LEGAL REPRESENTATIVE LIABILITIES IN PRC

LAW FIRM FRANCO FORNARI VALENTINO LUCINI LEGAL REPRESENTATIVE LIABILITIES IN PRC 2013 WANG JING & CO. LAW FIRM All rights reserved - 1 -

R ecently, the issue of legal representative liability of legal persons under Chinese law has acquired a central position among requests for assistance made by Italian and foreign businessmen who either wish to invest or have invested in China. The reason behind this increasing interest is found in the current economic situation affecting the West. The business world has begun to wonder what the consequences of a possible closure of production facilities in PRC would be and how they might directly or indirectly affect the legal representative. T LEGAL REPRESENTATIVE he legal representative is an essential and fundamental figure in the organization of all companies established under Chinese law. Each company must designate said representative, whether it is comprised of domestic or foreign investors. In Accordance with Art.13 of the Company Law of PRC ( Company Law ) - 中 华 人 民 共 和 国 公 司 法 -2006: The legal representative of a company shall, according to the provisions of its articles of association, be assumed by the chairman of the board of directors, acting director or manager, and shall be registered according to law. If the legal representative of the company is changed, the company shall go through the formalities for modifying the registration. Thus, the legal representative must be chosen from among the members of the core management. However, this freedom of choice is limited by law. - 2 -

According to Art.34 of The Regulation on Implementing PRC Law on Chinese Foreign Equity Joint Ventures ( Regulation JV )- 中 华 人 民 共 和 国 中 外 合 资 经 营 企 业 法 实 施 条 例 -2001, in the case of a Sino-Foreign Equity Joint Venture, the chairman of the board of directors will assume the role of the legal representative, (with a similar requirement applying to the Sino-Foreign Contractual Joint Venture or Cooperative). The later, however, requires clarification because it presents a conflict of laws between Company Law and Regulation JV. Under the general rule that specific laws prevail over general laws, the Regulation JV should prevail over the Company Law. This is also provided for in Article 218 of the Company Law which reads: Article 218 The limited liability companies and joint stock limited companies invested by foreign investors shall be governed by the present Law. Where there are otherwise different provisions in any law regarding foreign investment, such provisions shall prevail. On the other hand, under the rule of new laws prevail over old laws provided in Article 83 of the PRC Legislation Law 中 华 人 民 共 和 国 立 法 法 - 2000, the Company Law should prevail over the Law JV and Regulation JV when it comes to the topic of legal representative of a Sino-foreign joint venture. Under Article 85 of the PRC Legislation Law, if there is a conflict between a new general law and a previously existing specific law on the same issue, it should be decided by the Standing Committee of the National Congress. However, the Standing Committee of the National Congress has not published or made a clear determination on the conflict between the Company Law and the Law JV and Regulation JV regarding the provisions of legal representative of a Sino-foreign joint venture. In practice, the issue is up to the government administrations who are responsible for establishment of the Sino-foreign joint venture. - 3 -

In our experience and as our research with the governments (such as AIC or BOFTEC) who are responsible for establishment of Sino-foreign joint ventures shows, the governments generally discuss and apply the Company Law, the Law JV and Regulation JV to resolve conflicting provisions. On the issue of legal representative of a Sino-foreign joint venture, in particular from January 2007, the majority of government authorities (including the authority charged with approving establishment of a Sino-foreign joint venture and the authority that registers companies) hold that a joint venture company may, pursuant to the Company Law, approve and register the chairman of the board of directors, executive director or manager as the legal representative in accordance with its articles of association. Regarding appointment of a legal representative for a Wholly Foreign-Owned Enterprise (WFOE), the Company Law principle stated above will apply, meaning the chairman of the board of directors, acting director or manager may also assume the role of the legal representative. Finally, it is essential to remember that the title of legal representative must be recorded in accordance with the formalities prescribed by law and that the name of the latter must be regularly reported on the Business License of the company. The Company Law does not provide a clear definition of legal representative, therefore we must refer to the Art.38 of 1.1 General Principles of the Civil Law of the PRC ( Civil Code ) - 中 华 人 民 共 和 国 民 法 通 则 -1986 to clarify this issue: In accordance with the law or the articles of association of the legal person, the responsible person who acts on behalf of the legal person in exercising its functions and powers shall be its legal representative. - 4 -

The Chinese law does not impose any special requirement in order to qualify for the position of legal representative; in fact it is not required that the legal representative reside or be domiciled in China, and there are no limits on the representative s nationality. However, since the legal representative of an entity possesses peculiar powers, and is able to influence the performance of the company represented, Art. 147 of The Company Law provides the following persons cannot be appointed as legal representatives: (1) Those being without or with limited capacity of civil conduct; (2) Anyone who has been sentenced to any criminal penalty due to an offence of corruption, bribery, encroachment of property, misappropriation of property or disrupting the economic order of the socialist market economy and 5 years have not passed since the completion date of the execution of the penalty; or anyone who has ever been deprived of his political rights due to any crime and 5 years have not passed since the completion date of the execution of the penalty; (3) Anyone who was a former director, factory director or manager of a company or enterprise which was bankrupt and liquidated, and said person was personally liable for the bankruptcy of such company or enterprise, and 3 years have not passed since the date of completion of the bankruptcy and liquidation of the company or enterprise; (4) Anyone who was the legal representative of a company or enterprise, and the business license of this company or enterprise was revoked and this company or enterprise was ordered to close due to violation of the law, and said person was personally liable for the revocation, and 3 years have not passed since the date of the revocation of the business license thereof; - 5 -

(5) Anyone having a relatively large amount of debt which is due but uncleared. If a company elects or appoints any director or supervisor, or hires any senior manager who violates the provisions in the preceding paragraph, the election, appointment or hiring shall be invalidated. Likewise, if any director, supervisor or senior manager, during his term of office, is under any of the circumstances mentioned in the preceding paragraph, the company must dismiss him from his post. T POWERS OF THE LEGAL REPRESENTATIVE. he Company Law does not clearly define which powers are in the hands of the legal representative. In fact, the Company Law contains only a general reference to other laws and Articles of Association of the company represented. Nevertheless, it is clear that the legal representative has an extremely broad range of power and the right to represent his company to outside parties in almost every aspect. In addition, he has great responsibility for organizing and managing the operation of the company, including: Acting to conserve the company s assets; Convening and presiding over shareholders meetings and the meeting of the board directors; Executing powers of attorney on the company s behalf; Authorizing legal representation in case of litigation; and Executing any legal transactions that are within the nature and scope of company s business. Moreover, according to Article 148 of Company Law, the legal representative, as one of the company s directors, has fiduciary duties to the company he represents, including the duties of fidelity and diligence. Given these duties, Art.149 of the Company Law explicitly prohibits the legal - 6 -

representative from undertaking any of the following acts: 1. Misappropriating funds of the company; 2. Depositing the company's funds into an account in his own name or in any other individual's name; 3. Without the consent of the shareholders' meeting, shareholders' assembly or board of directors, loaning the company's fund to others or providing any guaranty to any other person by using the company's property as in violation of the articles of association; 4. Signing a contract or trading with this company by violating the articles of association or without the consent of the shareholders' meeting or shareholders' assembly; 5. Without the consent of the shareholders' meeting or shareholders' assembly, seeking business opportunities for himself or any other person by taking advantages of his authorities, or operating for himself or for any other person any like business of the company he works for; 6. Taking commissions on the transactions between others and this company into his own pocket; 7. Disclosing the company's secrets without permit; 8. Other acts that are inconsistent with the obligation of fidelity to the company. The income of any director or senior manager from any act in violation of the preceding paragraph shall belong to the company. Considering the legal representative s broad range of authority to represent the company and act on its behalf in all legal transactions, the prohibition listed above help to avoid the representative s abuse of his position. It is important to emphasize that all the activities and the actions listed in Article 149 imply a strict automatic liability of the legal representative with a potential civil or even criminal responsibility. In fact, even where the legal representative simply participates in the decision making process or prepares executive documents relating to these activities, such involvement can be enough to for him to be found - 7 -

liable, together with any collaborators, for the loss caused to the company, unless he proves that he explicitly voted otherwise at the board meeting, or was not aware of nor at fault for such activities. Should the representative be found to be in violation of any of these prohibitions, Chinese law provides different kinds of civil, criminal and administrative liability. G CIVIL LIABILITY. enerally speaking, liability for the legal representative s actions will either lie with the company he represents or with himself as an individual. If the legal representative acts in accordance with the laws, regulations and articles of association of the company, and at the company s direction, the company will be directly responsible for such acts. On the contrary, if the representative acts outside the scope of his duties as representative, or against the laws, regulations and articles of association, Chinese law provides various kinds of individual liability which may result in the representative having to compensate the company for damages suffered. We will first examine the instances in which the company is held liable for the actions of its legal representative. Art. 43 of the Civil Code provides: An enterprise as legal person shall bear civil liability for the operational activities of its legal representatives and other personnel. An important caveat arsing from this provision is that the company will face civil liability for harm arising only from the legal representative s actions that occurred in the course of "operational activities." While the general requirement is that a causal relationship exist between the operational activities of the company and the loss suffered in order for the company to be held liable, Chinese contract law provides an exception to this rule when it comes to transactions with third parties. Under certain circumstances, a company may be held liable for an agreement entered into with a third party by the legal representative on behalf of the company even though it was outside the - 8 -

scope of his duties (acts ultra vires). Article 50 of the Contract Law of the People's Republic of China elaborates: Where the legal representative or the person-in-charge of a legal person or an organization of any other nature entered into a contract acting beyond his scope of authority, unless the other party knew or should have known that he was acting beyond his scope of authority, such act of representation is valid. Thus, as long as the third party with whom the legal representative was dealing had a good faith belief that the legal representative was acting within the scope of his authority when entering into a transaction, the company will be bound to and liable for his actions. In conclusion, there are two primary instances in which a company will be held liable for the acts of its legal representative. The first is when the representative carries out operational activities on behalf of the company. The second is when the legal representative enters into a transaction with a third party. The company will be liable for the outcome of the transaction whether or not the representative had actual authority to undertake it, as long as the third party did not know or should not have known the representative lacked authority. We next examine the situations in which a legal representative can be held individually liable for his actions seemingly carried out in furtherance of his duties as representative. First, following from the above analysis regarding a third party s perception of the representative s authority to enter into a contractual agreement, if the legal representative was not authorized to enter into the agreement, and the third party knew or should have known he lacked such authorization, the legal representative will be individually liable for the obligations and undertakings to which he agreed. Apart from dealings with third parties, the second instance in which a legal representative will be held individually liable is as a result of his own unlawful actions. Art. 150 of the Company Law explains further: - 9 -

Where any director, supervisor or senior manager violates laws, administrative regulations or the articles of association during the course of performing his duties, if any loss is caused to the company, he shall make compensation.. Article 148 of the Company Law highlights a specific type of unlawful activity leading to the individual liability of the representative, stating that a legal representative must make compensation for damages arising when: [the]director, supervisor or senior manager may take any bribe or other illegal gains by taking the advantage of his authorities, or encroach on the properties of the company. Thus, a legal representative who, intentionally or through gross negligence, causes a loss to the company will be held individually liable and will be forced to provide compensation for the damages that result from his actions. Along the same lines, the legal representative shall be civilly liable and must compensate the company for damages arising from his receipt of bribes or illegal gains that come as a result of his position as representative. The final way a legal representative may be held individually liable for actions undertaken while fulfilling his role as representative is when he takes advantage of business relationships for personal gain. Art.21 of the Company Law focuses attention on the advantageous position occupied by the legal representative and the business relationships that he/she can use to his/her advantage: Neither the controlling shareholder, nor the actual controller, any of the directors, supervisors or senior managers of the company may injure the interests of the company by taking advantage of its business relationships. Anyone who has caused any loss to the company due to violation of the preceding paragraph shall be subject to providing compensation. - 10 -

A ADMINISTRATIVE LIABILITY. nother area of liability to which the legal representative can be subject is administrative liability. Under certain circumstances, if the company violates any provision of law or regulations, the legal representative may be liable together with the company and subject to fines and administrative sanctions. Art. 49 of the Civil Code states: Under any of the following circumstances, if an enterprise as a legal person shall bear liability, its legal representative may additionally be given administrative sanctions and fined and, if the offence constitutes a crime, criminal responsibility shall be investigated in accordance with the law: 1. conducting illegal operations beyond the range approved and registered by the registration authority; 2. concealing facts from the registration and tax authorities and practicing fraud; 3. secretly withdrawing funds or hiding property to evade repayment of debts; 4. disposing of property without authorization after the enterprise is dissolved, disbanded or declared bankrupt; 5. failing to apply for registration and make a public announcement promptly when the enterprise undergoes a change or terminates, thus causing interested persons to suffer heavy losses; 6. Engaging in other activities prohibited by law, damaging the interests of the state or the public interest. These cases are considered with a strict liability, as the legal representative shall be jointly liable with the company, and then subjected to administrative sanctions and fines, unless he proves he was not aware of and was not at fault for such activities Under Article 63 and 164 of the Regulation on the implementation of the Civil Code, the legal representative could be subject to a fine of up to RMB 2000 for its violation of law and could be detained for a maximum of 15 days for the act under - 11 -

paragraph 3 of Article 134 of the Civil Code. In practice however, no court or administrative agency applies such penalties against legal representatives whose companies violate the provisions of Art. 49. However, in the case of companies subject to bankruptcy proceedings that hide properties or falsify financial statements, the penalties are applied and can reach amounts ranging from 10,000 to 100,000 RMB. G CRIMINAL LIABILITY. enerally, under Chinese law the legal representative of a company is not criminally liable for the crimes committed by the company. However, in certain cases, the Criminal Law of the People's Republic of China punishes not only the company but also the person directly in charge or directly responsible for the criminal activity, meaning the legal representative could be personally liable if he was involved in the company s criminal activity. The question then becomes what level of involvement by the representative is sufficient to impose such liability. Article 31 of Criminal Law provides some guidance on this point: A unit which commits a crime shall be punished with a fine, and the person(s) directly in charge and other person(s) directly involved in the crime shall be given a punishment. Where Specific Provisions of this Law or other laws stipulate otherwise, such stipulation shall be applied. It is important to highlight the fact that " persons who are directly in charge and the other persons who are directly responsible for the crime " are not explicitly defined by Chinese law. As one might imagine, this is a common point of contention arising in the cases that deal with this issue. While the subject matter of such cases varies, the most common are those dealing with smuggling and tax violations by a company (addressed by articles 151, 152, 153, 154 of Criminal Law for smuggling cases and articles 205, 206, 211, 220 and 231 of Criminal Law for tax cases).where the legal representative is in charge of the - 12 -

activities leading to criminal liability, he often satisfies the conditions necessary to be held liable for the crimes mentioned above, whereas if he was never personally and directly in charge of a matter which constitutes a crime, he should not be held criminally liable. The Criminal Law provides eighty types of crimes imputable to the legal person (or company) and its legal representatives. The punishment for these offenses include fines, public surveillance, detention, imprisonment and, in severe cases, life imprisonment or capital punishment. The list of crimes for which the representative can be held concurrently liable with the company includes, but is not limited to, crimes of manufacturing and selling toxic or harmful foodstuff, crime of falsely declaring registered capital, crime of false capital contribution, or withdrawing capital contribution upon registration, crime of issuing stock or bonds by fraudulent means, crime of presenting false financial statement, crime of impairing liquidation, etc. An example of criminal liability imposed on both a company and its legal representative is found in Art. 153 of the Criminal Law, which addresses the crime of smuggling. The article provides: Where a unit commits the crime mentioned in the preceding paragraph, it shall be fined, and the persons who are directly in charge and the other persons who are directly responsible for the crime shall be sentenced to fixed-term imprisonment of not more than three years or criminal detention; if the circumstances are serious, they shall be sentenced to fixed-term imprisonment of not less than three years but not more than 10 years; if the circumstances are especially serious, they shall be sentenced to fixed-term imprisonment of not less than 10 years. However, for the act of smuggling, in judicial practice, whether the legal representative can be deemed as personally and directly in charge of or responsible for a matter which constitutes a crime may depend on whether the legal representative is the chief party responsible for organizing, deciding or giving orders in furtherance of the matter which constitutes the criminal smuggling, he should be regarded as personally responsible for the matter. On the - 13 -

contrary, if the legal representative was not involved in organizing, deciding, or giving orders in furtherance of the matter, or was just generally involved in but not the key element of the criminal smuggling, he should not be held liable for the criminal smuggling. In the majority of cases, the person in charge means a section chief or lower level staff person who directly commits the act of criminal smuggling. Therefore, the key issue is whether the legal representative is the party "directly responsible or directly in charge ". If the representative is never DIRECTLY responsible or in charge of the matter being charged by the government, he should not be accused. Under PRC laws, the government has the burden of providing evidence justifying their charges against an individual and a company. However, in many cases, the person and company who are suspected may also submit evidence to prove their innocence. B THE SUPERVISORS. eginning in 2006, the Company Law added a new form of "constraint" on the power of the legal representative by establishing the position of the supervisor. A special feature of this position is that members of the core management are prohibited from filling it. Therefore, neither administrators, directors nor managers can have supervisory responsibilities. The supervisor's role is to safeguard the company s interests and oversee the legality and regularity of its operations. For this reason, the Chinese law delegates broad powers to the supervisors, including the ability to inspect the financial situation of the company, supervise the directors and managers, propose the removal of directors or managers who have violated the law or statutes, require that directors or managers the rectify their acts, etc. The supervisor, like the company s directors, is not required to reside in or visit China. The role of supervisor is very relevant to the potential liabilities of the legal representative as it includes the supervision and constraint of the legal representative. - 14 -

B COMPULSORY MEASURES. esides the instances of liability set out above, the legal representative of a company under Chinese law can be subjected to coercive measures which, in certain cases, can restrict his personal freedom. The cases dealing with the application of these measures are various and range from bankruptcy to the failure to pay taxes. Art.255 of the Civil Procedure Law of the People's Republic of China (amended in 2012) provides an example of such measures applied in civil disputes or upon failure to comply with the provisions laid down by the courts,: Where the party against whom enforcement is sought fails to perform obligations determined in a legal instrument, the people s court may take or notify a relevant entity to assist in taking the measure of restricting exit from China, the measure of recording the failure in the credit system, the measure of publishing information on the failure on media and other measures prescribed by law. Moreover, in conjunction with the above-mentioned article, the interpretation of the Supreme Court on application of the Enforcement Procedures in the Civil Procedure Law of the People's Republic of China is also relevant: "Where an enforcee is an entity, its legal representative, main personnel in charge or personnel directly responsible for influencing the performance of its obligations may be restricted from leaving the country." Therefore, from the analysis of these provisions, it is clear that if a company does not comply with legal documents and legal orders of the Court, its legal representative, or those directly responsible, can be held liable for any costs of non-compliance and ultimately shall be subjected to compulsory measures that can restrict his exit from the country. The restriction of the legal representative s departure from the country is especially relevant when it comes to bankruptcy proceedings. Art.8 of the Law on the Control of the Exit and Entry of the Citizens provides: - 15 -

Approval to exit from the country shall not be granted to persons belonging to any of the following categories: (1) defendants in criminal cases or criminal suspects confirmed by a public security organ, a people's procuratorate or a people's court; (2) persons who, as notified by a people's court, shall be denied exit owing to involvement in unresolved civil cases;[ ] The unresolved civil case mentioned in Art. 8(2) applies to bankruptcies or unpaid debt of large amount filed by a company or a claimant, and the legal representative is considered to be particularly involved with such proceedings. Thus, if a company is subject to a bankruptcy proceeding, its legal representative is not even allowed to leave his residence without the permission of the court. In addition, for the entire duration of the bankruptcy procedure (and in some cases even prior to its initiation), the legal representative will be responsible for the protection of the business property and custody of its stamps, accounting books and other documents. He must comply with all assignments given by the Court and administrators, and must answer their questions truthfully. Moreover, he must serve as a delegate to attend the meeting of creditors without the right to vote and must answer creditors questions. Finally, he should not accept the position of director, supervisor or senior official in any other company. The third instance of the application of compulsory measures against the legal representative is provided by the Tax Law. As is the case when the representative s company s bankruptcy is pending or when a court s order has yet to be fulfilled by the representative, competent authorities may prevent the legal representative from leaving the country in certain instances related to a company s tax liability. According to Art. 44 of the Law of the People s Republic of China on the Administration of Tax Levying: Where a taxpayer who has defaulted on tax payment, or his legal representative need to leave the territory of China, either of them shall pay the amount of the tax due together with the surcharge thereon, or provide a guaranty to the tax - 16 -

authorities before leaving the country. If the tax payable and surcharge thereon are not paid nor is a guaranty provided, the tax authorities may notify the exit administration to prevent either party from leaving the country. B METHODS FOR MINIMIZING THE RISKS OF THE COMPANY AND THE LEGAL REPRESENTATIVE. ased on the information above, both the company and the legal representative are exposed to legal risk through their relationship with one another. When the company appoints someone as their legal representative it is giving him broad-ranging power to represent and bind it in legal matters. On the other hand, the person filling the role of legal representative undertakes a wide range of duties and responsibilities, failure at which can lead to legal liability. Each party has an interest in minimizing the risks they face. In order for the company to minimize its risks it should ensure that the powers of the legal representative are somehow limited. For this purpose it is necessary: To provide within the company s Articles of Association a detailed list of the limitations on the powers of the legal representative. In addition, it is essential to disclose (through forms of advertising) such limitations to third parties with whom the company deals, since, as discussed earlier, an agreement signed by the legal representative that is outside the scope of his authority is still effective and binding on the company, unless it is proved that the third party was aware the representative s conduct exceeded his authority. To restrict access to the company stamp. In China, business contracts are signed with a company stamp that is registered with the Public Security Bureau. The company stamp is much more powerful than a written signature, as contracts are legally binding even without the signature of the company's authorized representative, as long as they are properly stamped. Thus, rules monitoring stamp use and procedures restricting access to the stamp are strategic aspects of managing and supervising the - 17 -

activities of the legal representative. Moreover, it is not uncommon for the company to find itself in the unfavourable situation where, upon termination, a legal representative keeps the company stamp and demands a financial settlement. A good strategy to facilitate termination is to ask the person to be appointed as legal representative, to sign and stamp an undated termination agreement. When it comes to protecting the legal representative from potential risks, he can generally enter into an agreement with the company exempting him from liability as long as he did not engage in wrongful conduct leading to the liability. The company can also include an explicit liability exemption within its Articles of Association. However, the company cannot exempt the legal representative from liability to the government or a third party. The remedy for such liability is the execution of an indemnity agreement, whereby the company agrees to compensate the legal representative for any fines or losses incurred and provide evidence to defend him in case he is charged by said parties for actions carried out in the course of his duties as representative. To provide for such indemnification, the company can secure liability insurance for the legal representative. According to Article 39 of the Code of Corporate Governance for Listed Companies issued by the China Securities Regulatory Commission: "after approval in a shareholders' meeting, a listed company may purchase liability insurance for directors. Such insurance shall not cover the liabilities arising in connection with directors' violation of laws, regulations or the company's articles of association." Therefore, the legal representative may request the company buy insurance packages in order to limit the damage and risks suffered by their legal representatives from involvement in civil, administrative or criminal litigation arising from the exercise of their functions. - 18 -

CONCLUSION On the basis of the above is clear that the legal representative represents an important element for the company as well as the source of liability to do not underestimate. Thus, the best solution is to choose a trusted person to be the legal representative of your company as well as defined in the Article of Association (AoA) his/her limits and powers. On the other hand, the legal representative must supervise the work of the directors and employees of the company since the conduct of third parties could affect his/her rights and interests. 广 州 北 京 上 海 天 津 香 港 青 岛 厦 门 福 州 海 口 深 圳 Canton Beijing Shanghai Tianjin Hong Kong Qingdao Xiamen Fuzhou Haikou Shenzhen

Contact For more information, please don t hesitate to contact: Mr. Franco Fornari Senior Client Service Manager +86 137 252 38764 (mobile) fornari@wjnco.com Mr. Valentino Lucini Assistant to Mr. Franco Fornari +86 13424493843 (mobile) lucini@wjnco.com Wang Jing & Co. Law Firm, Guangzhou Office 11/F., Block D, G.T. Land Plaza, 8 Zhu Jiang West Road, Zhujiang New Town, Guangzhou 510623, P. R. China Tel +86 20 8393 0333 Fax +86 20 3808 2995 For more information regarding our services, please visit our website at: www.wjnco.com 2012 WANG JING & CO. 广 州 北 京 上 海 天 津 香 港 青 岛 厦 门 福 州 海 口 深 圳 Canton Beijing Shanghai Tianjin Hong Kong Qingdao Xiamen Fuzhou Haikou Shenzhen