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By establishing the double derivative lawsuit system, the new Company Law not only strengthens the ability of actual rights holders to protect their interests, but also increases the deterrent effect on directors, supervisors and senior management harming company interests. This system marks a further improvement in China’s corporate legal framework and demonstrates progress in the rule of law for companies in China.
However, there remain numerous issues regarding the interpretation and application of this system, requiring further discussion and observation of judicial practice. This article focuses on the context of foreign investment, exploring the feasibility of foreign shareholders exercising rights through this mechanism.
The background
Zuo Yuru
Partner
Zhong Lun Law Firm
Under the previous Company Law, the shareholder derivative suit system clearly stipulated that only direct rights holders of the company (namely shareholders) were eligible to initiate such lawsuits. However, in certain regions and under specific circumstances, judicial practice has recognised that shareholders of a parent company may file lawsuits on behalf of a wholly owned subsidiary. For example, the court accepted this approach in Zhao Xiaohai v HNA Hotel Group (2016).
The new Company Law formally establishes the double derivative suit system in article 189(4). According to this provision, shareholders of a parent company may initiate a double derivative lawsuit if the following conditions are met: (1) the shareholder must maintain their shareholder status throughout the litigation process, and shareholders of a joint stock company must also have held at least 1% of the company’s shares, individually or collectively, for more than 180 consecutive days; and (2) before initiating the lawsuit, a written request must first be submitted to the board of supervisors (supervisor) or board of directors (director) of the wholly-owned subsidiary to initiate litigation.
Only if the board of supervisors (supervisor) or board of directors (director) refuses to initiate the lawsuit may shareholders of the parent company file a lawsuit in their own names, unless the circumstances are urgent and failure to immediately initiate litigation would cause irreparable harm to the interests of the wholly owned subsidiary.
Compared with the previous shareholder derivative suit system, the double derivative suit system does not introduce substantive changes in the exercise path or preconditions. The core difference lies in the expansion of eligible parties from “company’s shareholders” to “company’s shareholders and shareholders of the parent company”.
While this system facilitates the exercise of rights by actual interest holders, it also introduces new legal issues, particularly in the context of foreign investment, where two scenarios may arise.
Zeng Heng
Associate
Zhong Lun Law Firm
Scenario one: “Foreign-China-China” structure, where both the parent company and its wholly owned subsidiary are registered in China, but the parent company’s shareholder is a foreign entity. In this scenario, the parent company’s shareholder is entitled to initiate a double derivative lawsuit. According to article 14 of the Laws Applicable to Foreign-related Civil Relations, although the parent company’s shareholder is a foreign entity, its rights and obligations as a shareholder are determined by the law of the place where the parent company is registered (i.e. Chinese law). Apart from the rules on the exercise of rights through penetration, this scenario is essentially the same as the previous shareholder derivative lawsuit system.
Scenario two: “Foreign-Foreign-China” structure, where both the parent company and its shareholder are foreign entities, and only the wholly owned subsidiary is registered in China. In this scenario, due to the absence of a domestic company as a connecting point, it is generally considered that the parent company’s shareholder should not be able to directly initiate a double derivative lawsuit.
However, this is not absolute. In practice, if a party (as a parent company’s shareholder) needs to initiate a double derivative lawsuit, a comprehensive assessment should be made of the relevant laws of the parent company’s place of registration, the parent company’s articles of association and the shareholders’ agreement.
If the law of the parent company’s place of registration also supports – or at least does not explicitly prohibit – such exercise of rights, or if the articles of association or shareholders’ agreement contain provisions supporting the exercise of rights through penetration, the parent company’s shareholder has grounds to attempt to initiate a double derivative lawsuit.
In the “Foreign–Foreign–China” structure, the parent company’s shareholder must collect and prepare sufficient evidence regarding their shareholder status, relevant laws of the parent company’s place of registration, the articles of association and shareholders’ agreement, before completing the necessary certification procedures under Chinese law to ensure the evidentiary effect of foreign documents.
On this solid evidentiary basis, the parent company’s shareholder should fully explain to the court that: (1) they are indeed a shareholder of the wholly owned domestic company; and (2) the exercise of rights through penetration does not create legal conflicts and is a necessary legal means to protect the legitimate interests of the domestic company.
Takeaway
Finally, it should be noted that, even in the current climate of rising deglobalisation, foreign investment and the establishment of offshore holding structures by domestic companies remain common.
This inevitably imposes higher requirements on the interpretation and application of the double derivative suit system.
It is reasonable to believe that, even if the current wave of globalisation that began in the last century comes to an end, it will only lay the groundwork and accumulate momentum for a new round of globalisation. The new Company Law will continue to provide legal safeguards for the liberalisation of international trade and the facilitation of investment.
Zuo Yuru is a partner and Zeng Heng is an associate at Zhong Lun Law Firm
Zhong Lun Law Firm
22-31/F, South Tower of CP Center
20 Jin He East Avenue
Beijing 100020, China
Tel: +86 10 5957 2288
Fax:+86 10 6568 1022
E-mail: zuoyuru@zhonglun.com
zengheng@zhonglun.com
www.zhonglun.com
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