5.4.3.2.3 Recommendations to define the interpretation — Guidance from the UK and US

So far, little has been written by scholars on Article 20 and Article 153 in China. This phenomenon is due neither to the lack of noteworthy points for discussions nor to scanty oppressive conduct found in close companies in China. Two reasons have been identified to explain the lack of discussion. Firstly, the newly introduced remedies, with very general provisions, deal with two extremely complicated areas in the company law, namely, shareholder's fiduciary duties and director's fiduciary duties, and it is thus a daunting task to explore the contour of the articles without proper guidance. Secondly, lack of a tradition of reporting cases in China adds extra difficulties in exploring issues regarding these two remedies. In my view, a comparative study in reference to principles developed and experience gained in the UK and US will be helpful. In spite of different ideologies concerning corporate issues, there are common problems in close companies as well as shared concerns in relation to the remedies no matter which jurisdiction we are referring to. The development of the oppression and unfair prejudice remedy can provide us with valuable insight into the scope of the remedy and point out the aspects to which we should pay special attention.

Breach of director's duties falls into one of the case categories in the oppression/unfair prejudice remedy. But because issues regarding director's duties, such as the standards and court opinions, are a complicated area and a huge research topic in themselves, it is too ambitious deal with them in detail here. Furthermore, in close companies, conflicts between shareholders (majority vs minority) are generally more serious than conflicts between shareholders and directors. My suggestions for the application of the oppression remedy in China thus concentrate on Article 20.

As shown in the discussion of the oppression and unfair prejudice remedy, the most important yet most time-consuming task is the construction of "oppressive" and `unfairly prejudicial'. The term "abuse of rights" in Article 20, like "unfairly prejudicial" and "oppressive", is an open-ended term, and experiences from the UK and US have pointed out that to ensure the effective functioning of this remedy, no precise boundaries should be set beforehand, and the court should work on a case by case basis with wide discretion. A clear articulation of judicial standards can nevertheless assist the court in judging cases and foster legal certainty.

After defining the nature of a close company, two standards have been established in the US and UK, namely "enhanced fiduciary duty" by the Massachusetts court and "legitimate expectations" proposed by Lord Hoffinann.1 The fiduciary duty standard attempts to regulate oppressive conduct from the perspective of the majority, i.e. attempts to find misconduct on the majority side and to regulate such behaviour accordingly. The court drew the analogy of a close company to a partnership and imposed the stricter duty of "the utmost good faith and loyalty" on members in close companies.2 The frustration of reasonable expectations, by contrast, shifts the considerations to the minority side, trying to identify the explicit and implicit terras based on which parties come together to set up a business, and the development of such terms over time.3 According to the courts, such expectations are not submerged in the corporate structure.4 Both standards stress the concept of fairness but the standard of frustration of reasonable/legitimate expectations is gaining more popularity because it is relatively easier for the court to apply.5 In view of the common features of UK, US and Chinese close companies and the similarity of the problem of oppression within such companies, the Chinese court should give weight to the standards developed in the UK and US, especially the standard of breach of reasonable expectations which was hailed as "the most important development in the closely held corporation field over the last 20 years."6 Nevertheless, in order to avoid the remedy becoming a "coercive tool" for the minority, several limitations on employing the standard of reasonable expectations have to be observed. Oppression and unfair prejudice are not equivalent to the breakdown of mutual trust and confidence.7 The expectations should be objectively viewed on the basis of terras mutually agreed by shareholders, and the minority shareholders and employees who happen to own stock should be treated differently.8

The interpretation standards from the UK and US also suggest that though the first part of Article 20 aims to prohibit shareholders from acting against the law, the remedy should also include the situation where certain conduct "falls short of actual illegality".9 This position was reflected in the Taifu case judged by the Shanghai No.1 Middle Court.

Taifu was a company in the field of real estate construction. The majority shareholder, Shunda Company, held 85 per cent of Taifu's shares, and the minority shareholder Mr Dong held 15 per cent. In May 2005, the company passed a resolution to increase the registered capital from 21 million RMB to 50 million According to the scheme, 19 million of the increased part was supposed to be paid up by the Shunda Company and Mr Dong in proportion to their original capital contribution to the registered capital, and 10 million was to be paid by a newly introduced member, the Chuangli Company, the so called strategie investor. The resolution was passed according to requirements by law in substance and in procedure. The minority shareholder, Mr Dong, was against the increase and gave up his pre-emptive rights. His part was paid up by Shunda Company. After the increase, the shareholding structure of the company was: 73.7% by Shunda, 20% by the new member, and Mr. Dong 6.3%. In August 2006, Mr Dong filed a lawsuit onder Article 20, alleging that the majority shareholder had increased the registered capital for the purpose of watering down his shareholding and harming his interests in the company.

In this case, the court first confirmed that the resolution was adopted at the general meeting according to law botte substantially and procedurally. But the court also called attention to the issue that when a majority shareholder votes for the resolution, he should not harm the interests of the minority shareholders. The defendant in this case could not offer a reasonable purpose of the increase, so the court found in favour of the plaintiff. But it was not clear how much the notion of "for the best interests of the company" could count in the view of the Chinese court and if permitted, what kinds of reasons contribute to the defence of "for the best interests of the company". In the UK, court decisions in this area are not tidy either.10 The starting point for the court review, as stated in section 4.3.4.2, is bona fide for the benefit of the company as a whole.11 And in a close company where the scale of conflicts between the interests of majority and minority is quite high, such a standard may not always be adequate for the majority shareholders to defend themselves.12 The current trend in UK case law is to endorse stricter security in case of close companies. Specifically, cases are subdivided into two groups: the assertion of "benefits for the company as a whole" advanced by way of avoiding (potential) harm to the company can probably gain support from the court;13 while the allegation of "benefits for the company as a whole" simply based on the majority's belief is less powerful to convince the court, and the possibility of being judged as unfairly prejudicial cannot be ruled out, especially when the action discriminates against the interests of the minority shareholders.14

In this case, the court ruled that the interests of the minority shareholder had been damaged and asked the majority shareholder to compensate the minority shareholder for his loss.15 The Chinese court therefore shares the same view as the UK and US — legal rights should not only be exercised against law, but should not be entirely freely exercisable either. This is progress of the new company law.

Besides the standards and guidance of interpretation, there are also other issues that need clarification for Article 20, such as the meaning of a member 's interests, the eligible petitioner, and the scope of company affairs.

As explained, interests are a wider concept than legal rights.16 They are generally more subjective and "soft" in nature than legal rights. Members of a company might also have different interests even though their rights may be identical. Case law has shown that conduct can be unfairly prejudicial/ oppressive to the minority shareholders even if all members suffer from the same alleged conduct, such as a self-interested transaction controlled by the majority or failure to distribute dividends for a long time.17 An issue for the Chinese court to consider is whether to recognize that in a close company, interests encompass not only the legal rights of the petitioner but also legitimate expectations, which may arise from agreements or understandings between the members,18 and furthermore, whether Article 20 only provides relief for interests harmed by past events or potential harm from proposed acts and anticipated instances of abuse of power can be grounds for relief as well. It is believed that an approach at the level of interests should be different from the approach of rights and involve considerations of the future.19 The position of the UK court is that it is immaterial that there is no immediate threat to the petitioner at the date of the petition onder s. 994; it is sufficient that a prejudicial act has been proposed.20 S. 14.30 in the RMBCA also includes oppressive acts that will happen in the near future. It is wise to prevent the possible damage than to repair harm after the damage has actually been done. So although Article 20 is silent on this point, the court is advised to allow petitions for potential harm by proposed acts, based on the concept of interests.

Both s. 14.30 of the RMBCA and s. 994 (1) of the UK Company Act require the petitioner to be a member of the company. The general understanding is that a former shareholder who later finds unfairly prejudicial conduct at a time when he was a member of the company cannot file a petition.21 Nor can a member make allegations of conduct that pre-dates his registration as shareholder unless the conduct existed before he acquired his shares and still continued after he became a member.22

Under Article 20, a shareholder is liable for compensation if he causes any loss to the company or to other shareholders by abusing his rights. Litigation is thus divided into three categories. The fist category is the interests of shareholders are damaged by the majority. In this case, a shareholder can bring a direct action and the practice summarized in the previous paragraph applies; the second is the interests of the company are harmed by the majority and the company can sue the shareholders. But it is not always in the interests of those controlling the company to sue, therefore, if the company decides not to sue, in the last category, individual shareholders can bring a derivative action. One question arises: when the damage is done directly to the company and indirectly to shareholders, can the minority shareholder be deemed as an eligible petitioner of a direct action for himself? It is unclear from Article 20 in itself. In the UK and US, when the action which infringes the interests of the company also harms the interests of the minority, the line between derivative and direct actions is blurred in the case of close companies. Under these circumstances, a direct action is usually allowed on account of the features of a close company and the limitations on derivative actions.23 As to Article 20, I think it is justifiable to include such situations for direct actions. In other words, the court should take a lenient stance by allowing lawsuits through a direct action which should theoretically be filed under a derivative action; otherwise the biting power of the remedy would be reduced.

But at present, when no exit remedy is available and the only possibility is a claim for compensation, I do not think the court would favour the choice of direct actions when the shareholder is indirectly affected. First of all, when the harm to the company is confirmed, a direct action under this category, instead of exit, only allows the minority shareholder who has petitioned to be compensated, but in a derivative action, the company can be compensated and the damaged interests of all the shareholders can be repaired at the same time. Secondly, the greater the amount of compensation, the more deterrent power against abuse of power is generated by the remedy.24 Under the current provision, the court would therefore be in favour of derivative actions. But direct actions based on this category will certainly make sense when the exit relief is added, which I think is the future direction of reform.

S. 994 of the UK Companies Act requires that claims be based on the company's affairs rather than on personal rights as shareholders.25 Such a limitation is not mentioned in Article 20, but I think the Chinese legislators mean the same.

Another noteworthy issue regarding "company affairs" is how to distinguish company affairs of the parent company from those of its subsidiary. In theory, both the parent and the subsidiary have their own independent personality. Decisions made in the parent company are not recognized as affairs of the subsidiary and the other way around. Shareholders in the subsidiary therefore cannot sue for relief based on decisions made in the parent company; they can only invoke the oppression remedy based on issues within the subsidiary. Nonetheless, in certain situations, when the independent personality is not respected or a clear structure of parent and subsidiary companies is not observed, corporate decisions in the parent company can be taken as company affairs of the subsidiary. In this case, shareholders in the subsidiary can bring actions against decisions made within the parent company as abuse of rights onder the oppression remedy.

This is a thorny issue because it takes time and efforts to develop a guiding line to identify the exceptional situations beyond the general principle of independency of personalities, but it is also an important issue because with the economie development, the business structure in China becomes increasingly delicate and complicated. Accordingly, the form of parent and subsidiary companies will be more and more popular. In particular, the FlEs, except wholly foreign owned ones, involve often than not the form of parent and subsidiary companies.26 Therefore, guidance to distinguish affairs between the parent and subsidiary companies is a precondition to apply the remedy effectively. In fact, the Chinese Supreme Court had drafted a few articles governing the relationship of group companies or parent and subsidiary companies in relation to the revision of the company law, but they were not adopted.27 Three major points of this aspect can be learned from the case law in the UK. Firstly, in the situation of parent and subsidiary companies, if the independent status of the subsidiary is ignored, it is possible for actions carried out by a parent company to be ruled as related to the affairs in the subsidiary company. By the same token, shareholders in the parent company could file suits against conduct within subsidiary companies as coming under the parent's affairs for the purposes of the unfair prejudice remedy under s. 994.28

Secondly, according to case law, the symptoms of ignoring independent status have been reflected so far by loosely planned structure or allowing no possibility of independent decisions by the subsidiaries.

Thirdly, even if an act or decision is recognized as the affairs of the company, and would probably be oppressive in a normal setting, this is not a guarantee of a successful petition in the context of parent and subsidiary companies. The established standard in the UK is that there should be no subordination of interests between each other, and based on the case of Re a company Nicolas, it is even safer to say that the entity is free from punishment if the action, without subordination of interests, was also intended to save the whole group from crisis.29

So far, no established practice or case law can be identified on this aspect based on Article 20 in the Chinese Company Law. Clarification by means of SPC interpretations will be very helpful in the application of this remedy.