HOW COULD DERIVATIVE ACTION WORK IN CHINA: THE FUNDING ISSUE

Lin Shaowei

I. INTRODUCTION

Derivative action was introduced into the Chinese Company Law for the very first time during the revision process in 2005. Some scholars have argued that derivative action was actually permitted under the Chinese Company Law of 1993 because article 111 of the Chinese Company Law of 1993 provided that shareholders have the right to raise a suit when directors violate the law. However, mainstream scholars object to this view and assert that this article was only intended for shareholders’ personal actions in joint stock companies.

During the period before the revision of 2005, calls to introduce a new statutory derivative action became louder, though some conservatives strongly opposed this proposal preferring to seek alternative mechanisms. This opposition movement argued that in many cases the courts would be reluctant to accept derivative litigation not only because of a lack of procedural rules but also because of economic development in respective local cities. They further argued that if a new statutory derivative action were adopted in the new company law, the courts would become bewildered by the procedure in the absence of a revision of the Chinese Civil Procedure Law.

Derivative action in China does indeed require the revisions of the  Company Law and the Civil Procedure Law. However, some argued that we should not waste valuable time waiting for the change in the Chinese Civil Procedure Law, meanwhile ignoring the interests of minority shareholders. Furthermore, some derivative suits were actually initiated successfully against wrongdoers without the relevant procedures, though their application was very limited as the courts failed to point out the exact requirements for derivative actions. Calls for the introduction of derivative action were finally successful and the mechanism was adopted in the recent revision. This is a major development in the Chinese Company Law and has been regarded as a milestone in reform. The revision of 2005 provides a general legal framework for the initiation of derivative actions, intended to function so as to control management and majority shareholders.

However, the application of this right is not as effective as expected. Huang Hui has conducted an empirical research about this and found that there were only 50 cases during the first five years after its implementation. This seems to be a good number comparing with Japan. When Japan adopted derivative action in 1950, it laid moribund for the first thirty-five years of its existence. However, although there were very few cases for the first forty years after derivative action was enacted in Japan, one should not neglect the fact that the number of derivative actions cases skyrocketed from the early 1990s. In 1993, there were 86 cases pending before Japanese courts and the number continued to rise, peaking in 1999 with 95 new cases filed and a total of 222 cases pending. Comparing with this figure, 50 cases for eight years in China does not seem to be a good number. 

In fact, many problems with this new rule were found. For example, the standing requirement for shareholders in joint stock companies is too high and the procedure of demand requirement is unclear. However, this article is not intended to examine all these problems as there are a vast amount of literature about this. Instead, this article aims to explore derivative actions from the perspective of funding rule as the funding rule is very important in derivative actions. As such, this article first introduces the unique economic nature of derivative actions so as to demonstrate the importance of funding rules. It then proceeds to discuss the current funding rules in China. The third part will evaluate funding rules in the English and the US laws and the possibility of whether they could be transplanted will be examined. The last part discusses the issue that why derivative actions can be encouraged if the new funding rule is introduced.

II. THE UNIQUE ECONOMIC NATURE OF DERIVATIVE ACTIONS

Generally, prospective plaintiffs would consider the amount at stake, legal costs and the probability of success in deciding whether an action should be brought as litigation is not free and can be expensive. Litigation is rational where sums recoverable and the chances of success exceed the cost of legal expenses and the probability of losing the action. However, the unique nature of derivative action makes the incentive for shareholder litigation different from that of other types of action. As the traditional rule of proper plaintiff principle reveals, shareholders are not entitled to initiate litigation against wrongdoer directors or majority shareholders on behalf of the company as the company itself is considered to have suffered the wrongdoing rather than the shareholders. A derivative action allows company claims to be raised by shareholders, making those shareholders nominal claimants while the company is the actual claimant in terms of the underlying interest. In recognition of the unique economic nature of the derivative lawsuit, the conclusion can be drawn that any recovery from the litigation would be accrued by the company rather than plaintiff shareholders. 

This obviously has a considerable impact on the latter’s decision to raise proceedings as they would need to consider the gains and losses before doing so. In derivative actions, shareholders have to pay lawyers’ fees and the legal costs of the defendant if an action is unsuccessful. On the other hand, they are not eligible for compensation directly from the defendant if they win the case. In consequence, a rational shareholder might not choose to bring derivative litigation. Instead, they might prefer to sell their shares and leave the company. Furthermore, bearing in mind that any compensation or other relief obtained from the defendants flows directly to the company, the phenomenon of the free-ride problem is also brought into operation. Individual shareholders would be strongly discouraged from bringing derivative actions as each shareholder would expect others to raise such proceedings. However, if all shareholders share the same view, then no derivative action is likely to be initiated even if such litigation may bring substantial benefits to the company.

Although it is argued that a plaintiff shareholder can benefit indirectly from recovery, the average value of any expected award that such a shareholder could receive pursuant to a successful claim is low. The value of a plaintiff’s shareholding would probably be increased if recoveries accrue to the company and thus augment its asset base. However, this is a somewhat hypothetical benefit and far less certain as the value of a company’s shares is determined by a large number of factors beyond underlying asset value. In fact, the value of a company’s shares may be reduced if the company’s reputation is damaged or the public loses confidence in its management as a result of the litigation. Even if an action is successful and thus increases the value of a company’s shares, what shareholders will receive is a pro rata share of the gains from such an action. In light of the small amount of shares that plaintiff shareholders as minority shareholders hold, one would imagine that they will gain insignificant or even negligible benefits indirectly from any successful litigation. This is particularly true in the case of listed companies which are very big and have highly dispersed share ownership.

III. THE FUNDING RULES IN CHINA

In view of the unique economic nature of derivative action, shareholders would be strongly discouraged from raising proceedings without other sources of funding. If funding rules were appropriately established and effectively used, the hurdles hindering the operation of derivative actions would be largely removed, and the interests of the company and minority shareholders better protected. However, there is no special funding rule for derivative actions in China. According to the Measures on the Payment of Litigation Costs (hereinafter referred to as the MPLC), shareholders who wish to bring actions to the people’s court have to pay court fees and lawyers’ fees.

A. Court Fees

Court fees consist of filing fees, application fees and court expenses. Filing fees, also called as case acceptance fees, are the fees that any person who files a suit counterclaim or appeal has to pay to the court within seven days upon a notification made by the court on the payment for such court fees. If a plaintiff fails to submit such fees to the court without justification, the case will be treated as withdrawn by the litigant. Application fees include the costs of applying for security over property, the order of payment, public notice, etc. Court expenses are the fees that are incurred during the hearing of the case, including the costs of travelling, accommodation, living allowances and subsidies paid to witnesses, experts and translators.

Application fees and court expenses are charged according to the amounts that are actually incurred and covered by the initiating party. Generally, the amount of such fees is low in practice and thus they would not constitute an obstacle to a shareholder wishing to bring a derivative action. On the other hand, filing fees follow the principle of loser pays. This means if a plaintiff wins the case, he or she could recover these fees from the defendant. If an action is unsuccessful, then the plaintiff has to bear this cost. This could be a real problem for a prospective shareholder as the amount of such a fee could be huge and thus unaffordable. According to article 13 of the MPLC, court fees can basically be calculated in two ways. Where the nature of a case is monetary, the court will charge the case by a percentage of the claimed amount. Where the filing is non-monetary, the court fees are fixed; derivative actions are regarded as being of a monetary nature. As such, a plaintiff shareholder has to pay the filing fees calculated on a percentage of the value of the claim before continuing to the trial stage. According to article 13(1) of the MPLC, the standards of the amount of filing fees in respect of monetary cases are as follows: 

If a plaintiff shareholder decides to withdraw an action, he or she still has to pay half of the above filing fees. A derivative action is regarded as being monetary in nature and thus the filing fees could be very high under the above standard. For example, if a plaintiff shareholder wishes to raise proceeding in court claiming damages of twenty million yuan, he or she would have to pay 120,000 yuan in filing fees. If he or she is lucky enough to win the case at the first instance and no appeal is raised by the defendant, he or she can recover those fees. However, this would not be the end of the matter as the plaintiff may have to apply for the enforcement of the judgment and thus have to pay an additional 20,000 yuan in application fees. If a plaintiff loses a case in the first instance and decides to appeal, he or she would have to pay the same amount of filing fees again, which would be a total of 240,000 yuan. Although this is a hypothetical example, some plaintiffs have even had to pay more than this amount in practice. For example, in the case of Xin Jiangnan, the plaintiff had to pay 152,573 yuan in filing fees. In the Zhongqi Qihuo case, the filing fee was approximately 830,000 yuan. As the lawyers in that case pointed out, the plaintiff could not afford such a large sum if they were not financially sound and strong. Some plaintiffs, therefore, have to reduce the disputed amount so as to pay lower filing fees. For instance, in the Hongshi Shiye case, three plaintiff shareholders claimed only 100 million yuan while the actual damage caused has been over one billion. Even so, it was still difficult for the plaintiffs to pay 500,000 yuan for the filing fees, one can only imagine how hard it would be for the plaintiff shareholders to pay five million yuan if they claimed for the true disputed amount. Although filing fees can be recovered from the defendant if the plaintiff wins the case, the prospects for this are far from certain. Furthermore, few plaintiffs as minority shareholders are likely to be able to afford this filing fee as they are unlikely to have such large amounts of money. However, if this practice were to be widely followed by other prospective plaintiffs, two issues would emerge. Firstly, the company’s damages would not be fully recovered and thus the compensation function of derivative action would not function properly. Secondly, directors or controlling shareholders are unlikely to be deterred by a derivative action if prospective plaintiff shareholders are compelled to reduce the disputed amount in order to pay lower filing fees. If the deterrent function of derivative actions is compromised in such a severe way, they would be reduced to a glamorous-looking mechanism that lacks effectiveness in constraining misconduct.

B. Attorney’s Fees

There is currently no law regulating attorney’s fee as this is regarded as a private business matter for plaintiffs and lawyers. Therefore, a plaintiff shareholder has to pay his or her lawyers fees regardless of the outcome of the action. This means a plaintiff shareholder has to pay not only court fees but also lawyer’s fees if an action is unsuccessful. Indeed, even where a lawsuit is successful, plaintiffs must still pay attorney’s fees. This is somewhat confusing, and at worst absurd, if one considers the economic nature of derivative actions. As stated earlier, any compensation recovered from the defendants will accrue to the company rather than plaintiff shareholders if they win the case. Plaintiff shareholders will only benefit indirectly from an increase in the value of the company’s shares which is uncertain because the value of a company’s shares is affected by many factors. As such, it seems that a plaintiff shareholder has nothing to gain, but much to lose under the current legal system.

It is argued that the attorney’s fees rule operates in a similar way to the American rule. This is because each party does not need to pay the counter-party’s lawyer’s fees irrespective of the outcome of the lawsuit. Therefore, a plaintiff can conclude an agreement with his or her lawyer that the attorney’s fees would only be charged contingent on the result of the action, which is similar to the American contingency fee arrangement. This practice is not uncommon in China as there is no law regulating the issue, and thus such an arrangement can be reached as long as both the plaintiffs and lawyers are willing to accept it. Indeed, the contingency fee arrangement could help to reduce a plaintiff’s burden as he or she does not need to pay the attorney’s fees if the action is unsuccessful. As such, the practice in China functions in a reverse fashion to that in the US. Unlike the US, there is no law in China stipulating that attorney’s fees must be compensated out of the sums recovered if an action is successful. In practice, a defendant rarely bears the burden of paying the plaintiff’s attorney’s fees when he or she loses a derivative action. Therefore, under the Chinese so-called contingency fees arrangement, a plaintiff shareholder does not need to pay the attorney’s fees if the case is unsuccessful, but has to pay such an amount if the lawsuit is successful. Another absurd issue may thus arise: a successful action would increase the legal costs payable by a plaintiff shareholder. In this situation, rational shareholders would prefer to adopt other mechanisms to protect their interests and those of the company.

IV. FUNDING DERIVATIVE ACTIONS IN THE ENGLISH AND THE US LAWS

A. The English Law

In most commonwealth jurisdictions, the obstacle of funding derivative actions is addressed by recognising that claimant shareholders have a right to be indemnified for costs incurred by litigation. This rule is established in the well-known case of Wallersteiner v. Moir. In this case, Dr. Wallersteiner, the defendant who was a director of the company at issue, had successfully prolonged the case for over 10 years. In spite of exhausting all his financial resources in obtaining a judgment against Dr. Wallersteiner, Mr. Moir had been unable to enforce and recover compensation for the company.

Considering the plight of Mr. Moir, the court of appeal held that although a plaintiff in a derivative action was not entitled to apply for legal aid and the contingency fee arrangement was beyond the court’s mandate, the shareholder should be indemnified by the company for the costs incurred, and to be incurred, in proceedings. The rationale behind this judgment is that the court established a rule based on the trust law in which a plaintiff shareholder is like a trustee and the company is analogous to a beneficiary. As such, a plaintiff shareholder is entitled to be indemnified by the company in the proceedings. The test for the plaintiff shareholder to obtain the indemnity order is that he or she is acting in good faith and it would be reasonable for an independent board of directors to initiate such an action in the company’s name. The court also ruled that a plaintiff shareholder is still entitled to indemnity regardless of the result of the action. This means that a plaintiff is eligible to apply for an indemnity order even if an action is unsuccessful. This is justified on the ground that the company who receives the benefit of a venture also ought to bear the risk of losing the case.

It was further held that an indemnity order should be applied at the stage when the plaintiff applies for leaving to initiate the action, but that an exception should be allowed if the court thinks it is appropriate to grant such order by the end of the proceedings. The court further held that such an application should be made ex parte and the procedures should be simple and inexpensive. However, this rule eventually came to be regarded as oppressive for companies as they would have to pay costs without advance notice shortly after the beginning of the proceedings. In Smith v. Croft (No.1), Judge Walton recognised that the Wallersteiner rule was unfair to the company and thus held that the company should participate in the application so that the indemnity order could be made on the basis of sufficient evidence. He also held that a plaintiff shareholder should pass a financial need test, so that an indemnity order is available only if a plaintiff is genuinely in need. Although this narrow approach has been followed by courts in other commonwealth countries, it was not adhered to in a later case.

In order to simplify the procedure, rule 19.9 of the Civil Procedure Rule (Amendment) (hereinafter referred to as the CPR) stipulated that a court is authorised to grant an indemnity order to the claimant in respect of costs incurred in the proceeding as it thinks appropriate. This provision remains unchanged as the Companies Act of 2006 does not mention legal costs in derivative actions. However, the provision in the CPR is simple and does not lay down any specific procedure that the party or the court must follow. The problems this creates will be examined below.

B. The US Law

The position in the US is quite unique in comparison to the English law. The general rule is that each party is responsible for his own lawyer’s fees regardless of the result of litigation. This is called the American rule and is also applicable to derivative actions. In addition, it is very common for a plaintiff shareholder to have a contingency fee arrangement with his attorney in derivative litigation. This means that a claimant does not need to pay his attorney’s fees if the litigation is lost. However, a plaintiff shareholder has to pay the lawyer’s fees if an action is successful. Two questions arise in relation to this principle of no win no fee. Firstly, considering the fact that any recovery from litigation will accrue to the company rather than the plaintiff shareholder, it seems that such shareholders are still strongly discouraged from bringing such litigation as they have to pay attorney’s fees. Secondly, the question arises as to what makes an attorney take on a derivative action under the contingency fee arrangement.

Two approaches have been adopted in order to address the above concerns: the common fund and the substantial benefit tests. First of all, if a lawsuit is successful and thus creates a fund for the company, then the plaintiff shareholder is entitled to be compensated out of the fund for his attorney’s fees. This principle is based on the theory of unjust enrichment. According to this doctrine, legal costs can be treated as a first charge against the fund if this benefits a class of shareholders beyond the nominal plaintiff. During the early application of this doctrine, the common fund was confined to a monetary fund. This was obviously unfair for the plaintiff in the situation where an action was successful and brought non-pecuniary recovery to the company. Recognising the shortcomings of this restrictive approach, the judiciary established a substantial benefit test: This requires determining whether litigation has achieved a result which corrects or prevents an abuse which would be prejudicial to the rights and interests of the corporation or affect the enjoyment or protection of an essential right to the stockholders’ interest. Under this test, a monetary relief apparently constitutes a substantial benefit, but non-pecuniary relief may also meet this test and thus attorney fees can be paid out of the fund. For example, it was held that an action resulting in a judicial declaration of the defects of proxy statements soliciting votes for a corporate merger conferred benefits upon the company. Nevertheless, although the test has been established as entitling a plaintiff to payment even if an action brings non-pecuniary relief, it is still unclear under which precise circumstances the plaintiff would be qualified for fee awards. It is argued that this needs to be decided on the individual circumstances of each case.

Under the contingency fee arrangement, attorneys may gain nothing if a case is lost. Derivative actions can be made attractive for attorney via two ways of deciding how much a plaintiff’s attorney can be paid. The first method is the percentage scale, which rewards attorneys with a percentage of the total recovery. This is normally applicable when the case generates a tangible monetary relief. Historically, attorneys can be paid in the range of 20 percent to 30 percent when the total recovery is below one million dollars and 15 percent to 20 percent when it is over that amount. The other method of calculating attorney’s fees in derivative actions is known as the lodestar method. Attorneys’ fees are determined by their work including the reasonable time they spent in conducting the litigation, the attorney’s customary hourly rate and the quality of their work.

V. A CRITICAL EVALUATION OF THE ENGLISH AND US RULES

A. Solution in the English Law: Indemnity Costs Orders

As discussed earlier, the common law recognises the special economic nature of derivative actions and thus confers the right on a plaintiff shareholder to apply for an indemnity order. Although this attempt to deal with the funding problem was regarded as imaginative at that time, its inherent deficiencies have become evident with the passage of time. This part will demonstrate the major flaws of the indemnity costs order approach and how the funding rule applicable in the English law may not be suitable for China.

First of all, it remains unclear in what circumstances an indemnity cost order can be granted. Although the Civil Procedure Rules of 2000 (Amendment) stipulates that a court may order a company to indemnify a claimant, they do not detail the conditions in which a claimant would be allowed to obtain such an order. As such, the court has to examine each case as it thinks fit. However, this substantial discretion may create uncertainty and cause great concern for shareholders. 

Indeed, the case law itself is also vague in many respects. The financial test provides a good example to explain this. In Smith v. Croft, Judge Walton approached the funding issue cautiously and added a financial needs test for the application of indemnity orders. He found that a company should not have to bear the cost of indemnity if a claimant has sufficient resources to fund the action. In other words, a plaintiff shareholder has to demonstrate that they genuinely require funding support. Otherwise, they will not be granted an indemnity order. This narrow approach has been criticised on the grounds of both principle and practicality. In principle, the rationale in favour of allowing an indemnity is that the plaintiff brings an action as a representative of the company. As such, the financial status of the claimant should be an irrelevant consideration in deciding whether an indemnity order should be granted. Thus, the court in a Canadian case pointed out that a test based on the financial means of the claimant offended against the principle that the claimant is acting as the agent of the company. Practically, this financial need test could be easily evaded by a shareholder whose financial status precludes them from obtaining an indemnity order. For example, if the aforementioned shareholder wishes to bring a derivative action against wrongdoers, he or she can ask a shareholder who meets the financial need test and who is also willing to act as a nominal claimant. In this situation, the financial need test seems useless in considering whether an indemnity cost order should be granted.

In addition to the above drawback, the procedure to grant an indemnity cost order is also ambiguous. Two problems have been identified in this regard. Firstly, the court emphasized in Wallersteiner that an application for an indemnity costs order should be kept simple and inexpensive and thus should not be allowed to escalate into a minor trial. The simple and inexpensive procedure requires the court not to spend much time on the application. However, it is argued that it would be palpably unjust for a court to grant an indemnity costs order without a full investigation. The second problem is the peculiar relationship between granting an order for indemnification and permitting an action to continue which is related to the first problem. In Smith v. Croft, the procedure for the application of an indemnity order was separated from the procedure for the evaluation of the locus standi to bring an action. This separate approach may create a paradoxical situation wherein an indemnity order has been granted while the action is dismissed at a later stage. In this situation, a company would have to indemnify the claimant even if the action is unsuccessful. With these procedural obstacles, the court would be very cautious in awarding an indemnity order to a plaintiff shareholder.

Thirdly, it is argued that one of the fundamental problems of an indemnity order is that it fails to provide incentives for shareholders. An indemnity order can be granted to a plaintiff shareholder after he or she has initiated proceedings, which presupposes that an individual shareholder is willing to commence the derivative action in the first place. In other words, an indemnity order does not provide the shareholder with any incentive to raise proceedings, but rather, once he or she has decided to bring an action, permits him or her to be indemnified for costs incurred in this decision. Although the deterrent to the initiation of derivative actions is removed as the claimant shareholder may be indemnified for costs involved in the proceedings, it does not mean these orders provide a significant incentive for shareholders to use derivative actions. As Reisberg points out, removing a deterrent is simply not the same as providing an incentive. In fact, it has been confirmed in the case law that the indemnity order is not a direct incentive given to a claimant shareholder to facilitate the use of a derivative claim, but rather a reflection of the rights being protected in the action or a form of legal aid.

In addition to the fact that indemnity orders do not provide direct incentives for shareholders, other disincentivising factors may discourage the use of derivative actions. A claimant shareholder will only receive a percentage of the recovery that reflects the shareholding that this person holds if the litigation is successful. This might not be a real or immediate cash return for shareholders as the recovery may be invested in some venture instead of being paid by way of dividend. Furthermore, not all successful litigation leads to tangible relief. The relief might take the form of a tracing order against, and a charge over, the assets that wrongdoers misappropriated from the company. These factors, which discourage the use of derivative actions, cannot be dislodged by an indemnity order.

A further drawback that is often overlooked is that a claimant shareholder will not be recompensed if the company is found to be insolvent even if an indemnity order is granted. This is obviously another disincentive for shareholders. Under the funding rule in the English law, a shareholder has to make a decision on whether they will pursue litigation where they do not know if an indemnity order would be granted. Moreover, even if an indemnity order is granted and the action is successful, a claimant shareholder may still not be compensated if the company is insolvent. This is because an indemnity order does not confer any security in the nature of a lien on the company’s assets. This would strongly discourage shareholders from bringing derivative actions as they may feel that they are going to throw away good money after bad or are putting their own money at risk.

B. Solution in the US Law: Contingency Fee Arrangement

Contingency fee arrangements are much more favourable for individual shareholders compared to condition fee agreements. Under this US style system, plaintiff shareholders are not liable for their attorneys’ fees under any circumstance. Although they might have to pay some costs that are not attorney’s fees in proceedings, it is very common for them to sign a contingency fee arrangement with their attorneys asking the latter to advance such expenditures or providing that plaintiff shareholders are not liable for the expenditures in any event. Even where there is no such contract and thus plaintiff shareholders have to pay the defendant some non-fee costs, such costs are very limited. As such, the costs of the litigation are shifted to the plaintiff’s attorney while plaintiffs are insulated from the exposure to the risk of paying litigation costs. For the plaintiff’s attorneys, it seems that they bear a high risk of working for nothing or even losing money out of their pocket if they agree to advance up-front expenses. However, this loss is not significant, or at least much smaller, compared to the situation for plaintiffs and lawyers where one of them would have to pay the legal costs of the defendant under the conditional fee agreement. As a result, the financial disincentive against derivative actions is not an issue under the contingency fee arrangement. This is principally why derivative actions in the US are much more active than in other countries.

In fact, a key role in derivative actions is thereby shifted from the plaintiff to the attorney under this arrangement. There are even some attorneys who are dedicated to derivative actions, spending much time on monitoring companies. After detecting a corporate wrongdoing, they seek a nominal plaintiff shareholder to bring an action against the wrongdoer. Since shareholders can receive some pro rata benefits from the recovery and have little financial risk in doing so, they are at least not difficult to find. In this sense, attorneys act as private attorney generals.

C. Which Model Is Suitable for China?

As discussed earlier, there are many inherent drawbacks to indemnity cost orders in the UK, which make such orders inappropriate for China. For example, the circumstances under which an indemnity cost order can be granted remain unclear. As such, it would be difficult for Chinese courts to apply this rule fairly and systematically without clear clarification. Given that Chinese judges only decide cases strictly following the law, it is even more essential to clarify this rule. If it were to be transplanted to China, this key issue would therefore have to be addressed. However, this problem still exists even in the UK from which this rule originates. Arguably, it would be even more difficult for Chinese legislators to clarify this rule. In addition to their ambiguousness, the disincentive that indemnity cost orders generate in discouraging shareholders from bringing derivative actions, constitutes another obstacle. As revealed earlier, an indemnity order presupposes that shareholders would want to pursue litigation on behalf of the company in the first place. They only have the possibility of being indemnified after they have made the decision to sue.

The US funding rule can overcome the above shortcomings. Under contingency fee arrangements, plaintiff shareholders do not need to pay their attorney’s fees if the action is unsuccessful. If he or she wins the litigation, the attorney’s fees will be paid out of the recovery received from the defendants. As such, plaintiff shareholders are not liable for their attorneys’ fees regardless of the outcome of the litigation. As a consequence, Chinese shareholders would be encouraged to bring derivative actions if this rule was adopted in China.

The contingency fee arrangements are not without drawbacks. One major problem has been identified in the application of this funding rule: cheap settlements. It is said that cheap settlements would prevail as lawyers prefer definite rather than probably substantial but uncertain payment. However, the settlement itself is not a problem. Rather, the problem is that lawyers may use the settlement for their personal gain as they have different interests from their clients under a contingency fee arrangement. A common concern in this respect is that companies may receive little or no monetary recovery while lawyers are rewarded with substantial fees. In addition, a settlement may be secretly reached on terms advantageous to both parties while not in the interests of the company. Therefore, courts should step in and such settlements should need judicial approval. With the rigorous judicial control, it could be expected that the settlement problems can be addressed.

As discussed earlier, the filing fees may constitute another obstacle for the promotion of derivative actions. Filing fees follow the principle of loser pays, which means a plaintiff shareholder may have to bear this cost if an action is unsuccessful and the amount of this fee can be very high.

The experience in Japan has shown that the above problem is not difficult to address. In 1950, the Japanese Corporate Law was substantially revised under the influence of the US Corporate Law and derivative action was adopted for the first time. However, for the first forty years after its enactment, derivative action was rarely used by Japanese shareholders. The situation was significantly changed from the 1990s when the rate of derivative actions started to increase enormously. The vast majority of scholars believe that the explanation behind this is clear and simple: the rule of percentage calculation of filing fees, which was similar to China’s current rule, was changed. Filing fees were reduced to a small fixed amount in 1993 following the Tokyo high court’s decision in the Nikko Securities Case. Under this amendment, derivative actions were treated as incalculable claims and the filing fees of such cases were lowered to a nominal fixed rate of 8,200 yuan (about 54 pounds). The significant increase in the number of derivative actions since 1993 has demonstrated that filing fees can play a key role in derivative litigation and the reduction of such fees could encourage shareholders to raise proceedings. In light of Japan’s experience, it is clear that filing fees should be reduced and changed to a fixed rate if China’s shareholders are to actively use derivative actions as a tool for the enforcement of directors duties. Given the current classification of the court fees system in China, the filing fees for derivative actions can be categorized as non-monetary which would make them a lower and fixed amount.

VI. WHY DERIVATIVE ACTIONS CAN BE ENCOURAGED?

 

If the US style funding rule is adopted for China, it is expected that shareholders would be encouraged to exercise this right. This raises two questions: will Chinese people be willing to resolve disputes to the courts? If the question is positive, the next issue is that would Chinese judges be competent to deal with such cases?

A. Culture

It is recognised that culture can deeply affect the means of resolving disputes. Indeed, the choice of means for dispute resolution is strongly influenced by the peculiarities of traditional culture. As Bee Chen Goh argues, the means adopted by a society to resolve disputes depends on its available resources, cultural inclinations and philosophic leanings. From this theoretical perspective, it is argued that Chinese culture is not suited to encouraging litigation. It is well-known that Confucian ethics are strongly rooted in Chinese culture and that the core principle of these ethics is the belief that harmony among persons must be achieved. The influence of this Confucian culture means that Chinese people are not willing to resolve their disputes in courts or even have disgust to litigation. Instead, they might choose a means of settling disputes privately. In light of this, it is argued that court-based dispute resolution would not be popular in China and thus shareholder litigation would not be aggressively used.

However, this article opposes the above arguments for the following reasons. Firstly, while the Confucian culture is widely known in traditional China, another school of Chinese thought, the legalists, has been intentionally or unintentionally neglected in the debate. This school of thought believes that a nation’s cohesion can be secured by the application of strict legislation as well as harsh and draconian punishment. The application of this school of thought was exemplified by the first emperor of unified China, the First Emperor of Qin, who organised the construction of the Great Wall and who also emphasized the necessity of using cruel punishment for those who dared to show even the slightest resistance. Throughout the history of China, the legalist school has been accompanied by the Confucian school. Its main belief of adopting strict laws to secure social stability has undoubtedly had an influence on Chinese dispute resolution. Therefore, the Confucianism is not the only traditional culture to affect methods for resolving disputes; another traditional counter-culture has encouraged people to use the law to resolve disputes. 

Secondly, even though the Confucianism has had much more influence than the legalist school on Chinese culture, its ability to play a significant role in litigation is highly doubtful given China’s increasing economic and social development. Unlike China’s ancient society, the Chinese society is now experiencing a fast economic miracle growth, leading to transformation in almost every aspect of the nation. Consequently, a commercial culture is gradually becoming established. One of the core principles in commercial culture is that everyone should be held accountable for his or her behaviour. For example, anyone who fails to perform obligations under a contract should be held responsible for that failure and thus be prepared to be sued if they do not redress the damage caused by their non-compliance. Therefore, in commercial culture it is normal, or at least not unusual, to resolve disputes by bringing litigation. Another factor that encourages litigation as a result of commercial culture is that people are not afraid to do business with strangers. This inevitably leads to the phenomenon that one party would not hesitate to initiate an action against another if they have violated an agreement. This is particularly true in China as Chinese people are not willing to raise actions against those they are familiar with, owing to the need to face and favour (renqing).

Thirdly, empirical studies have shown that the Confucianism may not have any bearing on private shareholder litigation. For example, in Japan, which was and still is dominated by Confucian culture, only twenty derivative lawsuits were raised in the first thirty-five years after the introduction of derivative actions. It was argued that Japanese shareholders would forgo bringing derivative suits for financial gains owing to the cultural obsession with maintaining social harmony. However, this argument lost its ground as the number of derivative actions being raised started to rise in the 1980s. After litigation cost reforms in 1993, the number of derivative actions being brought rose rapidly, peaking in 1999 with ninety-five new actions filed and a total of 222 actions pending. This fact strongly refutes the argument that Japan’s culture was solely responsible for low litigation rates. Mark Ramseyer has even claimed that the cultural theory was little more than a tautology. In China, the increasing amount of litigation being engaged in also shows that Confucian culture may have less influence on private litigation than expected. After the 1976, litigation actions rose significantly from 613,272 cases in 1979 to 7,462,488 cases in 2009. Civil litigation constituted 51.9 percent of these actions in 1979, rising to 86.2 percent in 2009. In the first half of 2012, the number of private lending cases alone was 376,000, an increase of 24.78 percent compared with the same period in 2011. The boom in commercial suits reveals that the influence of Confucian culture, which discourages litigation, is declining.

B. The Judiciary

Another argument seeks to posit that China’s current judiciary may not be able to deal with the increasing volume of litigation, especially derivative actions needing specialist securities knowledge. This is true to some extent as the competence of Chinese judges has been criticised for a long time owing to an earlier policy permitting retired military officers to work as judicial authorities. As a result of this policy, many judges lacked legal knowledge as they had little or no legal education. However, the situation has been changing in recent years making the judiciary capable of dealing with derivative action cases for the reasons outlined below. 

Firstly, Chinese judges are becoming increasingly competent. A brand new Judges Law of the People’s Republic of China has replaced the previous policy and stipulates the need for qualifications for becoming a judge. For example, it requires an academic degree and work experience. Furthermore, entry-level judges are to be selected from individuals who not only meet the basic requirements, but also have passed a National Judicial Examination (Bar Exam). The bar exam in China is known to be the most difficult exam in the world because of its low pass rate. With these strict requirements, it is believed that Chinese judges will become increasingly competent.

Secondly, it is argued that if shareholders are encouraged to raise litigation, the courts will be heavily burdened in light of the prevailing exploitation of minority shareholder interests. Indeed, derivative actions may rise sharply if unnecessary restrictions are removed and shareholders are given strong incentives to exercise their right to take derivative action. However, there are sufficient judicial resources to deal with this increase in shareholder litigation as judges have risen in number from 130,000 in 1991 to 250,000 in 2010. This has created the availability of approximately one judge to every 48,000 people, a ratio that is much higher than in other jurisdictions. Although it is argued that some judges do not engage in the business of rendering judgment as they are responsible for administrative affairs, one of the tendencies of modern judicial reform in China is a reduction in the number of administrative judges. In addition, every year courts are recruiting increasingly qualified people to engage in judgment business with the retirement of non-competent judges who have no or little legal training. As a consequence, it can be expected that the judiciary would have little difficulty in dealing with the increase in such cases.

Thirdly, the courts are now more willing to accept shareholder litigation. Traditionally, courts have been unfriendly to private securities litigation. As early as 1996, shareholders repeatedly attempted to file suits with the courts, without one case being accepted. One example can vividly illustrate the unfortunate situation at that time. A company shareholder brought an action after the company’s chairman was sentenced to prison for committing financial fraud. However, the shareholder’s application was refused by the court despite the clear evidence of wrongdoing, demonstrated by the chairman’s criminal conviction. This position continued even after the enactment of China’s Securities Law in 1998. In the face of this situation, the Supreme People’s Court (hereinafter referred to as the SPC) surprisingly issued a report in 2001 stating that all lower courts should refuse to hear private securities litigation cases. However, this prohibition was suddenly changed in 2002 as the SPC lifted the restriction on accepting cases, though the only available cause of action was limited to false disclosure. After specific rules for handling private securities cases were issued by the SPC, the courts started to accept such litigations. Although the limited availability of civil remedies continues to be criticised, it is apparent that the attitude of the courts towards shareholder litigation has changed in a direction that is increasingly friendly towards shareholders. With the increasing awareness of the need to protect investors, Chinese courts can be expected to be more open to shareholder litigation.

VII. CONCLUSION

The new statutory derivative action was intended to play a key role in monitoring managers and majority shareholders. However, it has failed to fulfil its functions in practice owing to its drawbacks. This article examines derivative actions from the perspective of funding rule as it is the key issue to resolve the problems of derivative actions considering its unique economic nature. In order to encourage shareholders to bring derivative actions to protect their rights and interests, proper funding rules should be established. With a comparative perspective, the English law is found to be under-incentive and inherently defective while the US style funding rule would be far more favourable for China. In addition, the adoption of contingency fee arrangements would not encounter many difficulties because of the culture and judiciary in China. It is worthwhile to note that changing the funding rule cannot address every problem in China’s derivative action, but there is no doubt that its improvement would make derivative actions work to some extent.