Chinese law provides minority shareholders with robust avenues to pursue derivative litigation for breach of fiduciary duty, because it sees them as structurally vulnerable in corporate governance. Despite various statutory rights in China, their interests are often harmed when controlling shareholders, ultimate beneficiaries, or executives abuse their power. Minority shareholders may bring derivative litigation to recover losses indirectly, but they must meet derivative standing and satisfy procedural requirements. Because fiduciary breach sounds in tort, minority shareholders may lose relief if they do not file within two years of discovering the harm. Common fiduciary breaches include related-party transactions and corporate opportunity usurpation. Beyond proving tort elements, plaintiffs must also show noncompliance with the fairness standards or requirements for seizing a corporate opportunity.
In this CBL explainer, we’ll go over the breach of fiduciary duty claims, derivative litigation prerequisites, and fairness standards and requirements for seizing a corporate opportunity, to help identify the elements required, and offer strategies to protect minority shareholder rights.
Contents
- Derivative Litigation
- Suit Standing and Process
- Related Party Transactions and Fairness
- Usurpation of Corporate Opportunities
- Case Study: Shanghai Fluid Equipment Technology
- Conclusion
Breach of Fiduciary Duty Claims in Derivative Litigation
Fiduciary breaches are tort claims, so litigants need to prove tort elements. A controlling shareholder breaches a fiduciary duty when the shareholder abuses power and causes harm to the company, which renders them liable for damages. Since abuse of shareholder rights is common, the China Company Act § 21 explicitly prohibits such abuse and imposes liability for damages on shareholders who abuse their rights, such as to cause harm to the company or other shareholders.[1] The fundamental policy is that shareholders must exercise their rights in accordance with the law and the governance documents.
A claim for breach of fiduciary duty against directors and officers arises when they violate statutes, regulations, or governance documents in the performance of their duties, such as to cause harm to the company. To deter moral hazard, the Company Act imposes duties of loyalty and care on directors and officers and holds them liable for resulting company loss.[1]
Elements. A breach of fiduciary duty claim in China is actually brought as a tort claim. Therefore, a minority shareholder bringing a derivative action must prove the four tort elements:
- Intent: The directors, supervisors, or officers acted intentionally or negligently and harmed the company or shareholders’ interests;
- Breach: An abuse of shareholder rights or a breach of fiduciary duty by directors and officers;
- Damages: Resulting harm to the corporation; and
- Causation: A nexus of causation between the controlling shareholders’, directors’, or officers’ breach and the harm to the company or minority shareholders’ interests.
Failure to prove any of these elements in court by the plaintiff shareholders risks dismissal or adverse judgment.
Derivative Suit Standing and Procedural Requirements
Shareholder standing and pre-suit demand are usually required to bring a derivative action in China. To start off with, shareholder status is the prerequisite for enforcing shareholder interests. To bring an action, the plaintiff must be a shareholder at the time of filing. Shareholder derivative litigation allows a shareholder to sue in their own name on behalf of the company.
In an LLC, members have derivative standing, whereas in a corporation, shareholders must meet statutory ownership thresholds, which require at least 1% ownership interest held individually or jointly for at least 180 consecutive days.
Procedural prerequisites. Under the China Company Act and applicable case law, any LLC member or corporate shareholder who has held at least 1% ownership interest for 180 consecutive days, either individually or jointly, may demand in writing for the audit committee to file suit.[1] If the committee or board of directors refuses to sue or does not sue within 30 days after receiving the demand, or if delay would cause irreparable harm to the company’s interests, or if urgent, the member or shareholder may sue in their own name on behalf of the company against controlling shareholders, ultimate beneficiaries, directors, or officers to recover losses sustained by the company.
Except if urgent or where delay would cause irreparable harm to the company, a shareholder in China must make a pre-suit demand on the audit committee as required by the prior provision and case law; shareholders may sue derivatively only if the audit committee refuses or fails to act.
Common Fiduciary Breach: Related Party Transactions and Fairness Standards
Beyond tort elements, minority shareholders challenging a related party transaction must also prove noncompliance with fairness standards.
The Chinese law permits related party transactions but prohibits transactions that harm the company. Affiliates must ensure that transactions are fair and do not harm any party’s interests, or they may be liable for damages. The company must do a substantive fairness review to ensure no harm occurs. This review looks for three factors that are prerequisites for a valid related party transaction:
Information disclosure. Full disclosure is necessary for fairness in related-party transactions. The Chinese law requires disclosure of the relationship with the affiliates, the proposed transaction, the price, any security interests, and the pricing method.
Fair dealing. Related-party transactions in China must follow the company’s internal fairness procedures, including review and approval by the company’s governing bodies under applicable law and governance documents. The related party and its affiliates must abstain from voting. Such a transaction will not be voidable if approved by disinterested directors and the shareholders’ meeting. A vote in favor of a majority of disinterested directors ratifies it on behalf of the company. A disinterested director is a director who is not a party to the transaction, has no direct or indirect interest in the transaction, and has no material relationship (family, business, professional, or employment) with any interested director.
Fair value. To be legal, the related party transaction must also satisfy substantive fairness in addition to adequate disclosure and procedural compliance. Fair value means the transaction is a measure of actual commercial value and is fair to the company and other shareholders.
In Shaanxi Turbines v. Gao and Cheng, China Supreme Court held Gao and Cheng liable for the company’s losses from a related-party transaction.[2] In China, a related-party transaction is valid if it satisfies a multi-factor test grounded in directors’ and officers’ duties of loyalty, care, and disclosure. Here, Gao and Cheng, directors of Shaanxi Turbines, transacted with another company they collectively owned 60% of, making the deal a related-party transaction. They failed to disclose the transaction to Shaanxi Turbines and used it to inflate the prices of Shaanxi Turbines’s purchases. That conduct violated the fairness requirements of full disclosure, fair dealing, and fair value, causing corporate waste and harming Shaanxi Turbines. Therefore, the court held them liable for Company A’s $1.03 million USD loss.
A breach of fiduciary duty via related party transactions sounds in tort; minority shareholders may bring derivative litigation within two years from when they knew or should have known of the harm. Knowing when to act to preserve recovery rights can be difficult; consult a CBL legal expert to help you navigate this.
Common Fiduciary Breach: Usurpation of Corporate Opportunities and Tests
In corporate opportunity cases, Chinese courts determine a corporate opportunity procedurally and substantively and apply multiple tests to identify usurpation of corporate opportunities.
Corporate Opportunity Test. Attribution is determined by reviewing both the stated and substantive business purposes. The formal review involves verifying the business purpose shown on the business filings, recognizing that related opportunities may belong to the company even if not yet pursued.
The substantive review involves examining actual operations when the opportunity falls outside the company’s stated business purpose. Courts in China consider what company resources were invested; whether core assets used originated from the company; and what the counterparty’s expectations were. Here, investment of resources includes the company staffing and financing to obtain the opportunity, for example, preliminary negotiations, contract negotiations, and advance payments.
In this context, company resources encompass whether core capabilities originated from the company, for example, its proprietary technology, customer contacts, and business intelligence. The analysis of counterparty expectations looks into whether the counterparty specifically intended to transact with the company, for example, by sending a business invitation to the executive’s business email address or naming the company as a business partner. Even without a written agreement, intent can be found with the totality of the circumstances, for example, considering the use of the company’s business infrastructure or whether status as an executive enabled the transaction.
What counts as usurpation of a corporate opportunity in China?
Failure to disclose in good faith. Disclosure of a business opportunity should be prompt, truthful, and complete to demonstrate good faith. An executive must disclose the opportunity before pursuing it unless they can demonstrate that the conduct is fair under the circumstances, for example, where there is a short window of opportunity. The disclosure should include the counterparty, subject matter, transaction type, related parties, and major risks, and be sufficient to support informed decision-making by the company, without being compromised by omissions or inaccuracies.
Lack of the company’s informed consent. For LLCs, the executive must demonstrate that the company was fully informed of the opportunity and knowingly waived it. Bad faith may be inferred from fraud, concealment, or conflicts of interest. For example, simultaneously working for a competitor may create a presumption of bad faith.
Case Study: Shanghai Fluid Equipment Technology
In this section, we’ll introduce a case widely cited by law firms in China, because it explains exactly how corporate fiduciary litigation will play out in China.
In Shanghai Fluid Equipment Technology LLC v. Shi (Shanghai Case 0118-cv-17485 (2019)), the Qingpu District Court applied the entire fairness doctrine to attributing business opportunities in a fiduciary duty breach claim, which inquires into the company’s permitted business activities and interest and expectancy to pursue the opportunity.[3] The judge explained, attribution is assessed objectively through a multi-factor test tailored to the context of the parties’ roles. The company’s permitted business activities were dispositive, requiring both procedural and substantive review to determine attribution.
Below, we’ve paraphrased the Chinese court’s judicial opinion, which shows the exact thought process.
Courts in China apply two tests: first, a procedural review to see if the opportunity falls within the registered business activities, then a substantive review to see if it falls within the actual operations. The court also separately examines whether the company has an interest and expectancy to pursue the opportunity. Attribution to the company requires an interest and expectancy to pursue the opportunity.
The judge will consider whether an interest and expectancy were manifested through fiduciary actions, including those of directors and officers, staffing and financing, and if core assets accumulated through its business operations were necessary for the opportunity.
Core assets include inputs that materially enabled the opportunity, such as human capital, financing, information, sales channels, and data. Courts in China also considered the counterparty’s expectations regarding for whom the opportunity was intended. Both academics and practitioners recognize reasonable expectations should be considered. A judge can find there is intent based on the admissible evidence, even if the counterparty does not clearly state their intent.
Courts reviewing for D&O usurpation of corporate opportunity under a good faith standard, looking for whether disclosure was made promptly, truthfully, and completely. Under the limited companies’ contractarian governance theory, D&O must disclose the opportunity to the company first as a condition precedent to deeming the company to have given informed consent.
Good-faith disclosure satisfies the duty of loyalty. A court in China applying the reasonably prudent fiduciary standard requires them to have seasonably disclosed the opportunity before pursuing, unless doing so was nonetheless fair to the company. The disclosure must be truthful, providing accurate, complete information about the opportunity, including the counterparty, transaction type, subject matter, and any other information related to the company’s interests. Directors and officers in China must not misrepresent or withhold material information. Courts judge this based on what a reasonably prudent fiduciary, acting with due care and loyalty, would disclose in similar circumstances. Completeness is satisfied if the company can make an informed decision based on the promptly and fully disclosed information, and does not act on defective information.
After applying the doctrine to the details of the case, Shi was ordered to pay damages in the amount of $1.2 million USD to Shanghai Fluid Equipment Technology LLC.
Conclusion
A fiduciary breach claim is an important method for protecting minority shareholder rights by holding controlling shareholders, ultimate beneficiaries, directors, and officers liable for abuse of power or breach of fiduciary duty. This approach requires minority shareholders to satisfy standing and procedural requirements, gather tort evidence, and develop a litigation strategy supported by controlling precedents to avoid dismissal for insufficient evidence or procedural noncompliance.
To protect minority shareholders, consider the following good practices. Secure contractual protection through shareholders’ agreement. Require disinterested shareholders for approval during decision making. Before pursuing a derivative suit, consider alternative dispute resolution methods to potentially resolve the issue more efficiently and cost-effectively, such as negotiation, arbitration, or mediation. Also consider buyout of the controlling shareholders’ shares at fair value if they divert company assets or withhold dividends.
As the above case shows, Chinese law in this area is highly specialized. If you need assistance, CBL can help you find professional yet affordable lawyers in China to handle fiduciary matters properly.
FURTHER READING
Get more insights on D&O breaches of fiduciary duties and resulting liability in China.
FOOTNOTES
[1] China Company Act (中华人民共和国公司法), (China National Congress, Dec. 29, 2023) (in Mandarin)
[2] Company A v. Gao and Cheng (西安陕鼓汽轮机有限公司、高少华等公司关联交易损害责任纠纷民事再审民事判决书), (China Supreme Court, Dec. 14, 2021) (in Mandarin)
[3] Shanghai Fluid Equipment Technology LLC v. Shi (上海福路流体设备技术有限公司与施志斐损害公司利益责任纠纷一审民事裁定书), (Shanghai Qingqu District Court, Apr. 1, 2021) (in Mandarin)