First Chinese special representative securities action spikes demand for D&O insurance, but coverage availability remains unclear
Jenner & Block, Chicago
Yinuo (Norah) Zhang
David M. Kroeger
Jenner & Block, Chicago
Purchasing directors and officers insurance (D&O insurance) is a standard practice for public companies in the United States. D&O insurance is often critical to recruiting and retaining quality directors and officers for companies, because it helps to protect them from personal exposure to significant damages and attorneys’ fees resulting from the execution of their job duties. Without adequate D&O insurance coverage, potential qualified candidates might be deterred from serving as directors and officers, which would be a loss to the company, the shareholders, and to society at large.
The same is not standard practice in another major economic power, China. With only 15 per cent of public companies (or 650 out of over 4,500) carrying D&O insurance, and with overall annual premiums of only CNY 100m (around $15.8m), the Chinese D&O insurance market is obviously underdeveloped and likely underpriced.
The reason for this phenomenon is two-fold. First, the regulatory fines for false representations, which had been the major financial deterrence to companies and D&Os, given that investor collective actions in court had virtually been non-existent until very recently (more discussion below), were extremely low (with an upper limit of CNY 300,000, or $47,500, for individual directors and officers). These low regulatory fines, coupled with a lack of enforcement by regulators, contributed to the low demand in the Chinese D&O market. Second, although D&O insurance rates were relatively low in China compared with those in the US, the premiums still seemed unjustifiably high to most public companies in China, particularly considering the lack of material securities-related penalty, indemnification precedents, or a major example of a successful D&O insurance policy payment in the market.
But that may no longer be the case. The demand for D&O insurance has recently spiked in China in response to the new Chinese Securities Law that went into effect in March 2020, which raised regulatory fines up to CNY 5m (or around $792,000) for individual D&Os. Recent Chinese court rulings have further implemented a new type of securities class action, which could render directors and officers personally liable for billions of Chinese yuan. Since the beginning of this year and as of 20 February 2022, 32 publicly listed companies in China have announced plans to purchase D&O insurance – more than three times compared to the same period last year. We also understand that at least one insurer expects a sales increase of over 50 per cent for D&O insurance this year. This article discusses the new Chinese legal regime that gave rise to this change, as well as the likely future trend of D&O insurance development in China.
On 12 November 2021, in China’s first-ever ‘special representative’ securities action brought by over 55,000 investors, Guangzhou Intermediate People’s Court ruled that Kangmei Pharmaceutical Co., Ltd. (Kangmei), a public company listed on the Shanghai Stock Exchange, was liable for more than CNY 2.4bn (around $379m) due to fraudulent accounting representations in its public reporting between 2016 and 2018.
According to the Supreme People’s Court, the highest court in China, the landmark ruling was among the top ten commercial cases in China in 2021 and was further picked up by Western financial and legal media. The significant price tag is only one of the noticeable factors that brought attention to the Kangmei ruling; the shocking effect it exerted on the Chinese business and legal world is largely attributable to who was found to be personally responsible for that huge amount of damages. Six directors and officers, including Kangmei’s Chairman and Vice Chairman (who was also the Chairman’s wife), were found to have directly and deliberately participated in the accounting fraud and were held jointly and severally liable for the entire damages amount. Over a dozen other directors and officers were signatories to the fraudulent reporting at issue and were found to have breached their duty of care in not spotting the massive inflation of revenues, profits, and cash in the company’s public statements. For these co-defendants (which included five independent directors), their liabilities were capped at between five and 20 per cent of the damages. That is, each independent director was jointly and severally responsible for at least CNY 120m (around $19m). To put this into context, according to a recent report, the average annual salary for independent directors in China is around CNY 84,000 (around $13,280), a negligible sum compared to that which each was held responsible for in the Kangmei ruling.
Also at fault for the CNY 2.4bn damages were Kangmei’s outside auditor (GP Certified Public Accountants) and one of its partners, who issued an unqualified opinion for Kangmei’s 2016 and 2017 financial statements. As per a Chinese regulation jointly issued by the Ministry of Finance and China Banking and Insurance Regulatory Commission that went into effect on 1 July 2015, accounting companies auditing public companies are required to purchase professional liability insurance with an aggregate limit of at least (1) CNY 1m (around $158,000) multiplied by the number of partners; or (2) CNY 50m (around $7.9m), whichever is higher. Before this regulation came into effect, only around 500 accounting companies in China had bought professional liability insurance, or six per cent of all accounting firms nationwide.
Assuming GP Certified Public Accountants had bought the required professional liability insurance, it is unlikely that the policy limit would have been high enough to cover the considerable joint and several liability sum – if the policy provided coverage at all. Like professional liability policies in the US, such policies sold in China usually contain an ‘intentional act’ exclusion. A form policy issued by one of China’s largest insurers, Ping An Insurance, for example, excludes losses arising out of ‘intentional acts, criminal acts, gross negligence, fraudulent or dishonest acts’ of the policyholder, the insured, or their representatives or employees. Considering that the Court found the auditing work to have been ‘seriously flawed’, the partner involved ‘grossly negligent’,  and that the parties had not decided to appeal the Kangmei ruling, it could be disputed whether the ‘intentional act’ exclusion applies to bar coverage.
In addition to the damages, the defendants were also jointly and severally liable for court costs of over CNY 12m (around $1.9m). Unlike in the US, where court costs are usually a relatively small amount, court costs in China in commercial and property cases are charged at a degressive rate of the disputed amount, with a percentage of 0.5 per cent for any amount over CNY 20m (around $3.1m). The court costs need to be prepaid by the plaintiff and are ultimately shouldered by the losing party. This is, of course, on top of the attorneys’ fees—the defendants in the Kangmei case were separately represented by over ten different law firms.
The Kangmei case is not the first securities collective action in China, contrary to what many headlines suggest. It is the first ‘special representative’ securities action in the country, a novel collective action mechanism authorised by the Supreme People’s Court in a judicial interpretation that went into effect on 31 July 2020. When there are more than ten plaintiffs in an action that satisfies the conditions for joint civil action under China’s Civil Procedure Law, the plaintiffs can nominate two to five representatives to pursue such an action on their behalf, and the trial court will determine the ‘class’ definition and publish it for 30 days to allow investors to register as class members. This is the ‘ordinary representative action’ under Chinese law. The first-ever ordinary representative action related to securities violations and misrepresentations in China was a lawsuit against another public company, Shanghai Feilo Acoustics, brought by 315 investors in August 2020, which resulted in damages and costs totaling CNY 146m (around $23m) against the company. No directors or officers were sued in that lawsuit.
A ‘special representative’ action, on the other hand, is where an investor protection institution receives authorisation of more than 50 investors during the 30-day publication period in an ordinary representative action, and represents all investors in the defined class, unless an investor opts out. The Kangmei case started as an ordinary representative action with only 11 investors as plaintiffs; it converted into a special representative action after China Securities Investor Services Center (a nonprofit organisation established in December 2014 under the direct supervision of China Securities Regulatory Commission) accepted authorisation of 56 investors during the publication period. The Court defined the class member as any investor who had bought Kangmei’s stock in the open market from 20 April 2017 to 15 October 2018 and still held the stock after the close of market on 15 October 2018, with certain exceptions. Only nine investors opted out from the class. The default rule of inclusion in special representative actions undoubtedly bolstered the number of plaintiffs and, hence, the ultimate damages amount.
Within two weeks following the Kangmei ruling, independent directors from 27 public companies in China submitted resignations. And in the five working days following 15 November 2021, over 50 publicly listed companies expressed interest in purchasing D&O insurance from Ping An Insurance, according to a news report. The trend of rising D&O demand in China continues to this date. The Kangmei ruling served as a wake-up call to directors and officers in this market, offering the potential for them to become personally liable for billions of Chinese Yuan under the new Chinese Securities Law regime.
But uncertainties remain as to whether insurers in China (whether local insurers or those with foreign investment from major insurers in the West) are willing and able to meet the rising demand. To start with, we observe that insurers in China have expressed mixed feelings about the Kangmei ruling. On the one hand, they recognise the greater demand for the D&O product, the significantly increasing possibility of claims under D&O policies, and that this case could be a game-changer for the industry. On the other hand, insurance actuaries are relatively undeveloped in China with respect to the D&O product, and the premium rate and the insurance coverage have been relatively low for the purpose of controlling risk, compared with the international market up to this point. So far, insurers may still not be confident enough in pricing the risk to develop and market a product that could satisfy increased market demand in the era following the Kangmei ruling. Insurance coverage in the market may need to increase significantly to cover potential losses under the new securities regulatory and litigation circumstances. The Kangmei ruling has turned a nightmare scenario that could bankrupt insurers into reality, and Chinese insurers can no longer view the D&O product as a source of steady profits with low risks. We anticipate Chinese insurers with international backgrounds, or those on a larger financial scale or with a better risk control system, will take the lead in setting the parameters of D&O product development in China, as they are relatively more experienced in this area and can shoulder more risk. In addition, traditional D&O insurance normally does not cover regulatory fines, which could make up a significant portion of directors’ and officers’ personal liability after the new Securities Law went into effect. This is another factor that injects uncertainties in the development of the D&O market in China on the demand side.
We also anticipate a rise in coverage disputes in the Chinese D&O insurance market in the near future. In China, insurance contract disputes must be resolved in the court where the insurer is located, and, given that Chinese insurers are mostly headquartered in the major cities with mature judiciary systems, we might very soon see precedent-setting cases coming out of China with respect to D&O coverage disputes. Policyholders should pay close attention to the exclusions included in D&O insurance policies and consider consultation with insurance counsel and brokers to minimize risks of coverage denial.
 Yang Qianwen, Kangmei Case Makes D&O Insurance Popular (24 November 2021), available at www.yicai.com/news/101238410.html.
 Su Xianggao, Public Companies’ Need for D&O Insurance Increases Rapidly This Year, Securities Daily (21 February 2022), available at http://epaper.zqrb.cn/html/2022-02/21/content_809563.htm?div=-1.
 A particular kind of collective action analogous to a class action in the United States. See discussion below.
 The USD amount in this article is based on the exchange rate on 20 February 2022.
 Gu Huajun v. Kangmei Pharmaceutical Co., Ltd, Guangzhou Intermediate People’s Court of PRC (12 November 2021), available at https://finance.sina.com.cn/stock/s/2021-11-15/doc-iktzqtyu7331636.shtml (‘Kangmei Decision’).
 The Supreme People’s Court of the People’s Republic of China, Top 10 Commercial Cases Nationwide in 2021 (29 January 2022), available at www.court.gov.cn/zixun-xiangqing-344441.html.
 See, eg, Reuters, Chinese Court Rules against Kangmei in ‘Milestone’ Case (12 November 2021), available at www.reuters.com/business/healthcare-pharmaceuticals/chinese-court-rules-against-kangmei-milestone-case-2021-11-12/; Kevin LaCroix, First-Ever Chinese Collective Investor Action Results in $385 Million Damages Verdict (15 November 2021), available at www.dandodiary.com/2021/11/articles/securities-litigation/first-ever-chinese-collective-investor-action-results-in-385-million-damages-verdict/.
 Kangmei Decision at 36–37.
 Id. at 37–38.
 China Merchants Securities, Quantitative Analysis Team, Market Hot Topic Analysis: Understanding Resignations of Independent Directors (26 November 2021), available at https://mp.weixin.qq.com/s/IL5cXSWvHDOkixLp3JL5Bw.
 Kangmei Decision at 38–40.
 The Ministry of Finance and China Banking and Insurance Regulatory Commission, The Interim Measures for Professional Liability Insurance for Accounting Firms (eff. 1 July 2015), Article 9, available at www.gov.cn/xinwen/2015-07/09/content_2894651.htm.
 The State Council Information Office of the People’s Republic of China, Q&A regarding the Interim Measures for Professional Liability Insurance for Accounting Firms by the Ministry of Finance and China Banking and Insurance Regulatory Commission (30 July 2015), available at www.scio.gov.cn/xwfbh/gbwxwfbh/xwfbh/bjh/Document/1442823/1442823.htm.
 See https://resources.pingan.com/app_upload/file/property/20110212175554997.pdf.
 Kangmei Decision at 39–40.
 Id. at 43.
 Decree of the State Council of the People’s Republic of China No. 481, Rules Governing Litigation Fees (eff. 1 April 2007), Article 13, available at www.gov.cn/gongbao/content/2007/content_512694.htm.
 Id. at Articles 20 & 29.
 Kangmei Decision at 1–7.
 Supreme People’s Court of the People’s Republic of China, Provisions of the Supreme People’s Court on Several Issues Concerning Representative Actions Arising from Securities Disputes (eff. 31 July 2020), available at www.court.gov.cn/zixun-xiangqing-245501.html.
 Id. at Articles 5 & 6.
 Guo Yan, Shanghai Supreme Court Rules in the First Ordinary Representative Securities Litigation, People’s Court Daily (12 October 2021), available at http://rmfyb.chinacourt.org/paper/html/2021-10/12/content_210084.htm?div=-1.
 Provisions of the Supreme People’s Court on Several Issues Concerning Representative Actions Arising from Securities Disputes, Articles 32 & 34.
 Kangmei Decision at 24.
 Id. at 25.
 Lin Jian, Independent Directors from 27 Public Companies Resigned within 13 Days (25 November 2021), available at www.jwview.com/jingwei/html/11-25/445547.shtml.
 Yang Qianwen, Kangmei Case Makes D&O Insurance Popular (24 November 2021), available at www.yicai.com/news/101238410.html.