Clearing away the mist: suggestions for developing a principled veil piercing doctrine in China.

• Author: Reed, Bradley C.

ABSTRACT

It was less than thirty years ago that China stood economically isolated from the rest of the world. Times have certainly changed. Today China's economy is one of the fastest growing in the world, and Western businesses are inundating the country to access the abundance of cheap labor. Corporate activity is progressing, yet it was only twelve years ago that China enacted its first corporate law which officially recognized the concept of limited liability. And it was not until less than a year ago that China recognized one of the most important (and most often litigated) corporate law doctrines: piercing the corporate veil.

This Note considers how the veil piercing doctrine fits into China's civil law system. In the United States, the doctrine has developed progressively through the courts. This Note argues that, contrary to the U.S. doctrine, veil piercing in China must be codified with specificity if it is to play a significant role. In particular, the statute must lay out guidelines for Chinese courts to follow when deciding whether to pierce the veil. The current veil piercing statute, enacted in January 2006, is too ambiguous to be useful. If left unchanged, it will likely produce the same confusion and unpredictability that has plagued the doctrine in the United States. As a result, this Note suggests specific guidelines that could be codified to avoid this result and to strengthen the doctrine's usefulness in China's civil law system.

TABLE OF CONTENTS I. INTRODUCTION II. LIMITED LIABILITY AND VEIL PIERCING A. Limited Liability B. Piercing the Corporate Veil III. CHINA: ITS POLITICS, ECONOMY, AND COMPANY LAW A. China's Economy B. The Company Law C. Piercing the Veil in China IV. REFINING CHINA'S STATUTORY VEIL PIERCING DOCTRINE A. Distinguishing Between the Parent-Subsidiary Context and the Human Context B. Distinguishing Between Tort and Contract Creditors V. CONCLUSION I. INTRODUCTION

Judge Cardozo once famously described the concept of piercing the corporate veil as being "enveloped in the mists of metaphor." (1) Despite the passage of eighty years, his colorful description of corporate veil piercing continues to be as timely and relevant as ever. Perhaps one fact best exemplifies the continued truth of his statement: "[p]iercing the corporate veil is the most litigated issue in [U.S.] corporate law." (2) The concept is not unique to U.S. law, however. Nearly all developed economies have adopted concepts analogous to the U.S. veil piercing doctrine. (3) Until quite recently, a notable exception had been China, one of the world's fastest growing economies. (4) However, China formally recognized the doctrine of veil piercing when the revised Company Law of China became effective on January 1, 2006. (5)

This Note explores China's veil piercing doctrine. Before delving into Chinese law, and in order to establish a background for reference, Part II explains the concept of limited liability as it is generally understood. This Part also defines piercing the corporate veil and discusses its application in U.S. jurisdictions. Having laid the foundation, Part III begins the analysis of Chinese law with a brief recitation of China's political and economic history over the past sixty years, followed by a more detailed discussion of the general framework of the Company Law and its key characteristics. Also, Part III examines the current state of veil piercing in China. China's civil law system mandates that the doctrine be codified in a statute rather than developing through common law--as has been the experience in U.S. jurisdictions. (6) This Part concludes with a discussion of some of the advantages and disadvantages of the statutory and common law approaches. Part IV argues that the veil piercing provision in the Company Law is inadequate. Because China is a civil law country and because its courts have very little discretion to adjudicate cases outside the four corners of the statute, the provision needs more specificity as to the factors that courts should consider when deciding whether to pierce the corporate veil. In particular, the Company Law should distinguish between situations where a creditor seeks to pierce to reach another corporation and where a creditor seeks to reach an individual. The history of veil piercing in the U.S. suggests that the two situations require different analyses, and therefore, the Company Law should delineate with some degree of specificity the factors that courts should consider in each case. Finally, the Company Law should distinguish between voluntary (contract) and involuntary (tort) creditors.

2. LIMITED LIABILITY AND VEIL PIERCING

   1. Limited Liability

      Limited liability is perhaps the distinguishing feature of corporate law. (7) Limited liability means that investors in a corporation are not responsible for more than their capital contributions to the corporation. (8) Likewise, a corporation's managers and workers are not vicariously liable for the firm's debts or other obligations. (9) Because of limited liability, a corporation is considered its own legal "person"--it is an entity separate from its shareholders, directors, or officers. (10)

      The rationale for and advantages of limited liability are several-fold. First, "limited liability allows [for] more efficient diversification." (11) Limited liability permits investors to decrease their exposure to risk by owning diversified portfolios of assets. (12) If unlimited liability existed, the risk faced by an investor would turn on the wealth of other investors because creditors would be more likely to go after the wealthiest of the investors. (13) Therefore, diversification in the context of unlimited liability would increase rather than decrease the risk faced by investors. "If any one firm went bankrupt, an investor could lose his entire wealth," (14) so he would therefore invest in a relatively few number of firms and monitor those firms more closely. Said differently, if an investor had to supply unlimited amounts of capital to satisfy a corporation's obligations, "[he] would be reluctant to make small investments." (15) Rather than many smaller investments, people would make relatively fewer larger investments. (16) The result would be lower economic activity. (17)

      Additionally, "[l]imited liability decreases the need to monitor agents." (18) The agency-problem (19) is inherent in the corporate setting, and "investors risk losing wealth because of the actions of [their] agents." (20) Therefore, the more risk that investors bear, the more they will monitor their agents. (21) However, because limited liability permits investors to diversify their investments, investors will be encouraged to hold a larger number of investments, with a smaller portion of their wealth invested in any one firm. (22) Diversified investors have neither the incentive (23) nor the expertise to monitor the actions of specialized agents, so passivity is a more rational strategy. In turn, the decreased need to monitor the agents potentially reduces the costs of operating the corporation. (24)

      The costs of monitoring other shareholders are also reduced by limited liability. (25) As already discussed, if unlimited liability were the rule, "the greater the wealth of other shareholders, the lower the probability that any one shareholder's assets would be needed to pay a judgment" against the corporation. (26) Therefore, existing shareholders would have incentives to monitor (presumably at some cost) other shareholders "to ensure that they do not transfer assets to others or sell to others with less wealth." (27) Limited liability renders irrelevant the identity and wealth of other investors, and therefore avoids these costs. (28)

      Because limited liability promotes the free transfer of shares, it gives managers incentives to act efficiently. (29) The ability of investors to sell their ownership interests constrains the actions of agents. (30) Investors respond to inefficient enterprises by disinvesting. (31) Assuming shares are tied to votes, "poorly run enterprises will attract new investors who can ... install new managerial teams." (32) The potential that the agent will lose his job provides him with an incentive to operate efficiently to keep share prices high. (33) By contrast, under an unlimited liability system, shares would not be fungible because "[t]heir value would be a function of the present value of future cash flows and of the wealth of [the other] shareholders." (34) Under such a system, a person wishing to acquire a controlling number of shares would perhaps have to negotiate with each individual shareholder, probably paying different prices and perhaps a surcharge. (35) Therefore, investors would be less likely to attempt to gain control, and managers would have less fear of losing their jobs. (36)

      Finally, limited liability promotes market efficiency. (37) When all shares trade on the same terms, "investors trade until the price of shares reflects the available information about a firm's prospects.... [I]nvestors ... can accept the market price as given and purchase at a 'fair' price." (38) As previously stated, if unlimited liability were the rule, shares would not be fungible, and therefore, the shares of a single company would not have one market price. (39) Thus, investors would be forced to expend greater resources researching the prospects of the firm to determine the right price. (40)

      These advantages of limited liability suggest that firms would attempt to invent limited liability if it did not exist. (41) Firms would create limited liability by contract; since "[n]onrecourse lenders are limited to the assets securing the loan, just as lenders to corporations are limited to the corporate assets," lenders would advance nonrecourse credit to firms in exchange for higher interest rates. (42) In essence, firms would purchase "failure insurance." Firms would buy (43) this insurance from the creditors...