Reduced Capital, Increased Liability
In the (2024) Jing 0115 Min Chu No. 3374 Judgment (the “Judgment”), a limited liability company (“Company A”) reduced its registered capital in 2023, during the course of which, Company A failed to give notice on such capital reduction to one of its creditors (i.e., the plaintiff of this case) pursuant to the PRC Company Law. The court ruled that Company A had conducted unlawful capital reduction and held that one of the current shareholders of Company A should bear the supplementary compensation liability for the outstanding debt of Company A to the extent of the capital contribution subscribed but not paid by such shareholder before the unlawful capital reduction, for which the supervisor of Company A who was at fault should be jointly and severally liable.
The main legal basis of the Judgement is Article 226 of the Company Law of the People’s Republic of China (Revised in 2023) (“2023 Company Law”) which was formally approved and published on December 29, 2023 and came into force on July 1, 2024. The date of effect is relevant to the facts of the case, particularly as in the previous PRC Company Law, there was no specific provision on liability for unlawful reduction of registered capital of a company. Article 226 of 2023 Company Law (i.e. the new provision) provides that a reduction in a company’s registered capital in violation of the Company Law, which causes losses to the company, the shareholders as well as the directors, supervisors and senior officers who are at fault shall bear liability for compensation. Such provision clarifies the legal validity and civil consequences of unlawful capital reduction and extends liability to directors, supervisors and senior officers who are at fault in the course of the unlawful capital reduction. This new liability represented a significant modification of China’s capital reduction system.
In respect of the liability of directors, supervisors and senior officers for unlawful capital reduction under Article 226 of 2023 Company Law, the following issues should be given attention based on the above Judgment:
First, does Article 226 of 2023 Company Law have retrospective effect? In accordance with item (5) of Article 1 of the Several Provisions of the Supreme People’s Court on the Temporal Effects of the Application of the Company Law of the People’s Republic of China, Articles 211 and 226 of 2023 Company Law shall apply to disputes over liability for damages for losses to a company which distributed profits to its shareholders or reduced its registered capital in violation of laws and regulations before the provisions contained within the 2023 Company Law were effective. According to the Judgment, despite the fact that Company A reduced its registered capital in 2023 before 2023 Company Law came into force, Article 226 of 2023 Company Law was still applicable.
Second, which losses shall be regarded as “losses caused to the company” under Article 226 of 2023 Company Law? According to the Judgment, such “losses” shall include without limitation: property which cannot be returned to the company due to insolvency of the shareholder involved in the capital reduction, costs for occupancy of the company’s capital due to unlawful capital reduction, loss of business opportunity due to decrease in registered capital or actual assets, fees for registration of changes with administration for market regulation.
Third, how should directors, supervisors or senior officers who are at fault be determined? According to the Judgment, whether directors, supervisors and senior officers shall be liable for damages for losses arising from unlawful capital reduction shall be determined mainly based on whether the directors, supervisors and senior officers have performed their statutory duties faithfully and diligently. Given that the duties and obligations of each director, supervisor and senior officer are different due to the division of duties within a company, whether a director, supervisor or senior is at fault in the course of the capital reduction shall be determined in consideration of their respective duties and powers, professional competence and the like, i.e., whether the director has formulated a reasonable capital reduction plan, whether the senior officer has proposed a reasonable capital reduction plan, prepared an accurate balance sheet and legally given notices to all the creditors and made an announcement, whether the supervisor has supervised the capital reduction process in compliance with laws and regulations. There has been other precedent supporting the similar view in the judicial practice. For example, according to the (2022) Jing 03 Min Zhong No. 3560 Judgment, considering that not all the directors shall perform the statutory duty of notifying the company’s creditors in the course of the capital reduction, four of the directors of the company involved in the case did not have such duty, and the unlawful capital reduction of the company resulting from failure to give written notice to the creditors should not be attributable to such four directors. Therefore, such four directors shall not bear compensation liability for the unlawful capital reduction.
Fourth, what is the extent and form of liability to be borne by directors, supervisors and senior officers for unlawful capital reduction? Article 226 of 2023 Company Law provides that “the directors, supervisors and senior officers who are at fault shall bear liability for compensation”, but does not specify the extent and form of such liability. The Judgment referred to Article 53 of 2023 Company Law. This provision states that in the case of a withdrawal of capital contributions by a shareholder of a company, resulting in losses to the company, the directors, supervisors and senior officers who are at fault shall be jointly and severally liable for damages together with such shareholder. The court held that the supervisor of Company A was at fault as the supervisor failed to ensure the statutory procedural compliance of the capital reduction procedure of Company A. The supervisor was therefore found to bear joint and several liability together with the current shareholder of Company A. However, there has been differing views on this subject with some arguing that it would be too harsh to require directors, supervisors and senior officers to bear joint and several liability in any case, and instead the liability to be borne by the shareholders, directors, supervisors and senior officers for unlawful capital reduction should be determined in proportion to their respective fault and causal contribution to the unlawful capital contribution.
Fifth, may creditors of a company request the company’s directors, supervisors and senior officers to bear compensation liability for unlawful capital reduction on the basis of Article 226 of 2023 Company Law? According to the literal sense of Article 226 of 2023 Company Law, the directors, supervisors and senior officers who are at fault shall make compensation to the company rather than the company’s creditors. Currently, there are different opinions regarding whether the subjects other than the company may bring a lawsuit pursuant to Article 226 of 2023 Company Law. For example, some argue that the unlawful capital reduction of a company might damage interests of the company’s creditors who upon the principle of protecting creditors may request the company’s directors, supervisors and senior officers to bear liability under Article 226 of 2023 Company Law, while others argue that if a director or senior officer plays a leading or supportive role in the capital reduction, such director and senior officer shall be determined as having willfulness or gross negligence and therefore make compensation directly to external third parties pursuant to Article 191 of 2023 Company Law, and the criteria for determining the willfulness and gross negligence of a supervisor in the capital reduction shall be more lenient than that for directors and senior officers; if a director and senior officer is not involved in the material matters of a company and subjectively has no willfulness or gross negligence, they shall make compensation to the company pursuant to Article 188 of 2023 Company Law. According to the above Judgment, the court supported the request of the creditor of Company A (i.e., the plaintiff of this case) for adding the supervisor of Company A as the defendant of this case, and ruled that such supervisor was at fault in the course of the unlawful capital reduction and shall be liable for compensation under Article 226 of 2023 Company Law.
Considering that China does not follow the doctrine of precedent, the above Judgment is for reference only and it is possible that other courts might issue different judgments in similar cases in the future. Given that, in general, 2023 Company Law is applicable to both domestic companies and foreign-invested companies in China, the above case study provides critical lessons to foreign-invested companies established in China who should consider the following advice:
1. Article 226 of 2023 Company Law reflects that the new PRC Company Law, follows the spirit of board centralism, strengthens director’s duty to maintain corporate capital and imposes more stringent liability on directors, supervisors and senior officers. In such context, the foreign-invested companies are advised to exercise caution and diligence in determining candidates for directors, supervisors and senior officers, clearly define duties and powers of each director, supervisor and senior officer in the articles of association, and purchase appropriate liability insurance for directors, supervisors and senior officers if feasible.
2. The foreign-invested companies must ensure that if they decide to reduce their registered capital, they do so in strict compliance with 2023 Company Law and other applicable laws and regulations, and properly maintain all relevant written supporting materials and documents.
3. The directors, supervisors and senior officers of foreign-invested companies shall faithfully and diligently perform their respective duties and obligations in accordance with 2023 Company Law and the articles of association, and are advised to retain written materials evidencing their proper performance, including without limitation voting document specifying any objection made by themselves, notices, letters, records of communications, meeting minutes and resolutions.
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