China: Minority Shareholder's Obligations In Liquidation Of Companies - Is Losing Your Investment The Worst Case?

Last Updated: 23 May 2014
Article by Catherine Shen

Venture capitalists will invest in lots of portfolio companies to look for the next Apple or Google. In many such investments, venture capital investors will only hold a minority share, which do not give them control over the portfolio companies' daily operation. In such cases, most investors believe that to lose the amount of invested capital will be the worst case if such investments turn out to be a failure given the "limited liability" rule under PRC Company Law. However, some recent cases ruled by the PRC courts have highlighted the risk for the corporate veil to be pierced if the minority shareholders do not properly fulfill their obligations in liquidating their invested companies.

I The Case

In 2005, Shenzhen Guocheng Venture Capital Limited ("Guocheng"), a State-owned venture capital firm in China, invested US$610,000 in Shenzhen Xieya Precision Industry Co., Ltd. ("Shenzhen Xieya"), a wholly foreign-owned company 100% owned by Xieya International Industrial Co., Ltd ("Xieya International"). After closing of the investment, Guocheng became a minority shareholder holding roughly 15% of the equity interest in Shenzhen Xieya and was entitled to appoint one director to the board of Shenzhen Xieya. Unfortunately, Guocheng's investment in Shenzhen Xieya was soon proven to be a disappointment. To make things worse, Shenzhen Xieya was involved in a law suit with Shanghai Dongyang Carbon Materials Co., Ltd. ("Shanghai Dongyang"). According to the settlement agreement reached between Shenzhen Xieya and Shanghai Dongyang in 2006, it was confirmed that Shenzhen Xieya owed RMB1,554,000 (about USD250,000) to Shanghai Dongyang. However, Shenzhen Xieya failed to repay the amounts to Shanghai Dongyang according to the settlement agreement.

The financial crisis in 2008 was the last straw that broke the camel's back. Given that Shenzhen Xieya accumulated heavy debts and that its operation conditions continued to deteriorate, Shenzhen Xieya's management together with its majority shareholder, Xieya International, simply disappeared. As a result, Shenzhen Xieya's operation came to an end in 2008.As Shenzhen Xieya did not go through the annual inspection procedure, the local company registration authority, i.e., the Market Supervision Administration Bureau of Shenzhen Municipality, revoked Shenzhen Xieya's business license in 2009. Shenzhen Xieya was therefore dissolved.

Since Shenzhen Xieya no longer had any assets available to pay off the debts owed to Shanghai Dongyang, Shanghai Dongyang initiated a law suit against Guocheng in May 2012 asking Guocheng to pay the USD250,000 debts. Shanghai Dongyang claimed that since Guocheng failed to fulfill its shareholder's obligation to liquidate Shenzhen Xieya after the latter's dissolution which made the liquidation impossible due to the loss, damage and destruction of Shenzhen Xieya's assets and accounting books, Shanghai Dongyang's interest was severely jeopardized; and therefore, Guocheng should be held jointly and severally liable for the USD250,000 debts owed to it by Shenzhen Xieya. The court of both first and second instances supported Shanghai Dongyang's claim and Guocheng was asked to repay the USD250,000 debts (plus interest) to Shanghai Dongyang for Shenzhen Xieya.

Besides Shanghai Dongyang, Shenzhen Xieya owed various debts to other creditors with a total amount of at least RMB7 million (about USD1.2 million). If these other creditors followed the same route as Shanghai Dongyang, it would be hard to predict how much losses Guocheng would suffer in the end in addition to losing its investment of USD610,000.

II Our Analysis and Comments

Liquidation Obligations of Shareholders

The PRC Company Law provides that where a limited liability company is dissolved as a result of the occurrence of certain situations (e.g., the revocation of its business license), the company's shareholders shall form a liquidation group within 15 days following the company's dissolution. The liquidation group is responsible for taking the required actions to properly liquidate the company, which includes, amongst other things, identifying, calculating and appraising the remaining assets of the company; notifying and registering the company's creditors; recovering creditor's rights and repaying debts and liabilities. If the remaining assets of the company are insufficient to cover its liabilities, the liquidation process will be terminated and the company will enter into bankruptcy proceedings in accordance with the PRC Bankruptcy Law. In such circumstances, given the limited liability principle under PRC Company Law, the shareholders will not be responsible for any liabilities of the company beyond the amount of the registered capital they have contributed.

In practice, some shareholders are reluctant to go through the liquidation process but simply leave it to the local company registration authority to close the company according to the law. In response to that situation and with a view to ensuring that creditors will have a chance to realize their debts owed by the companies to be liquidated, the Supreme People's Court issued the Provisions on Certain Issues in the Application of PRC Company Law (II) on 5 May 2008 reiterating shareholders' obligations to duly liquidate the companies they invest. According to such provisions, the shareholder (regardless of being a majority shareholder or a minority shareholder) will be held liable for the debts of its invested company upon the occurrence of any of the following circumstances:

(i) where the shareholder fails to form a liquidation group to commence the liquidation process within the applicable statutory time limit, which causes the depreciation, loss, damage or destruction of the assets of the company;

(ii) where the shareholder's failure to fulfill its liquidation obligations causes the destruction or loss of the company's primary assets, accounts or books or important documents, which makes the liquidation impossible;

(iii) where the shareholder maliciously disposes of the assets of the company after the occurrence of the dissolution event, thus causing losses to the company's creditors; or

(iv) where the shareholder deregisters the company without going through the liquidation process or with the submission of a false liquidation report.

There is no distinction between a majority shareholder and a minority shareholder for the purpose of the application of above provisions. In the Shenzhen Xieya case, the courts quoted the above provisions and gave their rulings in a consistent way for Guocheng to be liable for the debts of Shenzhen Xieya due to Guocheng's failure to fulfill its liquidation obligations which caused the loss of Shenzhen Xieya's primary assets, accounts or books and thus made the liquidation impossible.

Is Non-participation in the Company's Operation a Legitimate Defense?

Guocheng argued that it was only a minority shareholder which had no participation in the operation and management of Shenzhen Xieya. Furthermore, all the books and accounts, assets and important documents of Shenzhen Xieya had always been in the possession of the majority shareholder, Xieya International, which were out of the reach of Guocheng. Therefore, as a matter of fact Guocheng was unable to commence the liquidation process of Shenzhen Xieya even if it wanted to.

The courts rejected Guocheng's argument and ruled that Guocheng had the obligation to liquidate Shenzhen Xieya even though Guocheng was not the controller of and had not participated in the operation and management of Shenzhen Xieya.

According to the Provisions on Certain Issues in the Application of PRC Company Law (II), a shareholder is entitled to apply to the court for the appointment of liquidation group members to start the liquidation process if the liquidation group is not formed within 15 days upon the occurrence of the dissolution event. This provides the minority shareholder with an effective remedy where it is unable to properly liquidate its invested company due to its non-involvement in the company's operation. If Guocheng had applied to the local court to start the liquidation process after the revocation of Shenzhen Xieya's business license, the result of the judgment concerning the lawsuit brought by Shanghai Dongyang may be different.

III Conclusion and Suggestions

Guocheng's case was not alone. There had been various other cases for which the corporate veil was pierced and the minority shareholder was held liable for the debts of its invested companies due to its failure to properly liquidate the companies upon dissolution. Venture capital investors would typically be a minority shareholder without strong control over the operation of the portfolio companies, and therefore it may be very difficult for venture capital investors to be fully informed about the business situation of the portfolio companies and liquidate such companies alone. However, venture capital investors are commonly deemed as having deeper pockets by creditors and are very likely to become the first target pursued by the creditors if the portfolio companies are not properly liquidated or bankrupted.

In view of the above, venture capital investors and other minority shareholders are strongly advised to pay proper attention to the dissolution of invested companies and fulfill their shareholders' obligations in liquidating such invested companies upon dissolution. Otherwise, they may find them in very difficult situations rather than simply losing their original amounts of investment. If venture capital investors and other minority shareholders are unable to commence the liquidation process due to the disappearance of the majority shareholder, they must apply to the local court for the court to appoint the liquidation group members and start the liquidation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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