A New Chapter: The Beginning of the Next Evolutionary Phase of the New PRC Company Law – Part III: Liability

Other Author      Elfie Wang of Meng Bo Law Office, a PRC law firm based in Shanghai, with which Mayer Brown has a close working relationship.

China’s long-awaited amended Company Law (New Company Law) was enacted on 29 December 2023, effective from 1 July 2024. The new amendments are arguably the most significant since China established its company law regime back in 1993.

Part I of this series (and the subsequent update) considered issues relating to Capital Contributions, followed in Part II by discussing changes impacting corporate governance.

This third part of our series of updates concerns liability. The New Company Law contains several provisions either introducing new areas of potential liability or re-enforcing/expanding existing requirements.

These issues relate not only to directors but also supervisor, senior management team executives (Senior Company Officers) and shareholders.

Strengthening Internal Checks and Balances

An important feature of the New Company Law is a departure from corporate structures dominated by shareholders; to a new legal framework that encourages scrutiny through a much more independent board – and Senior Company Officers expected to act in the interests of the Company, rather than a dominant shareholder.

Shareholder activities/Senior Company Officers - The New Company Law seeks to encourage better internal policing of shareholder activities by making Senior Company Officers liable if they assist or ignore shareholder wrongdoing in certain cases.

Senior Company Officers can make demands of shareholders and shareholder ability to replace troublesome directors has been weakened, as the right to replace at will is now challengeable.

For example:-

• If a shareholder makes a false capital contribution or has failed to make a contribution on time, they may be fined.
• To encourage internal self-policing, individuals in charge and individuals directly responsible for making false capital contribution may be fined in their personal capacity.
• Senior Company Officers may be liable if they are involved in or fail to oppose shareholder abuse of power.

Shadow Directors/Shareholders - A further tightening of responsibility within the corporate structure concerns parties that may not hold office or are registered shareholders, but nevertheless enjoy control. 

• Parties that enjoy de-facto effective control¹ and are able to instruct directors or senior managers can now be held jointly liable for conduct deemed damaging to the interests of the company or its shareholders.
• The New Company Law also recognises the fact that controlling Shareholders² often control the acts and decisions made by directors. A provision states that where the controlling shareholder does not serve as director – but nevertheless controls the actions of directors – it would assume a duty of loyalty and diligence towards the company and will bare liability. 

Shared Liability Following Share Transfers

The discussion above concerns ways in which the New Company Law encourages internal checks by encouraging a more independent board, while Senior Company Officers have significant duties to look after the interests of the Company (with less scope for inappropriate shareholder direction). 

New provisions regarding share transfers appear to take a similar approach; introducing new checks on shareholder responsibilities in respect of Capital Contributions by imposing shared shareholder liability in certain circumstances between transferors and transferees (Article 88). 

• Where there is outstanding Registered Capital at the time of a transfer, if the transferee subsequently fails to make the contribution on time, the transferor will share liability to do so! 
• Similar rules apply in respect of transferred registered capital where future capital contribution obligations are not performed – the transferor will be jointly liability in respect of the shortfall. 

The impact of these provisions is likely to be significant and will certainly require careful documentation preparation, with transferees and transferors forced to safeguard the interests of the Company by ensuring their own interests are protected.

Corporate Structures

A number of provisions may also impact the way corporate groups are structured.

New potential areas of shareholder liability surround operations involving multiple companies. Where debts are evaded through use of two or more companies, it’s possible that each company may be required to bear joint and several liability for such debts. 

As noted, there are provisions regarding de-facto controllers and controlling shareholders. Such parties who instruct Senior Company Officers to carry out acts damaging the interests of a Company can be held liable; as if they had fiduciary duty to act in the interests of the Company they control (Article 180) and will share liability with the Senior Company Officers they instruct (Article 192).

It is also worth note that under Article 189, shareholders have a new right to take action against Senior Company Officers of wholly owned subsidiaries - exposing such persons to greater scrutiny and potential liability, which strengthens shareholder protection.

Duties of Senior Management

Fiduciary Duty and Duty of Diligence - Similar to many other jurisdictions, the Company Law has after many years imposed fiduciary duties and duties of Senior Company Officers, but provides no clear definition of such duties. 

Providing some clarification, among other things it requires:

• While senior management are already prohibited from concluding contracts or trading with the company in violation of the company’s Articles without the consent of shareholders, the New Company Law expands such requirement to supervisors as well. 
• Senior Company Officers must report to the Board or shareholders and obtain their approval, as required by the company’s Articles, before contracting or trading with the company either directly or indirectly. 
• Transactions with Senior Company Officers' close relatives, enterprises directly or indirectly controlled by Senior Company Officers or their close relatives, and other connected persons of Senior Company Officers, shall comply with such requirement as well.

Personal liability – There is a significant expansion of circumstances in which individual Senior Company Officers can be held personally liable.

• Senior Company Officers are liable in their personal capacity for any losses caused by shareholder withdraw of capital in violation of laws and administrative regulations, distribution of profits in violation of the law, and capital reduction in violation of the new law. Moreover, Senior Company Officers may even be personally liable towards third parties. Clause 191 of the New Company Law states that Senior Company Officers can be held personally liable if he/she performs his/her duties in a way that causes damage "to others", where the company is liable to pay compensation for wilful or gross negligence. 
• Senior Company Officers need to be aware that potential liability under the New Company Law can involve civil liability, administrative penalties and even criminal liability in serious cases. The Amendment XII to the PRC Criminal Law provides that certain individuals in non-state owned enterprises such as Senior Company Officers may also be exposed to criminal liability in very serious cases; such as (i) where an individual obtains illegal benefits by effectively operating the company business in their own interests or for another party, or (ii) undertaking a competing business to the company in which they hold the office in a way that results in severe losses to the company.
• In case the company is to be liquidated, the directors are ultimately responsible for the liquidation (and must form a liquidation committee). This is a departure from the current law (where the shareholders have such responsibilities). Very significantly, such directors can be held personally liable if they fail to perform relevant liquidation obligations and cause losses to the company or creditors.
• Where directors and senior managers following the instruction of a Controlling Shareholder cause losses or damage company interests, the directors and senior managers involved can be held to be jointly liable with the controlling shareholder. 

Need for Action

The amendments to the Company Law will expose Senior Company Officials and shareholders to new responsibilities. Senior Company Officials may face administrative penalties or liability to third parties if they fail to act against non-compliant shareholders.

Equity Transfer Agreements will need to be carefully drafted in view of the shared liability for contributions of registered capital – for example, additional indemnity provisions and guarantees may need to be considered.

The days of board meetings essentially being shareholder meetings are also numbered as directors are now expected to act independently; while there is considerable new encouragement for boards to also be more independent.

There are also some potential gaps in the new framework being introduced. 

For example, if a Senior Company Officer causes loss to a company due to misconduct, shareholders can take action after first asking the company’s supervisory body to act. However, as noted in our earlier update, some companies may not have a supervisory body/supervisor - in which case it remains unclear if immediate shareholder action is possible.

A number of Labour Law issues also arise from the introduction of new rights granted to shareholders and Senior Company Officials under the New Company Law. 

The new arrangements regarding Controlling Shareholders and Effective Controllers may complicate employee disputes where a parent company intervenes with the operations of a subsidiary. In addition, the right of a shareholder to simply remove directors is now subject to challenge – which could make such dismissals more complex (and may require much more careful drafting of directors’ service agreements at the outset).

Related to the above will be the need to provide comfort to Senior Company Officers worried about potential new liability. Some may be reluctant to accept appointments without protection.

This also raises questions about Management Agreements – for example, a hotel might be subject to a management agreement where employees of hotel owner are subject to direction from a third-party management company. The New Company Law may well mean that such arrangements will need review.

On-going Review

It should be noted that the Foreign Investment Law (effective from 1st January 2020) requires all foreign invested enterprises to comply with the Company Law in terms of organisational form (for example old fashioned Cooperative Joint Ventures need to restructure) by the 31st of December 2024 - only six months after the New Company Law comes into effect. 

Given the need for clarity in some areas, this will be a very challenging timeframe for many companies.

Clearly all companies need to be aware of the changes being introduced – and will need to examine internal structures, shareholder agreements, labour contracts and potentially management agreements in order to ensure that the balance of responsibility and liability is appropriately structured. 

Given that some matters will require clarification – and potentially new regulations – this will need to be an on-going process.

¹ De-factor controller refers to the person who, through an investment relationship, agreement or other arrangement, is able to exercise a dominant influence over the company's business and corporate governance.

² Controlling shareholders refers to the shareholder whose capital contributions account for more than fifty percent of the total capital of a limited liability company, and the shareholder whose capital contributions or shareholdings are less than fifty percent but whose voting rights based on their capital contributions or shareholdings are sufficient to have a significant impact on the resolutions of the shareholders' meeting.