The New Company Law: Part 4, Supervisors

Fiduciary duties

The new Company Law adds some indications as to the contents of the fiduciary duties of the directors (as well as of those of the supervisors and senior managers). Such duties mainly consisting in a “duty of loyalty” and a “duty of diligence”.

Under the duty of loyalty, directors (as well as supervisors and senior managers) will be required to take measures to avoid conflicts between their own interests and the interests of the company, and not to use their powers to pursue improper benefits. 

Under the duty of diligence, directors (as well as supervisors and senior managers) will be required to exercise such reasonable care as is normally expected of managers in the best interests of the company when performing their duties.

As a specification of such duties, directors (as well as supervisors and senior managers), will be required to report any contracts and other transactions to which they may be a party with the company (including those of their close relatives and affiliates) to the shareholders’ meeting or the board of directors and seek its approval as required under the company’s articles of association.

Similarly, they will be required not to take advantage from their positions to seek business opportunities belonging to the company for themselves or other persons, unless the company cannot pursue such opportunities, or such a situation is reported to and (as required under the articles of association) approved by the shareholders’ meeting or the board of directors.

More generally, they will also be required not to engage in the same type of business as that of the company, whether for themselves or other persons, without reporting such a situation and (as required under the articles of association) getting approval from the shareholders’ meeting or the board of directors.

Directors, supervisors, and senior executives may, therefore, have to re-examine their position vis-à-vis the company so as to avoid any actual or potential conflict of interests and consequent liability.

Although the new law has made improvements in defining the fiduciary duties of the directors (and other officers and senior managers of a company), such concepts will still have to be further defined by judicial interpretation and application.

Finally, the definition in greater details of the fiduciary duties of the directors, may also have an effect on the commonly adopted structure of foreign-invested LLCs. As a matter of fact, some of the directors of an LLC are often individuals residing abroad (often working for one of the shareholders of the LLC, a company of the same group, or the regional headquarters) and are barely involved with the day-to-day management and decision-making process of the Chinese LLC. 

Considering that the liabilities of the directors are now being more precisely defined by the law, and that such provisions are based on the assumption that liabilities are a consequence of actions taken and decisions made, it may be advisable to appoint individuals as directors (or senior managers) who are actively involved with the operations and affairs, and relevant decision-making process, of the Chinese LLC.

The new law also specifically provides for the “actual controller” or the “controlling shareholder” of a company will be subject to the same fiduciary duties normally applying to the officers of the company, where such persons actually hold a conduct that is typical of that of a director (so-called “de facto director”, that is a person who, regardless of any title he or she might be using or appointed with, actually behaves like a director, or “shadow director”, that is a person whom has not been appointed as a director but whose influence or wishes normally determine the conduct and decisions of the directors).

Consequently, "controlling shareholders" or "actual controllers" that determine, or are actually involved in, the company's decision-making process may be held directly responsible when their conduct can be associated with that of a director (or senior manager) and claims have been brought forward against them by the company, other (minority) shareholders, officers of the company or creditors of the company.

The application and consequences of these provisions are not merely theoretical since, as a matter of fact, many foreign-invested LLCs are organised under a structure where the directors (often the sole director) operate under a close supervision (if not the direction and control) of the foreign shareholder(s) who ultimately determine the level and scope of authority of the management organ of the company, sometimes to an extent where the management organ may be considered as not actually operating and deciding in full autonomy.

Dismissal of directors

The new Company Law introduces a provision regarding remedies for dismissed directors by giving the right to a director whom has been dismissed without any justifiable reason before the end of the term to ask the company for compensation. The understanding of shareholders has always been that, under the law currently in force and the current practice (at least as far as FIEs are concerned), no compensation has to be given in the event a director is removed from office before the expiry of the term.

The new provision will require that shareholders refrain from removing directors at will or, at least, that they motivate a decision for earlier removal of directors, so as to avoid the company being requested compensation for unjustified dismissal.

This new provision raises an additional issue in the event a dismissed director also serves the company under an employment contract (for example, as general manager). In the event of an unjustified dismissal as director (which, presumably, will also determine the end of the employment relationship) the dismissed director may now be entitled to claim compensation (under the new provisions) and severance payment (under the labour contract law provisions). 

The new Company Law does not provide any element of coordination between the two situations and, probably, we will have to wait for interpretation measures to be issued in the future or a judicial practice to be established by courts.

Supervisors

The current law allows LLCs to have only one supervisor, or two supervisors, instead of a board of supervisors, where they are relatively small in scale or have a relatively small number of shareholders. The new Company Law now provides that an “small scale” LLC can decide to have one supervisor only (but not two anymore) instead of a board of supervisors or even no supervisor at all if the shareholders so approve.

The requirement of having a board of supervisors can also be avoided in an LLC where the company opts for the establishment of an audit committee. An audit committee is an organ of control that is to be formed only by members of the board of directors (including employee representatives) and shall exercise the same powers of a board of supervisors. 

The new provisions were probably designed with in mind the governance structure of companies, such as listed companies or companies operating in finance, where the establishment of an audit committee is already required.  

As far as LLCs are concerned, having an internal committee may create problems in the governance structure as the members of the committee would be called to supervise the activities of the company, and in particular of the board of directors (of which they are members too), thus giving rise to situations of conflict of interests.