Chinese Regulatory Activities and D&O Liability Exposures

September 16, 2014

Recently, I published an article in Ignites Q&A  on “Five Questions Directors Should Ask About Chinese Regulators.”  Ignites is primarily directed to 70,000 leaders and decision makers in the mutual fund industry, but the questions are important for any company doing – or considering doing business – in China. The article addresses some of the issues for board members and D&O carriers regarding recent Chinese regulatory interest in foreign companies operating in China.

First, foreign companies generally believe they are under tighter scrutiny than Chinese competitors.  Regulatory interest appears to focus on:  (1) technology (Microsoft, Accenture, Qualcomm); (2) automotive (e.g., Fiat Chrysler, Audi); and (3) food production and the fast food industry (KFC, Heinz, and McDonalds).  If a foreign company is operating in these industries, it should expect elevated scrutiny and increased liability exposures. Scrutiny seems to be heightened due to protectionist concerns and in response to food safety and public health concerns.

Secondly, Chinese regulators are commonly believed to use competition and antitrust laws for protectionist ends – especially in the technology sector.  If a foreign hi-tech company has a Chinese competitor, it may anticipate increased regulatory interest.  If a foreign competitor is being or has been investigated frequently for antitrust issues, labor issues, consumer protection issues, etc., a company should expect the same level of examination – especially if there are Chinese competitors in the market.  Absent protectionist goals, Chinese regulators use anti-trust laws – like most countries – to prevent or break up monopolies (i.e. to protect consumer welfare and competition).  Finally, antitrust regulators are focused on Chinese companies’ arrangements with foreign partners, especially where the foreign company has a dominant market position and there are few or no alternative providers in China.

Thirdly, besides the industry-specific scrutiny, referenced above, Chinese regulators are more strictly enforcing Chinese labor and employment laws and regulations against foreign companies.  This is true at the regulatory level and by courts.  China’s 2008 Labor Contract Law (“LCL”) enacted employment requirements, including mandatory contracts with employees, severance payments, and social insurance payments.  A company that terminates an employee – even one that is engaged in criminal conduct or wrongdoing – can face stiff penalties, civil litigation, and/or a hefty “severance” payment.  Companies should have a program for dealing with the worst sorts of transgressions:  employee handbook detailing as grounds for dismissal FCPA violations or other wrongful conduct; employee training and robust compliance programs; and a vigilant system for detecting red flags.

Similarly, in July 2013, the Chinese LCL was amended to limit and tighten up the treatment of employees hired under “labor dispatch” arrangements where an employee has a labor contract with a labor dispatch agency and is then dispatched to work for an employer.  There is no labor relationship between an employee engaged through a labor dispatch agency and the employer.  The 2013 amendments limit labor dispatch arrangements to specific positions.  Tough penalties for violations of the amendments extend to dispatch agencies and employers and include fines per dispatched employee and civil liability with no statutory limit.  If an employee is not susceptible to a labor dispatch arrangement, there may be liability for violation of the Labor Contract Law if the employer failed to adhere to that law’s requirements.  Employers who hire foreigners to work illegally and those employees are subject to stiff fines per violation, and those foreign employees can have all remuneration confiscated, may be detained for up to 15 days, and face deportation.

D&O Insurance Focus:  In light of this increased regulatory scrutiny and liability exposure, directors, officers, and their insurance carriers should be asking whether existing D&O insurance policies cover regulatory claims in China or claims arising out of activities of Chinese regulators.  All foreign companies operating in China should review their D&O policies for:  coverage territory; whether a “claim” includes regulatory investigations; antitrust exclusion, employment or benefits related exclusions.  Moreover, the scope of these policy terms may have an effect on coverage for any tag-along securities litigation in the U.S. arising out of the Chinese regulatory or enforcement activity.