what we think

Effective Corporate Governance in China

20 February 2011

Foreign investors generally presume that management problems are inherent to Chinese-foreign joint ventures, but not to companies of which they are the sole shareholder. Unfortunately, this perspective does not take into account the rights and responsibilities of directors and senior managers.

Clients frequently ask us about the rights and responsibilities of directors and senior managers in a foreign-invested enterprise. Unfortunately, many of these clients have experienced directors and senior managers who abuse their positions to pursue private gains. In some cases, a director or general manager with a big influence over the business and factual control of operations will go so far as to refuse to follow the investor’s instructions, threatening the shareholder in order to obtain further financial benefits.

Directors and Senior Managers

The Board of Directors, consisting of at least three persons, is mandatory under the Company Law of the People’s Republic of China (“Company Law”), its directors appointed by the shareholder and registered with the competent registration authority. An exception is made for small-scale companies that benefit from a simple decision-making structure; they can have one Executive Director instead.

Under the Company Law, senior managers in a limited liability company are the general manager, deputy manager(s), chief financial officer or any other persons listed as such in the Articles of Association. In China, registration of the general manager usually is mandatory, while the registration of other senior managers is optional.

A director may concurrently hold the post of general manager, and either the chairman of the Board of Directors, the Executive Director or the general manager may be
appointed as the company’s legal representative, a decision which must be confirmed in the company’s Articles of Association. Under PRC law, the legal representative is the official representative of the company and is entitled to act on the company’s behalf, therefore investors should take extra care to make an appointment which is both practical and safe.

Rights of Directors and Senior Managers

1. The Director’s Authority

Directors shall exercise their authority through the Board of Directors, which in turn is accountable to the shareholder (note that this is different for Chinese-foreign Joint Ventures, where the Board of Directors by law is the highest authority of the company). Article 47 of the Company Law differentiates the functions of the Board of Directors as follows:

  • Statutory functions: responsible for convening shareholders meetings and presenting reports thereto; implementing resolutions adopted by the shareholders; preparing plans for issues such as increasing or reducing the registered capital, annual financial budget, profit distribution, the merger, division, transformation, dissolution and liquidation of the company (subject to shareholder’s approval or decision); appointing orremoving the general manager of the company, appointing or removing, upon the general manager's recommendation, deputy managers of the company and the financial managers, and determining the remuneration for these officers;
  • Functions stipulated in the Articles of Association. A company's Articles of Association are binding on the company, its shareholders, directors, supervisors and senior managers, and in many cases will list a number of decisions which must be made or approved by the Board of Directors.

Problems often arise where a decision, for statutory reasons or as per the company’s Articles of Association, must be made or approved by the Board of Directors but it is difficult to obtain the signatures of the directors. Say for example that the shareholder wishes to increase the registered capital, but one of the directors does not agree or has left the company. Presuming that the director’s agreement is indeed necessary (e.g. if the decision must be unanimous) then the shareholder must first replace the director, and only then can the capital increase by applied for.

2. The Authority of the General Manager and other Senior Managers

Senior managers shall be appointed and dismissed by the Board of Directors. However, presuming that the Articles of Association does not state otherwise, the general manager has the right to propose to appoint or dismiss the company’s deputy general manager(s), chief financial officer and other senior management.

Under the Company Law, the general manager is to implement Board of Directors’ resolutions and is responsible for the company’s business operations. Moreover he shall also engage in activities and have the right to make decisions on matters as provided in the Articles of Association, or as authorized in a resolution of the Board of Directors.

In practice, to prevent the general manager from obtaining too much control over the company’s operations, and to avoid the pursuit of private gains, it is best to include in the Articles of Association a clear scope of the general manager’s scope authority and the limitations thereto; alternatively or in addition, these may be confirmed in a resolution by the Board of Directors.

Obligations of Directors and Senior Managers

The job of director or senior manager also comes with obligations. Directors and senior managers shall bear legal obligations of fidelity and diligence to the company; Articles 148, 149 and 151 of the Company Law provides more details on what this entails. Where directors or senior managers fail in their performance or neglect their duties, this may result in civil liabilities:

  • The income of any director or senior manager from any act in violation of their obligations shall belong to the company.
  • Meanwhile where any director or senior manager violates any law, administrative regulation, or the Articles of Association during the course of performing his duties, if any loss is caused to the company, he shall be liable / responsible for compensation. Note that if involving third parties, the company can generally be held liable for such losses, but in turn it can demand compensation from the responsible Director or senior manager. Article 152 of the Company Law also specifies the shareholder’s right to request the supervisor or the Board of Directors to sue a director or senior manager. In case the supervisor or the Board of Directors fails to do so or in case of an emergency, then the shareholder may, on its own behalf, directly file the lawsuit.

In addition to economic compensation, a director or senior manager may also be held criminally liable for his misconducts, where this constitutes a crime such as of illegal operations or embezzlement. This depends on whether certain standards for criminal liability have been met.

Supervision of Directors and Senior Managers

The amendments to the Company Law in 2006 made the appointment of a supervisor mandatory to all companies in China, including WFOE’s. The supervisor serves as an external controller of the company and mainly supervises the activities of the directors and senior managers to ensure their compliance with relevant PRC laws and the company’s Articles of Association. The supervisor may demand of any director or senior manager that he makes corrections if his act has injured the interests of the company. This is also the reason why by law, a director or senior manager may not concurrently serve as supervisor.

In practice, foreign investors often limit the role of the supervisor, appointing someone who has no knowledge of the business in China. In many cases, investors themselves will actively supervise the activities of directors and senior managers, and indeed they are entitled to terminate a director’s tenure at any time, and may even file a lawsuit against a director or senior manager that damages the shareholders’ interests by violating any law, administrative regulation, or the Article of Association.

Conclusions & Suggestions

The first step to improve the corporate governance of a WFOE is to draft the Articles of Association in a way that properly divides responsibilities and authority between the shareholder, the Board of Directors and senior management, and facilitates decision-making within and by the Board of Directors, and between senior managers.

Next, care must be taken to appoint directors and managers that are actually involved in the business, can bring value to the company, and will communicate well with and, if necessary, follow instructions from the shareholder. The Board of Directors should also establish detailed rules for chop-management, and the authority that senior managers have to approve contracts or engage in other activities.

Finally, it is important to monitor the activities of directors and senior managers. Even a perfectly-designed system can be subject to abuse where implementation is not monitored. After years of operations, directors and managers may be so used to one way of doing things that they forget about the checks and balances that the system was designed with. The shareholder should ensure compliance, or instruct the supervisor to complete this task.