Abstract
When determining whether a director of a company has fulfilled his duty of diligence in a dispute over liability for securities misrepresentation, a people’s court should,first distinguishing between inside directors and outside directors,fully consider his scope of duty,his role in the company’s decision-making, and other related factors. An independent director who does not participate in the company’s operating activities should generally be determined to have performed his duty of diligence, if matters involved in misrepresentation are beyond his scope of duty and relevant professional intermediaries have reviewed the matters. By contrast, an inside director should be determined to have failed to perform his duty of diligence and accordingly compensate investors for their losses, if matters involved in misrepresentation fall into his scope of duty and his failure to carefully review the matters as required has caused the misrepresentation.
Basic Facts
In April 2013, China Security Co., Ltd. (“China Security”) initiated a major asset restructuring, intending to purchase a 100% equity interest in China Security & Fire Technology Co., Ltd. (“China Security & Fire Technology”) from Shenzhen ZhonghengHuizhi Investment Co., Ltd. (“ZhonghengHuizhi”) through a private placement.
On November 15, 2013 and March 12, 2014, China Security held two expert review meetings on the appraisal of assets to be purchased in the major asset restructuring.
On April 25, 2014, Yinxin Appraisal Co., Ltd. issued an Appraisal Report.
On June 10, 2014, the proposal for the major asset restructuring was considered and approved by the 14th meeting of China Security’s 8th Board of Directors. Directors Qiu X, Zhu X, Jiang X, Yin X, and Chang X voted for the proposal, while affiliated director Huang X withdrew from voting. Among the six directors, Huang X, Qiu X, and Zhu X are inside directors of China Security, serving as Chairman, General Manager, and CFO, respectively, while Yin X, Chang X, and Jiang X are independent directors.
On June 11, 2014, China Security released a Report on Related-Party Transactions (Draft), disclosing its plan to purchase a 100% equity interest in China Security & Fire Technology from ZhonghengHuizhi through a private placement. On the same day, China Security released its major asset restructuring documents including the Appraisal Report.
On January 23, 2015, the registration procedure was completed for the additional shares issued via the private placement for raising supporting funds, marking the consummation of China Security’s major asset restructuring.
On December 24, 2016, China Security issued an Announcement on Receipt of Notice of Investigation from the China Securities Regulatory Commission & Announcement on Risk Warning, stating that the China Securities Regulatory Commission (CSRC) decided to initiate an investigation against the company for suspected violation of securities laws and regulations. On May 31, 2019, China Security released an announcement disclosing its receipt of CSRC’s Administrative Penalty Decision, where CSRC determined that China Security had severely inflated the valuation and the operating revenue for 2013 of the purchased assets disclosed in the Report on Related-Party Transactions (Draft) dated June 11, 2014, and thus committed securities market misrepresentation. Also penalized were other defendants in this case, including a number of intermediaries.
The Plaintiff Peng X prayed the Shanghai Financial Court for ordering: 1. China Security to compensate Peng X for investment difference losses and commission and stamp duty losses, totaling RMB 1,248,012; 2. other defendants to be jointly and severally liable for the compensation.
The six directors responded as follows:
As administrative liability is different from civil liability, receipt of an administrative penalty from the competent authority by a director of a listed company does not necessarily mean or presuppose that the director is at fault in the civil dispute and liable for civil compensation. In this case, the six directors attended relevant board of directors’ meetings, and considered and signed relevant resolutions. During the restructuring, the six directors repeatedly discussed restructuring matters with the intermediaries, asked them to analyze and reply to problems found, and carefully reviewed the reports issued by them, without any neglect of duty.The six directors also required China Security & Fire Technology, ZhonghengHuizhi, and related intermediaries to undertake in writing that the documents issued by them are true, accurate and complete to prevent them from issuing false documents and materials.In addition, the six directors urged China Security and ZhonghengHuizhi to sign a stringent profit compensation agreement to prevent the listed company and its shareholders from suffering losses in case ZhonghengHuizhi could not meet the profit forecast.The six directors have tried to avoid possible overvaluation of assets involved in the major asset restructuring to protect China Security, its shareholders and minority investors from losses caused by ZhonghengHuizhi’s failure to meet the performance commitment. In view of the above, the six directors are not subjectively at fault for the investor’s losses, and Peng X should not claim joint and several liability for compensation against them by citing the administrative penalty.As directors of the shell company, the six directors are not the operator, manager or actual controller of the target company China Security & Fire Technology, and are thus unfamiliar with its operation. Because the Profit Forecast Report and the Appraisal Report are professional reports, the six directors should not be required to live up to the standard of a professional. In this case, the six directors also separately engaged an independent financial advisor to review the major asset restructuring documents, and it’s justified for them to rely on the opinions of the authoritative professional intermediary. Therefore, the six directors have performed their duty of diligence and should not be held jointly and severally liable for the payment obligation of the Defendant China Security.
Holding
On July 30, 2021, the Shanghai Financial Court rendered the following civil judgment ((2019) Hu 74 Min Chu No.2509): 1. The Defendant China Security shall compensate the Plaintiff Peng X for investment difference losses in the amount of RMB 259,718.28 and corresponding commission and stamp duty losses; 2. China Security & Fire Technology, ZhonghengHuizhi, Tu Guoshen, and Yinxin Appraisal Co., Ltd. shall be jointly and severally liable for the payment obligation of the Defendant China Security; 3. Huang X, Qiu X, and Zhu X shall be jointly and severally liable for up to 2% of the payment obligation of the Defendant China Security; 4. The remaining claims of the Plaintiff Peng X were dismissed. After the judgment was rendered, China Security appealed to the Shanghai High People’s Court, and the six directors were all satisfied with the judgement. On January 21, 2022, the Shanghai High People’s Court issued a civil judgment ((2021)Hu Min Zhong No. 870), dismissing the appeal and affirming the original judgment.
Reasoning
With regard to the liability of the six directors, the Shanghai Financial Court believes that, according to Article 69 of the Securities Law of the People’s Republic of China (revised in 2014), where the stock prospectus, bond prospectus, financial accounting reports, listing reports/documents, annual reports, interim reports, adhoc reports, and other information disclosure documents of an issuer or listed company contain false records, misleading statements or material omissions, the issuer or listed company shall be liable for any losses suffered by investors during the course of securities trading;and the directors, supervisors, senior officers, and other directly liable personnel of the issuer or the listed company, as well the sponsor and underwriting securities companies of the issuer or the listed company shall be jointly and severally liable for such losses with the issuer or the listed company unless they can prove that they were not at fault. The Article 21 of the Several Provisions of the Supreme People’s Court on the Trial of Civil Compensation Cases Arising from Securities Market Misrepresentation (the “2003 Several Provisions”) specifies that a promoter, issuer or listed company shall be liable for civil compensation for losses suffered by investors due to his/its misrepresentation; the directors, supervisors, managers, and other senior officers liable for the misrepresentation of the issuer or listed company shall be jointly and severally liable for the losses stated in the preceding paragraph unless it’s otherwise proved that they are not at fault.Directors of a company can be divided into independent directors and inside directors according to whether they work as a full-time director in the company. The role of independent directors is to ensure the company’s strategic decisions are proper and reasonable and enhance supervision over the company’s operation. By contrast, inside directors are primarily involved with the company’s day-to-day operation. Playing different roles, independent directors and inside directors should also be distinguished in terms of their liability.Among the six directors in this case, the Defendants Yin X, Chang X, and Jiang X, as independent directors, neither held positions in China Security nor participated in its operating activities, merely advising on and supervising its operating decisions.Moreover, in this case, they only voted on the operating conditions of China Security & Fire Technology, the target company involved in the major asset restructuring. In addition, professional intermediaries have audited and appraised the assets purchased in the major asset restructuring, finding no exaggeration of the operating revenue and valuation of the purchased assets. For the above three independent directors listed as defendants, who were neither involved in the operation of the company nor were they professionals, it was too onerous for them to track the progress of the target company’s “Ban BanTong” (班班通) project and review such a project that has been audited by professional intermediaries. Therefore, the Defendants Yin X, Chang X and Jiang X should be exempted from liability in this case. The Defendants Huang X, Qiu X, and Zhu X, inside directors of the Defendant China Security, should perform a higher-standard duty of diligence compared with independent directors. Having served as the company’s then Chairman, CFO and General Manager, they are obliged to carefully review the relevant materials provided by the counter party and the target company. Given their failure to provide evidence showing their performance of duty of diligence, the three inside directors should bear corresponding civil liability for the losses suffered by Peng X due to the Defendant China Security’s misrepresentation in the major asset restructuring.The scope of their compensation liability should be measured in view of the degree of their fault. First, in this case, their duty of care to the information from the counter party should be different from that from China Security. Defendants Huang X, Qiu X, and Zhu X,China Security’s then Chairman, General Manager and CFO, should, to some extent, be under a duty of care for the information required to be disclosed in the restructuring process.Second, Shenyin&Wanguo also provided professional advice for the restructuring transaction in addition to the independent financial advisor, audit agency, appraisal agency and other intermediaries. Further, China Security held two expert review meetings on the appraisal of the purchased assets. Notwithstanding the foregoing, the Defendants Huang X, Qiu X, and Zhu X, as inside directors, put excessive reliance on professional intermediaries and failed to fulfill their obligation to conduct reasonable investigation.In view of the above, the Defendants Huang X, Qiu X, and Zhu X were at fault to a certain extent for the Defendant China Security’s misrepresentation in violation of information disclosure obligations, and should, as appropriate, be jointly and severally liable for up to 2% of the Plaintiff’s losses.
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