China grants expansive statutory powers to one designated company director or officer, whose acts can bind the company in transactions with good faith counterparties even when internal limits were exceeded. This super-officer acts personally as a statutory representative of the company. As a legacy of management czars in China’s socialist law system, many limitations on D&O power in other countries are simply not recognized under China law.
Preventing theft and abuse by D&Os in China thus requires special strategies. In this article, we’ll go over how China’s D&O system affects binding authority, when internal approvals don’t affect enforceability, when a company is liable for unauthorized acts taken by D&Os, and risk control strategies to mitigate potential harm.
Contents
Why China D&O Have Extreme Power
Preventing Unauthorized Security Interests
Most Unauthorized Acts Can Bind the Company
Strategically Preventing Unauthorized Acts
Dealing with Unauthorized Transactions & Acts
Why China D&O Have Extreme Power
Historically, China was a communist command economy where all companies were state owned and run by party cadres who acted as economic czars. During the transition to a market economy, China borrowed from an old American law concept, statutory representation, to transition corporate identify from the party-state to individuals. Secondly, Chinese culture favors high personal liability exposure with no bankruptcy options; thus, policymakers imposed personal liability on some executives, as was done in the US and UK in the 19th century prior to the registered agent reforms.
Current law in § 10(a) of the China Company Act requires every company to select a single director or officer to provide personal statutory representation for the company. While the role is generally limited to acting on the board’s behalf when executing documents and transactions, a representative is empowered to bind the company externally in dealings with good-faith counterparties.
The representative’s internal authority is defined in the company’s articles of formation. An appointed representative exercises both the authority of their underlying role, such as the president’s authority over day-to-day-management or the board chair’s authority to preside over board meetings. If the board chair or an executive director is appointed as the representative, they may exercise the president’s authority internally to the extent provided in the articles.
Internal governance documents may allocate responsibilities among officers, but they do not eliminate the statutory authority granted by the appointment nor do they protect the company against being bound to good-faith counterparties.
A rationale for granting one D&O position non-waivable statutory powers is to make this person personally accountable for ensuring the company’s lawful operation. For example, in another CBL explainer, we show that occupational safety law in China imposes personal liability on the statutory representative for workplace safety violations. Thus, if you attempt to curtail the local China D&Os’ power by being the statutory representative yourself, you could be subject to civil and criminal liability for your local executives’ law violations. International enforcement for business law violation is very common.
Get legal advice from a CBL pro when deciding on D&O powers and appointments that involve significant business risk.
Preventing Unauthorized Security Interests
A common way of concealing theft is for the company to guarantee debts taken by an executive’s relatives by granting a security interest in the company’s property. These fraudulent transfers can be prevented only if the right process is used.
Under the China Company Act, security interest enforceability depends on whether the creditor acted in good faith and reasonably relied on a statutory representative D&O’s apparent authority, not on the company’s internal approval requirements. The law does nonetheless limit possible theft by imposing mandatory internal approval requirements for security interests.
Specifically, § 15 of the China Company Act requires board or shareholder approval before granting a security interest, which must comply with any collateral, asset, or debt limits in the company’s articles. Shareholder approval is also required before granting a security interest to a controlling shareholder or beneficial owner.
In practice, courts determine enforceability of a security interest agreement under the China Civil Code by inquiring into whether the creditor acted in good faith and reasonably relied on the company’s manifestations of the representative’s authority, even if internal approval requirements were met, after a review of board or shareholder resolutions (see China National Judicial Conference Minutes).[1] If the creditor reasonably relied on the company’s manifestations, the contract is enforceable. If the creditor has no reasonable basis for reliance, the contract is unenforceable and the creditor’s rights will be determined under the Secured Transaction Act and applicable case law.
A creditor has no explicit duty to thoroughly scrutinize corporate resolutions, a process also known as a “formalities review.” Thus, defects in internal approvals may not prevent enforceability if a creditor reasonably relied on apparent authority. If a creditor knows or has reason to know that the officer, especially the statutory representative, lacks authority or that the resolutions are fraudulent, the contract may be subject to rescission.
Additionally, § 59 of the China Company Act provides that the shareholder’s meeting is the company’s highest authority responsible for approving major actions, and that neither directors, officers, or the statutory representative can exercise authority over matters reserved by law to the shareholders. Matters reserved to the shareholders include business strategy, elections and reorganizations, budgeting and dividends, and corporate reorganizations, though enforceability disputes still rely on third-party good faith and reasonable reliance.
Most Unauthorized Acts Can Bind the Company
A common pattern of dishonesty by D&O in China is to make overpriced purchases from a supplier owned by their relative or child. Even if the company has explicit rules against nepotism, they are often circumvented through the statutory representation system.
In particular, § 11(b) of China’s Company Act states that any limits imposed by internal governance documents on directors and officers serving as a statutory representative cannot be asserted by a company against a good faith counterparty relying on apparent authority. Similarly, under § 504 of the China Civil Code, a company is generally bound by contracts entered into by a statutory representative acting with apparent authority, unless the counterparty knew or had reason to know they lacked authority. As noted above, only transactions involving a security interest also impose an obligation of due diligence on the counterparty, which affects whether reliance alone is considered reasonable.
Why might China law disregard governance limits on D&O authority in these cases? Under Chinese corporate law, a statutory representative personally represents the entity and can be found by searching the corporate registry. Unlike a Delaware registered agent, who primarily accepts service of process and notices, China’s statutory representative is empowered to bind an entity externally and perform its obligations on its behalf.
Lawyers in China conventionally call this representative role, fading daibiaoren, the “legal representative,” but the representative is typically not a lawyer, and this label hides the fact that this particular officer has expansive, statutory powers that cannot be limited internally. A single director or officer can expose the company to significant liability even if the governance documents deny them such expansive power. Due to their limited English proficiency and assumption that foreign legal systems must be “just like China,” lawyers in China routinely confuse clients about how their business structure really works. Fortunately, CBL has robust, affordable legal services through a strong network of China attorneys, which makes sure nothing is lost in translation.
How to Prevent Unauthorized Acts
Several strategies are commonly deployed by businesses in China to ensure directors and officers, especially the statutory representative, do not abuse their power for personal gain.
Vetting and oversight processes. Beyond business acumen, a company should consider ethical standards, work experience, reputation in the industry, and a demonstrated sense of accountability when appointing directors and officers.
Larger operations need a formal policy to select and appoint directors and officers. The policy should set specific selection procedures, objectives, and criteria, as well as executive search firm requirements. Hiring an outside professional services firm is generally recommended to help ensure an evidence-based and compliant selection process, and to minimize agency risk and abuse of authority.
Ask your attorney to draft an agreement that provides for prohibited conduct and liability, mirroring China Company Act § 181 about what constitutes unauthorized acts.
Establish oversight rules for directors and officers, especially the statutory representative, using this framework. Examples of statutorily prohibited acts include misappropriation, secret bank accounts, unapproved private loans, abuse of position to compete with the company, and divulging trade secrets.
The agreement should provide that the appointed director or officer is personally liable for unauthorized acts, including damages and reputational harm. Where appropriate, the agreement should also impose personal liability for security interests, particularly for the statutory representative.
Evidence-based managerial controls. To minimize the risk of unauthorized acts, establish evidence-based managerial controls that reasonably restrict director, officer, and statutory representative’ actions.
Implement an independent financial management process to reduce the risk of directors and officers misappropriating company funds or using personal bank accounts. Appoint a financial controller to oversee the policy and require them to report directly to the major shareholders to maintain independence from the statutory representative.
Unlike Western jurisdictions, signing authority in China is primarily controlled by a company’s corporate seal rather than a single person’s signature alone. Adopt a corporate seal policy that designates an officer as custodian to control internal access to the seal and restrict the statutory representative from executing agreements without shareholder authorization or in violation of the articles. Require that the custodian be appointed by and report to the major shareholders and operate independently to reduce the risk of seal use in violation of board or shareholder approvals.
Adopt an incentive policy that provides directors and officers with incentives such as stock options, annual bonuses, or fringe benefits to reward for driving business performance, which will mitigate the risk of unauthorized acts. Negotiate and define the incentives in a written agreement with your D&O, but especially the statutory representative.
How to Deal with Unauthorized Transactions & Acts
Even with controls in place, a statutory representative may still breach fiduciary duties and act without authority. Businesses should thus take proactive legal action to mitigate harm from unauthorized acts that nonetheless bind the company under apparent authority.
Notices and reports. Unauthorized acts taken under apparent authority often involve large sums of money and may constitute crimes. In addition to the acts provided in § 181 of China’s Company Act, these include unauthorized:
- Deals;
- Asset disposal;
- Asset purchases;
- Leasing;
- Financing;
- Loan guarantees; and
- Personal receipt of contract payments.
Have a business process requiring staff to report suspected intentional breaches of director or officer’s duty of loyalty to law enforcement for potential prosecution of the perpetrator and any accomplices. Failure to report can constitute a termination for failure to follow instructions, in which case they are denied the statutory severance pay. (see the full CBL explainer here)
Promptly notify any counterparty that relied in good faith on the statutory representative’s apparent authority that the acts lacked authorization from the board or shareholders or issue public notice if necessary. Where applicable, rescind the transaction pursuant to §§ 146, 148, or 149 of the China Civil Code, or assert invalidity under § 153.
Prove bad faith. If the statutory representative acted for personal gain and the counterparty participated or should have been aware, gather evidence that the counterparty acted in bad faith to avoid apparent authority liability under the representative authority provisions in the articles of formation.
§ 7(a) of the Civil Code Security Interest Adjudicative Guidelines (China Supreme Court) directs courts to apply §§ 61 and 504 of the Civil Code when evaluating a counterparty’s good faith after a statutory representative enters into an unauthorized security interest agreement.[2]
Whether a counterparty acted in good faith depends on if they knew or should have known that the representative exceeded authority under § 7(b) of the Guidelines. Actual knowledge is a fact question provable by evidence, while whether the counterparty should have known is a legal question informed by practice.
The China National Judicial Conference Minutes (China Supreme Court [2019] No. 254) provides that a security interest requires authorization by a board or shareholders’ resolution.[1] Counterparties are expected to verify that such a resolution exists, and any acts taken without proper authorization may exceed the representative’s authority and support invalidation of the security interest agreement.
Take legal action to recover losses. Under §§ 148 and 150 of the China Company Act, directors, supervisors, and executives owe fiduciary duties and must not use their position for personal gain. This also extends to the statutory representative, and companies are entitled to claim damages and disgorgement for losses caused by unauthorized acts.
Conclusion
Even though a company may still be bound by unauthorized acts taken by directors and officers due to the statutory representative’s expansive power, you can take action to deter abuse of authority and mitigate any resulting harm.
Define director, officer, and statutory representative authority in the articles of formation for your China company, including monetary thresholds for contracts and approval requirements for transactions above those limits to allocate internal responsibility and guide oversight. Add procedural protections, such as requiring the statutory representative to fully inform the counterparty and disclosing documents, which can deter abuse of authority by imposing liability. Provide in governing documents that the company may recover losses from unauthorized acts and authorize the board and shareholders’ meeting to adopt rules governing how the representative exercises authority internally in dealings with third parties.
Lastly, include authority limits within the governance structure and implement robust seal controls and contract approval rules to improve oversight and accountability.
Further Reading
Managing China Company Governance Legal Risks
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Sources
[1] National Judicial Conference Minutes (全国法院民商事审判工作会议纪要), (China Supreme Court, Nov. 14, 2019), https://www.court.gov.cn/zixun/xiangqing/199691.html (in Mandarin)
[2] Civil Code Security Interest Adjudicative Guidelines (最高人民法院关于适用《中华人民共和国民法典》有关担保制度的解释), (China Supreme Court, Dec. 31, 2020), https://fgw.sh.gov.cn/cmsres/29/29ccf1b2886f4a82abaaae59686694d7/3cf160197afff88a1f29cd3ee7f35522.pdf (in Mandarin)