That shareholders only bear limited liability within the scope of their investment into the company is an essential idea of modern corporation system. However we have seen more and more cases in mainland China’s legal practice in “piercing the corporate veil”.
If the creditors of a limited liability company can prove that there is no clear delineation between assets of the Shareholder and of the Chinese corporation they own shares in, especially where shareholders have misappropriated the corporation’s property, the shareholders will be held jointly liable for the corporation’s debt. Under the Corporation Law of the PRC, the Shareholder’s Meeting is the correct body to choose the management for a Chinese corporation, therefore they have the power to control the corporation by appointing management which will look after of the interests of the shareholders, rather than those of the Chinese corporation itself. Under Chinese law, these Directors and management, legally bear fiduciary duty to the Chinese corporation. This situation most commonly happens where a corporation has only one investor, whether a legal person or an individual. A sole shareholder finds it easily to manipulate operations of the corporation so as to hurt the creditor’s interests.
In past years, the legal practice in mainland China had tended to be conservative in such cases because piercing the corporate veil would deny the independent personality of a limited liability corporation, hurt the foundation of modern corporation system, and hinder economic development. However more recently, we have seen more and more judgments supporting piercing the corporate veil to hold shareholders accountable when the creditors can prove certain conditions have been satisfied.
When foreign investors set up shop in China, we often find that they play “fast and loose” with management of their WFOE, and enter into agreements which are not exactly “arms length” and are unfavorable to the WFOE. This helps make sure profits can easily be transferred outside of mainland China, beyond the government’s currency controls. If this is your typical
modus operandi
, you’ve been warned. The time is now to clean up your act because enforcement is only expected to get tighter. Shareholders of China WFOE’s are advised to talk to their China Lawyer before any major transaction involving their WFOE. Better to get it right now than to have these problems come back to bite you.