I. Background

Recently, an entrepreneur client came to consult with the author. This client has been operating a business for many years and has now reached retirement age. Since his children are unwilling to take over the business management, the client wanted to delegate management to a deputy general manager and grant the deputy some equity as an incentive. The issue troubling the client was: should he also replace the company’s legal representative with this deputy? On the one hand, the client believed that stepping down as legal representative would help isolate the company’s operational risks from his personal assets; on the other hand, after changing the legal representative to the deputy, the client worried whether he would be sidelined and whether the deputy might harm the interests of the company and the major shareholders.

The above issue is one that many entrepreneurs frequently consult about. The status of legal representative is both a power and a responsibility and risk. Therefore, who serves as the company’s legal representative is a decision that entrepreneurs need to make carefully.

II. Analysis of the Legal Representative’s Responsibilities

In commercial activities, it is common to encounter situations where the actual controller of an enterprise differs from the legal representative. For example, some entrepreneurs appoint their drivers, distant relatives, or other persons they trust as the legal representative.

One very important reason for this phenomenon is that these entrepreneurs want to create a risk isolation shield for themselves. This is because, under the legal context of Mainland China, when an enterprise needs to assume external liability, the legal representative bears the brunt. Specifically, the legal representative of an enterprise may face the following liability risks:

(1) Criminal Liability Risk

When an enterprise is suspected of unit crimes such as collusive bidding, major liability accidents, tax fraud or evasion, the legal representative is often held accountable. When public security departments investigate criminal cases involving enterprises, the legal representative is the primary subject of interrogation. Therefore, if the enterprise’s business activities involve areas that may trigger criminal liability, the legal representative faces a high risk of bearing criminal responsibility.

(2) Administrative Regulatory Liability Risk

When an enterprise is subject to administrative penalties for violations of environmental protection laws, securities misrepresentation, and other administrative regulatory liabilities, the legal representative is considered a “directly responsible supervisor or other directly responsible person,” and may therefore also be penalized by administrative regulatory authorities.

(3) Civil Liability Risk

When an enterprise is subject to court enforcement due to debts and has no property available for execution, the court may, in accordance with the “Provisions on Restricting High Consumption by Persons Subject to Enforcement” and the “Provisions on Publishing Information on Persons Subject to Enforcement Who Have Broken Faith,” include the enterprise’s legal representative in the restricted high consumption list, which causes significant inconvenience to the legal representative’s daily life.

III. Prevention of Legal Representative Power Abuse

It is precisely because of the above-mentioned risks of serving as legal representative that many entrepreneurs choose to operate behind the scenes.

However, one cannot have the best of both worlds. If an entrepreneur appoints someone else as legal representative, the entrepreneur then worries that the legal representative may be uncontrollable and harm the company’s interests. This risk is particularly acute when the legal representative is a professional manager with certain authority to manage the company’s business.

This is because a company is a legally created entity that requires a legal representative to express its intent on behalf of the company. Therefore, the legal representative has the authority to engage in civil activities on behalf of the company. For example, the legal representative has the authority to sign business contracts on behalf of the company (generally speaking, as long as the contract bears the signature of the legal representative, even without the company seal, the contract can be effective against the company).

Given the extensive authority of the legal representative, how can abuse of power be prevented?

The author believes that this can be discussed in two scenarios:

The first scenario: The company’s legal representative is truly a puppet—for example, the company’s actual controller arranges for their driver or a relative from a remote mountainous village to serve as the legal representative. In this scenario, the legal representative has essentially no opportunity to interfere with the company’s business, nor access to the company’s seals, bank accounts, or other important assets, making abuse of power unlikely.

The second scenario: The company’s legal representative is a professional manager with significant management authority. In this scenario, the company’s ownership and management rights are separated, and the legal representative has ample opportunity to use the company’s resources for personal gain. Therefore, it is essential to establish mechanisms to prevent abuse of power by the legal representative. The author believes that such mechanisms can be established from the following aspects:

(1) Checks and Balances in Management Authority

Checks and balances on power are an effective way to prevent abuse of power. Generally, the company’s legal representative is the chairman or general manager, meaning the legal representative is responsible for managing the company’s business. If a legal representative intends to harm the company for personal gain, they typically need the cooperation of financial personnel. Therefore, if the legal representative is in charge of the company’s business, the financial officer should be someone else appointed by the company’s actual controller. Separating business management authority from financial management authority can prevent the legal representative from having unchecked power at the source.

(2) Improving Internal Control Systems

Internal control systems cover various aspects of a company and become increasingly complex as the business scale grows. Overly complex internal control systems may not be truly implementable and will increase management costs. However, when a company founder hires a professional manager to manage the company and serve as legal representative, the author recommends establishing at least the following internal control systems:

1. Establish and Improve the Company Seal Management System

Although the legal representative has the legal authority to sign contracts on behalf of the company, according to domestic customary trading practices, contracts and documents issued by a company generally need to bear the company seal (if a company enters into multiple transaction contracts with the same counterparty but only the legal representative’s signature appears without the company seal, it can be argued that the counterparty is not acting in good faith).

Therefore, it is necessary for the company to establish a seal management system, designate specific personnel to keep the seal, and archive and track documents that have been stamped.

2. Establish a Delegation Manual and Reasonably Define the Legal Representative’s Authority

When the legal representative is a professional manager, the company’s actual controller needs to consider both preventing abuse of power and granting the legal representative sufficient authority to motivate them to operate the enterprise effectively and improve efficiency.

Regarding how to grant authority to the legal representative, the company can establish an internal delegation manual specifying which matters the legal representative can decide independently and which matters require board of directors or shareholders’ meeting approval.

Once the delegation manual is formulated, it must be accompanied by a accountability mechanism for violations of the manual’s approval procedures, established through the company’s rules and regulations. This is because the delegation manual is an internal company rule limiting the legal representative’s authority. According to Article 61(3) of the Civil Code, such rules can only bind the company’s internal management and cannot be used against bona fide third parties dealing with the company.

Therefore, to ensure the implementation and enforcement of the delegation manual, it is necessary to establish corresponding accountability mechanisms through the company’s internal rule-making procedures. For example, if the legal representative enters into business contracts externally in violation of internal decision-making procedures, causing losses to the company, the legal representative should bear compensation liability. Once this accountability mechanism is established, the delegation manual becomes an effective constraint, and the legal representative has greater incentive to comply with it.

3. Establish Internal Audit Mechanisms or Introduce External Audit Institutions

When a company’s business reaches a certain scale, the amount of external procurement also increases, creating opportunities for rent-seeking by management personnel. At this point, the company can establish relevant external procurement systems and, depending on the circumstances, set up an internal audit department or introduce external audit institutions to oversee the implementation of internal management systems.

(3) Appropriately Introduce External Shareholders to Improve the Company’s Equity Governance Structure.

Before a well-known home appliance manufacturing group transferred operational authority from its founder to a professional manager, it had already introduced external institutional investors as shareholders. External institutional investor shareholders generally have sharp insights and are less likely to form interest-based relationships with internal professional managers. They are willing to challenge the company’s management team, which also helps make the group’s operational management decisions more scientific and reasonable, avoiding the risk of internal control by insiders.

Therefore, when an enterprise founder wishes to transfer operational authority to a professional manager and appoint them as legal representative, they should consider appropriately introducing external shareholders.

IV. Conclusion

Generally, when a company’s actual controller hands over the position of legal representative to a professional manager, the primary purpose should be to grant the professional manager management authority over the company and to expect them to independently take charge and fully utilize their initiative, rather than to make them “dance in chains.” Therefore, when imposing certain restrictions on the legal representative’s power, the actual controller should not abandon the goal out of fear of risks. Instead, attention should be paid to unifying the principles of system design with flexibility, ensuring that the legal representative must adhere to certain bottom lines while also enhancing their motivation in business operations.

Of course, each company’s management style and corporate culture are unique, and system design should also take these specific characteristics into comprehensive consideration. What suits oneself is best.