Defending top execs against securities misrepresentation claims

Information disclosure is the cornerstone of the securities market’s existence and development, and an important safeguard for investor interests. Securities misrepresentation is a violation of this obligation of information disclosure, which damages the right of investors to obtain true and accurate public information; and in turn damages their property rights and interests.

In this article, the authors briefly analyse defence approaches that can be taken on behalf of directors, supervisors and officers (DSOs) of issuers/listed companies accused of gross negligence in civil compensation cases for securities misrepresentation.

Defence approaches

In typical civil compensation cases for securities misrepresentation in recent years, not only are issuers being held liable and adjudged to bear corresponding civil liability, but also their DSOs.

In judicial practice, there is not much controversy over whether DSOs are intentional in misrepresentation. The main controversy focuses on whether they are grossly negligent for the misrepresentation.

In this regard, defences for DSOs are mainly:

Lacking knowledge of the issuer’s misrepresentation may not be a separate defence but a supplemental defence.
Article 14 of the Several Provisions on the Trial of Civil Compensation Cases for Misrepresentation Infringement in the Securities Market makes it clear that if DSOs of an issuer “fail to provide appropriate evidence of their diligence and claim that they are not at fault on the grounds that they are not engaged in day-to-day operation and management, do not have the relevant professional background and expertise, believe in the information provided by the issuer or the management, or believe in the professional opinions issued by securities service organisations, the court shall not support their claim”.

It can be seen that relying only the defence of “not being engaged in the operation and having no expertise” is not enough to exempt DSOs from liability.

Guangzhou Intermediate People’s Court pointed out, in the civil judgment of Gu Huajun et al v Kangmei Pharmaceutical (2020), that: “Li, the defendant, claimed ignorance and non-involvement in the alleged illegal activities, asserting the absence of wrongdoing. However, Li and other defendants, despite not directly overseeing Kangmei Pharmaceutical’s financial affairs, were responsible for a prolonged period of financial fraud involving numerous accounting items and substantial amounts.

“As DSOs fulfil their duty diligently, even if only overseeing specific business areas, they could not have completely remained oblivious to the signs. The above-mentioned defendants are considered as other directly responsible persons for Kangmei Pharmaceutical’s illegal information disclosure practices.”

However, this does not mean that lack of knowledge may not be used as one of the defences. During the specific case’s evidentiary process, DSOs, while providing evidence to prove their diligence, can concurrently provide evidence demonstrating that they “do not participate in the operation, have no expertise, believe the issuer or the management and believe the professional intermediaries”, so as to form a chain of evidence that integrally affects the judge’s discretion.

In Wang Hui v Anshan Anzhong Mining Machinery et al (2017), Shenyang Intermediate People’s Court elaborated in its judgment that: “The listed company made false records when disclosing information of others. For the material asset reorganisation involved in the case, Yang Yongzhu, as the chairman of Anzhong, in line with the provisions of the Administrative Measures for the Material Asset Reorganisation of Listed Companies, actively supervised and arranged for the listed company to engage such securities service organisations as independent financial advisers, law firms, accounting firms and asset appraisal agencies to issue opinions on the material asset reorganisation, and carefully reviewed the transaction documents and the professional opinions issued by the securities service organisations, and did not find any obvious anomalies. Therefore, it should not be deemed that he has negligence.”

Fully fulfilling obligations of loyalty and diligence within scope of their duties.
As to whether DSOs have fulfilled their duties of diligence, the court will comprehensively review the specific duties and powers of DSOs under different circumstances and in different positions, and then make a judgment.

It is necessary to make specific judgments according to the relevant laws and regulations, articles of association, CSRC rules, companies’ internal rules and other relevant documents.

For example, in Peng v China Security (2019), Shanghai Financial Court pointed out that, “directors of the company can be differentiated into independent directors and internal directors, depending on whether the director is engaged in full-time director work in the company. The duties of independent directors and internal directors are not the same, so there should be a distinction between the liabilities to be borne by the two.”

Taking appropriate measures for the known misrepresentation.
Article 15 of the above-mentioned provisions provides that when any DSO disagrees with the contents of securities offering documents and periodic reports, he/she is required not only to issue a written opinion with specific reasons and disclose it, but also to vote consistently against the documents during their deliberation in order to be deemed subjectively not at fault.

Recommendations

To summarise, the authors suggest preventive measures DSOs should take in their daily work:

1. In performing their duties, DSOs should understand and continue to pay attention to the production, operation and financial conditions of the company, take the initiative to investigate and obtain information necessary for decision-making, and actively inquire and raise questions;
2. DSOs should scrutinise materials that require their signatures and clearly indicate any of their reservations on the relevant documents by giving a written opinion with detailed justifications, and refuse to vote in favour of them;
3. DSOs should keep records of their diligent performance of duties so that in the event of a dispute there is sufficient evidence to prove they have fulfilled their obligations accordingly; and
4. For issues they are not sure about, DSOs should consult with a lawyer, accountant or other professionals promptly, so as not to be in trouble.

Li Wenting is a senior partner and Zhou Rui is an associate at Hylands Law Firm