Perspective | How can creditors deal with debtors who evade debts through shell operations? (Part 2)

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 interests when facing the debtor's “shell operation”, as well as the views and handling methods of identifying shell operation and debt evasion in judicial practice.

Faced with the debtor's possible “shell operation” attempts, creditors should take timely, proactive, and targeted countermeasures to maximize the recovery of their claims. Based on the different stages of debt management and combined with specific practical experience and methods, this author will explore the countermeasures for creditors:

Prevention is better than cure. Before providing financing or engaging in transactions, creditors (especially financial institutions) should conduct thorough credit checks and background checks on their counterparties. Focus on the equity structure and history of the debtor's company, such as whether the debtor is a sole proprietorship (in law, the shareholder and company property of a sole proprietorship are more easily conflated; the court has a special provision of reversed burden of proof for the shareholders of a sole proprietorship in enforcement), and whether the company's shareholders and actual controllers frequently open and close multiple companies under their names. These could be signs of repeated shell operations.
 

In addition, creditors should also strictly review the debtor's financial condition, examine their balance sheet, and pay attention to any unusual large-scale related-party transactions and accounts receivable and payable situations. If it is found that the enterprise has transferred assets to related parties or transferred significant profits to related enterprises in the past, special attention is needed. Furthermore, if the company's core assets mainly exist in the form of real estate and equipment, creditors can consider requiring the establishment of mortgages or pledges to prevent their unauthorized disposal. If the assets are mostly liquid funds, the stability of their capital chain and the existence of abnormal large-scale transfers should be assessed.

In addition to the above methods, creditors can also check through various channels such as the National Enterprise Credit Information Publicity System and the Judgments Document Network whether the debtor has a record of dishonest execution, litigation records. For example, whether there have been creditors suing them for withdrawal of capital contributions or related-party transaction disputes. If a company has been applied for property preservation or sued for rescission of a transaction by other creditors due to property transfer, it indicates that its credibility and fulfillment performance have problems, and caution should be exercised.

As mentioned earlier, creditors can identify potential risks through prior due diligence. For trading partners suspected of having a history or signs of bad debt evasion, either increase the risk premium and guarantee requirements, or cautiously reduce the credit limit, and refuse cooperation if necessary. While due diligence cannot completely avoid problems in business operations and the occurrence of shell operation and debt evasion, it can significantly reduce the risk of falling into the “empty shell company” trap.

In addition to prior due diligence, in transactions, creditors should also set up contract clauses and safeguards to prevent shell operations as much as possible.
 

For example, creditors can stipulate restrictive clauses (protective clauses) in loan contracts, such as: restricting the debtor from engaging in major related-party transactions, asset disposals, external guarantees, and dividend distributions during the debt term. If necessary, they must obtain the creditor's consent in advance. Such stipulations can lock in the debtor's assets in advance so that they cannot be arbitrarily transferred. Once the debtor violates the agreement and transfers assets without authorization, the creditor can declare the debt due immediately and have the right to immediately take preservation, litigation, or arbitration measures.

Creditors can also require the actual controller or parent company of the debtor to provide a joint guarantee. Personal guarantees or cross-guarantees within the group can prevent the debtor from simply evading debt by transferring business to related entities. Because even if the debtor's company becomes an empty shell, the creditor can still claim directly from the related company or shareholder providing the guarantee based on the guarantee contract. In addition, they can also require the debtor to provide sufficient collateral/pledges (such as real estate mortgages, equity pledges, accounts receivable pledges, etc.). In this way, even if the debtor moves other assets, the relevant collateral and the established mortgage rights can still guarantee the realization of part of the debt to some extent.

In major transactions, especially large investments, creditors can also stipulate financial reporting and supervision mechanisms in the contract. Require the debtor to provide regular financial statements and reports on major matters, allowing the creditor to keep abreast of its operating conditions. Once anomalies are discovered, the creditor can request corrections or provide additional guarantees according to the contract. This actually puts a certain supervision on the debtor's asset changes, increasing the difficulty and breach cost of shell operations.

If the creditor finds that the debtor has suspicious behavior during the debt repayment period, such as the sudden transfer of large assets, cancellation of subsidiaries, and transfer of core business, and the debtor cannot provide a reasonable explanation, then the creditor can consider applying for property preservation measures to prevent problems before they occur. According to the provisions of the Civil Procedure Law, if the creditor has evidence proving that the other party may transfer or conceal property endangering the future judgment enforcement, the creditor can apply to the court for pre-trial or in-trial property preservation, and provide corresponding property clues. In practice, the court generally adopts the measures of seizing, freezing the debtor's bank accounts, real estate, equity, etc., for property preservation.
 

Property preservation can effectively curb the debtor's continued transfer and disposal of property, creating conditions for subsequent enforcement. In addition to the debtor itself, if the creditor knows that the debtor's related company may receive assets transferred from it, they can also apply for preservation of the relevant property held by the third party (such as requesting freezing the funds transferred by the debtor to the third party). After taking preservation measures, the creditor should promptly file a lawsuit within the statutory time limit to prevent the preservation measures from becoming invalid.

Litigation is the most common way for creditors to act when debtors refuse to repay due debts. Given the characteristics of shell operations by debtors resulting in insufficient company assets to repay debts, creditors can consider the following when filing a lawsuit:
 

(1) Add relevant responsible parties as defendants

If there is evidence showing that the debtor's shareholders or actual controllers have engaged in acts such as abusing the corporate independent legal personality, withdrawing capital contributions, or transferring assets, the creditor may, while suing the company for debt repayment, concurrently file a lawsuit to deny the corporate personality, listing the relevant shareholders or third parties as co-defendants. In this way, the court will adjudicate both the debt repayment issue and whether the shareholders, etc., should bear joint and several liability for the debt in the same case. The advantage of this approach is that it is more economical and convenient procedurally and avoids the cumbersome process of adding additional judgment debtors during subsequent enforcement. If the evidence is currently insufficient, the creditor may first sue to obtain a judgment confirming the debt claim and, if enforcement fails, subsequently file a separate lawsuit against the relevant shareholders based on the provisions of Article 23, paragraph 3 of the Company Law.

(2) Filing a subrogation suit or a rescission suit

In response to situations where the debtor has already implemented shell transactions, the creditor may legally file a rescission suit, requesting the court to confirm the invalidity of a certain asset transfer. For example, if the debtor sells real estate under their name to a related company at a low price, the creditor may sue to rescind the house sale contract. If the court rules in favor of the creditor, the property will remain owned by the debtor and can be forcibly executed, auctioned, and sold to repay the debt. Similarly, if the debtor fails to exercise its own claims against a third party, the creditor may file a subrogation lawsuit, requesting the third party to directly fulfill its obligations to the debtor (such as paying for goods, repaying debts, etc.). The judgment in a subrogation lawsuit generally orders the third party to fulfill its obligations to the debtor within the scope of the creditor's claims. It should be noted that the prerequisite for a subrogation suit is that the debtor's claim against the third party has matured and the debtor has failed to exercise it, while the prerequisite for a rescission suit is that the debtor's disposal has harmed the creditor's claim and meets the statutory conditions of malice or gratuity. In terms of evidence, the creditor should provide materials such as the unreasonableness of the debtor's transaction, related relationships, and harmful consequences for the court to review.

Through timely and targeted litigation, the creditor can obtain judgments with compulsory enforcement power, laying the foundation for subsequent execution and claim recovery. During the litigation process, the creditor should collect and submit sufficient evidence to prove the existence of the debtor's shell-trading behavior and the illegal acts to enable the court to clearly support the claims for rescission, subrogation, or joint and several liability of shareholders.

(3) Filing a lawsuit against the new entity

In some cases, the debtor's newly established company actually inherits the original company's business, personnel, and assets. If it can be proven that the new company and the original company constitute a de facto community of interest, the creditor may consider asserting claims against the new company, such as asserting that the new company bears joint and several liability for the debts of the original company (horizontal denial of personality). However, there is currently a lack of relevant precedents in practice, and only a very few cases in judicial practice have judged joint and several liability where the personality of related companies is extremely mixed, especially when the property is completely mixed. Therefore, holding the new company accountable often needs to be based on the above-mentioned rescission or personality confusion litigation: first, rescind the improper transactions between the original company and the new company, or prove that the property and business of the two companies are highly mixed and indistinguishable, thereby persuading the court to break through the principle of independent corporate legal personality for judgment. Therefore, directly suing the new shell company is difficult, and creditors should weigh the ease of evidence collection and the possibility of winning before making a careful choice.

(4) Application for compulsory enforcement and addition of judgment debtors

Winning a lawsuit and obtaining a final judgment is only a phased achievement of rights protection; the key is effective enforcement. If the debtor refuses to perform the judgment, the creditor should promptly apply to the court for compulsory enforcement. In the enforcement process, the creditor can also use enforcement methods to trace and add the person or unit that actually controls the property during the shell-trading process. Specific methods include, but are not limited to, finding clues to the judgment debtor's property, adding judgment debtors, filing objections to enforcement, and pursuing liability for refusal to enforce.

① Finding clues to the judgment debtor's property: The creditor can provide the enforcement judge with clues to the property of the debtor and its related companies, including bank accounts, real estate clues, equity investment information, etc., to assist the court in seizing, freezing, and seizing the corresponding property. If assets are suspected to have been transferred to specific third-party accounts or held by related parties, relevant evidence should also be provided to request an investigation. In the enforcement process, the court has the right to investigate banks, real estate registration agencies, and other institutions to inquire about the situation of the judgment debtor and related property. Creditors should actively cooperate in providing clues. In practice, there are various ways to find property clues of the debtor and its related companies, including entrusting a lawyer to retrieve their business records, querying relevant transaction flow and tax information, and obtaining information through social relations. These are all ways to unearth property clues, and the creditor needs to flexibly use various methods within the scope permitted by law to seek relevant information, thus maximizing the possibility of successful enforcement.

② Adding judgment debtors: The Supreme People's Court's "Supreme People's Court's Provisions on Several Issues Concerning the Change and Addition of Parties in Civil Enforcement" provides for the addition of responsible entities. Especially for a sole proprietorship limited liability company, if the company's assets as the judgment debtor are insufficient to repay the debt, and the shareholder cannot prove that the company's assets are independent of their personal assets, the court may rule to add the shareholder as a judgment debtor to bear responsibility for the remaining debt. That is, directly "piercing the corporate veil" in the enforcement stage to make the shareholder of the sole proprietorship company repay the debt. Even if the company is not a sole proprietorship company, if relevant responsible persons are not added in a timely manner during the lawsuit, the creditor may apply to the court during the enforcement process to add the shareholder or actual controller as a judgment debtor based on the shareholder's abuse of corporate personality as determined in the effective judgment, avoiding the need for a new lawsuit. For example, if the court previously determined in a judgment that a shareholder withdrew capital contributions and should bear supplementary compensation liability, the creditor can apply to include the shareholder in the list of judgment debtors during enforcement to directly enforce their personal property.

③ Filing objections to enforcement and pursuing refusal to enforce: In the enforcement process, situations may arise where a related third party asserts rights to the property being enforced, or the judgment debtor transfers property to resist enforcement. The creditor can use objections to enforcement or file a lawsuit for objections to enforcement to deal with malicious obstruction by third parties (e.g., if a new company claims ownership of a certain asset to prevent enforcement, the creditor can claim that the right is invalid due to the rescission judgment). If the debtor or relevant responsible person refuses to cooperate with enforcement or conceals property, the creditor may also apply to the court to take compulsory measures against them, and in serious cases, the matter can be transferred for criminal investigation, thereby putting pressure on them to perform.

It should be noted that adding shareholders and other responsible entities in the enforcement process usually requires a prior determination in the judgment. Therefore, it is best to include shareholders or actual controllers who may need to bear responsibility in the litigation stage. Adding new responsible persons in the enforcement stage is relatively more difficult and uncertain.

When the debtor's assets are insufficient, and the debt amount is huge and involves many creditors, applying for the debtor's bankruptcy is also a strategy to protect one's own interests. Although bankruptcy means that individual repayment is restricted, several mechanisms in the bankruptcy process are actually beneficial in dealing with the debtor's shell-trading behavior.
 

First, the bankruptcy administrator has the right to investigate and recover the debtor's revocable acts before the bankruptcy application is accepted. For the property previously transferred by the debtor, the administrator can, on behalf of all creditors, legally sue to revoke and recover the property and include it in the debtor's property. Therefore, individual creditors may not be able to find clues or revoke transactions, but the bankruptcy administrator can, from the perspective of all creditors, pool resources to recover. For example, if a bank finds that a borrowing enterprise is insolvent and is suspected of transferring over 100 million yuan in assets to a related party, and this borrowing enterprise has multiple loans and meets the conditions for bankruptcy, then the bank, as a creditor, can apply to the court for its bankruptcy, and the administrator can bring a lawsuit to revoke the related transaction and recover the assets for distribution to the creditors.

Second, creditors can exert influence through the creditors' meeting or creditors' committee during bankruptcy proceedings, requiring the administrator to actively pursue the liabilities of relevant responsible persons, including requiring them to contribute capital to pay off debts. The "Enterprise Bankruptcy Law of the People's Republic of China" stipulates that if the investor of the debtor has not paid the capital contribution after the bankruptcy is accepted, the administrator should request the payment of the capital contribution, regardless of the original capital contribution deadline. This is equivalent to accelerating the maturity of the capital contribution obligation that has not yet matured, which is beneficial to creditor repayment. Although the Company Law also stipulates an accelerated maturity system, in judicial practice, the application of accelerated maturity in bankruptcy proceedings has more abundant experience. In addition, the "Enterprise Bankruptcy Law of the People's Republic of China" stipulates that the illegal income and misappropriated property obtained by senior executives of the debtor using their positions should also be recovered, and the pursuit of the liability for compensation of relevant responsible persons can also be initiated by the administrator or creditor representative. These all provide creditors with practical ways to collectively recover assets transferred through shell companies.

Finally, it should be noted that after entering bankruptcy proceedings, individual creditors will be subject to the principle of equal repayment of creditors and cannot take enforcement measures on their own. Therefore, whether to apply for bankruptcy should be weighed according to the circumstances: If the debtor has indeed nothing left and has transferred a large amount of property, and the whereabouts are unknown, unified cleanup through bankruptcy proceedings may be a way to improve the overall repayment rate; however, if the creditor has the opportunity to receive repayment earlier than others through individual repayment (for example, in the case of secured property rights), applying for bankruptcy may delay or even reduce their repayment. Overall, when the debtor is insolvent and debt evasion behavior makes it difficult for a single creditor to recover property alone, bankruptcy liquidation can be considered as a last resort.

Below, through a typical case from the Supreme Court, we will see how the court determines the debtor's "shell operation" behavior, as well as the creditor's remedies and results. This case involves the debtor's shareholders suspected of transferring funds after receiving payments, and the creditor claims that the shareholders should bear the company's debts.

Case Number: (2019) Supreme People's Court Min Zong 960

A Hainan investment company (debtor, hereinafter referred to as Kelly Company) signed an asset transfer contract with a real estate company (creditor, hereinafter referred to as Country Garden Company), and Country Garden Company paid a 320 million yuan earnest money in accordance with the contract. However, Kelly Company failed to perform the contract, so Country Garden Company sued to terminate the contract and demanded the return of the 320 million yuan earnest money and liquidated damages. At the same time, Country Garden Company discovered that Kelly Company transferred approximately 29.52 million yuan to its controlling shareholder, Zhang, the day after receiving the huge sum of money. Zhang claimed that the transfer was to repay the money he had previously lent to the company, but failed to provide bank vouchers for the actual loan. Country Garden Company suspected that this was an act of the shareholder withdrawing funds through false debts, resulting in a reduction in company assets, and therefore requested the court to order Zhang to bear joint and several liability for Kelly Company's debts in accordance with the provisions of the Company Law.

The first-instance court found the fact of the above-mentioned huge transfer, determined that Zhang failed to prove the existence of a real creditor-debtor relationship between him and the company, and supported the creditor's request, believing that shareholder Zhang abused the company's independent legal personality to withdraw funds, seriously harming the interests of the creditors, and therefore ordered Zhang to bear joint and several liability for Kelly Company's debts.

In the second instance, the Supreme People's Court reversed the case. The Supreme Court first affirmed the first-instance court's factual finding that the 29.52 million yuan transfer lacked real lending basis. However, the Supreme Court believed that it is necessary to be cautious in determining that shareholders bear all the company's debts. In this case, based on this single transfer alone, it is not enough to prove that the company and the shareholder's personalities are so intertwined as to deny the company's independent personality. In other words, although Zhang withdrew nearly 30 million yuan, and there were abnormal asset transactions between the company and the shareholder, this single act was not enough to determine that the company had become a mere shell for the shareholder. However, the Supreme Court also pointed out that Zhang received a large sum of money from the company without being able to prove a legitimate creditor's right, objectively reducing the company's ability to repay debts, and should bear the corresponding responsibility. Based on this, the Supreme Court did not completely exempt Zhang from liability, but adopted a supplementary compensation approach: Considering that 29.52 million yuan far exceeds Zhang's capital contribution in Kelly Company, referring to Article 14 of the Judicial Interpretation (III) of the Company Law on the liability of shareholders for withdrawing capital contributions, it ordered Zhang to bear supplementary compensation liability for the unrecoverable portion of Kelly Company's 320 million yuan debt within the range of 29.52 million yuan plus interest. In simple terms, Zhang needs to fill the 29.52 million yuan (plus interest) he took from the company to repay debts, but does not bear joint and several liability for the remaining debts beyond this scope.

This case has guiding significance for the determination of shareholder liability in similar shell company debt evasion situations. The Supreme Court clarified the following two points through this case:

(1) Strict conditions are required for shareholders to bear all joint and several liabilities for company debts; it is not the case that piercing the corporate veil is always the case as long as there is an asset transfer. It must be proved that the shareholder abused the company's personality and the behavior seriously harmed the interests of the creditors. For example, if the creditor can prove that the company's account has been used by the shareholder for a long time, and the company's assets and the shareholder's assets are indistinguishable, it may support the creditor's request for the shareholder to directly bear joint and several liability. In this case, only one suspicious transfer is not enough to determine that the personalities are completely intertwined.

(2) Even if the high standard of "personality denial" is not met, the court will not ignore obvious debt evasion behavior. Withdrawing capital contributions violates the principle of capital adequacy in the Company Law, and the court regards the funds illegally transferred by the shareholder as funds that should be returned to the company for debt repayment, and pursues its liability in the form of supplementary compensation. This avoids the abuse of the principle of piercing the corporate veil and achieves partial relief for the creditor's losses. This approach reflects the concept of proportional liability in the judiciary, making the shareholder bear the responsibility commensurate with his or her improper behavior.

Therefore, when encountering abnormal loss of debtor assets, creditors should collect evidence to prove the suspicious points and illegalities, such as the evidence held by the creditor in this case of the company's transfer of funds to the shareholder and the lack of proof of lending. This evidence prompted the court to determine that the shareholder's behavior was improper and to bear responsibility. Without supporting evidence, the creditor's lawsuit requesting the shareholder to bear responsibility for withdrawing funds will be difficult to be supported by the court.

In addition, this case also reflects the court's flexible application of the creditor's right of rescission and shareholder liability. Although the judgment does not explicitly state that this is the exercise of the right of rescission as stipulated in the Civil Code, its substantive effect is similar to rescinding the false debt repayment behavior between Zhang and the company, restoring the funds to repay external debts. Moreover, by analogy with the handling of capital withdrawal, it is also a reflection of seeking just relief within the existing legal framework.

In summary, in financial transactions, if there are signs of the debtor "shedding its shell", the court will seek a balance between the principle of corporate independence and the protection of creditors based on the evidence provided by the creditor and relevant legal provisions. Creditors should make full use of various means granted by law (such as simultaneously claiming contractual debts and tort/rescission lawsuits) to prompt the court to comprehensively consider the case and protect their own legitimate rights and interests.