Joining finances of one-person company and its shareholder

Our law firm recently represented a party in a series of “education and training contract” dispute cases, but the focus of the trials was not limited to the contract itself – rather on the determination of commingling of finances between the shareholder of a one-person limited company and the said company.

In this article, the author illustrates the lawyer’s perspective from this case, with recommendations to reduce legal risk of commingling property of one-person companies and shareholders.

BRIEF OVERVIEW

In January 2021, the plaintiff, a Mr Hu, instituted a legal action in the People’s Court of Chaoyang District, Beijing against Beijing A Education Consulting (the education consulting firm), a provider of educational and training services, and B Education Consulting (the actual controller), the sole shareholder holding 100% of the equity of the education consulting firm, claiming the education consulting firm should refund the unused portion of his training fee, and that the actual controller should bear joint and several liability for the alleged debt.

At the court of first instance, our firm represented the actual controller and, having considered legal provisions and judgments in similar cases, expressed this opinion:
(1) based on contracts executed by the education consulting firm with third parties, the executing entity in all cases was the education consulting firm and the actual controller played no role;
(2) based on the payment account used by the education consulting firm in its business with third parties, in each case the payment account was the education consulting firm’s account, and the actual controller played no role;
(3) based on information in the education consulting firm’s 2020 financial year audit report, the claim-debt relationship between the actual controller and the education consulting firm was clear and unambiguous; and
(4) the places of business, financial personnel and systems, and payment accounts of the two companies were mutually independent and operated separately.

Evidence such as premises lease agreements, employment contracts, financial year audit reports and bank statements were submitted and, accordingly, the education consulting firm and actual controller were not commingled. The court accepted this opinion and rendered judgment rejecting the plaintiff’s demand that the actual controller bear joint and several liability for the debt of the education consulting firm. Dissatisfied with this judgment, Mr Hu appealed to the Third Intermediate People’s Court of Beijing Municipality, but the appeals court dismissed the appeal and upheld the original judgment.

LAWS, REGULATIONS, DISCOURSE

Pursuant to article 63 of the Company Law, where the shareholder of a one-person limited company fails to demonstrate that the company’s property is independent of the shareholder’s property, such shareholder is jointly and severally liable for the company’s debts. This provision directly provides the legal basis for a debtor to demand that the shareholder of a one-person company, as defendant, bears joint and several liability.

With respect to “commingled property”, article 10 of the Minutes of the National Work Conference on Civil and Commercial Adjudication by Courts considers that for “commingled personalities”, the key manifestation as to whether the personality of a company and that of a shareholder are commingled is whether their property is commingled and impossible to separate.

The following factors will be considered when determining whether commingled personalities is constituted:
(1) the shareholder uses the company’s funds or property without consideration and no financial record is kept;
(2) the shareholder uses company funds to repay shareholder’s debts or provides company funds for use by an affiliate without consideration and no financial record is kept;
(3) the company’s books and shareholder’s books are not separated, making it impossible to distinguish the company’s property from the shareholder’s;
(4) the shareholder’s own returns are not kept separate from the company’s profits, blurring the interests of both parties;
(5) the company’s property is recorded under the shareholder’s name and possessed and/or used by the shareholder; and
(6) other circumstances that give rise to commingled 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 “property commingling” means that either “property of the company cannot be clearly distinguished from that of the members of the company in question or other companies”, or that “there is no distinction between the profit of the company and the shareholders’ returns, with the profit of the company transformable into the personal property of the members of the company or into the property of another company at will”.

According to the court, property commingling mainly manifests “with the company and shareholder having the same place of business, no separation of the company’s books from the shareholder’s books, or mutual transfer of property between the shareholder and the company”.

CONCLUSION AND ADVICE

Our firm’s experience reveals that almost all plaintiffs will name the shareholder of the one-person company as a defendant, demanding that he/she bears joint and several liability for the company’s debts. Pursuant to legal provisions, the burden of proving that the finances of the company and the shareholder are mutually independent lies with the shareholder of the one-person company.

Such shareholders, particularly those with legal personality, in the majority of cases end up on the losing side due to lacking evidence, or insufficient evidence to disprove commingling of the company’s and the shareholder’s property.

To reduce legal risks arising from the commingling of property of one-person companies and their shareholders, the author recommends that one-person companies – particularly wholly-owned companies with legal personality – should, in their day-to-day operations (where the shareholder is a legal person), at a minimum:

• Not enter into contracts with third parties in the counterparty’s name;
• Not use non-company accounts for receipt of money from third parties;
• Ensure independence of office premises and working personnel, with each executing their respective lease agreements and employment contracts;
• Each formulate their own lawful and compliant financial management systems and implement them as formulated;
• Reduce non-essential connected transactions and cash transactions; and
• Conduct annual financial and accounting audits in accordance with the law.