Lifting the corporate veil: when shareholders are held personally liable in China

The corporate veil or the corporate personality is a legal term used to describe the separation of the corporate entity from the shareholder for the purpose of litigation. Usually, the court renders the shareholder personally liable for the debts, negligence, or mismanagement of the business, and personal assets may be reached.

In China, the shareholder in the governing body of the corporate entity holds the highest authority. The shareholder may protect the interests of the company through initiating legal proceedings against the appointed or elected directors, supervisors, or senior management who neglect their duties in accordance to the laws and administrative regulations and cause the company to suffer damage. A shareholder of a limited liability company (LLC) is liable for the company to the extent of the capital contribution it subscribes. A shareholder of a company limited by shares shall also be liable for the company to the extent of the shares it subscribes. In other words, the shareholder is generally liable to the extent of their capital contributions or shares and the company will be liable for the debts.

However, there are cases provisioned in statutory law in China, which the shareholder can be held personally liable. For foreign shareholders, understanding the corporate veil is crucial in establishing the governing body of the corporate entity, in particular the appointment of directors, legal representatives, and senior managers. Below, we outline the main cases in which the corporate veil could be pierced, and the shareholders could be held personally liable.

Abuse of shareholder rights

In a joint venture or board of shareholders, the interest of the individual shareholder may conflict with the interest of the company. The individual shareholder may abuse shareholder’s rights for the benefit of the individual and cause damages and losses to the company. In such cases, the Chinese law permits shareholder(s) to pierce the corporate veil and hold the violating shareholder liable for compensation.

Under Provisions on Several Issues concerning the Application of the Company Law of the People’s Republic of China V (“The Provisions”), shareholders are strictly prohibited from abusing shareholders’ rights, the independent company’s status as a legal person, or the limited liability of shareholders. Any shareholder that causes loss to the company or other shareholders by such abuse will be liable for compensation.

In practice, shareholders in a board of shareholders have been provisioned the right to initiate legal proceedings against another shareholder (s) who are acting against the interest of the company, such as diverting company funds or profits, entering into contracts against the interest of the company and so forth.

Equally, the Provision can be applied where there is a sole shareholder. The court can hold the shareholder personally liable where the shareholder abuses the company’s independent status or the limited liability of the shareholder.

Insolvency

If a company goes insolvent, there are certain situations where the courts may lift the corporate veil and hold shareholders liable for the outstanding debts to creditors. Such liability can be applied to the following circumstances in insolvency.

The controlled company

The corporate status of a controlled company is ignored if (i) its financing and management are closely connected to its parent company and does not have any independent decision-making authority and (ii) it is induced to entering a transaction beneficial to the parent company, but detrimental to it as well as any third party.

The Alter Ego

An Alter Ego company is not treated by its owners as a separate entity.

Undercapitalisation.

The shareholder(s) shall bear supplementary compensation liability to creditors to the extent of the capital not contributed and the interest for the part of debts of the company which the company is unable to repay – provided a shareholder fails to fulfill or fully fulfill its obligation of capital contribution.

Breach of duty.

If the shareholder commits a breach of duty, such as (i) failure to establish a liquidation group within the statutory time limit and to commence the relevant liquidation process; (ii) any delay in the performance of obligations during the liquidation; (iii) any malignant disposition of the corporate’s properties upon the dissolution of the corporation or without carrying out the relevant liquidation work in accordance with the law, conducting the corporate cancellation procedure by deceiving authorities with a false liquidation report.

Legal Representative

A legal representative is required in a corporate entity in China under The General Principles of the Civil Law of the People’s Republic of China (effective 1987). The legal representative is the responsible person who acts on behalf of the legal person (corporate entity) in executing a company’s functions and powers. Usually, shareholders cannot be appointed as the chairman of its board of directors, executive director or its general manager can serve as the legal representative under the Company Law of the People’s Republic of China.

However, we encounter common cases in which foreign investors of small and medium enterprises with a sole shareholder may appoint themselves as the executive director and concurrently as the legal representative. In such cases, the corporate veil can be lifted since the shareholder serves as concurrent roles which are subject to high standards of due diligence and can face liabilities accrued by the company.

For liabilities of directors in China, please see the article ‘When courts in China may hold a director personally liable for their actions under criminal law and civil law’

A legal representative may face civil, administrative, and criminal liabilities accrued by the company.

Civil Liability

The actions of the legal representative are deemed as activities of the company, with any civil liabilities arising from the legal representative’s actions being borne by the company. However, the company may claim damages from the legal representative for any losses caused by their improper actions.

Administrative Liability

If a company violates any laws in the People’s Republic of China (“PRC”), the legal representative of such company may be subject to fines and punishment, in addition to any punishments passed to the company.  Where the violation is deemed serious, the legal representative may be subject to criminal liability.

Criminal Liability

The PRC Criminal Law imposes criminal liability on both the individual and the company of whom the individual is in charge of, or responsible for, that commits a crime. As the main principle of the company, the legal representative will not be pursued with any criminal liability unless they have participated in the crime and are directly in charge of or responsibility for the crime committed by the company.

As result, we recommend shareholders reframe from serving as concurrent roles in a company to minimise personal liabilities, especially where the shareholder resides aboard since geographical distance can often lead to mismanagement of the company.

In conclusion, shareholders in China are obliged to act in the interest of the company and can face personal liabilities for violations. Foreign investors should understand the parameters and liabilities of the shareholder’s role is to mitigate any unintended violations. Equally, individuals within the governing body such as director(s), supervisor(s), and senior management should be carefully selected to establish robust corporate governance and minimise the risk of piercing the corporate veil.

If you have questions or concerns related to China Business, Tax or Labour Law or other corporate matters, please contact Horizons at +86 21 5356 3400 or talktous@horizons-advisory.com to schedule a consultation session. Horizons can provide insight, expertise and the right solutions for you.