome of excessive discretion is that ‘[a]t minimum, it typically increases transaction costs by making it more difficult, time-consuming, and expensive to figure out just what the rules are at any time in a given place. At worst, it breeds corruption and a reliance on connections that erodes the normative force of law’. 89 See, for example, Naughton supra n. 53, at pp. 473-474. Naughton shows how the process of the initial public offering (IPO) is manipulated by the CSRC to its own advantage, the advantage of securities companies, and that of the SOEs who seek the listing opportunities. 90 See, for example, La Porta et al., supra n. 18.

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that, while the punishment imposed on offenders may serve as an effective deterrent to opportunism, shareholders may have no interest in the enforcement outcomes because they cannot be compensated, even if they were the victims of such opportunism. In contrast, aggrieved shareholders (with the help of lawyers) can be compensated through private litigation and hence have a strong incentive to use their own resources to investigate whether there is fraud, insider trading and market manipulation in the capital markets and whether directors and senior managers have performed their duties effectively. The private enforcement mechanism may therefore be an important and effective constraint on company insiders by mobilising resources from numerous market participants. While the relative importance of private law enforcement and public law enforcement remains an issue under debate, it is undeniable that a complete corporate governance system needs both. 4.4

Some regularities in the CSRC’s enforcement actions

4.4.1

Who should be punished?

Under the current regulatory framework, there must be a determination as to who is ‘the person in charge’ and who else is ‘directly responsible’. In most cases, the chairman is identified as the ‘person in charge’, reflecting the chairman’s significant control over the company, either because of support from the controlling shareholder or as a result of his actions as general manager. The accountability of other directors depends on whether they have signed a resolution of the board that is ultimately harmful to the interests of the company. In some cases, directors pleaded that they approved the resolution because they did not regularly participate in business decisions and therefore knew nothing about the situation, or that they were not experts on the company’s operations. Fiduciary duties are the main principle accepted by the CSRC in deciding whether the directors of a listed company are exempt from punishment, and the directors of a listed company will be discharged from liability if the CSRC recognises that they have effectively performed their duty of loyalty and duty of diligence. In some of its decisions, the CSRC has attempted to provide a more detailed elaboration of directors’ duties, particularly with respect to the meaning of the duty of diligence. For example, in a case where a director claims that he should be exempt from punishment because he authorised another person to sign the resolution and was unaware of what occurred, the CSRC’s punishment decision (CSRC [2010] No. 13) states: [D]irectors are elected by shareholders because they are trusted by shareholders for their character and capability, and they should therefore perform their duties in person, which can be argued as the least and most basic requirement for directors of listed companies arising from the duty of loyalty and the duty of

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diligence. While in certain circumstances and with due reason, those directors who cannot attend a board meeting are allowed, under current legal rules, to appoint proxies to attend the meeting and exercise their rights on their behalf, they are not allowed to contract out their rights entirely. A director will be deemed to be incapable of his job or unwilling to undertake his duties and responsibilities if he ‘totally delegates’ or ‘generally delegates’ his rights to others.91

The most comprehensive description of directors’ duties offered by the CSRC can be found in the penalty decision regarding the Languang Technology Company (CSRC [2008] No. 50). In this decision, the CSRC indicates that all directors of listed companies, internal or external, independent or nonindependent, should perform their duties with the prudence, diligence and skill that a rational and prudent person would exercise under similar circumstances, and those who fail to exercise reasonable care should bear the corresponding legal responsibilities…. The basic standard that can be used to judge whether directors, supervisors and senior managers of a listed company have performed the duty of loyalty and the duty of diligence is whether they put the interests of the company above the interests of their own or of third parties, and whether they can take the initiative to discover, firmly put an end to, and immediately reveal the activities conducted by the controlling shareholder, the actual controller, or third parties, which harm the interests of the company. Those who shirk their legal responsibilities and therefore fail to discover, or fail to stop and reveal, or even plan, direct, indulge, conceal and assist activities that are against the interests of the company, should be punished by law.92

4.4.2

Loyalty or diligence?

In the CSRC’s punishment decisions, the concepts and terminology of loyalty and diligence are often used simultaneously. However, a more careful examination of the contents of these documents reveals that the majority of penalties are related to activities such as ‘oversight’, ‘negligence’ or ‘undutifulness’. In other words, when the CSRC attempts to enforce directors’ duties, the duty of diligence, rather than the duty of loyalty, attracts the most attention. In fact, there are only three cases in which the CSRC found that the duty of loyalty had been breached. Technically, this phenomenon can be explained by the fact that the CSRC classifies the failure to disclose information as breaching the duty of diligence rather than breaching the duty of loyalty. For example, in the Guideline for Articles of Association of Listed

91 Translated by the authors. The details of the case are available at: . 92 Translated by the authors. The details of the case are available at: .

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Companies, the CSRC stipulates that ensuring that disclosed information is authentic, accurate and integrate is a component of the duty of diligence. Because the CSRC cases are mainly about information disclosure, it follows that the duty of diligence is the dominant theory. The shortage of duty of loyalty cases does not indicate that directors of China’s listed companies have greater integrity or rarely engage in transactions tainted by conflicts of interest. Because concentrated ownership is prevalent in China’s capital market,93 it is more plausible to assume that dominant shareholders are able to use their power over a company to conduct transactions that are favourable to themselves and unfavourable to the company and its other shareholders, including blatantly one-sided transactions, such as the outright transfer of funds to the dominant shareholder with no pretence of an economic quid pro quo.94 The risk of directors and senior managers engaging in opportunistic behaviour and the likelihood that they will breach the duty of loyalty may be reduced when the company is under the control of shareholders; however, opportunism of controlling shareholders may ensue. In Roe’s terms,95 corporate governance problems faced by investors in China’s capital market are mainly horizontal (between controlling shareholders and minority shareholders) rather than vertical (between shareholders and directors or senior managers). In the face of threats from controlling shareholders, directors prove their value by disclosing relevant information with diligence, revealing potential risks, and resisting the looting of the company by such controlling shareholders. 4.4.3

External directors versus internal directors

In practice, a listed company’s directors can be divided into two groups, external directors and internal directors. Internal directors usually also serve as senior managers of a company and are directly involved in the company’s management and daily operations. External directors are usually defined as non-members of the firm’s top management team and their associates, its employees, its customers and its partners. External directors are therefore independent of the management and the

93 See Q. Liu, ‘Corporate Governance in China: Current Practices, Economic Effects and Institutional Determinants’, 52 CESifo Economic Studies (2006) p. 415. He shows that among China’s listed companies, the average number of shares held by the largest shareholder is 44.8%. 94 See supra n. 77. In 2002, a report issued by the CSRC and the National Economic and Trade Commission showed that, out of approximately 1,200 listed companies, 676 were found to have had the problem of fund misappropriation by controlling shareholders. See ‘dagudong taokong shangshi gongsi wenti tuchu’ [The Problem of Looting by Controlling Shareholders Is Serious in Listed Companies], available at: . 95 M.J. Roe, ‘The Institutions of Corporate Governance’, in C. Ménard and M.M. Shirley, eds., Handbook of New Institutional Economics (Dordrecht (the Netherlands), Springer 2005) p. 371.

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operations of the firm. These two types of directors should bear different responsibilities when damage occurs because their positions indicate that the scope and amount of information provided to them by the company will differ significantly. It is neither reasonable nor efficient to impose identical responsibility on these different types of directors. This issue has apparently been considered by the CSRC in its enforcement. In most cases, the chairman is identified as the ‘person in charge’ and receives the maximum fine of CNY 300,000, and, in certain cases, he may even be banished from the capital market in perpetuity. Other directors and senior managers who have signed the resolution are identified as ‘other person[s] directly responsible’ and are warned or fined according to factors such as the level of their participation in the illegal activities or the extent to which they have performed their duty of diligence. Directors may be exempted from punishment if there is evidence that they performed their duties effectively. For example, in the punishment decision on the Nanjing Zhongbei Company (CSRC [2010] No. 10), the vice-chairman (also the general manager) and deputy general manager (also the chief accountant) were identified as the ‘persons in charge’ and received the maximum penalty of CNY 300,000. However, the chairman, who was also identified as a ‘person in charge’, was punished by a fine of CNY 200,000 because he was blamed for failing to monitor the company’s operations effectively rather than for participating in the illegal activities. Two external directors were judged as failing to perform their duty of diligence and fined CNY 30,000, and an employee director was warned. Three independent directors were exempted from punishment because they were believed to have performed their duties with diligence.96 An important determinant of whether external directors may be exempted from punishment is their professional background. For example, in the punishment decision on the Datang Telecom Company (CSRC [2008] No. 28), an independent director was identified as the ‘other person directly responsible’ and was warned. The reason for this penalty was that the director was ‘an accounting professional, and at the time, the chair of the company’s Audit and Oversight Committee. While she disagreed with several accounting matters, she failed to pay diligent and careful

96 These directors were exempted from punishment for the following reasons. First, during their term of office, they took active part in board meetings, carefully reviewed documents and materials, expressed their views prudently, formed independent judgments, rejected premature investment projects proposed by the management, and managed to improve the company’s corporate governance mechanism and internal control system. Second, after the company was found to have lost significant amounts of funds, they immediately convened board meetings to question management, urged the board of directors to hire an accounting firm to conduct a special audit, sent a public notice to all shareholders, and reported the problem to the CSRC. Third, they actively pushed the company to recover the loss of funds and conduct an internal reorganisation. The details of the case are available at: .

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attention to other matters related to false statements’.97 In other words, as an accounting professional, the director should have better ability to monitor accounting problems than ordinary directors and should therefore bear a greater duty of care. 5.

CONCLUSION

Fiduciary duties are considered to be a core concept in the corporate law of common law jurisdictions. By requiring directors to be loyal to shareholders and to perform their duties with care and diligence, fiduciary duties regulate the relationship between shareholders and directors in an economically efficient way. In law and economics terms, fiduciary duties replace ex ante monitoring efforts (which are difficult and costly, if not impossible) with an ex post sanction mechanism, thereby reducing information costs and transaction costs. This approach, however, relies heavily on judicial discretion in applying this inclusive and flexible principle to individual cases and is difficult to codify. It is therefore easy to see that it would be difficult to transplant such a common law legal tool to countries with a civil law tradition. As Kanda and Milhaupt noted,98 for almost forty years after it was transplanted, the duty of loyalty was never separately applied by Japanese courts and played little role in Japanese corporate law and governance. A similar quandary can be witnessed in China. The legal texts are simple, vague and rigid, and formalised court judgments have limited precedent creation, thus reducing the deterrent effect. The judicial system is also reluctant to intervene in matters related to directors’ duties in companies listed on the stock markets. Some improvement can be observed, however. In a limited number of judicial decisions, courts have attempted to define the meaning of directors’ duties more clearly. In the CSRC’s penalty decisions, directors’ duties, and particularly the duty of diligence, have been interpreted in a more sophisticated manner. Different types of directors and different breaches of directors’ duties receive different punishments. This development is without a doubt too limited to result in the fundamental changes that would make fiduciary duties a guiding principle in China’s corporate law and governance. However, it is encouraging to see these improvements in judicial and regulatory practices, given China’s legal tradition and the stage of the development of the rule of law in the country. Future developments in directors’ fiduciary duties in China depend largely on the interaction between the legislature and judiciary, and on the interaction between

97 Translated by the authors. The details of the case are available at: . 98 Kanda and Milhaupt, supra n. 2.

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the judiciary and the regulatory regime. Fiduciary duties can be expected to play a more important role in China’s future legal system if more courts interpret and apply legal rules with flexibility, with references to cases and judges in other jurisdictions, thereby establishing more relevant cases; the legislature could then codify those principles and techniques emerging from cases in a timely manner. Similarly, a closer connection between the CSRC and the courts, such as a mutual citation system through which each institution can refer to the decisions of the other, is important for the development of the concept of fiduciary duties in China. As shown by the Japanese case,99 in the wake of economic transition and institutional development, fiduciary duties may be gradually adopted into a civil law environment and become a significant force in corporate governance.

99

Kanda and Milhaupt, supra n. 2.

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Appendix A: Cases in which directors were sued for breaching the duty of loyalty Case

Grounds

Type

Outcome

1. Zhou Yunfei v. Shi Xinzhang (Zhejiang Yuyao City Court, 2011 No. 413)

Breaching the duty of loyalty and infringing company interests.

Duty of loyalty: conflict of interest.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

2. Beijing No. 3 Construction Company v. Duan Zhaoyu (Beijing Second Intermediate Court, 2011 No. 19238)

Breaching the duty of loyalty and infringing company interests.

Duty of loyalty: conflict of interest.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

3. Shenyang Tekesi Company v. Zhang Mo (Shanghai Second Intermediate Court, 2011 No. 1836)

Breaching the duty of loyalty and infringing company interests.

Duty of loyalty: conflict of interest.

The claim was upheld. The defendant was found to have breached the duty of loyalty.

4. Jishuntong Transport Company v. Kang Jingxian (Beijing Second Intermediate Court, 2011 No. 17136)

Breaching the duty of loyalty.

Duty of loyalty: business decision not in the best interest of the company.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

5. Tan Hui v. Li Jia (Beijing Second Intermediate Court, 2011 No. 16710)

Breaching the duty of loyalty and misappropriating company funds.

Duty of loyalty: conflict of interest.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge funds to the company.

6. Shenzhen Long Digit Control Technique Company v. Li Da (Shenzhen Baoan District Court, 2011 No. 1025)

Breaching the duty of loyalty and misappropriating company funds.

Duty of loyalty: conflict of interest.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge funds to the company.

7. Huzhou Shengli Company v. Li Jinghui (Huzhou Intermediate Court, 2010 No. 226)

Breaching the duty of loyalty and running a competitive business after resignation.

Duty of loyalty: conflict of interest.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

8. Liu Bin v. Li Zhanjun (Beijing First Intermediate Court, 2010 No. 1099)

Breaching the duty of Duty of loyalty: loyalty and involvement conflict of interest. in a competing business.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge profits to the company.

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Type

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9. Ningbo Dahongying Medical Company v. Shen Yongren (Zhejiang Province High Court, 2009 No. 1212)

Breaching the duty of Duty of loyalty: loyalty and involvement conflict of interest. in a competing business.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge profits to the company.

10. Huayuan Shutong Technology Company v. Liang Baoshan (Beijing First Intermediate Court, 2009 No. 16916)

Breaching the duty of loyalty and misappropriating a company business opportunity.

Duty of loyalty: conflict of interest.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge profits to the company.

11. Zhejiang Sanlian Construction Company v. Zhang Xuefa & Zhang Shiming (Zhejiang Taizhou Intermediate Court, 2009 No. 545)

Breaching the duty of Duty of loyalty: loyalty and involvement conflict of interest. in a competing business.

The claim was dismissed. The defendants were not found to have breached the duty of loyalty.

12. Beijing Jinghua Sifang Trading Company v. Yu Qian (Beijing First Intermediate Court, 2009 No. 13800)

Breaching the duty of Duty of loyalty: loyalty and involvement conflict of interest. in a competing business.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

13. Beijing Jingyu Tianhe Computing Company v. Wen Qiusheng (Beijing First Intermediate Court, 2009 No. 15769)

Breaching the duty of loyalty.

Duty of loyalty: business decision not in the best interest of the company.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

14. Ningbo Saite Metal Product Company v. Gong Yongsheng & Gong Yongfeng (Zhejiang Province High Court, 2009 No. 77)

Breaching the duty of loyalty and transferring company assets to a third party.

Duty of loyalty: conflict of interest.

The claim was dismissed. The defendants were not found to have breached the duty of loyalty.

15. Qingdao Oil Company v. Yu Changchun (Shandong Province High Court, 2008 No. 103)

Breaching the duty of loyalty and misappropriating the seal of the company and financial documents.

Duty of loyalty: breaching the articles of association of the company.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

16. Beijing Bailixing Real Estate Developing Company v. Zhang Hao (Beijing Second Intermediate Court, 2009 No. 13966)

Breaching the duty of loyalty and misappropriating a company business opportunity.

Duty of loyalty: conflict of interest.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

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Type

Outcome

17. Shanghai Weigela Printing Equipment Company v. Andreas, Albert & Uhlemayr (Shanghai First Intermediate Court, 2009 No. 33)

Breaching the duty of loyalty and misappropriating a company business opportunity.

Duty of loyalty: conflict of interest.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge profits to the company.

18. Beijing Lisheng Qianyi Technology Development Company v. Gao Shangli (Beijing Second Intermediate Court, 2009 No. 10857)

Breaching the duty of loyalty and misappropriating company funds.

Duty of loyalty: conflict of interest.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge funds to the company.

19. Jingbei Lixigong Tech Company v. Wang Anguo (Beijing First Intermediate Court, 2009 No. 6049)

Breaching the duty of loyalty and concealing the company seal and financial documents.

Duty of loyalty: breaching the articles of association of the company.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

20. Shanghai Medical and Biotechnology company v. Mao Mo (Shanghai Pudong District Court, 2008 No. 3719)

Breaching the duty of Duty of loyalty: loyalty and involvement conflict of interest. in a competing business after resignation.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

21. Shanghai Dekun Industry and Commerce Company v. Huang Yufeng (Shanghai Second Intermediate Court, 2008 No. 283)

Breaching the duty of Duty of loyalty: loyalty and involvement conflict of interest. in a competing business after resignation.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge profits to the company.

22. Ningbo Lianying Company v. Zheng Deshu (Zhejiang High Court, 2006 No. 121)

Breaching the duty of Duty of loyalty: loyalty and involvement conflict of interest. in a competing business.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge profits to the company.

23. Shanghai Xingyun Real Estate Consulting Company v. Directors of Shanghai Lianji Investment and Consulting Company (Shanghai Second Intermediate Court, 2008 No. 29)

Breaching the duty of Duty of loyalty: loyalty and involvement conflict of interest. in a competing business after resignation.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge profits to the company.

24. Zhang Junjie v. Zhang Jianwei (Shanghai Second Intermediate Court, 2008 No. 93)

Breaching the duty of loyalty and misappropriating company funds.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge funds to the company.

Duty of loyalty: conflict of interest.

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25. Shanghai Pudong Yacheng Auto Company v. Ye Chengying (Jiangsu Province High Court, 2007 No. 0070)

Breaching the duty of loyalty and misappropriating company funds.

Duty of loyalty: conflict of interest.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge funds to the company.

26. Zhao Yu v. Zhu Yuchao (Foshan Intermediate Court, 2007 No. 348)

Breaching the duty of loyalty and misappropriating company funds.

Duty of loyalty: conflict of interest.

The claim was upheld. The defendant was found to have breached the duty of loyalty and required to disgorge funds to the company.

27. Wuhan Diguang Communication Company v. Liu Sheng (Wuhan Intermediate Court, 2006 No. 125)

Breaching the duty of loyalty and misappropriating company assets.

Duty of loyalty: conflict of interest.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

28. Fujian Yatong New Material Technology Company v. Liu Daomin & Huang Shanshan (Shenyang Intermediate Court, 2006 No. 1)

Breaching the duty of Duty of loyalty: loyalty and involvement conflict of interest. in a competing business.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

29. Lin Xiangyang, Lin Luqiang & Lin Xiongjie v. Lin Yijun (Guangzhou Intermediate Court, 2006 No. 1)

Breaching the duty of loyalty and transferring company assets to a third party.

Duty of loyalty: conflict of interest.

The claim was upheld. The defendants were found to have breached the duty of loyalty and required to disgorge funds to the company.

30. Shanghai Taijia Precision Equipment Company v. the Company’s executives (Shanghai Second Intermediate Court, 2011 No. 552)

Breaching the duty of loyalty and infringing company interests.

Duty of loyalty: conflict of interest.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

31. Chen Ju v. Orient Construction Company & Zhu Guihua (Zhejiang Zhuji City Court 2009, No. 4058)

Breaching the duty of loyalty and engaging in a self-dealing transaction.

Duty of loyalty: conflict of interest.

The claim was upheld. The defendants were found to have breached the duty of loyalty and required to disgorge profits to the company.

32. Beijing Management Company v. Chou (Beijing First Intermediate Court, 2012 No. 3552)

Breaching the duty of loyalty and transferring company assets to a third party.

Duty of loyalty: conflict of interest.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

Duty of loyalty: conflict of interest.

The claim was dismissed. The defendant was not found to have breached the duty of loyalty.

33. Shanghai Qile Breaching the duty of Company v. Su Yanping loyalty and infringing (Shanghai First company interests. Intermediate Court, 2010 No. 414)

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Appendix B: The CSRC’s penalty decisions related to directors’ duties Company involved

Grounds

Date of punishment

Outcome

1. Chaohua Technology

Failure to disclose 2005 annual report because of the negligence of two directors.

15/1/2007

Two directors were warned.

2. ST WeiDa

Failure to disclose significant related transactions.

18/6/2007

Eight people, including the chairman and other directors, were warned and fined CNY 280,000 in total.

3. Shen-Benshi

Failure to disclose a total of 26 matters.

29/9/2007

The chairman was fined CNY 300,000; four directors were fined CNY 160,000 in total.

4. Hailong Technology

Failure to issue a notice on matters such as acting as guarantor and transferring funds to the dominant shareholder.

2/1/2008

The chairman and vicechairman were warned and fined CNY 50,000, respectively; other responsible persons were warned.

5. Sanmao Paishen

Major matters were not approved by the board and not disclosed; fictitious profit was reported.

20/3/2008

The chairman was fined CNY 300,000; the CFO CNY 200,000; three directors CNY 50,000 each.

6. Xinlian

Failure to disclose external guarantee, lawsuits, related transactions, etc.

31/3/2008

The chairman was fined CNY 300,000; two directors CNY 150,000; one director CNY 50,000.

7. Sanlian Shangshe

Failure to disclose financial transactions and guarantee matters between the company and its controlling shareholder and related parties.

8/4/2008

The chairman was fined CNY 100,000; four directors and CFO were fined CNY 230,000 in total.

8. Yahua Zhongye Failure to accurately disclose bank loans and the relationship between shareholders, funds misappropriation by controlling shareholders, etc.

4/8/2008

Six people, including the chairman, were fined CNY 390,000 in total.

9. Wai-gao-qiao

Failure to notice that a large amount of cash was deposited in securities companies.

23/4/2008

Six directors were fined CNY 290,000 in total.

10. Xichang Electrics

Failure to disclose external guarantees.

23/4/2008

Nine directors were fined CNY 390,000 in total.

11. Datang Telecom

Reporting fictitious profits.

7/5/2008

Three people, including the chairman, were fined CNY 500,000 in total; others were warned.

12. Jiufa

Failure to disclose financial transactions and guarantee issues with related companies; false financial statements.

14/7/2008

Eight directors were fined CNY 660,000 in total.

94

Guangdong Xu et al. Company involved

EBOR 14 (2013)

Grounds

Date of punishment

Outcome

13. Chang-yuan Investment

Failure to disclose related transactions and misappropriation of funds by related parties.

14/10/2008

The chairman was banned from the market for life; other four directors were fined CNY 250,000.

14. Lan-guang Technology

Failure to disclose misappropriation of funds by controlling shareholder and related parties.

11/12/2008

Sixteen directors were fined CNY 2,670,000 in total.

15. Jiugui Liquor

Failure to disclose funds misappropriation by related parties; false financial statements.

24/3/2009

Nine directors were fined CNY 440,000 in total.

16. Beiya Industry

Illegal disclosure and false financial statements.

7/4/2009

Six directors were warned and one director was given a criminal punishment and was banned from the market for life.

17. Sihuan Medicine

Failure to make timely disclosure; false statements.

5/5/2009

Ten directors were fined CNY 370,000 in total.

18. Ronghua Industry

Failure to disclose that the company had changed the use of raised funds; failure to disclose connections with shareholders.

10/9/2009

The chairman was fined CNY 200,000; eleven other directors were fined CNY 370,000 in total.

19. Amoi Electronics

Misleading statements and inflated profits.

14/9/2009

Six people, including the chairman, were fined CNY 390,000 in total.

20. Chuang-zhi Technology

Failure to disclose connections with shareholders, and misappropriation of funds by controlling shareholder and related parties.

26/10/2009

The chairman was fined CNY 300,000; seven other people were fined CNY 370,000 in total.

21. Danhua

Failure to timely disclose related transactions; false information in annual report.

6/1/2010

The chairman was fined CNY 300,000; ten other people were fined CNY 450,000 in total.

22. Juyou Network

Failure to disclose financial transactions with related parties and external guarantee; reporting fictitious income.

11/2/2010

Ten directors were fined CNY 550,000 in total.

23. Tianyi Technology

False disclosure about related parties.

19/3/2010

The chairman was warned and fined CNY 30,000.

24. Nanjing Zhongbei

False disclosure of bank loans, notes payable, misappropriation of funds by related parties, etc.

19/3/2010

Six people, including the chairman, were fined CNY 1,060,000 in total.

25. Siwei

Failure to disclose related transactions.

6/4/2010

Three people, including the chairman, were fined CNY 110,000 in total.

Directors’ Duties in China Company involved

95

Grounds

Date of punishment

Outcome

26. Keyuan Group

Failure to disclose securities investments and bank loans; reporting inflated fixed assets.

6/4/2010

The chairman was banned from the market for life; a director was banned from the market for five years; the vicechairman was banned from the market for three years.

27. Shanghai Technology

Failure to disclose significant bank loans and notes payable; failure to disclose financial transactions with related companies and guarantee issues.

6/4/2010

Five directors were fined CNY 1,000,000 in total.

28. Dong-sheng Technology

Failure to disclose related transactions, external guarantee and bank loans.

13/4/2010

One director was fined CNY 300,000; another director CNY 200,000; the remaining thirteen directors were fined CNY 390,000 in total.

29. Liang-mianzhen

Reporting fictitious income and profits.

26/5/2010

The chairman was fined CNY 300,000; the remaining eight directors were fined CNY 330,000 in total.

30. Yuan-dong

Failure to accurately disclose connection with related parties and short-term investments; reporting fictitious sales.

20/8/2010

The chairman was fined CNY 300,000; the remaining seven people were fined CNY 370,000 in total.

31. Huaxia Jiantong

False statement about significant transactions; false statement about controlling shareholder and actual controller; reporting fictitious profits.

12/9/2010

The chairman was banned from the market for life; two directors were banned from the market for three years.

32. Tianmu Medicine

Provided funds to dominant shareholder by indirect means.

6/1/2011

The chairman was fined CNY 300,000; five directors were fined CNY 170,000 in total.

33. Bei-hai-gang

Information disclosure was neither timely nor complete.

10/1/2011

Nine directors were fined CNY 400,000 in total.

34. Wu-liang-ye

Information disclosure was neither timely nor complete.

29/4/2011

The chairman was fined CNY 250,000; the remaining six people were fined CNY 390,000 in total.