Evolution of inferior rank repayment rule for shareholder claims

By Xu Bangwei and Zhang Xiaotong, Jingtian & Gongcheng

The phrase “inferior rank repayment rule for shareholder claims” generally means that when an enterprise goes bankrupt, if a shareholder’s claim against the company satisfies certain specific conditions, it should be ranked after common claims during repayment so as to protect the lawful rights and interests of all creditors in a fair manner.

Similar rules are embodied in US law as the “equitable subordination doctrine” (also known as the “deep rock doctrine”) and in German law as the “automatic subordination principle”.

repayment rule
Xu Bangwei
Jingtian & Gongcheng

Previously, China’s Enterprise Bankruptcy Law simply divided claims into only two repayment ranks, “priority claims” and “common claims”, failing to further specify which claims among the “common claims” ranked as inferior claims.

Through the publication of a typical case, Shagang v Kaitian, an opposition to distribution plan case, in March 2015, the Supreme People’s Court (SPC) clarified for the first time that the claim against the company of a shareholder that made a false capital contribution cannot stand at the same repayment rank as other external claims. This case is regarded as the origin of the Chinese version of the inferior rank repayment rule for shareholder claims.

The SPC specifically pointed out that this rule should be regarded by courts as the rule for handling similar cases. Failure to do so would result in the external creditors of the company being treated unfairly and run counter to the legal liability inuring to a shareholder that makes a false capital contribution, as specified in the Company Law.

rank repayment
Zhang Xiaotong
Jingtian & Gongcheng

In March 2018, the SPC further specified, in the Minutes of the National Court Conference on Bankruptcy Trial Work, that, “a claim arising from improper use by affiliated enterprise members of their connected relationship shall be inferior to common claims in the sequence of repayment, and such inferior creditor may not receive priority repayment from specific property provided by other affiliated enterprise members”.

This provision has now become the key legal basis for determining that a shareholder’s claim is an inferior claim when a Chinese court tries a bankruptcy case. Although the minutes do not more clearly define what an “affiliated enterprise member” is, or what “improper use of their connected relationship” is, based on the authors’ judicial practice experience the following common points of consensus on the substantive rules and the issue of procedural application relating to the inferior repayment ranking for shareholder claims have now taken shape in bankruptcy practice:

Liability of shareholders towards company. If a company shareholder bears a liability towards the company due to its failure to perform its capital contribution obligation, in whole or in part, or due to its having illegally withdrawn its capital contribution, it is very likely that the portion of its claim falling within the said scope will be found to be an inferior claim.

A major shareholder’s bankruptcy claim accounting for a high percentage. If a company shareholder (including the actual controller) holds an absolute majority of the company’s equity and the bankruptcy claim declared by such major shareholder accounts for a fairly high percentage of all of the claims filed, the administrator/court will examine whether the major shareholder in question has performed a clearly “unfair act” in the course of the relevant claim arising, and if so, the relevant claim is very likely to be found to be an inferior claim.

For example, with respect to a claim arising from a loan made to the company by a major shareholder, if the amount of the loan used in the company’s operations far exceeds the debtor’s registered capital, no interest is charged on the loan and the loan exceeds the company’s capacity to repay it, the administrator will lean toward regarding such loan as not being consonant with common practice, constituting an instance of a major shareholder substituting the loan for the company’s registered capital, causing it to become the company’s major creditor, thereby shifting the business risks onto the other creditors. Accordingly, the same constitutes an “unfair act”.

As another example, with respect to a claim arising from a major shareholder advancing an amount for the company, if the company lacks autonomy in terms of business decision-making or use of funds, particularly if the company lacks the right to set the price for its products or services in the course of a connected transaction, it is very likely that it will be held that between the company and the major shareholder there is a commingling of legal personalities and/or property, and an unfair connected transaction. Accordingly, the relevant claim arising from it also constitutes an “unfair act”.

Procedure for determining that a shareholder’s claim is an inferior claim. Generally, the bankruptcy administrator will first conduct a review and arrive at a determination when reviewing the filed claims. If a creditor (including a shareholder that filed a claim or other creditor) or the debtor objects to the finding of the administrator, it may first raise the same with the administrator. If the administrator rejects the objection, the creditor or debtor may institute a bankruptcy claim confirmation suit with the bankruptcy court, in accordance with article 58 of the Enterprise Bankruptcy Law, and request that the court render a ruling or judgment on the confirmed amount and/or repayment rank of the disputed claim.

Burden of proof in determining whether a shareholder claim is an inferior claim. Generally, a court will hold that a creditor that questions the claim of a major shareholder is only required to bear a preliminary burden of proof, and provide certain substantive factual bases, e.g., the intermingling of the shareholder’s assets and the company’s assets, following which the burden of proof then passes to the major shareholder, requiring it to show that its claim against the company arose through a fair and bona fide act, failing which its claim will be found to be an inferior one.

Due to the absence of an express and specific written law as a basis, together with the current lack of in-depth understanding of relevant legal theory in practical circles, different judges will, in practice, have different understandings of, and methods of judging, the key constituent conditions and application conditions for the inferior rank repayment rule for shareholder claims – meaning that a relatively uniform adjudication rule has yet to take shape.

Accordingly, the authors would recommend that when a party encounters such an issue, it formulates an investigation, evidence gathering plan and litigation strategy that takes into account the specific circumstances of the case in question, so as to fully protect its lawful rights and interests.

Xu Bangwei is a partner and Zhang Xiaotong is a trainee at Jingtian & Gongcheng.

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