Protection of Minority Shareholders in the PRC Context

This article examines the provisions of PRC Company Law as the primary piece of legislation applicable to PRC companies, generally and particularly in the context of protection of minority shareholders.

Introduction

In May 1997, a corporatised state-owned enterprise was listed on the Shanghai Stock Exchange as Hongguang Industry Co Ltd. Shortly after the listing, it came to light that the public offering was characterised by fraud and misrepresentation. The company’s share price dropped sharply. Jiang Shunzhen, a shareholder, sold her shares and suffered a loss on her investment. In December 1998, Jiang sued the company’s directors, officers and external accountants in Shanghai. The Shanghai court refused to hear the case on the basis that the case should be handled by the China Securities Regulatory Commission¹ and did not come within the jurisdiction of the court.

This was reportedly the first case in the People’s Republic of China (‘PRC’) in which a minority shareholder had initiated action in court in an attempt to seek redress for loss suffered.

This article examines briefly the historical development of PRC Company Law, from the time it first came into force in 1994 to the recent revisions which came into force in 2006, generally and particularly in the context of protection of minority shareholders.

It should also be mentioned that, apart from the PRC Company Law, the other major piece of legislation relevant in this context is the Securities Law, which applies primarily to the public issue of shares and other securities in the PRC. It was first enacted in 1998 and took effect in 1999, after the Jiang case mentioned above. The Securities Law was also amended recently and the revisions came into effect in 2006. This article focuses more on the PRC Company Law as the primary piece of legislation applicable to PRC companies generally and does not discuss the Securities Law. Suffice it to say, in respect of PRC public listed companies, the Securities Law also provided little protection to minority shareholders of listed companies until the recent amendments which took effect in 2006.

Historical Background²

Surprising as it may seem, the PRC Company Law was first enacted only in 1993 and took effect on 1 July 1994 (‘1994 Law’), and was the first codified law on this subject matter.

It may perhaps not be so surprising once it is remembered that the PRC was run as a centrally planned economy from 1949, when the communist party assumed power. As a centrally planned economy, the production of goods and services was substantially conducted by state-owned enterprises (‘SOE’s). The state owned all the property and also controlled the management of the SOEs.

Economic reforms to transform the centrally planned economy to a market economy (with socialist characteristics) were introduced only from 1978 by the late Deng Xiaoping. SOEs slowly evolved from being state owned and controlled into a model where there was separation between state ownership and management rights. The property of the SOEs was owned by the people (in accordance with socialist philosophy), but management was (with the authority of the state) vested with the SOEs which were responsible for their gains and losses in the market.

The reforms culminated with the enactment of the 1994 Law, which forms the foundation for the PRC’s modern company law and modern-day corporations. Corporations under the 1994 Law are similar to our incorporated companies under the Singapore Companies Act (Cap 50), and are generally characterised by independent corporate entity status, limited liability of the shareholders and more well-defined shareholders’ rights. The 1994 Law provided a clear legal basis for, and facilitated, the corporatisation of many SOEs and establishment of private enterprises. It is against this backdrop that a new class, who will eventually turn to the courts to enforce their rights, arose – minority shareholders.

The 1994 Law

There were provisions in the 1994 Law which provided for the rights of shareholders generally,³ such as the right to appear and vote at shareholders’ meetings,⁴ to inspect minutes of shareholders’ meetings and financial and accounting reports of the company⁵ and to request for interim shareholders’ meetings to be convened.⁶

Minority shareholders could no doubt avail themselves of some of these general rights, but arts 63 and 111 were perhaps the provisions most relevant to a situation where the majority shareholders and/or management (especially when controlled by majority shareholders) are acting in their own interests at the expense and to the detriment of the minority shareholders.

Article 63 states that:

Directors, supervisors and the manager shall be liable for compensation, if they violate the laws, administrative rules and regulations or the articles of association in performance of their duties and thus cause damage to the company.

Article 111 states that:

Where a resolution of the shareholders’ general meeting or of the board of directors violates the law or administrative rules and regulations and infringes the lawful rights and interests of the shareholders, the shareholders concerned shall have the right to bring a lawsuit in a people’s court demanding that such illegal or infringing action be stopped.

The main criticisms against these provisions focus on their scope and the remedy provided, and may be summarised as follows:

1    Article 63 applies only to acts of directors, supervisors and manager (but not shareholders), and its scope is limited to violation of laws, rules and regulations or articles of association.

      Whilst art 63 provides that directors, supervisors and the manager shall be liable for compensation if the company suffers damage, there is no specific mechanism, such as a derivative action, by which a minority shareholder may be able to commence action against the directors, supervisors or manager. The lack of such a mechanism means that art 63 is of little practical use, especially since the company and its management may be controlled by the majority shareholders.

2    Article 111 applies only where a shareholders’ or board resolution: (a) violates any law, rules or regulations; and (b) infringes the lawful rights and interests of shareholders.⁷ However, for some reason, it does not extend to violation of articles of association.

      In contrast with art 63, art 111 specifically provides for shareholders to have the right to initiate action in court. However, the only right is to seek an injunction to stop the infringing acts, but not to seek compensation. In the case where the offending action has occurred and can no longer be stopped, compensation may be the only effective remedy for minority shareholders. The failure of art 111 to provide for compensation significantly weakened its effect.

Taking into account the above, particularly art 111, the decision of the Shanghai courts in refusing to hear the Jiang Shunzhen case cited above can be supported from a technical legal perspective, as there was no clear legal basis at that time for the claimant to seek compensation.⁸ Would the position be any different under the revised Company Law that took effect in 2006? It is to the 2006 Company Law that we now turn.

The 2006 Law

The 1994 Law has since undergone minor amendments in 1994 and 1999, and fairly significant amendments in 2005. The current applicable Company Law (‘2006 Law’) took effect from 1 January 2006.

In respect of provisions relating to the rights of shareholders generally, the relevant provisions in the 1994 Law which minority shareholders could also rely on have largely been retained and, in certain cases, expanded upon. Certain new provisions have also been added. Briefly, and by way of illustration:

1    The right to attend and vote at shareholders’ meetings has been retained.⁹

2    The right to inspect minutes of shareholders’ meetings and financial and accounting reports has now been expanded to cover (amongst others) resolutions of directors and supervisors.¹⁰

3    The right to require interim shareholders’ meetings to be convened has been retained.¹¹ In the case of limited liability companies, 
the percentage shareholding needed in order to require interim shareholders’ meetings to be convened has been lowered from one-fourth to one-tenth. The 2006 Law also goes further than the 1994 Law by empowering shareholders with the requisite percentage shareholding to convene the meeting if the board of directors and the board of supervisors failed to do so.¹²

4    Shareholders holding one-tenth or more of the company’s shares may require interim board meetings to be held.¹³ There was no such right under the 1994 Law.

5    Shareholders holding three per cent or more of the company’s shares may require the directors to place their written proposal before a shareholders’ meeting that has been convened, for consideration by shareholders.¹⁴ Minority shareholders did not previously have such right.

6    For the election of directors or supervisors at shareholders’ meetings, the 2006 Law introduces a cumulative voting system under which a minority shareholder may multiply his voting rights by the number of candidates and vote them all in favour of one candidate.¹⁵ This seeks to enable minority shareholders to multiply their voting rights and enhance their ability to vote for a director or supervisor of their choice.

In the context specifically of situations where the majority shareholders and/or management (especially when controlled by the majority shareholders) are acting in their own interests at the expense of the minority, the 2006 Law provides significantly more protection to minority shareholders. In this regard, the main provisions are discussed below.

Article 20 provides that:

The shareholders of a company shall comply with the laws, administrative regulations and articles of association, and shall exercise the shareholders’ rights according to law. None of them may injure any of the interests of the company or of other shareholders by abusing the shareholders’ rights … , [and] … where any of the shareholders of a company causes any loss to the company or to the other shareholders by abusing the shareholder’s rights, it shall be subject to compensation.

Prior to the 2006 Law, there was little fetter on the right of the majority shareholders to act as they wish in relation to their majority shareholding. For the first time, art 20 clearly enunciates a general principle that majority shareholders may not abuse their rights to the detriment of the company or other shareholders.

Article 21 provides that:

Neither the controlling shareholder, nor the actual controller, any of the directors, supervisors or senior managers of the company may injure the interests of the company by taking advantage of its connection relationship. Anyone who has caused any loss to the company due to violation of the preceding paragraph shall be subject to compensation.

One way in which majority shareholders may benefit at the expense of the 
company and/or minority shareholders is through transactions between the company and entities which they control, entered into at less than arms’ length terms. Article 21 seeks to address this issue by prohibiting majority shareholders from acting against the interests of the company through such transactions, and providing that the offenders shall be liable to pay compensation.

Article 22 provides that shareholders’ or board resolutions that violate any law or administrative regulation shall be null and void. In addition, where procedures for the convening of, and voting at, meetings violate any law, administrative regulation or the articles of association, or the resolution is in violation of the articles of association, any shareholder may apply to court for revocation of the resolution. Article 22 is similar to art 111 of the 1994 Law cited above, but goes further in at least two respects: (a) resolutions that violate law and regulations are null and void, whereas previously, a shareholder only had the right to initiate action in court to stop the offending acts; and (b) the scope of art 22 extends to a situation where the convening of, and voting at, meetings are in violation of law, regulation and articles of association, or the contents in the resolution are in violation of the articles of association.

The 2006 Law provides minority shareholders with the right to exit the company under certain circumstances. Article 75 provides that a shareholder who voted against a shareholders’ resolution may request the company to purchase its shares at a reasonable price under the following circumstances:

1    where the company has made profits and meets the profit distribution conditions prescribed by law for five consecutive years, but failed to distribute any profit to shareholders;

2    where the company is merged or divided, or transfers its substantial assets; or

3    the operation term specified in the articles of association of the company expires or other events for dissolution specified in the articles of association occur, while the shareholders’ meeting adopts a resolution on revision of the articles of association to make the company continue to exist.

If no agreement on the purchase of shares is reached within 60 days after the resolution is adopted, the shareholder may initiate action in court against the company within 90 days after the resolution is adopted.

Article 148 provides that the directors, supervisors and senior managers shall comply with laws, administrative regulations and the articles of association, and shall bear obligations of fidelity and diligence to the company. No director, supervisor or senior manager may take any bribe or other illegal gains by taking advantage of his authority, or encroach on the property of the company. This is perhaps a more explicit enunciation of the duty of loyalty and fiduciary duty on the part of directors, supervisors and senior managers, as compared with the 1994 Law.

Article 150 of the 2006 Law is similar to art 63 of the 1994 Law cited above, ie directors, supervisors and senior managers shall be liable for compensation if they violate the laws, administrative rules and regulations or the articles of association in performance of their duties and thus cause damage to the company. One criticism of the previous art 63 was that there was no specific mechanism for a minority shareholder to initiate derivative action in the name of the company.

The 2006 Law now provides a clear basis for such derivative action. Article 152 provides that any shareholder of a limited liability company or any shareholder of a company limited by shares holding one per cent or more of the company’s shares for 180 consecutive days may require the board of supervisors or the board of directors (where the supervisors are the perpetrators of the alleged act) to initiate action in court. If they refused to do so or failed to do so within 30 days, or where there is an emergency, such shareholder may directly initiate action in court in his own name.

The last paragraph of art 152 also provides generally that if the legitimate rights and interests of a company are impaired and losses are caused to the company, any shareholder of a limited liability company or any shareholder of a company limited by shares holding one per cent or more of the company’s shares for 180 consecutive days may initiate action in the courts. This paragraph would arguably provide the basis for a minority shareholder to initiate derivative action when damage is caused to the company under other provisions in the 2006 Law – particularly arts 20, 21 and 148 mentioned above, which do not specify that minority shareholders may initiate such derivative action.

Conclusion

Whilst certain provisions in the 2006 Law could be criticised for not going far enough, it is fair to say that the 2006 Law has significantly enhanced the rights and remedies of minority shareholders. Well, on paper, at least. Interpretation of the 2006 Law by the PRC courts is, of course, a different matter altogether and it remains to be seen how effective the 2006 Law would be in practice. Nevertheless, it augurs well for legal developments in the PRC, as the 2006 Law has aligned the PRC Company Law closer to those of other major jurisdictions.

Andrew Lai

Tracy Chen

China Practice Group, Kelvin Chia Partnership

E-mail: andrew.lai@kcpartnership.com and tracy.chen@kcpartnership.com

The Gazette is grateful to WongPartnership’s China Practice Group for their contributions to this special focus issue on China.

Notes:

1    The China Securities Regulation Commission (‘CSRC’), an institution under the State Council of the PRC, is the main regulatory authority regulating the securities markets in the PRC.

2    This section deals only very briefly with certain key milestones in the development of Chinese company law. The entire process was, of course, longer and much more complex, and is beyond the scope of this article.

3    It is beyond the scope of this article to list out all these rights. A few have been cited for illustrative purposes.

4    Articles 41 and 106, which apply to limited liability companies and joint stock companies respectively. In general terms, in the Singapore context, limited liability companies are similar to private companies and joint stock companies are similar to public companies.

5    Articles 32 and 110, which apply to limited liability companies and joint stock companies respectively.

6    Article 43 (limited liability companies) – shareholders’ meeting must be convened on the request of shareholders holding one-fourth or more of the company’s shares. Article 104(3) (joint stock companies) – shareholders’ meeting must be convened on the request of shareholders holding 10 per cent or more of the company’s shares.

7    Based on an interpretation of the original 1994 Law in Chinese, these two conditions should be read conjunctively, ie both (a) and (b) must be satisfied in order for the provision to apply. Unofficial English translations of the 1994 Law publicly available typically translate it as disjunctive, ie the provision will apply as long as either (a) or (b) is satisfied.

8    Please note the decision of the Shanghai court that the case was outside of its jurisdiction was based more on the Civil Procedure Law of the PRC, rather than specifically on the 1994 Law.

9    Articles 43 and 104, which apply to limited liability companies and joint stock companies respectively.

10 Articles 34 and 98, which apply to limited liability companies and joint stock companies respectively.

11 Articles 40 and 101, which apply to limited liability companies and joint stock companies respectively.

12 Articles 41 and 102, which apply to limited liability companies and joint stock companies respectively.

13 Article 111.

14 Article 103.

15 Article 106.