ON ACTIVATING A CREDITOR-DRIVEN DETERRENCE MECHANISM IN RELATED-PARTY ULTRA VIRES CORPORATE GUARANTEES
The US Supreme Court Justice Oliver Wendell Holmes once said, ‘Pretty much all law consists in forbidding men to do something that they want to do’. Such is the case with laws regulating related party ultra vires corporate guarantees in China, which account for the majority of corporate guarantee cases and continue to grow despite legislative and judiciary deterrence efforts. In 2005, in light of the high rate of controversy in related party corporate guarantees, the newly modified Company Law distinguished related party corporate guarantees from ordinary guarantees for the first time. According to article 16 of the modified Company Law, related party corporate guarantees must be approved by vote of the majority shareholders with those receiving the guarantee recusing from the vote. For ordinary guarantees, article 16 gives the corporation a certain degree of autonomy in the manner of approval. Both types of guarantees are considered ultra vires in the Chinese legal discourse if they violate article 16. However, the law did not explicitly make clear the validity of such ultra vires guarantees and the implications for involved parties. As a result, in the decade or so following the Company Law of 2005, there appeared a multitude of rulings where ultra vires corporate guarantees were ruled to be valid, voidable or void at different times. This inconsistency triggered waves of academic debates that extended from validity of the resolution to validity of the guarantee contract and ultimately centered around the nature of article 16 of the Company Law.To unify the standard and principle to be applied in such cases, the Supreme People’s Court of China included a typical case on ultra vires corporate guarantee in its Gazette of 2015 as a guidance case for reference by lower courts, i.e. the case of Dalian Donggang Sub-branch of China Merchants Bank v. Dalian Zebon Group and Dalian Zebon Fluorocarbon Paint Incorporated (hereinafter referred to as the Merchants Bank Case). In this case the Supreme People’s Court made its stance clear on the nature of article 16, labeling it as a mandatory provision on administration, instead of mandatory provision on validity. This labeling, however, did not end debates once and for all as might have been expected, because being a mandatory provision on administration only meant contracts in violation of article 16 are not automatically voided and their validity should be decided ‘in light of specific circumstances’, leaving open the question of what exactly constituted such specific circumstances.For a long time, related party corporate guarantees and ordinary corporate guarantees were discussed as a whole, with the presumption that same set of rules and principles should apply to both, until Liu Guixiang, Luo Peixin and Wang Baoshu pointed out that the very type of the guarantee, be it an ordinary guarantee or a related party guarantee, is a very important circumstance that should have implications for the validity of the guarantee and legal consequences for involved parties. As separation of the two types of guarantees gradually gained some traction in the academic world, more scholars began to focus on differences between the two types of guarantees. Yang Daixiong, Wu Yue, Fu Yunfei and Lai Hongyu directed their attention to different inspection duties imposed on the guaranteed creditors in the two types of guarantees. They pointed out that related party corporate guarantees deserve a higher level of procedural integrity both from the corporation and from the parties involved, therefore powers of corporate officers are not to be lightly inferred by the creditors, who in turn should fulfill a generally higher level of inspection duty to obtain the protected good faith status if validity of the guarantee was later called into question.In the realm of related party ultra vires corporate guarantee cases, whether the guaranteed creditor is in good faith determines whether he can bind the corporation to the ultra vires act. The widely accepted criterion of good faith in China is whether the creditor ‘knew or should have known’ about the guarantee being ultra vires. However, current scholarly discussions and judicial rulings rarely spell out how the decision is reached as to whether the creditor is deemed to ‘know or should have known’. Some equate that question with whether the creditor performed the vaguely defined formal inspection duty while others seemingly consider that question to be part of tacit practitioner know-how without feeling the need to elaborate. Creditor inspection duty, creditor knowledge and creditor good faith are important variables that shape attribution of losses among involved parties in controversial related party corporate guarantees and as such warrant more attention than is currently bestowed upon them. This article contextualizes the vaguely defined notion of formal inspection duty in relation to different procedural requirements in related party corporate guarantees and applies the Baden Scale developed by the eminent English Judge Peter Gibson to calibrate the abstract notion of knowledge; with both formal inspection duty and creditor knowledge clarified and their correspondence established, this article attempts to lay the foundation for a framework of criteria for determining the good faith status of creditors. Throughout the above discussions, this article looks into how the parties’ positions define their actions and how these actions interact with and affect each other, in order to understand the mechanism at work in the whole process of a related party corporate guarantee and in that light how to tweak that mechanism toward better achievement of legislative purposes, so that creditor inspection duty may be used a lever to create systematic disincentives for related party ultra vires corporate guarantees and article 16 of the Company Law may work in a way that, instead of ‘forbidding men to do something that they want to do’, turns the ultra vires act into something men do not want to do. II. ISSUES REVEALED BY A GUIDING CASE ISSUED BY SUPREME PEOPLE’S COURTA. A Closer Look at the Merchants Bank Case and Its Curious AftermathApart from voicing the stance of the Supreme People’s Court on the nature of article 16 of the Company Law, another reason the Merchants Bank Case stood out in a forest of ultra vires corporate guarantee cases is that in its journey along the entire judicial course, it reflected two contrasting views on the validity of ultra vires corporate guarantees. The facts of the case are clear: Dalian Zebon Group (hereinafter referred to as Zebon Group) applied for a loan from Dalian Donggang Sub-branch of China Merchants Bank (hereinafter referred to as the Merchants Bank). At the same time, Dalian Zebon Fluorocarbon Paint Incorporated (hereinafter referred to as Zebon Incorporated), which was 60.5 percent owned by Zebon Group, entered into a contract of guarantee with the Merchants Bank for repayment of the loan and produced the legally required shareholders’ resolution. It also provided some land use rights it owned as collateral. The contract of guarantee and the submission of land use right as collateral were filed with the Land and Resources Bureau for registration. The Merchants Bank then issued the loan to Zebon Group. When Zebon Group defaulted on the loan, Zebon Incorporated refused to fulfill its obligation as guarantor. The Merchants Bank sued Zebon Group and Zebon Incorporated, holding them jointly liable for the loan. Zebon Incorporated claimed that the contract of guarantee should be void because its shareholders did not really vote on the matter and their seals were forged. Two of the seals on the resolution did not even bear legitimate company names. The only authentic seal on the shareholders’ resolution belonged to Zebon Group, who ironically should have recused itself from the vote according to article 16 of the Company Law. The trial court and appellate court held that the aforementioned defects were violations against mandatory provisions of the Company Law and therefore ground enough to render the contract of guarantee void. The courts further pointed out that the Merchants Bank should have noted these obvious defects in guarantee documents had it exercised proper due diligence. Its failure to note these defects was gross enough to impose on its knowledge of the defects and deprive it of the protected good faith status. The courts therefore held the Merchants Bank liable for its negligence, which in this case amounted to 50 percent of the guaranteed debt. The Merchants Bank then took the case to the Supreme People’s Court, whose ruling turned out to be a 180 turn from those of the lower courts’ on the following two accounts: first, the Supreme People’s Courts held that although article 16 of the Company Law was mandatory, it was a mandatory provision on administration and only geared towards the inner management of the company, therefore violation of article 16 should not automatically render the contract void; Second, the Merchants Bank should not be burdened with the task of verifying the authenticity of the resolution and should not suffer losses for failing such a task, that its inspection duty was one of formal inspection which went only so far as ‘making sure such a resolution existed’. Following this logic, the Supreme People’s Court overturned the lower courts’ verdict and held that the guarantee contract between the Merchants Bank and Zebon Incorporated was valid and that Zebon Incorporated and Zebon Group were jointly liable for payment of the loan.One would expect the publishing of this case to prompt later courts to protect creditor rights over the legal procedural integrity of corporate guarantees and consequently hold more ultra vires corporate guarantees valid. The reality, however, spoke otherwise. After reviewing 418 cases involving ultra vires corporate guarantees from 2013 to 2017, it was noted that while guarantees ruled to be valid peaked in the year immediately after the final ruling of the Merchants Bank Case, the number tilted downward the next year, as shown in Chart 1 below.
Most notable of later cases that took different paths from the Merchants Bank Case was one determined by the Supreme People’s Court itself in 2016, in which it was ruled that the creditor should know the Company Law requirements, demand relevant shareholders’ resolution from the guarantor and inspect the proper form of the documents; failing such a task, the creditor could not bind the guarantor corporation to the guarantee contract. In lower courts, rulings that went separate ways with the Merchants Bank Case were too many to name. At any rate, it is safe to say that the issue of ultra vires corporate guarantees has not been put to bed yet. B. Good Faith: An Attempt at ReconciliationIn the Merchants Bank Case, the courts’ different conclusions are traceable to their different choices and interpretations of applicable laws. It is therefore necessary for this article to present a clear picture of the relevant legal framework, before diving into other aspects of the case. In related party ultra vires corporate guarantees, most frequently quoted legislations are the Company Law (including the accompanying Judicial Interpretations) and the Contract Law. Citing one law instead of the other may lead to different conclusions as to the validity of the guarantee. Article 16 of the Company Law lays out the proper requirements for passing resolutions on related party corporate guarantees, thus failure to meet such requirements renders the resolution ultra vires. Article 22 of the Company Law governs the validity of corporate resolutions, providing that shareholder resolutions which do not follow legal procedures are voidable by the shareholders. Article 6 of the Fourth Judicial Interpretation of the Company Law further provides that in the event of corporate resolutions that are set aside or ruled to be void by the court, legal obligations based on such resolutions to parties dealing with the company in good faith shall remain unaffected. To sum up, within the realm of the Company Law, related party ultra vires corporate guarantees that are in violation against article 16 of the Company Law are voidable without affecting parties dealing with the corporation in good faith based on the said resolution. The involvement of a guarantee contract and the resulting application of the Contract Law complicate the matter a little more. Two most pertinent provisions in the Contract Law are articles 50 and 52. Article 52 as a generic provision on contract validity provides that contracts in violation against mandatory provisions of the law are void. Article 50 provides that contracts entered into with the legal representative of the corporation are effective even when the legal representative exceeds their authority, unless parties dealing with the corporation know or should know about the lack of proper authority. Two questions have long since been raised regarding these provisions: first, according to article 52 of the Contract Law, is a guarantee contract which violates article 16 of the Company Law void? Second, does ‘exceed their authority’ in article 50 of the Contract Law refer only to ‘their authority as prescribed in the corporation’s articles of association’, or does it include ‘their authority as vested by law’? The first question has been addressed by the Merchants Bank Case, in which the Supreme People’s Court judge made clear that contracts in violation of article 16 of the Company Law are not automatically void. As to the second question, scholarly opinions are almost equally divided. Rather than take a side, it might yield more insights to have a go with both interpretations and see where they lead to. Suppose ‘exceed their authority’ in article 50 encompasses situations of legal representatives exceeding their authority as vested by law (interpretation A), then guarantee contracts that violate article 16 of the Company Law, thus exceeding the legal representative’s authority as vested by law, fall within the purview of article 50 and should be valid save for instances where parties dealing with the creditor knew or should have known about the lack of proper authority; suppose ‘exceed their authority’ in article 50 encompasses only situations of legal representatives exceeding their authority as prescribed in the corporation’s articles of association (interpretation B), then article 50 does not apply to guarantee contracts that violate article 16 of the Company Law, in which case article 22 of the Company Law becomes the only remaining source of reference for validity of such contracts and the application of article 22 renders these contracts voidable. The company law approach and the contract law approach (including interpretations A and B under this approach) seem to lead to different conclusions, making the contract of guarantee either voidable or valid with exceptions. But for creditors dealing with the corporation, such differences are only dogmatic. Creditors that did not have knowledge of the defects of the guarantee are recognized as in good faith and can enjoy the benefit of the guarantee even when resolution about the guarantee and the guarantee contract are both voided. On the other hand, if circumstances indicate that creditors ‘knew or should have known’ about the guarantee being ultra vires, creditors will lose the good faith status and bear losses for the loan, epitomizing the exception of the law that would otherwise make the ultra vires guarantee valid. In essence, good faith creditors will always be protected in related party ultra vires corporate guarantees, it is only those that lose the good faith status that should be worried, as shown in Chart 2 below.
As this section shows, in related party ultra vires corporate guarantee cases, equally important as what the law says about the validity of the guarantee is whether the creditor is deemed to have knowledge of the defects of the guarantee and thereby deprived of the good faith status, because that question is where the money is. Unfortunately, that is also where a lot of discussions seemed to skim over.C. Unexpected Muddying of the Waters: Who Did Not Do Their Homework?When should the creditor be deemed to ‘know or should have known’? In the Merchants Bank Case, the Supreme People’s Court tied that question into whether the creditor performed his inspection duty regarding the guarantee documents, and most of the controversy surrounding this case had to do with the judge’s assessment of the creditor’s inspection duty. According to the judge: ‘The task of inspecting guarantee documents should not fall on the Merchants Bank, for it does not specialize in law, neither is it an administrative organ regulating industry and commerce nor the (public) organ accepting filing of the guarantee documents...... The law does not require the bank to be familiar with the Company Law and its duty of formal inspection regarding the shareholders’ resolution goes only so far as making sure such a document exits.’To apply the above conclusion to an imagined scenario where seals on the shareholders’ resolution simply read ‘Enjoy Our Guarantee’, the Merchants Bank would still be deemed to have fulfilled its duty of formal inspection, as the duty ‘goes only so far as making sure such a document exits’. If that conclusion ruffles with common sense, then there must be something wrong with the judge’s assessment of the Merchants Bank’s formal inspection duty. In fact, a number of subsequent court opinions on creditor inspection duty showed efforts by legal practitioners to veer backwards from the Merchants Bank Case, which was perceived as going overboard in its protection of creditors. For example, in a similar case, Justice Zhang Ya of the Jiangsu High People’s Court held that ‘the law on companies providing guarantee to its shareholders is presumed to be known by all’, in direct opposition to the stance of the Merchants Bank Case that ‘the law does not require the bank to be familiar with the Company Law’. However, it is not the purpose of this article to join in criticism of the Merchants Bank Case. Rather, the ostensible lenience shown to the Merchants Bank that triggered debates in the legal community should not be taken out of context, for the Merchants Bank was not the only one that turned a blind eye to the defective documents. Someone else with an admittedly greater obligation to scrutinize had done so before the Merchants Bank, i.e., the Land and Resources Bureau, the organ with which the contract of guarantee and accompanying shareholders’ resolution were filed for registration. The judge pointed out that ‘the Merchants Bank as a financial institution had to demand guarantee and register the security interest it received with the relevant registrar’, and that ‘the Merchants Bank did nothing wrong in relying on the public credibility of the registrar and approving the loan only after the registration’. It was in this context that the judge expressed the view that the bank itself ‘does not specialize in law and neither is it the organ accepting filing of the guarantee’, something that seemed to go without saying, but which hinted to a knowing ear as to where the judge was implicitly laying the blame. According to the then effective Opinions of the Ministry of Land and Resources on Regulating the Land Registration, the Bureau of Land and Resources was charged with the obligation to conscientiously inspect documents that are submitted to it for filing and registration. Despite lack of clarification as to its meaning, conscientious inspection, a form of inspection duty usually imposed on public organs, is clearly a higher requirement than formal inspection, the obligation that was imposed on the Merchants Bank. Since the Bureau of Land and Resources was never on trial, its performance of conscientious inspection and acceptance of defective documents standing unchallenged, it is only logical that the Merchants Bank, having performed the same act to meet a lower requirement, should be held harmless. In the realm of related party ultra vires corporate guarantees, inspection duty of the creditors has always been a source of controversy. In the Merchants Bank Case, negligence on the part of the Bureau of Land and Resources and the resulting lenience with the Merchants Bank on the part of the Supreme People’s Court surely made the water even muddier. Small wonder a new round of debate and a new wave of inconsistent rulings arose in the aftermath of the ruling. III. CREDITOR KNOWLEDGE: THE CRUCIAL LINK BETWEEN INSPECTION DUTY AND GOOD FAITHA. Insight from the History of Ultra Vires DoctrineStudies on related party ultra vires corporate guarantees in China have largely focused on corporate laws and the imported notion of ultra vires, which was born in the UK, traditionally making corporate acts void that went beyond the objects of the corporation set out in its memorandum. But this doctrine has lived past its prime. The days are almost over when a corporation existed only by virtue of a charter granted by the government and had no more powers than were bestowed upon it in the charter. It is increasingly recognized that a corporation has power to carry out any lawful business, thus the influence of the ultra vires doctrine has gradually diminished. Apart from a tremendous body of English case law that reflects the wax and wane of the doctrine, this process is also marked by two pieces of legislation in section 2(1)(c) of the Companies Act 1985 of UK provided that the memorandum of a company was required to ‘state the objects of a company’, making corporate acts outside of the scope of objects ultra vires and void, whereas sections 31 and 39 of the Companies Act 2006 provided that a company has unlimited capacity to act unless a company’s articles specifically restrict the objects of the company. Section 40 further provides that for a person dealing with a company in good faith, the power of the directors to bind the company is deemed to be free of any limitation under the company’s constitution. It is generally agreed that these provisions in Companies Act 2006 in effect abolished the doctrine of ultra vires.Development of the ultra vires doctrine followed a similar curve in other countries such as the US, with ultra vires corporate acts going from void in principle to valid in favor of a good faith party dealing with the corporation. In China, the ultra vires doctrine, though never officially appearing in corporate legislation, has long since been an indispensable part of scholarly legal discourse and has had tremendous influence on judicial practice. Since the inception of the Company Law of 2005, the thrust of the ultra vires claim in corporate guarantee cases has been constantly on the wane, with increasing percentages of ultra vires corporate guarantees ruled to be valid, until the number peaked in 2015 (See Chart 1).Research on the ultra vires doctrine in China, this paper included, invariably referred to its western origin and interpretations. However, the Chinese version of ultra vires (translated as Yue Quan) is a varied notion compared to the original western doctrine that it stemmed from. Chinese corporations have never been restricted by a government charter in its scope of objects, as used to be the case in the UK and the US. In other words, Chinese corporations have always been allowed to engage in any lawful business activity at least since the Company Law of 2005. What is commonly referred to as ultra vires acts in the Chinese corporate world is quite often intra vires to the corporation and ultra vires only to the persons carrying out the act. Therefore, judicial treatment of these acts should not automatically conform to the western trend of rejecting ultra vires doctrine as antique, a preoccupation that seems to affect some Chinese scholars and practitioners. B. From Ultra Vires Doctrine to the Law of AgencyCorporate guarantees given to a related party pose a conflict of interest between the related party and the corporation itself. In handling transactions with a conflict of interest, some legal systems apply an intrinsic fairness test, essentially burdening the acting agent with the task of proving that the proposed deal is fair to the corporation. Some legal systems adopt so-called safe harbor procedures, subjecting the proposed deal to more procedural hurdles as a way to weed off shady deals and also afford the conflicted agent some protection against future challenges on the merit of the deal. What article 16 of the Company Law prescribes is precisely this kind of safe harbor procedure, requiring resolution of the shareholders and recusal of the conflicted shareholder from the vote. When guarantees are given in violation of such procedural requirements, the act does not go beyond the powers of the corporation; it simply has not been properly approved by the requisite corporate authority. In other words, the CEO, director or legal representative of corporation, acting as agents of the corporation, went beyond their scope of authorization vested by the principal, i.e. the corporation. Therefore, at the root of the matter, the tension between the creditor’s claim of ignorance and desire to be protected in its reliance on defective documents, and the corporation’s assertion that the documental defects are apparent enough to be seen by any reasonable person, falls within the purview of agency law. Whether or not the corporation is bound by the guarantee ultimately depends not on the prowess of the classic ultra vires doctrine, but on the law of agency, especially on the notion of ‘apparent authority’, which allows an outside party, e.g. the creditor, to rely on what reasonably appears to be proper authorization, and hold the principal, i.e. the corporation, accountable for such appearances.When are appearances sufficient to warrant reliance by an outside party? The usual analytical approach adopted in Chinese courts is that appearances that stand up to formal inspection of the outside party are sufficient to warrant reliance, otherwise the outside party is deemed to ‘know or should have known’ about the lack of authority and loses the good faith status that protects him. But what is the scope of formal inspection? How is the decision made that the outside party ‘knows or should have known’? These questions seem to be considered as part of tacit professional know-how that allows practitioners to draw intuitive conclusions without elaborating why, as was the case with the Merchants Bank Case. Essentially, it is using one undefined condition as prerequisite for the satisfaction of another undefined legal status. This line of reasoning seems self-contained on the surface but runs the risk of being tautological in nature and gives rise to confusion and inconsistencies, unless the specific scope of formal inspection is defined which corresponds with a clarified standard of knowledge, which then points to a conclusion about good faith. C. Degrees of Knowledge: The Baden ScaleIn related party ultra vires corporate guarantees, the creditor presumes validity of the guarantee based on documents that are submitted to him. There will be a point where defects of the documents are so obvious that the creditor cannot reasonably claim to be unaware of the lack of authorization and even if he so claims, knowledge shall be imputed to him; at the other end, there will be a point where defects of the documents are so hidden that knowledge cannot be reasonably imputed to the creditor. Between the two extreme points is a continuum of increasing degrees of knowledge that need to be demarcated to separate the culpable from the inculpable.In the 1983 English trust law case of Baden Delvaux and Leuit v Societe Generale pour Favoriser le Development du Commerce et de l’industrie en France SA, Judge Peter Gibson did exactly that. He articulated five categories of cognizance which later became known as the Baden Scale and had since had tremendous influence on cases involving possible liability of third party recipients. Creditors in related party ultra vires corporate guarantees, just as recipients in the Baden Scale, receive certain benefit that was bestowed upon him through faulty process and defective authority, and their knowledge of the defective authority determines whether they ultimately get to enjoy the said benefit should a controversy later arise. Thus, the Baden Scale can serve as a framework for determining creditor knowledge and ultimately creditor good faith in cases of related party ultra vires corporate guarantees.The aforementioned five categories are: (i) actual knowledge; (ii) willfully shutting one’s eyes to the obvious; (iii) willfully and recklessly failing to make such inquiries as an honest and reasonable man would make; (iv) knowledge of circumstances which would indicate the facts to an honest and reasonable man; (v) knowledge of circumstances which would put an honest and reasonable man on inquiry.Of the five categories, the first is the only category where the third party subjectively and actually ‘knows’ about the lack of authority. For the rest, knowledge of the lack of authority however probable, is imputed, i.e., the third party ‘should have known’, to adopt the term more commonly used in the Chinese legal discourse. This differentiation is not of much practical significance though, as it is not possible to get into the head of anyone to ascertain his actual thoughts, and all that matters is the objective manifestation of the subjective mental state. Following the same logic, ‘know’, indicating actual knowledge, and ‘should have known’, indicating constructive knowledge, also point to the same legal result in Chinese commercial laws.The second and more significant line is drawn between categories (i) to (iii) and categories (iv) and (v). In the first three categories an element of dishonesty is often present. Category (i) being the most culpable actual knowledge, in category (ii), the third party suspects wrongdoing yet failed to make inquiries because he ‘did not want to know (for fear of what he might find)’; In category (iii), the third party failed to make inquiries because he recklessly regarded it as ‘none of his business’. All three are unconscionable and thus deserving penalty. In categories (iv) and (v), facts that went unnoted were often less obvious, sometimes circumstantial and not directly linked to the defective authority itself. The third party may know of certain suspect circumstances yet failed to raise questions because of his inexperience, but this failure fell short of being willful or reckless. In this regard, the Baden Scale considers not only the obviousness of the facts, but also the third party’s position in relation to the facts, lending itself to application in distinguishing between different types of third parties when inferring knowledge. In judicial practices, categories (i) to (iii) usually lead to the conclusion of knowledge on the part of the third party, while categories (iv) and (v) usually are not sufficient to support such a finding.In related party ultra vires corporate guarantees, the creditor’s fulfillment or failure of inspection duty reflects his state of knowledge which determines his good faith status. The Baden Scale, by calibrating the abstract notion of knowledge, refines the largely under-studied link between creditor inspection duty and their good faith status, and thereby lays the foundation for a framework of criteria for determining the good faith status of creditors, one which integrates the creditor’s performance of inspection duty and his corresponding knowledge of the lack of authority, as shown in Chart 3 below.
As the chart shows, failure of inspection duty lands creditors in categories (i) to (iii), deprives them of the good faith status and makes them bear losses for the loan, while fulfillment of inspection duty lands creditors in categories (iv) or (v), secures the good faith status for them and insures them against the defaulting loan to the extent of the guaranteed amount. This framework is far from thorough, as it remains to be studied the specific scope of inspection duty to be imposed on the creditors, which the following section will elaborate on.
VI. INSPECTION DUTY IN DIFFERENT SCENARIOS OF DEFECTIVE AUTHORITY
A. Three Kinds of Inspection DutiesIn the Chinese legal framework, recipients of documents may be charged with one of the three kinds of inspection duties, i.e. the duty of formal inspection, the duty of substantial inspection and the duty of conscientious inspection. At the lower end in terms of inspector burden is the duty of formal inspection, requiring the recipient to examine whether all legally required documents are presented in the manner dictated by law and specifying the legally required contents. At the higher end is the duty of substantial inspection, which requires that the inspector to not only check the documents themselves, but also verify whether what is on paper corresponds with what really happened. One could say that the scope of formal inspection is confined to the four corners of the instrument, whereas substantial inspection extends into real life. A latecomer to the scene is the notion of conscientious inspection, appearing first in an intermediary level court opinion in 2007 and then made its way into legislations. Despite lacking clear definition, conscientious inspection is generally recognized as a point of junction between formal inspection and substantial inspection. It requires the recipient to first examine the formal elements of the documents with reasonable care and diligence, and if his experience and expertise suggest something suspect, he could then veer into the realm of substantial inspection and conduct necessary fact checking to rule out or confirm his doubt, if it is within its function and capacity to do so.These three kinds of inspection duties are meant to be imposed on different recipients of documents depending on different circumstances to achieve a nuanced balance of equity and efficiency. Unfortunately, that is not the case in current judicial practices. In the collected 248 related party ultra vires corporate guarantee cases where the court stated its stance on inspection duty, 77 percent of courts just presumed creditors to be in good faith and considered it unnecessary to impose any kind of inspection duty on them, that is to say, as long as a contract of guarantee was executed on behalf of the corporation, the guarantee shall be valid and binding on the corporation, even without the shareholders’ resolution, making it a strict liability of the corporation for the wrongful actions of its agents. This flat and arbitrary conclusion stems from perceiving of article 16 as targeting only the internal governance of the corporation and insulated from the creditor, and it also falls conveniently in line with the misguided preoccupation to abandon the outdated ultra vires doctrine. The value orientation reflected in this approach is to put transactional efficiency above transactional equity and security. This orientation, though not necessarily wrong in theory, in practice puts the corporations at unreasonable risks and becomes a source of controversies, ultimately undermining the notion of transactional efficiency that it set out to promote. Right now related party ultra vires corporate guarantees amount to 72 percent of all cases involving corporate guarantees, and of all corporate guarantee cases that went to the Supreme People’s Court, 90 percent were related party guarantees (See Table 1). The tendency towards litigation and a prolonged judicial process speaks to the need for a more reasonable imposition of creditor inspection duty.
With different stakeholders and potential conflict of interests within the corporation, related party corporate guarantees are more complicated and deserve more attention from the creditor than guarantees given to parties at arm’s lengths. The Supreme People’s Court recognizes the specialness of related party corporate guarantees and generally opts for a duty of formal inspection charged to the creditor, despite the bulk of court opinions that speak otherwise. In the widely quoted Zhong Fu Industrial Guarantee Case, the Supreme People’s Court ruled that the creditor could not assert good faith status by claiming ignorance of mandatory provisions of the law, because ‘no one is exempt from application of the law by claiming ignorance of it’. This stance has remained unchanged to this day. Even in the Merchants Bank Case which was seen as been too lenient on the creditor and too tough on the corporation, it remained the position of the Supreme People’s Court that the bank should nevertheless make sure that ‘the shareholders’ resolution exists’, as it is so prescribed in article 16 of the Company Law. These precedents, though not legally binding, usually would enjoy significant levels of deference by lower courts. The reason why the Supreme People’s Court signals for formal inspection duty fail to filter through the entire system in related party ultra vires corporate guarantee cases may have something to do with the lack of clear specification as to the scope and content of so called formal inspection. The following subsections shall attempt to put formal inspection duty into perspective in the context of related party ultra vires corporate guarantees.B. Documental Requirements for a Related Party Corporate GuaranteeFor a related party corporate guarantee to be unimpaired in its validity, two basic conditions should be met. First, the corporation assumes contractual obligation as guarantor. Document-wise, this means: (i) a guarantee contract executed on behalf of the corporation; (ii) the said guarantee contract bears the corporate seal; (iii) the corporate seal on the contract is authentic; The second condition is imposed by article 16 of the Company Law, dictating that the guarantee be properly approved by the shareholders. This condition is manifested in the following documental requirements: (iv) a written shareholders’ resolution of said corporation; (v) the said shareholders’ resolution should attest to the guarantee; (vi) the shareholders’ resolution should bear seals of voting shareholders; (vii) voting shareholders should be qualified to vote on the matter, i.e. those to whom the guarantee is to be given should not vote; (viii) qualified shareholders constitute a legally required majority; (ix) corporate seals of shareholders on the shareholders’ resolution are authentic.Some of the above requirements can be verified with little effort while others involve more work. The following subsections shall discuss which of the above requirements should be included within the scope of the creditors’ formal inspection. C. Requirements that Are Easily VerifiableAt the outset, a simple and direct reading of article 16 translates it into two documents: a contract of guarantee and the shareholders’ resolution. The creditor should see to it that these two documents at least exist. Therefore, aforementioned requirements (i) and (iv) should be the starting point of the creditor’s formal inspection duty. A written contract is formed when the parties execute it with a seal or signature, hence aforementioned requirement (ii). At a slightly higher level, anyone with basic common sense in commercial dealings should know that a written manifestation of intention does not come into effect unless it bears the seal or signature of the party making the manifestation, therefore shareholders have to indicate their consent to the guarantee by applying their seals (or signatures in case of natural person shareholders) on the shareholders’ resolution, hence aforementioned requirement (vi). The above (i), (ii), (iv), and (vi) involve elements of the documents that are strictly formal in the literal sense of the word, so much so that they could be checked without basic comprehension of the roles of the parties involved. That, of course, is rarely the case in the real world, as one would not hope it to be. It is thus reasonable to expect the creditor to at least read through the content of the shareholders’ resolution to see what it is about, instead of just glancing at the title of the document, hence requirement (v). Requirement (vii) on recusal of conflicted shareholders is a straightforward reflection of paragraph 3 of article 16, and checking this requirement involves just a little more effort, i.e. reading through the guarantee contract to know the parties and then double checking with the shareholders’ resolution to make sure the guaranteed in the guarantee contract does not appear as a voting shareholder in the shareholders’ resolution. To sum up, requirements (i), (ii), (iv), (v), (vi) and (vii) are direct implications of article 16 of the Company Law. The act of checking these requirements is also confined to the documents themselves without entailing consultation of other sources of information. As far as the nature of inspection is concerned, it is well within the realm of formal inspection and does not overburden the creditor, of whom due diligence of a reasonable business person is expected, especially regarding the particular transaction of related party corporate guarantees which are known to breed controversy. Therefore, overlooking these requirements would only indicate the creditor’s implicit knowledge of the lack of authority or his intentionally turning a blind eye to the defects. This puts the creditor in categories (i) or (ii) of the Baden Scale and deprives him of his good faith status. The said creditor should be imputed knowledge, or in other words be deemed to ‘know or should have known’ that the guarantee lacked proper authorization and as a result does not bind the corporation, as shown in the following Chart 4.
D. Requirements that Give Rise to Controversy
1. A Legally Required Majority. — For creditors to check requirement (viii), they have to have reliable information on the shareholding structure of the corporation so that they can count the shareholding percentages of voting shareholders. For a public corporation, the shareholding structure is readily accessible by the creditor. For a closed company, the creditor has two options. One is to go to the local Bureau of Industry and Commerce to request such information. This option can be problematic as different regions have different policies on providing such information, most involving a power of attorney from the corporation itself. The other option is to simply demand from the corporation a copy of the shareholder’s ledger which is on file with the Bureau of Industry and Commerce and bearing the Bureau seal. In this way, no unreasonable ex ante burden is imposed on the creditor as it is the corporation that bears the ultimate burden of providing the required document.Some argue that whether the shareholders’ resolution manifests a majority shareholder vote is a matter of internal governance and not subject to the creditor’s double checking. Granted, it would not be the creditor’s place to make sure majority shareholders actually voted on the matter. But it would be the creditor’s duty to make sure that the shareholders’ resolution manifests a majority shareholder vote in appearance. The prescription in article 16 as to the specific manner of reaching the shareholders’ resolution in related party corporate guarantees is essentially legislative intervention recognizing different stake holders and possibly different wills within the corporation that needs to be officially and ostensibly unified. The legitimate formation of the shareholders’ resolution is thus not only about internal process management but also about signifying unity and validity to outside parties. Therefore, the internal management rule whereby outside parties can presume fulfillment of internal procedures does not automatically apply in related party corporate guarantees as it would in ordinary guarantees where the corporation can be seen as an indivisible entity with a single manifested will of itself.To expound on the imperfect validity of related party corporate guarantee contracts entered into without complying with article 16, an analogy can be drawn with contracts made with minors. The option to later rescind or confirm the contract lies with the minor because it is the minor that the law on contractual capacity aims to protect in this case. A look at the legislative history of article 16 reveals that it was adopted to curb the rampant ultra vires related party corporate guarantees that hurt the corporation’s interest. In other words, the legal intent of article 16 is to protect corporations from misconduct by its acting agents. If legally required procedures are easily circumvented by acting agents and the corporation gets the blunt of the blow, as is often the case in real life, then the law is not serving its purpose. The current mechanism to achieve protection of the corporation is essentially by forcing the corporations to keep a closer eye on their agents or else suffer dire consequences. Judging by the current rampancy of related party ultra vires corporate guarantees, this mechanism does not seem to be working effectively, and it is not hard to fathom why. Solving the age-old agency problem requires comprehensive arrangements and long term efforts on corporate governance. It cannot be achieved by simply making corporations suffer for their governance failures, because they already do. On the other hand, shifting the potential consequences towards the creditors might actually create barriers for the corporation’s acting agents who intend to circumvent legally required procedures, because creditors, fearing possible legal consequences, will request more reliable documents before entering into a deal, making it more difficult for acting agents’ opportunistic behaviors.Under this new mechanism, creditors about to enter into the related party guarantee contract should consider it a prerequisite to have reliable documents attesting to the majority shareholder vote and to that end should reasonably request information on the shareholding structure of the corporation so that they can go through the step of calculating the shareholding percentages of voting shareholders to determine that a legally required majority was reached. If the corporation refuses to cooperate by supplying the shareholder’s ledger, the creditor has ground for suspecting that the voting shareholders did not in fact constitute a legally required majority and should stop the deal. Creditors who go ahead with the deal without bothering to inquire about the shareholding structure, or fail to do the simple calculation with requisite shareholding information in their possession shall fall in category (iii) of the Baden Scale, because of their ‘willfully and recklessly failing to make such inquiries as an honest and reasonable man would make’. Whether the creditor’s failure is a result of his intentionally turning a blind eye or not paying enough attention has no bearing on the result, as both mental states land the creditors in the same category, as shown in the following Chart 5.
It should be emphasized that the ultimate goal of shifting the negative legal consequences toward the creditors is not so much for punishment as it is for nurturing a good industry practice. With shifted judicial rulings sending strong signals to the creditors to take formal inspection duty more seriously, a good industry practice will gradually develop to nip in the bud potential ultra vires related party guarantees and reduce risks for not only the corporations but also for the creditors.2. Authenticity of Corporate Seals. — Requirements (iii) and (xi) both have to do with authenticity of corporate seals. To an untrained eye, a forged corporate seal can look the same as the real one. In cases such as these, there is no way for the creditor to know that the seals are forged short of bringing in a professional judicial authenticator, which would constitute unreasonable burden on the creditor. That is why there is almost a consensus of court opinions excluding seal authentication from the scope of creditor formal inspection duty. However, it may be just too soon to equate all kinds of seal authentication with substantial inspection, as to do so ignores scenarios where the untrained eye can notice forgery of the seal without help of a professional authenticator. In a case involving defective filing for corporate changes, the Shanghai Intermediate People’s Court held that the Shanghai Bureau of Industry and Commerce was at fault for failing to discover that the corporate seal on the new documents was not the same as the one on the old documents already on file with the Bureau, that had the Bureau noticed the difference, it would have suspected a possible forgery. Although the Shanghai Bureau was charged with the higher duty of conscientious inspection, its negligence occurred in the first stage of its inspection duty i.e. the stage of formal inspection. The level of formal scrutiny the Shanghai Bureau should have applied would have led to discovery of inconsistent corporate seals, and it would also lead to discovery of other similarly gross irregularities, such as seals showing illegitimate corporate names in the Merchants Bank Case.This article is not proposing that said level of scrutiny be required of all creditors in related party ultra vires corporate guarantees, even though the scrutiny is formal inspection in nature, because it could be argued that formal inspection as part of conscientious inspection, which is generally imposed on public bodies accepting corporate filings, requires a higher level of experience and expertise than formal inspection as independently imposed on ordinary creditors who may not possess said experience and expertise. To notice gross irregularities in corporate seals requires experience with loans and guarantees and a certain degree of familiarity with corporate laws. For most corporations, loans and guarantees are not part of their ordinary course of business. As for corporate laws, while creditors are reasonably expected to be familiar with article 16 of the Company Law, which is the most pertinent provision for their contemplated deal, the same cannot necessarily be said of more detailed provisions on corporate names, which are scattered in different legislations. Given vastly different levels of experience and expertise, the same measure of diligence in the performance of inspection duty may lead to different results in what the performance yields. Therefore, the creditors’ good faith status and ultimately the legal consequences they are to face should not be determined purely on the grossness of the defects they failed to notice, but also on the categorical ease or difficulty with which they can reasonably be expected to notice such defects.Financial institutions are major providers of loans in corporate guarantee cases and as such they are distinguished from other corporations in both relevant experience and relevant expertise. So should financial institutions keep an eye out for the seals in order to discover at least gross irregularities? Those who argue against it might consider it unfair to impose a duty on financial institutions that even some public bodies have difficulty fulfilling. This argument confuses ‘what is’ with ‘what ought to be’. Public bodies are properly charged with a higher level of inspection duty; they are just not always held to it for reasons that are beyond the scope of this article. Unpunished negligence on the part of public bodies subtly contributed to the current low standard of inspection duty, first in the corporate world and then in judicial practice. And that is precisely where financial institutions, mostly state-owned and widely perceived as quasi-public bodies, can come in to uphold the sunken standard. While it is not within the prowess of the Company Law to hold public bodies to their lawful duties, a general enhancement of inspection standard throughout the corporate world will create an upward driving force even for public bodies that would be on the receiving end of better quality documents. In this way the Company Law realizes its mission to promote good industry practice, instead of allowing for downward compatibility. Financial institutions are best suited to set the ripples in motion, not only because of their superior experience and expertise as well as their special stake in the whole corporate guarantee arrangement, but also because they are quicker than ordinary corporations to read policy shifting and adjust behaviors accordingly, so that a little bit of pushing goes a long way as judicial signals filter fast through the financial community. For financial institutions themselves, the cost of reviewing documents will be spread out through economy of scale in the multiple loan transactions they engage in, thus the legislative mission can be achieved without taking a heavy toll on the financial institutions. Stricter inspection from financial institutions not only improves inspection standards and curbs ultra vires related party corporate guarantees, it is also conducive to good corporate governance in general by directing the flow of capital to better governed corporations. Financial institutions have the inherent motivation to issue more loans as long as revenues from loan interest outweigh costs and bad debt risks associated with the loan. When guarantee is provided for a loan, spending time reviewing guarantee documents adds administrative cost for the institution but offsets bad debt risks by increasing the chance of reimbursement based on the guarantee. The optimal equilibrium of reviewing cost (C) and bad debt risk (R) is the point where the combined value of the two is at a minimum. The current judicial practice, by putting insufficient burden on the institution to review documents and making it unlikely for it to face negative legal consequences, simultaneously lowers both C and R and thus broadens profit margins from loans on both ends. This will lead to financial institutions increasing the number of loans despite some of them being problematic. While more supply of capital might be beneficial for the economy as a whole, loans that are obtained with defective authority are less if at all beneficial, as they will end up in the hands of dishonest agents from poorly governed corporations. On the other hand, stricter inspection duty of financial institutions directs the flow of loans away from dishonest agents and towards better governed corporations. By demanding legally compliant documents and reviewing them more carefully, financial institutions in effect assume a monitoring role for the corporation, as their counterparts have done in the past few decades in Germany and Japan, where this banks-as-monitors system has proven to provide a valid source of outside monitoring for better corporate governance. Stricter inspection duty from financial institutions is essentially part of the mechanism analyzed in the previous subsection, i.e. to activate an outside force to fill a void in the corporation’s insufficient internal governance. It is the proposition of this article to include gross irregularities of corporate seals into the scope of formal inspection duty of financial institutions, which, with their superior experience and expertise, are capable of noticing such irregularities with relative ease and raise suspicions of a possible defect in authority. Under this proposition, if financial institutions failed this aspect of their formal inspection duty and it is later discovered that the seals are in fact forged, they would fall in category (iii) of the Baden Scale for willful or reckless failure to raise inquiries. For ordinary creditors, the same failure would land them in category (vi) or (v) of the Scale, because the task of checking corporate seals for irregularities is categorically more difficult for ordinary creditors and thus beyond their inspection duty. This differentiation between financial institutions and ordinary creditors is in line with the general interpretation of the Baden Scale as taking into account not only the obviousness of the facts, but also the creditor’s position in relation to the facts, as shown in the following Chart 6.
It should be pointed out that the delineation of inspection duty, creditor knowledge and creditor good faith status in this part by no means lends itself to ready application, as a lot remains to be filled out with judicial experience and discretion, such as what constitutes gross irregularities, or a possibly more elaborate typology of creditors rather than a simple dichotomy of financial institutions vs. non-financial institutions. The author primarily aims to sort out specific requirements of article 16 of the Company Law as well as how they translate into documents to be provided and correspond with the kind of inspection duty to be fulfilled. So much of the current discussion on creditor inspection duty in related party ultra vires corporate guarantee cases hinges on a macro choice between efficiency and security. This part of the article attempts to bring that discussion to the ground to encompass how the parties’ positions define their actions and how these actions interact with and affect each other, in the hope of understanding what mechanism is at work in the whole process of a related party corporate guarantee and in that light how legislative purposes can be better achieved. In the scenario of related party ultra vires corporate guarantees, the guarantor corporation has been taking the brunt of the blow, hijacked by its acting agents and then subjected to negative, sometimes dire financial consequences. In that light, article 16 of the Company Law prescribed specific procedural requirements to curb ultra vires guarantees and protect the corporation’s interests. In the current judicial practice, the price of not following these requirements is often paid by the corporation itself, the rationale being that under such threat the corporation would keep a closer eye on its acting agents to prevent unauthorized opportunistic behavior. However, judging from the continued rampant occurrence of related party ultra vires corporate guarantees, the corporation seems to have insufficient control over its acting agents who often have independent will, wide leeway and, more importantly, conflicting interests with the corporation. Article 16 of the Company Law recognized the diverging forces within the corporation by discriminating related party corporate guarantees from ordinary corporate guarantees, but the current mechanism of actualizing article 16, i.e. by forcing the corporation to reign in its agents, ignored that aspect of reality. An outside force needs to be brought in to create barriers for corporate agents who try to circumvent legal procedures. Creditor inspection duty has the potential of putting that force in place. By strengthening creditor inspection duty, especially that of financial institutions, creditors, out of fear for legal repercussions, will be more stringent in requesting and reviewing legally pertinent documents from acting agents of the guarantor corporation, rather than treat their formal inspection duty as a literal formality because they can later get away with claiming ignorance of the documental defects. In this way, creditors in effect assume the role of gatekeepers of the corporation who deter corporate agents from dishonest acts or prevent those acts from coming into fruition.