Exploring derivative action in Japan and China

Abstract

Derivative action is a means of enforcing directors to carry out their fiduciary duties to a company through judicial resolutions. Such a private enforcement is one of the essential mechanisms that reduce agency costs in a mature market economy. The institution of derivative action originated from the British equity law, and was further developed and implemented in the United States. Japan, South Korea, Taiwan and Mainland China all introduced derivative action one after the other. Among the transplanted countries, Japan experienced a sharp increase of derivative actions in the 1990s, while the other countries had fewer derivative cases.

This thesis first focuses on the popularity of derivative action in Japan in the 1990s by discussing the legal framework, social and economic backgrounds, and interconnected institutions related to derivative action, in order to determine the incentives for shareholders to sue. Professor Mark D. West, Professor Dan W. Puchniak and Professor Shiro Kawashima all conducted in-depth research and made outstanding contributions on this issue. West believed the direct benefits to Japanese attorneys led to the advent of derivative actions, while Puchniak disagreed, and indicated that shareholders and their attorneys in carrying out derivative actions are irrational and not economically motivated. Kawashima gave more attention to the social aspects of that period of time and inferred that a series of social events triggered the interest to sue.

Through a study on the degree of the development in derivative actions, as well as the related features and changes in Japan, my conclusion is that the establishment of self-reinforcing and interconnected institutions led to path dependence on derivative action, which is the real reason for the popularity of derivative action in Japan. Specifically, the crucial self-reinforcing institutions that contribute to the significant increase in derivative action comprise the common fund principle, which provides indemnity for the litigation costs of plaintiff shareholders when they win a case; the contingency fee arrangement, which transfers litigation risks from plaintiffs to their attorneys; and the discovery rule, which facilitates the access of plaintiffs to corporate internal information. The conclusion is drawn from the path dependence theory, in that the consolidation of any initial path requires the support of the interconnected institutions, especially those with a self-reinforcing nature.

This explanation goes beyond the case of Japan, and can also account for the case of China. Introduced in 2006, the derivative action in China has been modest, with around 10 cases per year. However, after studying the Chinese legal framework of derivative action, I have found an intriguing item, that among all of the derivative suits, only one involved a publicly held company. A cost-benefit analysis has indicated that there is a serious lack of incentives for shareholders in publicly held companies and their attorneys to sue because of the imbalance between litigation costs and benefits. Again, the reluctance to sue is found to originate from the incomplete interconnectedness of institutions based on the path dependence theory. Finally, the experience of Japan can be viewed as an example of establishing these critical self-reinforcing institutions.