A company organized in China traditionally had to install a board of supervisors, which would provide governance oversight. However, this requirement has proved burdensome and led to complaints among businesses. The revised China Companies Act of 2024 includes provisions allowing limited liability companies and corporations to establish American-style audit committees as a replacement or complement to the board of supervisors. This means you can specify in the Articles of Incorporation whether to have either an audit committee or board of supervisors, or to use both simultaneously.
The revised Act aims to enable bespoke private ordering of governance, and therefore gives a lot of choices in how to customize your governance. While a company may elect to utilize the traditional governance structure composed of both supervisors and a board of directors, the audit committee is worth considering for China businesses that want a more streamlined governance structure that can make decisions faster. The China Companies Act provides a great deal of flexibility in who is qualified to serve on an audit committee and how it operates. To help make sense of these choices, this article will walk you through the available options while ensuring you remain compliant with the oversight rules.
Four Choices for Structuring Oversight Governance
Appointment of Audit Committee Members
Audit Committee Powers and Rules of Order
Four Choices for Structuring Oversight Governance
Under the current China Companies Act, you have four choices of how to structure your governance oversight structure. First, you can establish an audit committee subordinate to the board of directors, replacing the board of supervisors. Second, you can also use both an audit committee and a board of supervisors but divide power between them. Third, you can use the traditional approach with only a board of supervisors, and a similar fourth option is to use a sole supervisor.
Use No Oversight Structure at All
The revised Act offers simplified governance structure requirements for eligible small businesses, which are any categorized as a “small or medium enterprise.” The Act at §75 and 83 allows limited liability companies (LLC) to use a sole director who is also a manager as their entire governance structure, freeing them from having to set up a board of directors, audit committee, or board of supervisors.
They may also designate a sole supervisor in lieu of a board of supervisors, and with a unanimous consent the shareholders may forego supervisors entirely. The Act does not have size rules about what constitutes “small” and instead gives broad administrative discretion to local regulators, and in turn those officials published guidance saying, “there are currently no rules on what business size is ‘small’. A business’s size is determined by the number of shareholders, scale of its business and assets, and total employees. In absence of applicable rules, we will use what the company includes in its declaration.”
While that sounds like a blank check, Chinese regulators making vague statements have been known to flip-flop. Before making a corporate filing with the business registrar to take advantage of simplified small business governance rules, it’s essential to have your lawyer consult with the local market regulator to gain clarity on what decision they will make.
Some attorneys in China say you can rely on the Ministry of Industry and Information Technology Rule No. 300 (2011), which defines size categories for small and medium enterprises in a variety of categories, but its applicability is debatable because these rules are outdated and were not intended to interpret corporate governance rules.
Designate a Board of Supervisors with no Audit Committee
When designating a board of supervisors, you must have at least three Supervisors. The China Companies Act §83 allows using a sole supervisor or alternatively a board of at least three supervisors; a two-supervisor board is not permitted under China’s revised policy because it can lead to deadlocks on the board. Some companies legitimately want to use exactly two supervisors on their board; here, regulators in different locales have different rules. In some jurisdictions, they will allow you to use two supervisors, but other jurisdictions insist you choose either between a sole supervisor or a board with at least three supervisors.
Set up a Sole Supervisor but no Audit Committee
The China Companies Act allows you to elect against using full supervisory board if that is what will best suit your needs. But this option is not ideal for all cases; minority shareholders not participating in business management should consider requesting a board of supervisors or sole supervisor, because the audit committee answers to the board of directors, therefore has less independence. Another benefit is the law is well understood in these cases where shareholder interests may sharply diverge, as the Act’s long-standing supervisor provisions predating its revision still apply.
Set up only an audit committee
The China Companies Act of 2024 has a corporate governance framework that allows for LLCs to use an audit committee to perform the board of supervisors roles, thus simplifying governance. A director or an employee representative may serve as on the audit committee; unanimous shareholder consent may be used to entirely waive the audit committee and shareholder requirement for a small business. In companies where shareholders manage the company and serve as directors, minority shareholders should consider adding more audit committee members.
Appointment of Audit Committee Members
The China Companies Act is silent on the appointment of audit committee members, leaving unresolved whether shareholders or the board should select them. One interpretation favors shareholder authority under China Companies Act §46 and §59 which provides freedom to write bylaws governing the LLC’s structure, procedure, and meetings, and therefore audit committee appointments are also reserved to the Articles.
An alternative interpretation holds that power to appoint audit committee members is vested in the board because, firstly, the Act §67 requires a board of directors be established to make decisions about how to set up the company’s departments, secondly, the audit committee under the Act answers to the board of directors. (Note that a board of directors is optional if the LLC is eligible for the §75 simplified procedures.)
Audit committee setup is subject to Chinese legal rules requiring shareholder approval for any change to a business entity’s structure. Therefore, the way audit committee members are appointed should be provided for in the articles of formation by the shareholders. While the China Companies Act does not provide for who is empowered to appoint subsequent audit committee members, the company articles of formation may include rules for their nomination and election.
The Act §69 permits the directors to set up an audit committee in lieu of a board of supervisors, eliminating the need for supervisors altogether; directors who are employee representatives may also serve on the audit committee. However, this raises questions about conflicts of interest. The Act requires that the employee representative directors must be selected either by a meeting of all the employees or a meeting of the employees’ representatives, or through any other kind of electoral process. The audit committee members on the other hand are selected by the board of directors, who are not aligned with the employees. This conflict requires careful internal governance and management strategy planning to resolve.
Audit Committee Powers and Rules of Order
The law on audit committees in China is very new, and there is virtually no case law or guidance on a number of key questions. Moreover, there are some questions about whether the rights granted to the board of supervisors by China Companies Act §78 can be handed over to the audit committee, in particular: financial oversight, management performance review, calling special shareholder meetings, and to file derivative lawsuits. While the Act is silent on these matters, one view holds that audit committee role is limited to oversight as in public companies, while the contrary view holds, they have all powers normally vested in the board of supervisors.
There is also currently doubt as to whether the audit committee is empowered to file a derivative lawsuit against the management; while the statute implies, they can, audit committee members are different from the board of supervisors in this respect because they have inherent conflicts of interest. This is a governance issue that should be tailored to the needs of the specific company.
Many lawyers have suggested that there is a body of existing law on audit committees in China’s corporate law regime, but these arguments are controversial. While audit committees only recently appeared in the China Companies Act, but their introduction can be traced back to the Public Companies Governance Standards. Audit committee rules then appeared in the State Council Guidance on State Owned Corporate Entity Governance Structures, which provided for ad hoc committees to counsel the board of directors on audits, nomination, compensation, and evaluation; it also, recommended that independent directors serve on compensation and evaluation committees.
The role of public and state-owned company committees is to assist the board in discharging its duties, which is a substantially different role from that served by this kind of audit committee. Under the China Companies Act §69, the audit committee’s role is a substitute for the oversight function of the board of supervisors.
Some law professors in China have pointed out that the securities regulation audit committee concept is narrowly construed, whereas the Companies Act audit committee is broadly construed, and therefore the two concepts cannot be conflated. This commentary raises the question as to whether the board of supervisors authority can be directly substituted with that of the audit committee.
Conclusion
Recent changes to Chinese corporate law now allow companies to dispense with using a board of supervisors and instead use Western-style audit committees, offering significant flexibility to customize oversight governance structures. The law’s short history however means that there are many questions about how to interpret the law that could arise in the event of a dispute. Therefore, parties should consult with a lawyer and regulators to come to a mutual understanding of how their company will be governed.