Legal Risks In Capital Reduction And Dissolution - Discussion From A Case

This writer recently encountered a case: a company (hereinafter referred to as "Company A") with a large amount of registered capital, felling such large, registered capital was unnecessary, reduced it. In the process of reduction, the capital reduction information was only announced in local newspaper but not notified to every single creditor. One shareholder of Company A is a limited partnership (hereinafter referred to as "Partnership B"). After the capital reduction, Partnership B was also deregistered through summary dissolution.

Later, Company A fell into financial difficulties. Many creditors sued Company A and applied for enforcement. Soon, they found Company A had no asset for paying debts. Therefore, the creditors sued all shareholders of Company A at the time of capital reduction, asking them to bear supplementary compensation liability within the scope of capital reduction. Further, because Partnership B had been deregistered through summary dissolution, creditors sued all partners of Partnership B at the time of the summary dissolution, requiring them to jointly bear the supplementary compensation liability of Partnership B within the scope of Company A's capital reduction.

With the imminent implementation of the new Company Law¹, a large number of companies with high registered capital subscription are busy on reducing their registered capital. The increased fiduciary duties of senior management, directors and supervisors under New Company Law also make many companies busy on liquidating and dissolving themselves. In this process, a little carelessness may trigger huge liability. Regardless capital reduction or dissolution, governing laws' core lies in protection of creditors. Only strict compliance with procedure laws to provide full protection to creditors, can possible compensatory liabilities under substantive laws be avoided.

1. Legal Risks in Process of Capital Reduction

Article 177 of current Company Law² provides that, when a company needs to reduce its registered capital, it must prepare a balance sheet and an assets list. The company shall notify creditors within 10 days from the date of making the reduction resolution, and make a public announcement in newspaper within 30 days. The creditors shall, within 30 days from the date of receipt of the notice, or within 45 days from the date of public announcement if they have not received the notice, have the right to require the company to pay off their debts or provide corresponding security.

According to provisions of the Third Judicial Interpretation of the Company Law³, if the company fails to comply with the notice or public announcement requirement during the reduction process, the capital reduction shall be regarded as illegal withdrawal of capital contribution, and creditors of the company shall have the right to require all shareholders of the company at the time of capital reduction to bear supplementary compensation liability for any unpaid debts within the scope of illegal capital reduction.

Chinese company law adopts a principle of capital maintenance. Shareholders' contribution to the company constitutes assets of the company and the basis for external creditors to trust in and deal with the company. If shareholders want to get back their capital contribution, they must follow the statutory capital reduction procedure. The core of the statutory procedure is protection of creditors. Therefore, in the reduction process, notice to every knowing creditor and public announcement are two independent steps.

As to whether public announcement can replace the notification to creditors, the Supreme Court in case Wuhan Sinochem Fuel Oil Co., Ltd. v Yueyang Tianyu Industrial Co., LTD ⁴ held that, improper reduction of company's registerred capital shall not have legal effect on creditors who have not notified the announcement. If this leads to that the company has no sufficient assets to fully pay creditors' debts in judicial enforcement procedure, shareholders of such company shall bear supplementary compensation liability for any unpaid debts within the scope of the capital contribution. In practice, most courts hold the same opinion.

Therefore, in the process of capital reduction, all knowing existing and possible creditors, including all creditors recorded in the company's financial books, all counterparties in the contracts signed by the company but not yet fully performed, and any party of transactions the company being involved in, shall be notified one by one. Failure to follow the notifying procedure may lead to shareholders of the company bearing supplementary compensation liabilities.

It is worth noting that Article 226 of the new Company Law provides that, where the registered capital is reduced in violation of laws, the shareholder who have received reduced funds shall return such funds, and such shareholder's contribution shall be restored to the original state. If any loss is caused to the company, such shareholder and any responsible director, supervisor and senior manager shall be liable for compensation. This Article 226 only requires the shareholder return funds he illegally received from the company, and bear compensation liability to the company, but is silent in whether such shareholder should bear the compensation liabilities to creditors. Theoretically, after the returning of funds, the company's capital is enriched, and creditors can further obtain repayment from the company. However, from perspective of creditors, it is obvious that the direct compensation to creditor is more protective. Therefore, after the new Company Law comes into effect, will the shareholders' supplementary compensation liability to creditors under current the Third Judicial Interpretation of the Company Law still apply? This needs to be further clarified in judicial practice.

2. Legal Risks in Process of Dissolution

Current Company Law, Partnership Law⁵ and Market Entity Registration Regulations⁶ provide two ways for market entity's dissolution: liquidation dissolution and summary dissolution.

In terms of liquidation dissolution, Articles 183 to 189 of current Company Law, Articles 86 to 90 of the Partnership Law, and Article 3 of Guidelines on Enterprise Dissolution⁷ require that a company or a partnership shall set up a liquidation panel within 15 days from the date of dissolution, and within 10 days from setting up the liquidation panel, publicly announce the information of liquidation panel through the National Enterprise Credit Information Publicity System (the "NECIPS"), and notify all creditors.

The liquidation information announcement shall be circulated through NECIPS and newspapers within 60 days from setting up the liquidation panel. On completing of liquidation, the liquidation report shall be submitted to the competent registration authority to apply for deregistration of the market entity.

Similar to the company's capital reduction procedure, notifying creditors in liquidation process is a necessary procedure, and such notification cannot be replaced by dissolution announcement. According to Article 10 of the Second Judicial Interpretation of the Company Law⁸, if the liquidator fails to notify creditors and circular liquidation announcement as required by law, and resulting in creditors failing to declare their claims in a timely manner further leading to their debts not being fully paid off, the creditors have the right to require the liquidation panel to assume compensation liability for the resulting losses.

Further, According to Article 18 of the Second Judicial Interpretation of the Company Law, if shareholders of a limited liability company fail to fulfill their liquidation obligations or deregister the company without liquidation, which results in the loss of the company's assets, account books, or important documents, etc., and further leads to liquidation not being able to be initiated or completed, the creditors have the right to require shareholders of the company to bear joint and several liabilities for the company's debts.

In terms of "failing to fulfill liquidation obligations", the nineth Minutes on National Courts Civil and Commercial Trial Conference (Law [2019] No. 254) (hereinafter referred as the "Nineth Minutes") elaborates that, "failing to fulfill liquidation obligations" shall refer to the company shareholders, after the occurrence of liquidation, in the case of being able to perform liquidation obligations, either deliberately delay or refuse to perform liquidation obligations, or negligently fail to initiate the liquidation. However, if a shareholder can prove any one of the following, the shareholder shall not be jointly and severally liable for the repayment of the company's debts:

1. he has taken positive steps to fulfill his liquidation obligations;
2. all these conditions are satisfied:
3. 1. he is only a minority shareholder;
   2. he is neither director nor supervisor of the company;
   3. he didn't elect any person to serve as director or supervisor of the company; and
   4. he has never participated in the operation and management of the company; or
3. there is no causal link between his passive inaction of "failing to fulfill liquidation obligations" and the result of "loss of the company's assets, account books, or important documents, etc. which leads to liquidation not being able to be initiated or completed".

As to summary dissolution, Article 33 of Market Entity Registration Regulations and Article 4 (2) of Guidelines on Enterprise Dissolution provide that, if all following conditions are satisfied, a market entity may be deregistered without liquidation:

1. all investors of the market entity have signed a deregistration application and a letter of commitment, promising that:
2. 1. the market entity has not incurred any claim, debt or expense;
   2. any claim, debt or expense of the market entity (if any) has been fully paid off;
   3. all investors are willing to bear all legal liabilities;
2. such deregistration application and letter of commitment have been announced through NECIPS for 20 days.

Article 20 of the Second Judicial Interpretation of the Company Law provides that, if a shareholder of a limited liability company, in the process of summary dissolution, commits to assume liability for the company's debts, the creditor shall have the right to require such shareholder to assume "corresponding liabilities" . From the Article 20's wording, a shareholder commits to assume "corresponding liabilities" does not necessarily mean that shareholder undertakes to assume joint and several liability for the company's debts. As Article 178 of PRC Civil Code provides, joint and several liability shall only be imposed by law or by agreement entered by parties. Therefore, in absence of any provision which articulates "joint and several liability", any person shall not bear such liability.

As we can see, in practice, where there is a summary dissolution, the registration authority usually requires all investors of the applying entity to sign a standard template commitment letter as being exhibited in Annex 2 of Notice of SAIC and SAT on Strengthening Information Sharing and Joint Supervision, the last paragraph of which is: "all investors of the company shall be responsible for the authenticity of the commitments, and if anyone violates the law, all investors shall bear corresponding legal responsibilities, and voluntarily accept the constraints and punishments from competent administrative or legal enforcement departments." From this wording, we cannot find that the signatory undertakes to assume the joint and several liabilities for the company's debts.

Given there is no judicial interpretation of the Partnership Law, in practice, judicial institutions usually apply the judicial interpretations of Company Law to partnerships by analogy. However, such analogy application may face some practical problems:

First, if the partnership liquidation panel fails to notify creditors and make a liquidation announcement in accordance with the provisions of the Partnership Law, resulting in any creditor failing to declare their claims in a timely manner and not being fully paid off, is the creditor of such partnership entitled to require all member of the partnership liquidation panel to bear compensation liability for the resulting losses suffered by creditors?

It is certainly that, in a general partnership, all partners shall bear joint and several liabilities for the debts of the partnership. In a limited partnership, only the general partner bears unlimited joint and several liability for the debts of the partnership, and the limited partner shall only bear limited liability for the debts of the partnership to the extent of its capital contribution. This writer understands that, if the limited partner participates in the liquidation of partnership as a member of the liquidation panel, the limited partner shall be jointly liable for the liquidation panel's liabilities.

Second, if partners of a partnership fail to perform the liquidation obligations, or the partners directly deregister the partnership without liquidation, should the partners, like shareholders of a limited liability company, be jointly and severally liable for the debts of the partnership?

As discussed afore, all partners of a general partnership, as well as general partners of a limited partnership, shall bear unlimited joint and several liability for the debts of the partnership. What about the limited partner of a limited partnership?

In Nineth Minutes, the Supreme Court holds that, the nature of liability arising from shareholders' failing to fulfill their liquidation obligations is tort. Therefore, there must be a causal link between the behavior of the shareholder and the result of company's failing to liquidate which leads to losses of creditors.

This writer understands that, the nature of liability arising from partners' negligence in performing liquidation obligations shall similarly be tort. Hence, for a limited partner to assume tort liability, under tort laws, four components shall be satisfied under:

1. the limited partner shall commit infringement, i.e. being negligent in performing liquidation obligations；
2. there must be objective consequences from that infringement, i.e., the partnership is not able to liquidate which leads to losses of creditors；
3. the limited partner shall be subjectively at fault；
4. there is a causal link between the limited partner's subjective fault and the objective consequences of the infringement.

Usually, in a limited partnership, the limited partner does not participate in the day-to-day operation of the partnership, and the partnership affairs are solely shouldered by the executive partner (general partner). If the partnership agreement stipulates that, the general partner is responsible for all affairs (including the liquidation affair) of the limited partnership, then the limited partner is not at fault for failing to perform the liquidation obligations, and there is no causal link between his non-action behavior and the damage consequences. Hence, the limited partner shall not be jointly liable for the partnership's debts.

However, Article 86 of the Partnership Law presumes that, the liquidation penal of a partnership, regardless general partnership or limited partnership, shall be constituted by all partners. Therefore, if the partnership agreement is silent in liquidation panel's specific composition, the limited partner will be legally presumed to be liquidator, and if he fails to perform the liquidation obligations at the time of liquidation, his joint and several liability will be triggered.

Third, if a partnership goes through summary dissolution, shall all partners be jointly and severally liable for the debts of the partnership?

Article 91 of the Partnership Law provides that, after the dissolution of the partnership, the general partner shall still bear unlimited joint and several liability for the debts incurred during the existence of the partnership. Accordingly, all partners of a general partnership and general partners of a limited partnership shall bear unlimited joint and several liability for the debts of the partnership, while the limited partners of a limited partnership shall only bear liability for the debts of the partnership up to the limit of their contributions, unless otherwise undertaken by the limited partner. As mentioned above, if the limited partner signs a template "All Investors Commitment Letter", such letter doesn't direct confer a joint and severally liability to the limited partner.

It is worth noting that, Article 240 of the new Company Law provides that, if the company has not incurred debts during its existence, or has paid off all its debts, upon the commitment of all shareholders, it may be deregistered after summary dissolution procedure. The summary dissolution shall be announced through NECIPS, and the announcement period shall not be less than 20 days. If there is no objection after the expiration of the time limit for the announcement, the company may apply for deregistration within 20 days. If a company deregisters through summary dissolution, and the content of shareholders' commitment during this is untrue, shareholders shall bear joint and several liability for the debts incurred before the deregistration. Accordingly, the new Company Law directly confers joint and several liability to shareholders who make untrue statement in summary dissolution, and this provision is likely to be applied by analogy to all partners of partnership.

After the new Company Law comes into effect, shareholders and partners should pay special attention to the potential joint and several liability risks which may be triggered in summary dissolution. This writer suggests that, after the new Company Law comes into effect, unless the company or partnership has never carried out any business activities, a company or partnership, when going into dissolution, shall always follow a liquidation procedure rather than summary procedure to avoid potential legal risks.

Footnotes

1. Refers to the Company Law of the People's Republic of China (amended in 2023).

2. Refers to the Company Law of the People's Republic of China (2018 Amendment).

3. Refers to Provisions of the Supreme People's Court on Several Issues Concerning the Application of the Company Law of the People's Republic of China (III) (2020 Amendment).

4. (2019) Supreme Court Ruling No. 5203.

5. Refers to Partnership Enterprise Law of the People's Republic of China (Revised in 2006)

6. Refers to Regulations of the People's Republic of China on the Administration of Registration of Market Entities

7. Refers to Guidelines on Enterprise Cancellation (Revised in 2023), jointly issued by the General Administration of Market Regulation, the General Administration of Customs and the General Administration of Taxation on 21 December 2023 (Announcement No. 58 of 2023 of the General Administration of Customs for Market Regulation).

8. Refers to Provisions of the Supreme People's Court on Several Issues Concerning the Application of the Company Law of the People's Republic of China (II) (2020 Amendment).

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.