The Company Law of the People’s Republic of China (the “New Company Law“) was amended on December 29, 2023, and significantly expands the duties of directors, supervisors and senior managers (collectively “DSMs”) (for further details, please refer to Impact of the Amendment to PRC Company Law on Compliance Obligations and Risks for Directors, Supervisors and Senior Managers). This is the first time that the duty of diligence for DSMs has been explicitly defined at the level of stipulated law and is one of the highlights of the New Company Law.
According to the new law and judicial practice, if DSMs violate their statutory duties and cause losses to a company, the company or the shareholders (subrogated) can file a case for damages to the company’s interests. We have dealt with a number of these cases in recent years and this article summarizes the legislative history of the duty of diligence for DSMs, outlines our observations and thoughts on such cases, and predicts the influence of the New Company Law on judicial proceedings.
I. The Legislative History of the Duty of Diligence
Before the promulgation of the New Company Law, there was no clear definition of “duty of diligence” in laws.
The concept of the duty of diligence was first introduced into the Chinese legal system when the Company Law was amended in 2005. Article 148 of the Company Law (amended in 2005) stipulates that, “Directors, supervisors, and senior managers shall comply with the laws, administrative regulations, and the articles of association of the company, and shall have the duty of loyalty and diligence to the company.” After amendments in 2013 and 2018, the duty of diligence was outlined in Article 147(1) of the current Company Law (amended in 2018), which reads, “Directors, supervisors and senior managers shall comply with the laws, administrative regulations and the articles of association of the company and shall have the duty of loyalty and diligence to the company.” However, the PRC Company Law stipulated a duty of loyalty and diligence in principle only, and did not define the duty of diligence, or the specific behaviors corresponding to the duty of diligence.
On May 1, 2009, The Law of the People’s Republic of China on State-owned Assets of Enterprises came into force. Article 26 of the Law stipulates that, “Directors, supervisors and senior managers of state-invested enterprises shall comply with laws, administrative regulations and the articles of association of the enterprise, shall have the duty of loyalty and diligence to the enterprise, and shall not use their positions to accept bribes or obtain other illegal incomes and benefits, encroach or misappropriate the assets of the enterprise, make decisions on major matters without authorization or in violation of procedures, or engage in other acts that infringe upon the rights and interests of investors of state-owned asset.” The law is applicable to the DSMs of state-invested enterprises and lists the behaviors prohibited by the duty of diligence in the form of a negative list, indirectly indicating that the duty of diligence is to be performed within the scope of authority and in accordance with the procedural requirements.
On December 15, 2023, The Guideline on the Articles of Association of Listed Companies (amended in 2023) was implemented1. Article 98 stipulates that “Directors shall comply with the laws, administrative regulations and the Articles of Association, and shall have the following duty of diligence to the company: (i) they shall exercise the rights conferred by the company in a prudent, conscientious and diligent manner, so as to ensure that the company’s business conduct complies with the requirements of the national laws, administrative regulations and various national economic policies, and that the business activities do not exceed the business scope stipulated in the business license; (ii) shall treat all shareholders fairly; (iii) shall keep abreast of the company’s business operation and management status; (iv) shall sign a written confirmation of the company’s periodic reports and ensure that the information disclosed by the Company is true, accurate and complete; (v) shall truthfully provide the board of supervisors with relevant information and data, and shall not impede the board of supervisors or supervisors from exercising their powers; and (vi) other duties of diligence as stipulated in the laws, administrative regulations, departmental rules and the Articles of Association.” The guideline lists the specific codes of practice of the duty of diligence in detail, and contains references for the judiciary. However the Guideline is only applicable to the directors of listed enterprises and is not generally applicable to non-listed ones. Additionally, it is only a departmental normative document in terms of legal hierarchy and does not have any mandatory legal effect.
On December 29, 2023, the Seventh Session of the Standing Committee of the National People’s Congress passed the New Company Law, which will come into force on July 1, 2024. For the first time, the New Company Law provides a clear definition of the duty of diligence, and Article 180, paragraph 2 states that “directors, supervisors and senior managers have the duty of diligence to the company and shall perform their duties with all the reasonable care that a manager should normally exercise in the best interests of the company.” In the initial review in December 2021, the second review in December 2022, and the third review in August 2023, the aforementioned provision of the duty of diligence was retained without change.
The legislator adopts a subjective and objective judgment in defining the duty of diligence: (1) subjectively, DSMs should perform their duties in good faith in the best interests of a company; (2) objectively, DSMs should have the appropriate ability to manage a company’s affairs in their positions to reflect their performance of the duty of reasonable care.
II. Our Observations on the Current State of the Legislation
Obligation without responsibility is easily turned into castles in the air. The obligation of DSMs and the liability for a breach of this obligation are stipulated in different articles of the company law, and the scope of the obligation and the liability have slightly different wording, which adds confusion as to whether this has been designed intentionally. Take the current Company Law (amended in 2018) as an example:
Paragraph 1 of Article 147 of the Company Law (Amended in 2018) provides that “Directors, supervisors and senior managers shall comply with the laws, administrative regulations and the articles of association of the company and shall have a duty of loyalty and diligence to the company.“
The liability of DSMs is also set out in Article 149, which provides that “Directors, supervisors and senior managers shall bear compensation liability for the losses caused to the company if they violate the laws, administrative regulations or the articles of association of the company in the course of performing their duties for the company.“
The law stipulates that DSMs shall comply with the laws, administrative regulations and the articles of association of the company and shall have a duty of loyalty and diligence to the company. The law also emphasizes that DSMs shall bear liability when they violate the laws, administrative regulations or the articles of association of the company.
This legislative approach separates obligations and liabilities and raises questions for both enterprises and courts:
What is the relationship between DSMs’ compliance with the laws, administrative regulations and articles of association of a company and their compliance with the duties of loyalty and diligence?
If both obligation and liabilities exist in a parallel manner, does the duty of diligence become an obligation without any corresponding liability?
If the two overlap, are the DSMs’ duties of loyalty and diligence limited to the laws, administrative regulations and articles of association of the company? Should DSMs be held liable for acts that are inconsistent with the business logic or other management systems of the company without violating the laws, administrative regulations or articles of association of the company?
The enactment of the New Company Law has not changed the legislative approach which separates obligation and liability; therefore these questions remain unanswered at a legislative level.
III. Our Observations on the Current Judicial Practice
Because the questions above have not been clearly answered at the legislative level, the courts have dealt with cases relating to the duty of diligence differently, leading to a lack of uniformity in the judicial outcome of cases concerning the duty of diligence. Specifically:
1. Definition of the Duty of Diligence
From our observations, the majority of courts have formed a relatively unified criteria for the definition of the duty of diligence, and this is similar to the definition of the New Company Law. For example, as early as 2007, in the (2007) Ci Civil II Initial No. 519 case2, the court held that “the duty of diligence in the company law is similar to the duty of care in the tort law, that is, DSMs must be prudent in the fulfillment of the duty to realize the company’s best interests like a normal prudent person in a similar situation“. In the (2020) Supreme Court Civil Appeal No. 640 case, the Supreme People’s Court also held that “senior managers of a company should perform their duties in the best interests of the company with the carefulness of a benevolent manager and the reasonable care of an ordinarily prudent person“. In a recent case we dealt with, an intermediate court held that “The duty of diligence means that senior managers should perform their duties in the best interests of the company with the carefulness of a benevolent manager and the reasonable care of an ordinary prudent person. …… The duty of diligence requires performing the duty of reasonable care to the extent that an ordinary prudent person would be expected to do in similar situations…….”
Nevertheless, due to a lack of a clear definition of the duty of diligence at the legislative level, some courts do not specifically interpret the duty of diligence when adjudicating these types of cases, and directly judge whether DSMs should bear the liability based on the provisions of the liability of DSMs, as detailed in Part 2 below.
2. Liability for Breaching the Duty of Diligence
There are different views in legal practice as to whether the circumstances under which DSMs bear liability for a company’s losses are limited to the violation of the laws, regulations and articles of association of the company.
In determining the liability of DSMs for a breach of duties, some courts have directly examined whether DSMs have violated the specific provisions of the laws, regulations and the articles of association of the company, and when DSMs have not violated such provisions, the court will not continue to substantively examine whether the specific acts of DSMs have violated the duty of diligence. For example, in the (2020) Supreme Court Civil Appeal No. 640 case mentioned above, though the Supreme Court interpreted the duty of diligence, the Court ultimately emphasized that “In situations that do not involve a possible breach of the duty of loyalty, such as a conflict between the personal interests of a company’s senior managers and the interests of the company, the acts of a company’s senior managers in performing their business management duties in accordance with the law and the articles of association of the company shall be recognized and protected by the law. ” In the (2021) Beijing 01 Civil Final No. 1688 case, the Beijing No. 1 Intermediate People’s Court held that the company’s senior managers “knew that internal procedures are required for external borrowing under the articles of association of the company, but violated the provision of the articles of association of the company by approving the unauthorized payment of money to external parties, which resulted in the failure to recover the loan so far, and should be held responsible for the debt repayment“.
There are some courts that have determined whether DSMs have failed to perform the duty of care of an ordinary prudent person in terms of the substance of their acts without being confined to the laws, regulations and articles of association of the company. For example, in the (2022) Shandong 06 Civil Final No. 253 case, the Yantai Intermediate People’s Court held that “the duty of diligence means that directors, supervisors and senior managers of a company shall, in the fulfillment of their duties, have the carefulness of a benevolent manager and the reasonable care of an ordinary prudent person in the best interests of the company. If senior managers failed to exercise their rights and fulfill their duties in a timely manner and in accordance with the law when executing the affairs of the company, resulting in the claims that should be attributed to the company not being effectively paid off, they should be held liable for the damage because they failed to fulfill their duty of diligence as senior managers and were at fault for the damages. “
We understand the court’s caution in not hastily judging the correctness of commercial activities in the absence of any clear regulatory guidelines. However, where a company has already formulated a large number of internal management and control systems to regulate behaviors of DSMs, the courts are still inconsistent in their attitudes as to whether or not DSMs should be held liable for the damages caused by their acts in violation of such internal management systems (but not the articles of association of the company). For example, in the (2018) Zhejiang 07 Civil Final No.5602 case, the court found that the CEO of the company was at fault and should be held liable for the company’s losses after violating the Employee Professional Conduct and Promise Keeping Agreement which he had signed and confirmed. In the (2018) Guangdong 13 Civil Final 6211 case, and in the (2019) Fujian 0802 Civil Initial 1305 case, the court held that there was a violation of the duty of diligence when the company’s senior managers violated the company’s approval system by entering into contracts with external parties without the approval of their superiors, and senior managers should be held liable for the company’s losses. However, we also discovered a court judgement which held that “Internal business regulation is not part of the articles of association of the company, and even if the defendant has violated the regulation, it would be inappropriate to seek judicial judgment on the basis of liability for damaging the company’s interests.”
IV. Our Views and Forecast for Future Judicial Trials
We understand that the courts are prudent in adjudicating such cases, and we respect the professional judgment of commercial parties, particularly in the complete absence of any regulatory reference, so as to avoid imposing excessive obligations on directors and senior managers and hindering the efficient operation of commercial activities.
However, we believe that the non-violation of the laws, regulations and articles of association of a company is the minimum obligation that a company’s senior managers should perform, which is far from the standard of “diligence”. The laws, regulations and articles of association of a company only regulate the behavior of DSMs in principle, but in commercial practice, many companies have formulated complete internal management systems to specifically regulate the behavior of DSMs. These internal management systems are clear, explicit, documented and easy to review. They are an extension of a company’s autonomy and do not interfere with the autonomy of an enterprise’s commercial decision-making. Obviously they should be included in the scope of a court’s review on whether DSMs have fulfilled the duty of diligence. An ordinary employee who violates an internal management system may be dismissed by a company without responsibility. Similarly, if a company’s senior managers cannot obey the rules and regulations, it is difficult for them to meet any kind of “diligence” requirement.
We look forward to the promulgation of the New Company Law in further standardizing the determination of the duty of diligence of DSMs. Although the New Company Law does not change the dualistic legislative model of obligation-liability, it has for the first time defined the meaning of “the duty of diligence” at the legislative level. This is conducive to the courts motivation to examine whether DSMs have made efforts to perform their duties in the best interests of a company from a perspective of the reasonable care that is normally expected of a manager, regardless of the constraints of the laws, regulations and articles of association of a company when adjudicating such a case.
V. Compliance Suggestions for DSMs
Combining the provisions of the New Company Law and some of the key concerns in judicial practice, our suggestions for DSMs are as follows.
1. Learn and understand the provisions of the New Company Law related to DSMs and pay attention to the further refinement of the law for specific enterprises (e.g., listed companies and state-invested enterprises). For example, the duty of diligence of directors of listed companies has been further refined in accordance with the “Guidelines on the Articles of Association of Listed Companies (Amended in 2023)” which is different from that of non-listed companies in general. For example, DSMs of central state-owned enterprises need to pay special attention to the various documents regulating central state-owned enterprises. The State-owned Assets Supervision and Administration Commission of the State Council issued “the Notice on Regulating the Trade Management of Central State-owned Enterprises and Strictly Prohibiting Various Types of False Trade (SASAC Economic Commentary and Regulation No. 74 of 2023)” in October 2023, which regulates trade businesses and has the requirement of “ten forbidden”. It specifically requires the establishment of a sophisticated internal control system for trade businesses, the establishment of specialized positions for trade internal controls, and strict business approval procedures. It also puts forward requirements on the duties of DSMs of central state-owned enterprises.
2. Learn and understand the articles of association of the company, its internal systems and decision-making mechanisms, and clearly know the scope, content and procedural requirements of their duties.
3. Record the performance of duties to avoid facing potential investigations and disputes with little evidence to rely on.
For further information, please contact:
ZHANG, Jie, Partner, JunHe
zhangjie@junhe.com
1. Previously amended in 2006, 2014, 2016, 2019, 2022, 2023, respectively.
2. See Zhu Jinqing. Corporate Jurisprudence. 2nd edition, May 2019. Tsinghua University Press. Page 628.
