Reconciliation of the finances of the sole proprietorship and its shareholder

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OOur law firm recently represented a party in a series of litigious “education and training contract” cases, but the lawsuits weren’t limited to the contract itself – rather determining the mix of finances between the shareholder of a public limited company and said company.

In this article, the author illustrates the lawyer’s point of view from this case, with recommendations to reduce the legal risk of mixing the assets of sole proprietorships and shareholders.

BRIEF OVERVIEW

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Gang Xiong
Associated
Zhilin Law Firm

In January 2021, the plaintiff, a Mr. Hu, filed a lawsuit in Chaoyang District People’s Court, Beijing, against Beijing A Education Consulting (the education consulting company), an education service provider. education and training, and B Education Consulting (the effective controller), the sole shareholder holding 100% of the capital of the education consulting company, claiming that the education consulting company reimburse the unused part of its training costs and that the effective controller is jointly and severally liable for the alleged debt.

In the court of first instance, our firm represented the data controller and, after examining the legal provisions and judgments in similar cases, expressed this opinion:
(1) based on the Education Consulting Firm‘s contracts with third parties, the Executing Entity was in all cases the Education Consulting Firm and the Effective Controller played no role;
(2) based on the Payment Account used by the Education Consulting Firm in its dealings with third parties, in each case, the Payment Account was the Education Consulting Firm’s account and the actual controller did not play no role;
(3) based on the information contained in the education consulting firm’s 2020 audit report, the receivable-liability relationship between the actual controller and the educational consulting firm was clear and unambiguous; and
(4) the two companies’ places of business, personnel and financial systems and payment accounts were mutually independent and operated separately.

Evidence such as leases of premises, employment contracts, exercise audit reports and bank statements were presented and therefore the education consultancy firm and actual controller did not were not confused. The court accepted this opinion and rendered a judgment dismissing the plaintiff’s request that the effective controller be jointly and severally liable for the debt of the educational consultancy firm. Dissatisfied with this ruling, Mr. Hu appealed to the Third Intermediate People’s Court of Beijing Municipality, but the appeal court rejected the appeal and upheld the original ruling.

LAWS, REGULATIONS, SPEECH

In accordance with article 63 of the Companies Code, when the partner of a single-member public limited company does not demonstrate that the assets of the company are independent of the assets of the partner, this shareholder is jointly and severally liable for the debts of the company. This provision directly provides the legal basis for a debtor to demand that the shareholder of a sole proprietorship, as defendant, be jointly and severally liable.

With regard to “combined goods”, article 10 of the minutes of the National Working Conference on Arbitration of Civil and Commercial Courts considers that for “combined personalities”, the main manifestation allowing to know if the personality of a corporation and that of a shareholder are mixed is whether their assets are mixed and impossible to separate.

The following factors will be considered in determining whether mixed personalities are made up:
(1) the shareholder uses company funds or property without consideration and no financial records are kept;
(2) the shareholder uses company funds to pay off shareholder debts or provides company funds for the use of an affiliate without consideration and no financial records are kept;
(3) the books of the company and the books of the shareholders are not separated, which makes it impossible to distinguish between the assets of the company and those of the shareholder;
(4) the shareholder’s own returns are not separated from the company’s profits, which blurs the interests of both parties;
(5) the property of the company is registered in the shareholder’s name and owned and/or used by the shareholder; and
(6) other circumstances which give rise to mixed personalities.

Furthermore, according to the Supreme People’s Court in the article “Loan Contract Dispute Retrial Case Between Hainan Rifa Industrial Development Corporation and Hainan Shengtai Jiayuan Industrial: Actual Application of the Theory of Disregard of Legal Personality”, the term “bundling of property” means that either “the company’s assets cannot be clearly distinguished from those of the partners of the company in question or of other companies”, or that “there is no distinction between the profit of the company and the return of the shareholders, the profit of the company being able to be transformed into the personal property of the partners of the company or into the property of another company at its option”.

According to the court, the commingling of property manifests itself primarily “with the corporation and the shareholder having the same place of business, no separation of the books of the corporation from those of the shareholder, or mutual transfer of ownership between the ‘shareholder and society’.

CONCLUSION AND ADVICE

Our firm’s experience shows that almost all plaintiffs will name the sole proprietorship’s shareholder as a defendant, demanding that he be jointly and severally liable for the company’s debts. In accordance with legal provisions, the burden of proof of the financial independence of the company and of the shareholder rests with the shareholder of the single-member company.

These shareholders, especially those with legal personality, in the majority of cases end up on the losing side due to lack of evidence or insufficient evidence to refute the commingling of the assets of the company and the shareholder.

In order to reduce the legal risks arising from the commingling of the assets of sole proprietorships and their shareholders, the author recommends that sole proprietorships – particularly wholly-owned corporations with legal personality – should, in their day-to-day business (when the shareholder is a legal entity), at least:

  • Not enter into contracts with third parties on behalf of the counterparty;
  • Do not use non-company accounts to receive money from third parties;
  • Ensure the independence of the premises and the work staff, each executing their respective rental contracts and employment contracts;
  • Each formulates its own legal and compliant financial management systems and implements them as formulated;
  • Reduce non-essential connected transactions and cash transactions; and
  • Perform annual financial and accounting audits in accordance with the law.

Xiong Gang is associated with the law firm Zhilin

Zhilin law firm logoRooms 2001-2007, 20th floor, Tower C

Global Trade Center, 36 North Third Ring Road East

Dongcheng District, Beijing 100013, China

Tel: +86 158 1093 0489

Fax: +86 10 8400 4936

Email: [email protected]

www.zhilinlaw.com

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