In today’s China, companies require effective governance structures and compliant operation to provide a foundation for their long-term stability. You run major legal risks that can impair decision-making, business continuity, and risk litigation, if you have weak governance, limited compliance, and bad business practices. This article will go over the several major legal risks and offers practical solutions backed by case studies, so your business in China can compliantly avoid these risks.
Contents
Common Shareholder Governance Problems
Board of Directors Best Practices
Common Shareholder Governance Problems
Non-Compliance with Shareholder Meeting Procedures
In China, the shareholder meeting and board of directors are the crux of major corporate decision-making, therefore your decisions may be invalidated should you fail to comply with the required procedures in the Companies Act or the Articles of Formation. For example, this could result if you give insufficient notice, use the wrong notice method, or do not provide a clear meeting agenda in advance. That can be disruptive to the business, lead to disputes, and make it hard for management to exert control.
Therefore, your China company should ensure the legality of the meetings, by adequately defining a compliant meeting process, including who calls the meeting, and how advanced notification is provided. Ensure that all of the shareholders receive timely notification and there is enough time for them to participate in discussions.
This protects minority shareholders and enhances decision transparency. Establish minute taking rules that require thorough and accurate notes, and have each participant confirm with a signature the contents, so as to ensure the legality and effectiveness, also making it available for inspection or audit. In one case, a company provided only fifteen days’ notice to minority shareholders to attend the meeting, resulting shareholder litigation to invalidate the resolutions. The court in China held the resolution invalid and ordered the company to convene another meeting in a manner that respects the shareholders’ rights to attend. Subsequently, the company amended its procedures and governance practices to comply with its Articles of Formation so as to avoid future problems.
You might have heard English as a second language lawyers describe business structures called Foreign Invested Enterprise (FIE) or Wholly Foreign Owned Enterprise (WFOE), and wonder why they aren’t being mentioned here. Under the China Foreign Investment Act, these exotic acronyms don’t refer to a business structure. They are actually just translations for everyday Chinese words borrowed from a United States law (NAFTA/CFIUS), meaning that a foreign investor owns part or all of an entity. However, the entity you own will usually be a Limited Liability Company (LLC) or a Limited Partnership (LP).
Shareholder Disputes Over Dividend Distributions
The China Companies Act entitles shareholders to request dividends once the company becomes revenue positive, and failure to draft dividend distribution rules can cause those distributions to be unfair. That, in turn causes shareholder disputes that can damage relationships or tarnish the company’s reputation. In China’s cultural context, conflicts can explode when the company becomes revenue positive but each shareholder came to the table with different expectations. Lacking a clear policy to govern dividends and financial transparency aggravates the situation.
Include rules governing dividends in the articles of formation, with specifics about ratios, frequency, and transparency. Making periodic financial disclosures reduce the possibility of shareholder misunderstandings and can facilitate dividend related decision making.
Divergent shareholder expectations can be a problem if the company is not making significant profits; control the situation by adding deliberation rules. In one case, a company was sued by a shareholder who was unhappy with the dividends they were receiving, who then filed a lawsuit and obtained a judgment requiring a payout. Only after losing in court, did the company amend its governance documents to provide for how it would distribute profits and provide periodic financial disclosures.
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Non-compliant Share Transfers
When processing share transfers or change of shareholders, non-compliance with notice provisions or the articles of incorporation rules, especially in right of first refusal or in documentation, can invalidate the sale contract and lead to disputes. The company must therefore follow the notice requirements in the articles of formation to ensure that share transfers are legal. When signing an agreement, have a lawyer review it for legal risks, and protect shareholder rights by updating the appropriate updates to the shareholder ledger and records.
In one case, a shareholder transferred shares to a third party without obtaining authorization; a new shareholder demanded their identity be disclosed, then successfully filed a lawsuit to void the transfer on grounds that their right of first refusal was not honored. Only after being sued, did the company correct deficiencies in its share transfer and document retention processes.
Shareholder Right to Inspect Records is Frustrated
Chinese corporate law guarantees shareholders can have adequate knowledge of governance through the right to inspect corporate records. Shareholders are likely to feel frustrated and may file lawsuits if corporate records such as financial statements or board decisions are withheld. These disputes typically arise from a law of transparency and disclosure about the company’s governance, and they can prove very damaging to the company’s reputation within China.
Include provisions for shareholder rights to inspect corporate records in the articles of formation with disclosure obligations that ensure minority shareholders have the right to view the relevant records. Furthermore, give minority shareholders a representative on the board of directors so that their views are taken into account. Business transparency in China is also important to prevent suspicion, and you can do that by making regular financial disclosures to shareholders, highlighting major transactions and the direction of the business.
In one case, a minority shareholder repeatedly asked to inspect corporate financial documents but was denied. The shareholder sued the company and won, obtaining a court order enabling him to inspect corporate records. After this defeat, the company changed its policies on right to inspect records so that shareholders could appropriately access financial information.
Unequal Shareholder Powers
The shareholders in the company need to have equal kinds of rights, otherwise if a controlling shareholder marginalizes minority participants from decision-making, in the China business context this can cause discord at the company because the minority shareholder’s rights are inadequately protected.
A best practice with China companies is to provide for equality of shareholder rights in the Articles of Formation and Shareholders Cooperation Agreement, specifically governance provisions that ensure that minority shareholders will have a meaningful voice in the decision-making process. Shareholders’ right to participate in material decisions so as to protect their own rights and ensure fair treatment.
In one case, a controlling shareholder used its power to deprive minority shareholders of having a voice in company decisions, angering them and leading to a lawsuit. The held that the parties must change the entity’s governance rules and appoint a representative empowered to protect minority shareholder interests.
Board of Directors Best Practices
Material Decisions without Board Resolution
The company can be seriously damaged for any material decisions made without the requisite shareholders meeting or board of directors’ resolution, and can cast doubt on the legality of the company’s decisions. Material decisions that under the China Companies Act require board of directors’ resolution in China include significant loans, acquisitions, and investments. Failure to follow the required corporate formalities can undermine the legality of the decision, which can make it impossible to perform the contract or otherwise harm shareholders.
Therefore, make sure to establish a clear approval to policy in the Articles of Formation for material decisions that will require material decisions to be approved through board or shareholder resolution, which describes the authority of the executives, directors, and shareholders, ensuring procedural compliance. Retaining legal counsel to review for the legality of corporate decisions can further mitigate legal risks.
In one case in China, a company’s executive entered into a major contract with a third-party company, but without first obtaining board approval, and that contract was subsequently repudiated by the board. That caused the company to be liable for colossal breach of contract damages that resulted in a financial loss. Only after this defeat, did the company amend its procedures to ensure that material decisions have board of director approval.
Undefined Director and Supervisor Duties
Chinese corporate law vests directors and supervisors with power over the management and oversight of the company. However, disorderly decision-making and even executive misconduct or abuse of power can result if these roles are not clearly defines.
Many companies in China fail to provide for robust responsibilities in their governing document, which undermines corporate oversight and shareholder ability to hold executives accountable. Furthermore, lack of definition for these roles limits the ability of the company to hold shareholders and supervisors liable in the event of a major incident where their negligence caused the company serious losses.
Make sure to clearly define in the China company’s Articles of Formation what the powers and duties of directors and supervisors are; divide up management responsibilities clearly to avoid overlap or blind spots. You can ensure strategic goals are still being followed by regularly reviewing and updating director and officer job descriptions. Supervisors and directors should receive legal compliance training so that they perform their duties with greater care, thus reducing legal risks. In one case, a director’s negligence caused substantial losses to the company, resulting in a derivative suit by the minority shareholders. The China court dismissed the claim because the director’s duties were not clearly defined in the Articles. After this defeat, the company amended its governance documents.
Directors’ Violation of Duty of Loyalty and Duty of Care
Chinese corporate law requires directors to avoid conflicts of interests and to refuse receiving improper personal benefits from company transactions, under its requirements of duty of loyalty and duty of care. When a director violates these duties by taking advantage of opportunities belonging to the company or diverting gains towards themselves, the company will face losses and could be sued. In the Chinese cultural context, failure to abide by the duties of loyalty and care means the company is unjust because it is not making decisions objectively, and this will destabilize your governance structure.
To mitigate these risks, require directors to disclose their personal interests and be required to recuse themselves from voting on any matters with which they have a conflict. Conduct regular assessments of whether directors are performing these duties, whether conducted under internal oversight rules or through a third-party auditor. Encourage employees to report suspected fiduciary duty violations and have protocols in place to initiate an independent internal investigation.
In one case, a director in China diverted company resources to support a business he owns. When this was later discovered, the other shareholders filed a lawsuit, and while they successfully recovered damages, they subsequently realized they need stricter disclosure rules and internal controls to prevent it from happening in the future.
Governance Control Over CEO & Executives
Executives not Following the Articles
The China Companies Act envisions the articles of formation provide the legal basis for a company’s subsequent business management by executives. Practices that deviate from the Articles can raise questions about their legality, which can raise legal risks. For example, if a company’s Articles require shareholders meeting approval for certain actions but management proceeds without it, that will cause legal risks and degrade the company’s creditworthiness.
When making material decisions, the company should hold a shareholders meeting or board of directors meeting to deliberate on the decision and take a vote, ensuring compliance with the Articles. Additionally, the Articles of Formation can become outdated over time and need to be updated to see that they conform to current management practices. Undertake periodic compliance reviews to compare management practices with the provisions in the Articles to ensure there is no deviation.
In one case, a company’s executives took action that did not comply with the provisions of the Articles of Formation. Impacted shareholders filed a lawsuit, and obtained a court order invalidating the management’s unauthorized actions. Subsequently, the company amended its articles to ensure that it would accommodate the necessary management practices.
Lack of an Effective Internal Controls Policy
In China, you are likely to encounter serious misconduct by management and financial waste, along with theft of company property and fraudulent financial reporting if you lack effective internal controls. Day to day business operations can be compromised and shareholders angered when inadequate governance framework results in irresponsible management or embezzlement. The company needs to set up a full suite of internal controls with clearly stated objectives, approval policies, and regular financial reviews; involve a third-party auditor to catch serious problems early. Train China based employees in the process so that they take compliance with the internal controls policy seriously, thus reducing legal risks.
In one case with a company based in China, inadequate internal controls enabled a finance department employee to embezzle a substantial portion of the company’s assets. After this nightmare, the company established an effective internal controls policy by setting up approval processes and getting quarterly financial audits, patching the loophole in its governance.
Conclusion
In today’s China, compliance governance is a key pillar in business success. The company can achieve this by using transparent processes and well-defined decision-making processes. Use a software platform to keep and organize records, making them available for legal counsel to periodically review. Proactively ensure shareholders have a voice to avoid internal disputes. Overall, having adequate internal governance processes in your China company will protect you from legal risks and support long-term success. If you need expert advice on handling delicate issues like this, CBL can help you find a lawyer with affordable rates.