The shareholder derivative action serves as a safeguard for corporate and minority shareholder interests when internal governance breaks down, allowing shareholders to sue on the company’s behalf. Yet, in practice, the system remains contested.
Debates persist over the permissible scope of derivative claims, how to ascertain a company’s genuine and independent intent in transactions dominated by controlling shareholders, and whether counterparties in related-party deals may invoke the defence of a good-faith third party when internal resolutions are defective.
While these questions arise on different doctrinal fronts, they converge on a central concern: In companies with highly concentrated control, how should courts apply the derivative action to balance the prevention of control abuse with the protection of transactional certainty? Drawing on recent judgments, this article explores three aspects of how courts apply the derivative action in pursuit of that balance.
Director
Trophy Law Firm
Tel: +86 134 2631 0626
E-mail: zhaohanqing@zhuohuilaw.com
The scope of shareholder derivative actions should not be limited to tort claims. This issue has long divided judicial and academic opinion. Article 189 of the Company Law authorises shareholders to bring actions when “others infringe upon the lawful rights and interests of the company”. The controversy lies in whether the term “infringe” refers exclusively to tortious conduct, an interpretation that would confine derivative actions solely to tort claims.
Some opinions hold that a derivative suit arises only when another party “infringes” upon corporate interests, and thus must be limited to tortious acts. The Supreme People’s Court expressed this position in its civil ruling, in Han Liming v Shanghai Hangsheng Industrial (2017).
In the authors’ view, however, equating “infringe” mechanically with tort constitutes an unduly restrictive reading that overlooks the integrity of the company’s broader rights as a civil entity. A company’s lawful interests encompass rights arising from contract, property and other legal relations. When a breach of contract unlawfully harms the company, its wrongful nature and consequences are, in essence, no different from those of a tort.
From a functional perspective, the derivative action is essentially a mechanism for shareholders to exercise the company’s right of action by substitution. It is designed to remedy governance failure when corporate organs neglect to pursue litigation. Accordingly, the shareholder’s derivative right derives from the company’s own right to sue. Whatever claims the company itself may lawfully bring, a shareholder acting derivatively should, in principle, be entitled to pursue. The Supreme People’s Court adopted a consistent position in its judgment, in Zhongrong International Trust v Guangxi Construction and Fuel Corp (2020).
Associate
Trophy Law Firm
Tel: +86 185 0021 1593
E-mail: panhongkun@zhuohuilaw.com
In shareholder derivative actions, courts should apply heightened scrutiny when determining evidence of a company’s external declarations of intent. It is common in such cases for controlling shareholders to exploit their dominant position to induce the company to make statements or decisions that disadvantage minority shareholders.
In one recent representative case handled by the authors, the controlling shareholder claimed to have reached an agreement with the company to transfer a substantial contractual debt, originally owed by the shareholder to the company, to an affiliated entity with weaker solvency.
Although there was no direct evidence that the company had consented to the debt transfer, the controlling shareholder sought to rely on internal financial documents, such as accounting adjustment records and account confirmation letters between accounts, where the debtor was listed as the affiliated company. These, the shareholder argued, demonstrated the company’s consent to the transfer.
In the authors’ view, while a financial document recording a “debt transfer” might, in other contexts, be accepted as evidence of a company’s consent, a stricter standard must apply in shareholder derivative actions. Given the controlling shareholder’s strong influence, allowing internal financial records to substitute for duly executed, company-sealed legal documents would enable the majority shareholder to use accounting procedures to erode the company’s independent will.
Accordingly, courts should adopt a rigorous evidentiary standard when evaluating a company’s external declarations in derivative actions. The focus should be on whether formal external documents and internal resolutions meet statutory and constitutional requirements. Internal records alone, without the requisite external legal documentation, should not suffice to establish a valid declaration of intent on the company’s behalf.
The compliance of a company’s internal resolutions directly affects the validity of its external acts. In related-party transactions, the counterparty’s duty of scrutiny is significantly higher than in ordinary dealings. Accordingly, the good-faith counterparty defence should be applied restrictively.
This raises a question: if a company issues a formally complete document bearing its official seal, but the document has not undergone the required internal procedures, may the related-party counterparty rely on the good-faith principle to claim the transaction’s validity? The authors’ answer is no, for the following reasons.
(1) The Company Law establishes the principle of distinguishing between internal and external affairs to safeguard transactional security, but its application presupposes that the counterparty is genuinely acting in good faith. In related-party transactions, however, the counterparty and the controlling shareholder share close economic interests, which places the counterparty under a higher duty of care than an ordinary third party.
(2) If the related-party counterparty knew, or ought to have known, that the company’s articles of association require stringent resolutions for major matters, yet bypassed those procedures, it cannot reasonably claim good faith.
(3) When reviewing internal resolutions, it is important to consider whether interested shareholders were properly recused from voting. Under the rules governing corporate guarantees, a shareholder related to the beneficiary must abstain from voting on the guarantee resolution. Although the law does not expressly require shareholder recusal for major transactions such as debt transfers, the authors contend that, by analogy and applying the principle a minore ad maius (from the lesser to the greater), the rule should extend to such cases. The Beijing Third Intermediate People’s Court took a similar view in the civil judgment Beijing Wenxin Youpin Investment Fund et al v Wang Xin (2022).
Therefore, in shareholder derivative actions involving related-party transactions, courts should be cautious in applying the good-faith counterparty doctrine. The validity of the company’s external acts should instead be subject to stricter judicial scrutiny.
The shareholder derivative action functions as an institutional check on the abuse of control through the mechanism of derivative standing. In practice, its scope should not be confined to tort claims, nor should courts accept weak evidence of a company’s external declarations in transactions led by controlling shareholders.
In related-party dealings, the mechanical application of the good-faith principle risks undermining the governance rules that constrain controlling shareholders. Only by focusing judicial review on the substantive purpose of the system can courts strike an appropriate balance between transactional security and the protection of corporate interests.
Zhao Hanqing is the director at Trophy Law Firm. He can be reached by phone at +86 134 2631 0626 and by email at zhaohanqing.@zhuohuilaw.com
Pan Hongkun is an associate at Trophy Law Firm. He can be reached by phone at +86 185 0021 1593 and by email at panhongkun@zhuohuilaw.com
