Perspective | How can creditors respond when debtors evade debt through shell operations? (Part 1)

This article is divided into two parts. The first part focuses on clarifying the concept of "shell operation", summarizing common methods, and analyzing the legal issues involved in "shell operation". The second part focuses on sorting out the means for creditors to protect their own rights and interests when facing debtors' "shell operation", as well as the views and handling methods of identifying shell debt evasion behavior in judicial practice.

"Shell operation" generally refers to the practice of a debtor, when unwilling to repay debts, using improper means to transfer personnel, assets, and business from the original company to a new entity, turning the original company into an empty shell to evade the debts of the original company. In simple terms, this is the debtor using the independent legal personality of the company to leave the debt to the old shell company, starting a new business, and letting the creditor deal with an old shell company with no assets. Debt shell operations are often accompanied by various illegal or irregular operations. Common methods include:

(1) Withdrawal of capital contributions by shareholders:After the establishment of a company, shareholders withdraw their contributions without legal procedures, resulting in a reduction in the company's registered capital and assets. For example, shareholders transfer their contributions through fraudulent transactions, or withdraw assets after the company's capital verification. The withdrawal of capital contributions directly weakens the company's ability to repay debts and is one of the important means of shelling.

(2) Transfer or concealment of assets:The debtor sells high-quality assets at low prices or transfers them free of charge to related companies, shareholders, or other entities, resulting in a significant reduction in the original company's assets. For example, some debtors transfer their main business assets to new companies through internal restructuring or corporate division, while leaving the debts in the original company. Other debtors transfer funds to closely related third parties in the form of related-party transactions or forge debt offsets to achieve the covert transfer of assets.

(3) Benefit transfer through related-party transactions:The debtor uses transactions with shareholders or related companies to adjust prices, transfer profits or funds. For example, the debtor purchases raw materials from enterprises controlled by shareholders at prices significantly higher than market prices, or sells products to related companies at prices lower than market prices, thereby transferring profits out of the company. Such related-party transactions appear legitimate on the surface but are actually means of depleting company assets.

(4) False debts and lawsuits:In order to evade real debts, some debtors fabricate false creditor-debtor relationships with related parties and use false lawsuits to embezzle company assets. For example, shareholders initiate false lawsuits, manipulate the company to admit fictitious debts, and quickly pay them to related parties. In essence, this is transferring funds to accounts under their own control, resulting in a reduction in company property.

(5) Other methods:The debtor has a third party lease the company's main factory buildings, equipment, and other operating assets to the new company, with the income flowing into the new company while the old company is idle; or when the company is on the verge of bankruptcy, the debtor waives claims, maliciously extends the debt repayment period, etc., making it impossible for the creditor to repay in a timely manner.

Through the above methods, the debtor, in a way similar to a cicada shedding its shell, transfers the assets of the original company, turning it into a shell company that has lost its ability to repay debts, thereby harming the legitimate rights and interests of creditors. This shell operation is essentially a debt evasion behavior, which disrupts the normal trading order and the principle of honesty and credit, seriously harming the legitimate rights and interests of creditors.

Debtors' "shell operations" are an abuse of the independent personality of legal persons and will seriously infringe upon the legitimate rights and interests of creditors. Chinese law has clearly defined corresponding regulatory measures for such debt evasion behaviors. The Company Law of the People's Republic of China, the Civil Code of the People's Republic of China, the Enterprise Bankruptcy Law of the People's Republic of China, and related laws and judicial interpretations all stipulate the corresponding legal consequences and creditor relief channels for debtors' transfer of assets, withdrawal of contributions, and abuse of the independent status of corporate legal persons.

According to the basic principles of the Company Law of the People's Republic of China, a company has an independent legal person status and independent property, and shareholders bear limited liability for the company's debts to the extent of their capital contributions. However, the Company Law also stipulates a special exception, the system of denying legal personality: Article 23 of the Company Law of the People's Republic of China: "If a company's shareholder abuses the company's independent legal person status and the shareholder's limited liability to evade debts and seriously harms the interests of the company's creditors, he or she shall bear joint and several liability for the company's debts." This means that if shareholders engage in abusive behaviors such as using shell companies to evade debts, creditors can "pierce the corporate veil" and require the relevant shareholders to jointly and severally repay the company's debts. The Supreme People's Court also pointed out in the "Nine Civil Judgments" that common situations of shareholders abusing corporate personality in practice include: identity confusion (such as the indistinguishability of company property and shareholder property), excessive domination and control, and significantly insufficient capital. For example, the confusion of company funds and shareholder funds, separate accounting books, and the gratuitous use of company funds by shareholders are all important factors in judging identity confusion. Once it is determined that the shareholder and the company have a high degree of identity confusion, or the shareholder uses their controlling position to improperly withdraw company assets, causing the company's capital to be clearly insufficient to repay debts, the creditor may pursue joint and several liability of the shareholder according to Article 23 of the Company Law of the People's Republic of China.
 

In addition, the Supreme People's Court has further refined the legal liability of shareholders in certain shell situations in relevant judicial interpretations:

(1) Situation of withdrawal of capital contributions:According to Article 14, paragraph 2, of the Supreme People's Court's Several Provisions on the Application of the Company Law of the People's Republic of China (III): If a company creditor requests that a shareholder who has withdrawn capital contributions bear supplementary compensation liability for the company's unpaid debts within the range of the principal and interest of the withdrawn capital contributions, and that other shareholders, directors, senior executives, or actual controllers who assisted in the withdrawal of capital contributions bear joint and several liability, the people's court shall support it. This means that once it is ascertained that the shareholder has withdrawn capital contributions through shell means, the creditor can request that the shareholder first compensate the company's debtor with the amount of the withdrawn funds. If others have participated in assisting the withdrawal, they shall also bear joint and several liability for repayment.

(2) Unreal or uncontributed capital contributions:Similar to the aforementioned situation, if shareholder capital contribution defects (such as failure to pay within the prescribed period) lead to insufficient company assets, creditors can require them to assume responsibility for company debts within the scope of insufficient capital contribution. The failure of shareholders to fulfill their capital contribution obligations is similar in effect to the actual withdrawal of capital contributions; therefore, creditors also have the right to claim their debts from the relevant responsible persons.

(3) Illegal liquidation, company dissolution to evade debts:Articles 18 and 19 of the "Supreme People's Court's Provisions on the Application of the Company Law of the People's Republic of China (II)" stipulate the company's liquidation obligations: If a company should be liquidated due to dissolution, but the shareholders, directors, etc., fail to establish a liquidation group in accordance with the law within the statutory time limit for timely liquidation, causing the company's property to depreciate or be lost, the creditors may require the relevant responsible persons to bear the liability for compensation for the loss; if the company maliciously disposes of the company's property after dissolution, causing losses to creditors, or the company is deregistered through fictitious liquidation without legal liquidation, the creditors may also require the relevant shareholders and actual controllers to bear the liability for compensation or joint and several liability for the company's debts. This is actually to prevent shareholders from privately transferring or concealing property to evade debts during the dissolution of the company, harming the interests of creditors in liquidation. If the debtor attempts to "shed its shell" through non-liquidation or false liquidation, the relevant responsible persons will also need to bear joint and several liability.

Although there are exceptions to the denial of legal personality, it should be noted that the exception is different from the principle. To break through the principle, more and more sufficient evidence is needed, and it cannot be applied arbitrarily, otherwise it will destroy the basic principle of the independent legal personality. People's courts are cautious in the actual trial of piercing the corporate veil, and usually only when there is very sufficient evidence to prove that the shareholders have abused the company's independent personality and seriously damaged the interests of creditors will they order the shareholders to bear joint and several liability for repayment. Therefore, if creditors claim that shareholders should be held liable in shell operations, they should try their best to provide evidence of the situations stipulated by the law, such as the specific manifestations of personality mixing and financial mixing, and the fact that shareholders control the company's transfer of assets.

For the debtor's behavior of transferring property and shedding its shell to evade debts through individual transactions, creditors can regulate it through the creditor's right of rescission and subrogation system stipulated in the Civil Code of the People's Republic of China and can legally retrieve or prevent the debtor's asset transfer behavior.
 

The creditor's right of rescission is stipulated in Articles 538 to 542 of the Civil Code. When the debtor's actions (such as gratuitous transfer of property, or transfer of property at a significantly unreasonable low price) lead to a reduction in its responsible property and affect the realization of claims, the creditor has the right to request the court to rescind the debtor's actions. Specifically, if the debtor gratuitously disposes of property or maliciously extends the performance period of due debts, the creditor may request the rescission of the act; if the debtor transfers property at a significantly unreasonable low price or accepts property at a high price, or provides unreasonable guarantees for the debts of others, and the counterparty is aware of the situation, the creditor may also request rescission. The exercise of the right of rescission must be filed within one year of the creditor's knowledge of the reason for rescission, and no more than five years from the occurrence of the debtor's act. Once the court rules to rescind the debtor's act, the act is invalid from the outset, and the transferred property can be recovered, increasing the guarantee for the creditor to realize the claim.

It can be seen that the creditor's right of rescission is a remedy for the debtor's malicious disposal of property. If the debtor gives property to others after owing debts, or sells assets at a low price to related companies, so that the creditor cannot be compensated, this is clearly an act that harms the creditor. The creditor can sue to rescind the gift or low-price transaction and restore the assets to the debtor's name, and then execute debt repayment.

The creditor's right of subrogation means that when the debtor has a claim against a third party but fails to exercise it, affecting the creditor's claim realization, the creditor can exercise the debtor's right against the third party in its own name. The right of subrogation is commonly seen in situations where the debtor does not actively recover debts or rights from others, thus making himself insolvent. For "shell operation", if the debtor company still has claims against related companies or other connected entities but intentionally does not exercise or claim them, the creditor can sue to subrogate the exercise of these rights and recover the corresponding property to the debtor's name. For example, if company A, the debtor, owes money to the creditor but delays claiming an account receivable from its related company B, the creditor can bring a subrogation lawsuit to collect debts from B on behalf of A to increase A's assets for debt repayment. The right of subrogation and the right of rescission together constitute an important guarantee for creditors to protect their own interests and prevent the loss of responsible property.

It should be noted that the scope of exercise of the creditor's right of rescission is limited to the amount of the claim—that is, the value of the recovered property only guarantees enough to repay part of the claim; and the right of rescission has a strict time limit for exercise, that is, the exclusion period (within 1 year after knowing the reason, within 5 years after the act occurs). Therefore, once the creditor discovers that the debtor has suspicious asset transfer behavior, he should take action in time, and missing the deadline will cause the creditor to lose the right of rescission in substance.

If the debtor's shell operation ultimately leads to the bankruptcy liquidation of the enterprise being applied for by the creditor, the creditor can also find relevant provisions in the bankruptcy legal system to trace and revoke the debtor's improper disposal before bankruptcy and pursue the responsibility of the relevant entities.
 

According to Article 31 of the Enterprise Bankruptcy Law of the People's Republic of China, within one year before the people's court accepts the bankruptcy application, the manager has the right to request the court to revoke the following property-related acts implemented by the debtor: gratuitous transfer of property, transactions at a significantly unreasonable price, providing guarantees for unsecured debts, repaying due debts in advance, waiving debts, etc. These behaviors essentially cover the common means of transferring and abandoning property by debtors. If the debtor still repays debts to individual creditors within half a year before the acceptance of bankruptcy (collusion, favoring certain creditors), the manager can also request rescission. At the same time, Article 33 of the Bankruptcy Law further stipulates that the debtor's acts of concealing or transferring property to evade debts, or fabricating debts to erode property, are invalid. Therefore, once the bankruptcy procedure is entered, the debtor's previous shell operation and asset transfer behavior can be given a negative evaluation, and the transferred assets are recovered by the manager and included in the bankruptcy property for fair repayment.

In addition, Article 128 of the Enterprise Bankruptcy Law of the People's Republic of China stipulates that if the debtor has the acts listed in Articles 31 to 33 of this law and harms the interests of creditors, the legal representative and other directly responsible personnel of the debtor shall bear the liability for compensation according to the law. In other words, if the company's person in charge participates in the shell operation, transfer, or concealment of assets leading to insufficient bankruptcy property of the company, in addition to rescinding the relevant transactions, these responsible persons may also be required to compensate for the losses caused to the creditors. In the bankruptcy proceedings, the manager or the creditors' committee can investigate whether the company's executives and shareholders have malicious debt-evading behaviors during the debt crisis and pursue their personal liability accordingly. In addition, if there are acts that hinder liquidation or refuse to provide information, the relevant personnel may also face fines and criminal detention, and in serious cases, they may even be investigated for criminal liability (such as bankruptcy fraud, refusal to enforce judgments, etc.).

In summary, the debtor's shell operation is not justified, and the Company Law, Civil Code, and Bankruptcy Law all regulate this. Once the debtor's shell operation is determined to be malicious debt evasion, not only may the relevant transactions be revoked by the creditor or administrator, but the relevant responsible persons (shareholders, directors, senior executives, and actual controllers) may also be required to bear joint and several liability or compensation for the debt.