China: When equities are no longer equitable: applying the Deep Rock Doctrine in PRC

Last Updated: 1 May 2015
Article by Zhang Baosheng, Liu Bin and Zhu Jinshu

On 31 March, 2015, the Supreme People's Court issued four model cases, including Shagang LLC. (Shagang) v. Kaitian LLC.(Kaitian), a case in relation to an objection to the enforcement of a distribution plan. In the case, the Court has referred to the Deep Rock Doctrine originated from the United States, which states for the first time that shareholders whose capital contribution is insufficient shall be subordinated to external creditors of the company with respect to their payable debts. The Deep Rock Doctrine, as a rule established in other jurisdictions, shall be applied and considered in Chinese legal practice with prudence and comprehensive consideration.

  1. The background

On 11 June, 2010, Songjiang People's Court delivered a judgment that Rongcheng LLC. (Rongcheng) should make payment for goods and related losses to Shagang. The company registration of Rongcheng was subsequently cancelled. Shagang filed an application with court to add Kaitian which is Rongcheng's shareholder and seven other natural person shareholders into the enforcement and claimed them being jointly liable for the debts within the extent of their respective insufficient capital contribution to Shagang. The total sum of RMB 696,505.68 was actually enforced from these shareholders accounts, including RMB 0.45 of the insufficient capital contribution from Kaitian. On 18 July, 2012, Kaitian filed a lawsuit, claiming that other shareholders of Rongcheng should be liable within their respective portions of insufficient contribution for the payable amount of debts and damages that were claimed to be owed by Rongcheng to Kaitian. Such two cases also finally went into enforcement proceedings.

On 27 February, 2013, the Enforcement Division of Songjiang People's Court issued a compensation distribution plan for shareholders of Rongcheng, who were all added into the enforcement proceedings. The plan combined the above-mentioned three proceedings. After the litigation fees of the three cases were deducted from the executed funds of RMB 696,505.68, the remaining part was distributed at the same proportion of 31.825% to each case. Other amounts that may be executed and received thereafter shall be distributed accordingly.

On 27 April, 2013, Shagang raised an objection with Songjiang People's Court, arguing that Kaitian should not be entitled to participate in the distribution with respect to the specific amount enforced from Kaitian's account due to its insufficient capital contribution. The first instance court held that the sum of RMB 0.45 million enforced from Kaitian due to its insufficient capital contribution shall be the property of Rongcheng which shall be used to liquidate the debts to Shagang who is external creditor. If Kaitian participates in the distribution of the amount particularly enforced from its own account upon its rights as creditor of Rongcheng, it is unfair to external creditors and also contradicts with the principle that shareholder shall be liable for the invested company within its scope of capital contribution. Therefore the shareholders with insufficient capital contribution shall not be repaid in the same sequence as other external creditors.

Both parties did not appeal. The first instance judgment turns to be effective and final. There is not an established legal rule as to the above disputed issue. In the trial, the first instance court has actually referred to the Deep Rock Doctrine to protect external creditors. Such endeavors should be appreciated.

  1. The origin of Deep Rock Doctrine and its scope of application

Deep Rock Doctrine, or the Equitable Subordination Rule, was established in the case of Taylor v. Standard Gas and Electric Co. (Standard) by court of the United States in 1938. In the bankruptcy proceeding of Deep Rock Corporation (Deep Rock), the Court found that Standard failed to make full capital contribution to Deep Rock at the time of its incorporation, and the interest of business operation of Deep Rock Corp was generally under Standard's control. Thus the court held that Standard's claims upon debts against Deep Rock should be subordinated to those of other ordinary creditors. This rule was then provided for in the U.S. Bankruptcy Act.

In general, the U.S. court will examine closely on whether the shareholder company has any unfair conducts upon the subsidiary company which is under its control, and will focus on substance more than formalities. Those unfair conducts include: a. the subsidiary company is obviously undercapitalized; b. the management by controlling shareholder fails to be in line with their fiduciary duties; c. the assets of the controlling shareholder and the subsidiary company are confused or transferred improperly; d. the controlling company abuses the corporate personality of the subsidiary. If the controlling company abuses its management over the subsidiary and obtains credit from the subsidiary by unfair conducts, which harms the interests of other creditors of the subsidiary, the court may rule that the claim of the controlling company on debts shall be subordinated to that of other creditors.

  1. Analysis on the compatibility and adoptability of the Deep Rock Doctrine with the principles of the Corporate Law of PRC
  1. Is the Deep Rock Doctrine compatible with the principle of disregarding corporate personality (piercing the company veil)?

The shareholders' acts that harm the creditors' interest are mainly regulated by Article 20 of PRC Corporate Law, which provides that shareholders shall not harm the interests of the company's creditors by abusing the company's independent personality or limited liability. It is generally believed that this provision establishes the rules of disregarding corporate personality. However, both academic and people's courts consider that it shall be closely examined and strictly applied as exceptional. In occasions where the creditor's interest is slightly harmed by shareholder's conduct, it is rather difficult to specifically regulate and provide remedy.
In this particular case, the claims of the shareholder shall be subordinated to the claims of external creditor, otherwise, as the court states, it will be unfair to the external creditors of the company and also in violation of the principle that a shareholder of a limited liability company shall be liable to the company to the extent of its capital contribution. By properly applying the Deep Rock Doctrine and combining the principle of disregarding corporate personality, external creditors will be provided comprehensive remedies and protection.

  1. Feasibility to apply it reversely or to parallel affiliates

At present, PRC Corporate Law establishes the principle of disregarding corporate personality only in the circumstances that the shareholders harm the creditors' interest. The law has not established the principle of reverse or parallel disregard of the corporate personality. If the company harms the interest of its shareholder's creditor, or affiliate harms external creditor's interest of the company by unfair connected transactions, there is not established legal rule to provide remedy. If external creditor initiates such legal action, the court may reject the claim due to lack of legal basis. In a word, China has not yet established the principle of disregarding corporate personality in full aspects.

In this case, the basis of applying the Deep Rock Principle is that the company was undercapitalized due to the shareholder's failure to make full capital contribution. Then, the question is whether the Deep Rock Doctrine could be applied when the controlling company has other wrongful conducts, such as transferring assets or conducting unfair connected transactions. Further, is it feasible to apply the Deep Rock Doctrine against the company or its affiliate instead of its shareholder? In terms of academic analysis, the Deep Rock Doctrine could be applied if the controlling company conducts unfair transactions and transfers interest into its affiliated company, or certain unlawful transaction occurs between the affiliated companies. However, there is still a long trip to go to apply such doctrine in judicial practice. Before comprehensively establishing the principle of disregarding corporate personality, the Deep Rock Doctrine is not likely to be widely applied. The very few cases applying this doctrine will serve as valuable models in judicial practice.

  1. A reasonable scope to apply the remedy

The application of Deep Rock doctrine relies more on the court's discretion upon individual cases. In this case, the court applied the doctrine as Kaitian failed to make full capital contribution. The court determined that Kaitian's claim was subordinated to the claim of other creditors to the extent of its insufficient capital contribution. It can be seen that the court has affirmed the reasonable scope to apply this doctrine to subordinate shareholder's claims, which is limited within its insufficient part of the capital contribution. In addition, considering the principle that the shareholder should not be repeatedly liable for its failure to make capital contribution, if the debt owed to the shareholder has been subordinated to that of an ordinary creditor, the court would not sustain other ordinary creditors' claim for subordination again.

The remaining question worth discussion is that, if unfair transactions, especially which continuously occur between the controlling company and its subsidiary or affiliates, to what extent and what amount should the shareholder's claim be subordinated to the claim of other creditor. Is that the total sum of the debt claimed by the creditor, or the actual benefits from unlawful transactions, or its contract value, or the amount of expectation interest? Based on the principle of compensation for all loss and damages under tort law, the preliminary understanding is that, the amount of shareholder's credit subject to subordination should be determined by the actual loss or profits arising from the unfair transactions, so as to balance the interests of each party.

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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