I. Introduction
The corporate law doctrine ‘Piercing the Corporate Veil’ refers to a longstanding common law concept in which a corporate shareholder or director is held responsible for the liabilities or debts of a corporation in excess of their capital contributions; notwithstanding the general principal - that corporate shareholders and directors are immune from contract or tort liability when acting under the auspice of a corporation.
Under the PRC Company Law (effective January 1, 2006) and related judicial opinions issued thereafter, there are several instances where PRC courts will find it necessary to look beyond the ‘legal fiction’ of a corporate person or entity and lift the corporate veil - to hold owners and those who run group companies jointly and severally liable for the debts of a company.
In the current economic climate as companies face restructuring, bankruptcies and forced closures, the issue of piercing the corporate veil has become more relevant. Those in charge must ensure that they do not abuse the independent legal status of their invested companies nor use their limited liability status to evade payment of debts. Private equity and venture capital firms especially risk exposing their entire funds to liability, and foreign investors who operate in China by way of numerous subsidiaries should be especially cautious so as not to expose the parent corporation to liability.
Examined below are the main features of the PRC’s application of the corporate veil doctrine and some recommendations for best practices.
II. What are the PRC Courts’ justifications for piercing the corporate veil?Listed below are examples of improper formation and fraudulent and unfair corporate practices which will prompt piercing of the corporate veil in the PRC.
A. Invested companies that are deemed to lack independent legal person status.(i) Failure to pay-up registered capital.
Even if a business license has been issued, if investors fail to in fact fully pay up their subscribed registered capital, the invested company will not be deemed to have independent legal person status.
(ii) Pre-maturely withdrawing registered capital.
Withdrawal of registered capital immediately after it has been paid-up is another circumstance where PRC courts will find that the registered capital has not in fact been paid-up and therefore the invested company does not have independent legal person status.
(iii) Round-tripping investments.When capital that originated in the PRC exits and then re-enters the PRC as a foreign investment, it is referred to as round-tripping and is considered a ‘fake foreign investment’. In such cases, when the actual capital requirements as prescribed by the Ministry of Finance are not met, the foreign invested enterprise will be deemed as improperly formed and the ultimate investor whether on-shore or off-shore will be exposed to liability.
B. Parent company that meddles in the assets and operations of its invested company.
If there is a claim of ‘an abuse of the company’s independent legal status’, the burden of proof rests on the shareholders to prove that their assets are independent from the invested company’s assets.
Examples of such excessive meddling include:
Where the parent company and its invested company enter into related party transactions which are detrimental to the investee.
Where the parent company uses, claims, or does not otherwise differentiate assets of the invested company with its own.
Where the management and control over an invested company is fictional and actual authority is exercised by the parent company.
III. Can China pursue foreign investors for liability in their home country?In the absence of a bilateral or multilateral judicial assistance treaty, legislation of the country in question will dictate whether its courts will enforce a judgement rendered in China.
Common Law Jurisdictions. In common law jurisdictions such as Hong Kong, England, Canada, South Africa and the United States, a Chinese judgement may be generally enforced through case law. Creditors may seek enforcement through (a) breach of contract claim on an implied promise to pay, or otherwise as (b) a debt claim.
Civil Law Jurisdictions. In civil law jurisdictions such as France, Japan, Italy, Spain, Mexico, Switzerland and Belgium, national statutes constitute the exclusive basis for determining jurisdiction over Chinese judgements and prior judicial opinions play a slighter role in determining the outcome.
Test for Jurisdiction. In both civil and common law countries a relevant court’s jurisdiction over a particular defendant will depend on factors such as (i) domicile, (ii) notice, (ii) forum selection clause, (iii) location of assets (such as a bank account), and (iv) connection between the subject matter of the case and activities carried out by the defendant in the particular jurisdiction. Each country will have its own set of rules as to what constitutes a suitable basis to assert jurisdiction and generally the test is of compatibility between the Chinese court’s basis for assertion of jurisdiction when compared to its own laws.
IV. Best PracticesIt is commonly understood that in the PRC maintaining a favourable image in the eyes of government authorities can ensure smooth operations of a business. Leaving pending legal issues unattended to is never recommended. In order to avoid joint and several liability for corporate debts, below are some examples of practices that should be strictly adhered to.
A. Follow proper dissolution and liquidation procedures.
If it is necessary to dissolve a company for any of the statutory reasons listed under the Company Law, it is important to, among others, notify the authorities and make a public announcement, form a liquidation committee to deal with pending matters, and pay off all outstanding taxes, debt and employee salaries and benefits.
B. If necessary, file for bankruptcy.If after liquidation, the company’s property will not offset the outstanding debts, bankruptcy may be filed for by either the creditor or the company.
C. Keep accurate accounting records.Although foreign corporations are obligated to report accounting and financial records according to the jurisdiction where they have been incorporated, with respect to invested companies in the PRC additional records should be kept according to standards set by PRC law and maintained in Chinese, with audits conducted by a PRC qualified firm.
D. Insulate liability through an offshore holding company.To prevent the jurisdictional reach of China’s courts, if possible off-shore holding companies should be used to insulate the company from exposure of its entire asset base, because any further piercing of the corporate veil will be determined by the jurisdiction where the holding company is incorporated.
**and remember this is not legal advice!
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