How Does an Employee Director Fit into the Corporate Governance of a Chinese Company?

Under Articles 68 and 120 of the New Company Law, if a limited liability company or a joint stock limited company has 300 or more employees, employee representative(s) must be included on the board of directors (“Employee Director”), unless the same company has a board of supervisors with no less than one-third of the supervisors being employee representatives (“Employee Supervisor”).

This new requirement has caused concern in the business community, but contrary to popular belief, the concept of an Employee Director and Employee Supervisor is not entirely new. They have been part of the corporate governance structure of state-owned companies for over a decade. The New Company Law simply expands the requirements to all Chinese companies, including multinational companies and private companies.

The Employee Director requirement is a specific manifestation of the New Company Law’s condition that all Chinese companies have the assembly of employee representatives (AER) as the basic form of their democratic corporate governance system (Article 17.2). Employee Directors and Employee Supervisors are elected by the AER, the assembly of all employees (AAE), or other democratic measures. In other words, unlike other directors who are usually nominated by shareholders, Employee Directors are selected (and dismissed) directly or indirectly by employees.

The thresholds

By setting the 300-employee threshold, Chinese legislators are clearly targeting larger companies rather than smaller ones. It is not immediately evident, however, how the 300 employees are to be counted. On the face of it, those who enter into formal employment contracts, including those in a probation period, should be included. However, under the Provisions on Democratic Governance of Enterprises (“Democratic Governance Provisions”) jointly issued by the All-China Federation of Trade Unions (ACFTU) and five other government agencies, effective 17 March 2022, employees who have established a labor relationship with the enterprise and dispatched workers have the right to elect and be elected as representatives of the workers’ assembly. A reasonable interpretation from the Democratic Governance Provisions is that dispatched workers should also be counted in the 300 employees. If this is the case, then the scope of companies subject to the Employee Director requirement could apply to those who rely heavily on dispatched workers as part of their business model, such as many mobility companies.

The New Company Law permits a company that is small in size or has a small number of shareholders to have neither a board of directors nor a board of supervisors (Articles 75, 83, 128, and 133 of the New Company Law). If a company has only one or two shareholders but a large workforce (300 employees or more), will such companies be exempted from the inclusion of an Employee Director if they elect not to have a board of directors at all? One could wait for the Supreme Court or the State Council to issue guidance in this regard, but at this stage, it seems more reasonable to interpret that such companies will need to set up a board of directors and have at least one Employee Director. This is a compulsory requirement, and the election not to have a board of directors is just an option for operational efficiency purposes, which comes second to the principle of employees’ right to participate in the company’s governance as promoted by the New Company Law.

Who is qualified?

To be an Employee Director, the person must satisfy multiple criteria.

• First of all, a candidate must not be subject to any of the conditions set out in Article 178 of the New Company Law, which apply to all directors, supervisors and senior management.
• Second, the candidate must be a formal employee of the company when elected, effectively excluding retirees, external consultants or interns. Interestingly enough, the New Company Law does not specifically prohibit senior management from acting as Employee Directors, as it does for Employee Supervisors. However, the Democratic Governance Provisions clearly state that senior management cannot concurrently act as either Employee Director or Employee Supervisor. The Opinions on Strengthening the System of Employee Directors and Employee Supervisors in Corporate Enterprises issued by the ACFTU in 2016 (“Circular 33”) also specify that senior management and supervisors cannot act as Employee Directors, nor can their close relatives. It is worth noting, however, that under Circular 33, the president and vice president of the company’s trade union should generally be candidates for Employee Director and Employee Supervisor.
• Third, the candidate must meet other requirements set out under Circular 33, such as “familiarity with employment-related laws and regulations.”

It is possible under the New Company Law for the enterprise to establish other qualifications for Employee Director, such as having a minimum number of years of service with the company. It remains to be seen where the boundaries will be set and whether such requirements are consistent with ESG values.

Dual hats

Compared with “regular” board directors, Employee Directors have dual hats. On the one hand, they are directors of the company, enjoying the same rights and authorities and owing the same duty of care and loyalty to the company, and consequently bearing the same liabilities when they violate the law or articles of association. On the other hand, as Employee Directors are elected by the AER or AAE, they are expected to represent employee interests in the boardroom, including calling for (interim) board meetings and voting on decisions made by employees or their representatives. It will be very challenging for Employee Directors to perform their duties as directors, including meeting confidentiality obligations and exercising their business judgment, while also defending employee interests. For example, when a company considers potential business transformation that might entail employee redundancies, Employee Directors may risk breaching confidentiality requirements if they were to discuss it with the employees at large, as would be expected. There is no silver bullet for overcoming such a conflict of interest. To that extent, it would be better to put in place some form of code or protocol for Employee Directors or all of the organization’s directors.

How elections should be carried out

In Circular 33, the ACFTU has provided detailed guidelines for the overall process:

• Nomination of candidates for Employee Director may be made by: the company’s trade union based on employee recommendations and self-nominations, and consultation with employees; more than one-third of the employee representatives or more than one-tenth of the employees jointly; the joint meeting of the AER.
• Elections must be conducted in a competitive manner (i.e., with more than one candidate) by the AER through a secret ballot and must be approved by a majority of all the representatives of the AER.
• The results of the election must be announced before the appointment of an Employee Director, and the relevant formalities must be fulfilled as for other directors and reported to the higher-level trade union and the relevant departments or institutions, such as the CCP organization for record.
• Dismissal of Employee Directors must follow a similar procedure led by the AER.

It is fair to say that the current practice involving Employee Directors has been developed by and is applicable to state-owned companies, which have better employee-related infrastructure, such as a trade unions, AERs, or AAEs. In practice, a large number of private companies and multinational enterprises in China do not yet have an AER or trade union in place.

This is not due to the absence of relevant rules and regulations. On the contrary, the Democratic Governance Provisions have been in existence for over a decade. Multiple provinces and cities have also introduced their own regulations for convening and running an AER. But such local rules have not been proactively enforced in most parts of the country. This might change given the requirements laid out in the New Company Law.

Dynamics in the boardroom

Currently, there is no regulation stating that the composition of the board must reflect the company’s shareholding structure, although in practice, the board members largely reflect who holds major portions of the company’s shares. However, the New Company Law specifies that a quorum of more than half of all directors is needed for a board meeting to be valid, and that a resolution must be approved by more than half of all directors. In this sense, the addition of an Employee Director will significantly change the balance of power among the directors. For example, in a company with two shareholders and a board of four directors, each shareholder could nominate two directors and maintain a balance in the boardroom. If, after 1 July 2024, the company must have an Employee Director on the board, the Employee Director could potentially team up with directors from either side and form a simple majority. If the company’s articles of association allow for simple-majority decisions at the board level, then the Employee Director will essentially have a “casting” vote. This, however, may not be what the shareholders expected when they formed the company.

Employee Director vs. Employee Supervisor

Under the New Company Law, there is no need for an Employee Director if the company has a board of supervisors with one-third being employee representatives. Some commentators argue that, to avoid having an Employee Director, a sensible compromise might be for the company to set up a board of supervisors. However, we do not think this is would work for all companies and should not be taken lightly. Below are some pros and cons of having Employee Supervisors versus Employee Directors.

Act now

Following enactment of the New Company Law, a primary concern among many companies, particularly in the foreign business community, is the potential legal consequences of failing to elect an Employee Director or Employee Supervisor as required. The New Company Law itself does not clearly stipulate the corresponding legal consequences for failing to have an Employee Director. We expect it will take some time for the relevant regulators to form an implementation guideline in this regard. However, this does not mean that companies who must have an Employee Director can sit back and do nothing, for three reasons:

• First, there have been reported cases where courts rendered resolutions by a board of supervisors invalid because there were no qualified employee representatives on it. The same logic could well extend to the board of directors.
• Second, it is highly uncertain if the Administrations for Market Regulation (AMRs) in different places will start enforcing the Employee Director requirement immediately after the New Company Law takes effect. After all, Circular 33 clearly states that “at the initial stage of the establishment (or restructuring) of a company, the company shall reserve seats for employee directors and supervisors on the board of directors and supervisory board in accordance with the relevant laws and regulations and shall clearly stipulate this in the articles of association.”
• Third, it will undoubtedly take considerable time and effort, not to mention other resources, to identify, elect and integrate the Employee Director into the existing corporate structure, with all necessary amendments to the current practice, including policies, protocols and rules. If the company does not have a trade union or AER in place, it will have to establish one, another daunting task, particularly for multinational companies in China.

Takeaway

All sizable companies should seriously consider the new requirements for Employee Directors and involve all stakeholders and owners as they start communication and planning. Carrying out this process will demand both experience and professional judgment. We would therefore be happy to support you with any questions you might have.