Directors’ and Executives’ Liabilities under PRC Company Law (1/4)
Make it stand out
Whatever it is, the way you tell your story online can make all the difference.
(a) Article 22. Improper Related - Party Transaction
“The controlling shareholders, actual controllers (shadow directors), directors, supervisors, and senior management of a company shall not harm the interests of the company by abusing related-party relationships. If a violation of the preceding provision causes losses to the company, they shall be liable for compensation.”
The nature of this article can be found in other jurisdictions as well. Companies Act 2006 (UK) also addresses the prohibition against using related transaction to harm Company’s interests. Section 172 of 2006 UK Company Act requires the directors to promote the success of the Company in good faith and section 175 explicitly sets out the requirement for the directors to avoid conflict of interest. “Directors must avoid situations where they have, or can have, a direct or indirect interest that conflicts with the interests of the company”. Related-party transactions that harm the company would likely fall under this provision. The common practice dealing with sole-director’s conflict-of-interest transaction is to have the shareholder(s) to approve the transaction before the transaction.
Similarly in China, conflicting related party transaction can be pre-approved by shareholders under Article 182 of Companies Law, which prescribes: directors, supervisors, and senior management personnel who directly or indirectly enter into contracts or conduct transactions with the company shall report matters related to the contract or transaction to the board of directors or the shareholders' meeting and obtain approval through a resolution of the board of directors or the shareholders' meeting in accordance with the company's articles of association.
In a situation where a company has only one shareholder and one director, and the shareholder and director are the same individual, the approval of a related-party transaction by the sole shareholder (acting in that capacity) does not automatically result in the corporate veil being pierced. In other words, the shareholder—and consequently the director—does not lose the protection of limited liability solely because of this arrangement. While it may seem questionable for John Smith, as the sole shareholder, to approve a transaction involving John Smith in his capacity as the sole director or with another company he controls, this can be legitimate provided the roles are clearly distinguished, the transaction is conducted transparently, and no fraud or improper conduct is involved.
(b) Article 51 - Unauthorised Capital Contributions
“After the establishment of a limited liability company, the board of directors shall verify the shareholders' capital contributions. If it is found that a shareholder has not made their contribution in full and on time as stipulated in the company's articles of association, the company shall issue a written demand to the shareholder, urging them to fulfill their contribution. If the obligation stipulated in the preceding paragraph is not performed in a timely manner, causing losses to the company, the responsible directors shall bear liability for compensation.”
Article 47 of the new PRC Company Law stipulates that the total amount of capital contributions subscribed by all shareholders must be fully paid by the shareholders within five years from the date of the company's establishment, as specified in the company's articles of association. In other words, the shareholders' committed contribution period cannot exceed five years from the registration date. It further provides that if the company's promoters or shareholders make false capital contributions, fail to deliver, or fail to deliver on time the monetary or non-monetary assets as capital contributions, the company registration authority shall order rectification and may impose a fine ranging from 50,000 to 200,000 CNY(Article 252).
In such a context, Article 51 simply re-emphasises the importance of paid-up capital contributions by making directors responsible for compensation if they fail to keep a close watch on the shareholders in this respect. It seems easy that the only thing the directors need to do is to give a formal demand. However, in reality this may not be so and the directors may find themselves caught in whatever capacity they hold in the company. In a retrial case, the High Court upheld the judgment for the appellant (trustee of a bankrupted company) and required six directors jointly liable for the losses caused by the company’s shareholder’s non paid-up capital. Remember, three of the directors had retired from the directorship but were of the knowledge that the shareholder did not pay up when they were in the position. However, through financial records, board resolutions, and other relevant evidence, the bankruptcy administrator proved that the directors failed to fulfill their duties of verification and issuing payment demands. Additionally, the court, taking into account the directors' intentional misconduct or gross negligence, as well as the direct causation of the company's losses by their actions, held all six directors successively liable for compensation.
(c) Article 53 - Withdraw capital contributions
“After the establishment of a company, shareholders shall not withdraw their capital contributions.
If the preceding provision is violated, the shareholder shall return the withdrawn capital contributions. If such actions cause losses to the company, the responsible directors, supervisors, and senior management personnel shall bear joint and several liability for compensation along with the shareholder. If the preceding provision is violated, the shareholder shall return the withdrawn capital contributions. If such actions cause losses to the company, the responsible directors, supervisors, and senior management personnel shall bear joint and several liability for compensation along with the shareholder.”
To make an example of how this article operates in practice, the following case study is a good read. Company A and Company B jointly agreed to incorporate Company C, with Company B's capital contribution amounting to X yuan. According to the joint venture agreement, Company B transferred the capital contribution of X yuan to Company C. In the same year, with the consent of Company C's legal representative and financial officer, Company B borrowed X yuan back from Company C. Company A argued that Company B, through the related-party transaction of shareholder loans, transferred out its capital contribution, which constituted an act of withdrawing capital contributions. Furthermore, Company C's legal representative and financial officer assisted in the withdrawal of the capital contribution.
Company A filed a lawsuit requesting that Company B return the withdrawn capital contribution of 6X yuan along with interest, and that the legal representative and financial officer of Company C bear joint and several liability for the debt. Company A's claims were upheld in the first instance, and the appellate court affirmed the original judgment.
The difficulty of such cases often lie with the finding of evidence and piercing through multiple corporate veils to make sense of a transaction and hence convince the court the directors were fraudulent. In actuality, the facts may be not as straightforward as it looks like in the example case. However, once a case is made, the consequences followed from that are clear. Directors will be held liable for the losses of the company.
