The Derivative Action and Good Corporate Governance in China: Economic Theories and Legal Rules

Good corporate governance is crucial for the successful transformation of SOEs in China and the long-term success of Chinese economy. To improve corporate governance in China, the top priority is to curb serious managerial misbehavior such as misappropriation and fraud which has not yet been controlled. To achieve this end, market-based mechanisms are ineffectual, because they are not equipped with the ability to remove illegitimate benefits from misbehaving management or impose punishments on them. Only legal liability has this ability and can thus be effective in deterring serious managerial misbehavior. Legal liability comes from both the public and private enforcement of law. While the public enforcement of law produces harsher liabilities, it suffers from various limitations. Public law enforcement is particularly ineffectual in China where an accountable political system has yet to be established and law enforcement is impeded as a result of the dominance of state ownership in listed companies. For these reasons, the private enforcement of law is necessary. Both derivative action and securities class action are devices of private enforcement of law which produce legal liability, but derivative action is indispensable, not just because securities class action is unrealistic in China.To enable derivative action to become a realistic corporate governance tool, appropriate legal rules should be put in place. The traditional common law, which is based on the dichotomy of actionable and non-actionable wrongs, seems irrational, because actually there is no such distinction. The company’s interest is the paramount test of the permissibility of derivative action and this, in turn, is determined by the purpose of company. While the new derivative action in China does not differentiate actionable and non-actionable wrongs, it adopts the strategy of setting a minimum shareholding requirement as the condition for bringing suits. From the experience of continental Europe and the US, such a strategy would ensure that derivative action would not be vigorously pursued in China. The strategy should be changed and an approach enabling derivative action to be decided case by case according to the test of the interests of the company should be adopted. If this strategy is adopted, it might be better to assign the responsibility of assessing a case to the court rather than to the company. The assessment should be based on the probability of success and the potential net recoveries from the case. Another defect of the new derivative action is that it does not mention the issue of litigation funding. Without appropriate funding rules, derivative action would not actually be taken. The American contingent fees are most favorable in terms of facilitating derivative actions and current experience of derivative actions in the US indicates that contingent fees would not necessarily lead to frivolous litigation.