Perspective | A Brief Analysis of the Application of the Deep Rock Principle in the Review Process of Related Claims During Bankruptcy Proceedings

The Deep Rock Principle is a legal doctrine developed through judicial precedents by U.S. courts in handling bankruptcy cases involving affiliated companies, particularly concerning the treatment of creditors' claims among these entities. The specific conditions for applying this principle were clarified by the U.S. Supreme Court in the landmark case *Taylor v. Standard Gas & Electric Co.*, leading to its formal designation as the "Deep Rock Principle." In that case, when the subsidiary company Deep Rock filed for bankruptcy, its parent company, Standard Gas, stepped forward as a creditor seeking repayment. However, the Supreme Court ruled that Standard Gas had abused its controlling power, thereby harming the interests of the subsidiary and other creditors. As a result, the court determined that Standard Gas's claim should be subordinated to those of other creditors, marking the formal establishment of the Deep Rock Principle.

In the subsequent Pepper v. Litton case, William Douglas Justice William O. Douglas pointed out that the controlling shareholder manipulated the company's affairs, leaving unsecured creditors with no means of recovery. Therefore, he concluded that the debtor’s actions failed to meet the standard of whether "the transaction, under any circumstances, exhibited the hallmark of fair dealing." Justice Douglas found that Litton had breached its duty of good faith and fair dealing, allowing its claims to bypass the usual constraints of creditor equality and be treated as subordinated claims—thus paving the way for the development of the Deep Rock Doctrine.

In 1978, the U.S. Bankruptcy Code codified this system in Section 510(c), yet its evolution and expansion did not come to an end with formal legislation. Throughout the development of the Deep Rock Doctrine, U.S. courts typically begin by applying the "three-part test" established in the landmark case *In re Mobile Steel Co.*—specifically, the subordinate creditor must have engaged in inequitable conduct, such conduct must have harmed the interests of other creditors or conferred an unfair advantage on the subordinate creditor, and equitable subordination must not violate any other provisions of the Bankruptcy Code.

On December 24, 2015, the Supreme People's Court issued the "Several Specific Issues Concerning Current Commercial Trial Practices," which stated: "If a company opts for an excessively small amount as its registered capital—such as setting it at just 1 yuan—it becomes necessary to consider whether shareholders, relying on their claims against the company, should be allowed to participate alongside other general creditors in the distribution of the company's assets in the event of future insolvency. In this regard, we tend to believe that when shareholders engage in business operations with insufficient capital, they are likely to convert equity investments into debt investments, thereby effectively externalizing the risks associated with limited liability entirely. Since no specific legal measures have yet been established to address this issue, courts must promptly formulate reasonable rules in judicial practice. Notably, in foreign jurisdictions, it is common practice to rank shareholder claims behind those of other general creditors, ensuring that the latter’s rights are prioritized. This approach is certainly worth learning from."

Article 39 of the "Minutes of the National Conference on Bankruptcy Adjudication in Courts," issued by the Supreme People's Court on March 4, 2018, clearly states: "Coordinated proceedings do not eliminate the creditor-debtor relationships among affiliated corporate entities, nor do they involve the consolidation of assets belonging to these entities. Creditors of each affiliated entity shall continue to be entitled to lawful repayment, limited to the assets of their respective corporate member. However, claims arising from improper use of affiliated relationships among these entities shall rank lower than other ordinary claims in the order of repayment, and such creditors with subordinate claims shall not enjoy priority in receiving payment from specific assets provided by other affiliated corporate members."

On December 29, 2020, the Supreme People's Court revised and issued Article 46 of the "Provisions of the Supreme People's Court on Several Issues Concerning the Application of the Enterprise Bankruptcy Law of the People's Republic of China (II)," which states: "If a debtor's shareholder claims to set off the following debts against debts owed by the debtor to the shareholder, and the debtor's administrator raises an objection, the people's court shall uphold such claim: (1) debts incurred by the debtor's shareholder due to unpaid capital contributions to or withdrawal of capital from the debtor; (2) debts arising from the abuse of shareholder rights or related-party relationships that have harmed the interests of the company."

The minutes of the 15th Judicial Conference held in 2021 by the Second Circuit Court of the Supreme People's Court clearly stated: "Although China's legislation has not yet established provisions regarding the 'Deep Rock Principle,' guided by the principles of fairness and good faith in civil law, this principle remains practically applicable in China's bankruptcy cases. As an exception to the general rule of equal treatment for ordinary creditors under the Enterprise Bankruptcy Law, the application of the 'Deep Rock Principle' in bankruptcy proceedings should be grounded in its inherent institutional purpose. Importantly, subordination is not automatic; controlling shareholders whose claims against the bankrupt enterprise are fair and lawful should not be subject to subordination under the law. However, if controlling shareholders abuse their shareholder rights, leading to—" Corporate Personality Confusion "Engaging in unfair related-party transactions or maliciously colluding with bankrupt companies to harm the legitimate interests of creditors may trigger the application of the 'Piercing the Corporate Veil' principle within bankruptcy proceedings, thereby safeguarding the legal rights and interests of external creditors. This also naturally aligns with efforts to optimize the business environment."

As outlined in Article 204 of the "Guiding Principles on the Trial of Enterprise Bankruptcy Cases by the Shandong Provincial Higher People's Court (Trial)", Article 5 of the "Answers by the Chongqing Municipal Higher People's Court on Issues Concerning the Application of Law in Bankruptcy Cases", Article 5 on "Balancing Interests and Protecting Bankruptcy Claims in the Bankruptcy of Associated Enterprises" from the "Minutes of the Judicial Committee of the Tianjin Municipal Higher People's Court on Several Issues Related to the Acceptance and Adjudication of Bankruptcy Cases", as well as Articles 1 and 7 of the "Guiding Principles on Bankruptcy and Liquidation Work (Trial Implementation)" issued by the Shanghai Municipal Higher People's Court, among others.

On March 31, 2015, the Supreme People's Court announced four typical cases at a press briefing. In elaborating on the significance of the case involving Shagang Company’s challenge to the execution and distribution plan proposed by Kaitian Company, the court drew parallels with the landmark U.S. "Deep Rock" case. It emphasized that "in judicial practice involving such cases, allowing shareholders whose capital contributions are found to be false to rank equally with external creditors in terms of repayment would not only result in an unfair outcome for external creditors but also contradict the legal liabilities imposed on shareholders who make inaccurate contributions under corporate law." This reflects the court’s commitment to upholding the principle of substantive fairness for creditors and ensuring shareholders act with integrity. As a special law, the primary legislative purpose of bankruptcy law is to fairly settle creditors' rights and debts; therefore, when applying the Deep Rock principle, courts should carefully tailor their approach to the specific facts of each case. With the gradual release of judicial policy documents from the Supreme Court and high people's courts across various regions, courts nationwide have increasingly begun applying the "Deep Rock principle" in their judicial practices, leading to the emergence of relevant precedents.

1. (2023) Su 1324 Min Chu 3568 Hao

The SiHong County People's Court of Jiangsu Province held that, since the registered capital of a certain property development company was clearly insufficient to support its normal operations, the company relied on borrowing from shareholders or actual controllers to finance its activities. As Mr. Bai was a shareholder of the company, any creditor's rights he holds against the company should therefore be classified as subordinated claims, to be repaid after ordinary creditors' claims. Consequently, the court rejected the plaintiff's request to have his claim recognized as an ordinary creditor's right.

2. (2025) Shanghai No. 7101 Minchu 592

The Shanghai Railway Transport Court held that, considering the nature of Qian's claim for debt rights—specifically, Qian, as a company shareholder, failed to make proper capital contributions; the actual paid-up registered capital was insufficient to sustain the company's normal operations; and under circumstances where the company had accumulated substantial debts—Qian chose not to replenish the registered capital but instead opted for an alternative payment method, thereby causing the company to incur liabilities toward him. Based on these factors, the court determined that Qian's claim against the company, limited to the amount of his undercapitalized contribution, qualifies as a subordinated bankruptcy claim, to be satisfied only after ordinary bankruptcy claims have been fully settled.

3. (2020) Zhejiang 04 Min Zhong No. 707

The Intermediate People's Court of Jiaxing City, Zhejiang Province, held that the central issue in this second-instance appeal revolves around whether the primary court correctly determined that Dingsheng Company's claim should be subordinated to other ordinary creditors in the order of repayment. In this regard, based on the factual evidence showing that shareholders and senior management members of Dingsheng Company and Zhaosheng Company overlap significantly, coupled with the substantial mutual guarantee obligations between the two companies, the primary court's conclusion that an affiliated relationship exists between them was entirely justified. Since Dingsheng Company had already entered bankruptcy reorganization proceedings earlier, and its creditors had already filed their claims, Zhaosheng Company, as the guarantor, is unable to exercise its right of recovery or set-off against Dingsheng Company for the large debts it has paid on behalf of Dingsheng. Under these circumstances, treating Dingsheng Company's claim against Zhaosheng as merely another ordinary creditor claim alongside those of Zhaosheng's other creditors would clearly be highly unfair to the latter group. Therefore, to ensure equitable treatment for all creditors and prevent imbalances in their respective interests, the primary court's decision to uphold the subordination of Dingsheng Company's claim to the general creditors' claims was entirely appropriate.

1. (2021) Lu 06 Min Zhong 5442 Hao

The Intermediate People's Court of Yantai City, Shandong Province, held that claims arising from improper use of related-party relationships among affiliated corporate entities, as well as claims resulting from shareholders' abuse of the company's separate legal personality, should be repaid after other ordinary creditors. Whether such claims should indeed be classified as subordinated claims must be determined comprehensively, taking into account factors such as the subjective malicious intent behind the shareholder's abusive behavior, the duration of the misconduct, and the consequences caused by the abuse. Furthermore, the establishment and capital contributions of Changlin Company and Lihu Company did not violate the provisions of the Company Law. Given the current evidence, it is insufficient to support the appellant's claim, and thus the appellant must bear the consequences of failing to provide adequate proof.

2. (2024) Shanghai No. 7101 Minchu 1308

The Shanghai Railway Transport Court held that, at the time the disputed debt arose, the plaintiff was a shareholder and supervisor of the defendant, thus maintaining an affiliated relationship with the defendant. However, the court ruled that the disputed debt did not stem from the plaintiff improperly exploiting this affiliation; therefore, it should not be classified as a subordinated claim that ranks lower than other ordinary creditors in the order of repayment. Moreover, the law does not prohibit companies from borrowing money from their own shareholders or supervisors. In this case, after lending funds to the defendant, the plaintiff did not charge any interest, a move that actually helped bolster the defendant’s working capital without harming the company’s interests. Consequently, given that the disputed loan does not fall under the category of claims arising from the plaintiff’s improper use of its affiliated relationship, it should be recognized as an ordinary creditor claim.

3. (2022) Su02 Minzhong No. 6085

The Intermediate People's Court of Wuxi City, Jiangsu Province, held that the existing evidence shows the loan from Shanquan Company to Maitian Membrane Company was used to pay engineering costs on behalf of the wastewater treatment plant, rather than being a loan made to shareholders due to insufficient registered capital at Shanquan Company to support the company's normal operations. Moreover, even if the debt in question had not been used for paying the wastewater treatment plant’s project costs, Shanquan Company’s asset-liability status clearly indicates that there was no situation where "shareholders were operating with excessively minimal capital." According to a special audit conducted as of the date of the bankruptcy ruling, Shanquan Company’s total assets amounted to 57,271,214.76 yuan, total liabilities stood at 45,400,260.83 yuan, and its owners' equity reached 11,870,953.93 yuan. The debt owed by Maitian Membrane Company is already included within this total liability figure. Meanwhile, Shanquan Company’s paid-up registered capital is 20 million yuan, which means the shareholders’ limited liability fully covers the company’s external debts. Therefore, there is no evidence to suggest that shareholders have evaded their limited liability by shifting the risks entirely outside the company. Consequently, the court ruled that the claim cannot be classified as a subordinated claim solely on the grounds that "shareholders were operating with excessively minimal capital."

Regarding the identification of related parties, please refer to " Enterprise Accounting Standard No. 36 – Disclosure of Related Parties Article 3 stipulates: When one party controls, jointly controls, or significantly influences another party, or when two or more parties are simultaneously controlled, jointly controlled, or significantly influenced by the same party, they shall be deemed related parties. Based on current judicial practice, related parties primarily refer to controlling shareholders or individuals who effectively control the company. The Company Law provides clear definitions for both controlling shareholders and individuals with actual control. Specifically, Article 265, Item 2 of the Company Law defines a "controlling shareholder" as a shareholder whose capital contribution accounts for more than 50% of the total capital of a limited liability company, or whose shares held represent over 50% of the total share capital of a joint-stock company. Additionally, even if the proportion of capital contribution or shares held is less than 50%, a shareholder may still be considered a controlling shareholder if the voting rights derived from such investment are sufficient to exert a significant influence on resolutions passed at the shareholders' meeting. Meanwhile, Article 265, Item 3 of the Company Law defines an "actual controller" as any person who, through investment relationships, agreements, or other arrangements, is able to effectively direct and manage the company's operations.

Article 265, Item (4) of the Company Law defines "affiliated relationships" as follows: "An affiliated relationship refers to the connection between a company's controlling shareholder, actual controller, directors, supervisors, senior management personnel, and enterprises directly or indirectly controlled by them, as well as any other relationships that may lead to a transfer of the company's interests. However, enterprises under state control are considered affiliated not merely because they are both controlled by the state." China's laws do not prohibit legally valid transactions formed through such affiliated relationships. On the other hand, when affiliated relationships are improperly exploited to create related-party transactions, these transactions should be rigorously examined from both procedural and substantive perspectives: - **Procedurally**, it must be determined whether the relevant internal decision-making processes were properly followed, and whether these processes comply with the provisions of applicable laws, administrative regulations, or the company's articles of association. - **Substantively**, it is essential to assess whether the related-party transaction aligns with normal business practices, customary standards, and established rules, and whether it upholds the principle of substantive fairness. As for claims arising from related-party transactions improperly conducted through the abuse of affiliated relationships, such claims may be reviewed in accordance with Article 39 of the "Minutes of the National Court Conference on Bankruptcy Trial Work."

The independent legal status of a company and the limited liability of shareholders are fundamental principles of corporate law. Meanwhile, the application of the "Deep Rock" principle effectively protects the interests of external creditors of insolvent companies without necessarily piercing the corporate veil. At the same time, it is not prohibited by law for shareholders or de facto controllers to become creditors of their own companies. In fact, when companies seek to enhance financing efficiency—or face financial distress and struggle to secure funding—shareholders or controlling parties are often the most willing and capable sources of capital. Therefore, during bankruptcy proceedings, administrators reviewing related-party claims should prioritize substantive fairness over formal fairness. They must carefully assess whether shareholders or de facto controllers have abused their shareholder rights to harm the interests of the company’s creditors, as well as whether such actions violate the principle of shareholder good faith. When examining related-party claims—especially in cases where the "Deep Rock" principle may apply—it is crucial to thoroughly consult the summary of the applicable conditions outlined in the "Minutes of the 15th Judicial Conference of the Second Circuit Court of the Supreme People’s Court in 2021." This guidance emphasizes that the assessment should focus on whether the controlling shareholder or de facto controller has indeed misused their shareholder rights to prejudice the legitimate interests of the company’s creditors. Ultimately, the purpose of applying the "Deep Rock" principle is to rectify improper conduct by controlling shareholders that undermines the lawful rights of corporate creditors. It is important to remember that the "Deep Rock" principle does not automatically place related-party claims in a subordinate position; rather, it requires a case-by-case evaluation to determine whether such claims should, in fact, rank behind other debts—ensuring that substantive fairness prevails and all stakeholders’ legitimate rights are safeguarded.