Entity Shielding and the Rule of 'Debts-Follow-Assets' in China: An Empirical Law and Economics Analysis.

AuthorZeng, James Si


Legal personality has been recognized by scholars as "the most fundamental attribute of a corporate entity," which offers important economic functions. (1) One of the functions is what scholars call "entity shielding." A corporation's assets are protected from the claims of the creditors of its investors. (2) Although entity shielding may incur certain social costs mainly because of the problem of "debtor opportunism," (3) scholars generally regard entity shielding as one of the most important functions of organizational law, (4) resulting in the reduction of information costs and protection of the going-concern value of a corporation. (5) Scholars have employed the cost-benefit analysis of entity shielding to explain the evolution of organizational forms in western countries. (6)

In 2003, The Supreme People's Court ("SPC") of China issued the controversial DFA Rule ([phrase omitted]), which allows a court under certain circumstances to hold a corporation responsible for the debts of its investors. (7) Although the DFA Rule originally was proposed to govern the corporatization of state-owned enterprises ("SOE"), (8) courts have expanded its scope to cover other types of entities, including private corporations and state-owned corporations, and transactions that do not involve corporatization or restructuring of SOEs. (9) One common scenario under which the DFA Rule may apply is when a debtor invests a substantial proportion of its assets in a new corporation and receives consideration in the form of equity interests. (10) Suppose a Chinese company, C. Corp, establishes and transfers substantially all of its assets to a subsidiary, C. Sub. The creditors of C. Corp may request C. Sub to be responsible for the debt of C. Corp, as illustrated in Figure 1, when certain conditions are met. Exactly when courts will apply the DFA Rule remains unclear. (11) In practice, courts exercise significant discretion and have issued seemingly inconsistent decisions. (12)

This article attempts to examine whether the theory of asset partitioning can explain the Chinese courts' application of and coherent rationale for the DFA Rule. The DFA Rule disrupts the entity-shielding arrangement by allowing the creditor of a shareholder to "reverse pierce" the corporate veil of the corporation to reach its assets. The costs and benefits of this Rule can be explained by the theory of asset partitioning. Currently, many scholars generally criticize the DFA Rule for disrupting the entity-shielding effect offered by Chinese corporate law. (13) Meanwhile, some scholars also have recognized that entity shielding may incur certain social costs mainly because of the problem of "debtor opportunism." (14)

This article employs empirical methods to analyze courts' decisions regarding the DFA Rule. It reveals certain patterns in the application of the Rule. Courts consider not only legal issues, such as whether the transaction constitutes a fraudulent conveyance and whether the debtor transferred sub' stantially all assets to the new corporation, but also non-legal factors not contained in the DFA Rule itself, including the identity of creditors and the number of investors.

Applying the theory of asset partitioning provides more protection to non-Financial corporations or involuntary creditors because they often lack the capacity to use contractual covenants or obtain secured property rights for protection. Indeed, the benefits of offering such creditors additional benefits with the DFA Rule may be greater when the creditor is not a financial institution. Courts are less likely to apply the DFA Rule when the number of investors is large because higher information costs would result from the need for each investor to monitor the financial status of others. The asset-partitioning theory seems to provide an explanation for courts' varying application of the DFA Rule, and the empirical findings cannot be fully explained by alternative theories, such as the theory-of-interest group. (15)

Although scholars have examined whether the theory of owner shielding (or limited liability) can explain courts' decisions that pierce the corporate veil, few studies have tested empirically the entity-shielding theory. Current studies of entity shielding focus mainly on the historical development of bush ness forms in western countries. (16) This article constitutes the first attempt to examine how economic considerations affect courts' decisions concerning entity shielding in a particular jurisdiction, which allows testing of the theory of asset partitioning while controlling for many confounding variables that may be seen in a cross-country historical analysis. Moreover, given that China is currently the second largest world economy and the largest developing country, its experience should shed new light on the academic literature and provide an important reference for other countries.

Part I of this paper describes the legal elements of the DFA Rule and some major decisions by the SPC before presenting a preliminary analysis of the costs and benefits of the DFA Rule in light of the theory of asset partitioning. Part II presents the results of an empirical study about how courts enforce the DFA Rule in practice and discusses whether the theory of asset partitioning can explain the results. Part III considers the implications and lessons to be learned from China's experience.


    1. The Legal Elements of the DFA Rule

      Legal personality has been regarded as one of the essential characteristics of modern corporations. Because a corporation is a legal entity separate from its shareholders, its assets are usually shielded from the creditors of its share' holders. This arrangement is referred to as "entity shielding." (17) In 2003, the SPC of China issued a judicial interpretation, the ERP, (18) in article 7 of which it created the DFA Rule that imposes significant limitations on entity shield' ing. Pursuant to the Rule, if an enterprise forms a new corporation with other investors (19) and transfers its high-quality assets, the newly established subsidiary corporation may be jointly and severally liable to the original enterprise's creditors.

      Application of the DFA Rule requires two legal conditions: (1) the original enterprise must establish a new corporation, (20) and (2) the original enterprise must transfer its "high-quality assets" (21) to the new corporation. (22) Apart from these two conditions, courts often limit application of the DFA Rule to "restructuring" transactions because the Rule is found in the ERP. (23) The meaning of restructuring, however, remains unclear and is subject to interpretation. Courts generally exercise discretion in deciding whether to apply the DFA Rule. (24) Article 1 of the ERP provides that restructuring transactions include the corporatization of enterprises, corporate divisions, and mergers between enterprises. (25) Restructuring transactions are quite common in China because China has adopted a nationwide policy of corporatizing SOEs. In a typical corporatization transaction, the government orders the transfer of as* sets from the SOE to the new corporation, and as consideration, the corpora' tion issues stocks to the owner of the SOE, i.e., the government (26) When an SOE is corporatized in this way, the SOE's creditors may be negatively affected because the SOE received nothing from the transaction. The liability created by the DFA Rule, thus, is understandable because the new corporation is merely continuing the business of the original SOE.

      Application of the DFA Rule, however, is not limited to the corporatization or restructuring of SOEs. It frequently applies when a debtor's investment of its high-quality assets in a newly established corporation also includes fair consideration in the form of equity interests in the new corporation. (27) For example, in one SPC case, a corporation, Xinhui Dilun Corporate Group, formed a new corporation, Dilun Company, with three other investors, investing RMB5.4 million (28) in the new corporation in exchange for 43.58% of the stock. (29) The SPC held that the new corporation should be responsible for the debts of original corporation despite the fact that the original entity had received stock of the new entity in consideration of the asset transfer.

      Nonetheless, the DFA Rule does not always apply when a debtor invests its assets into a new corporation. In another SPC case, a corporation, Shenyang Gaokai, invested its assets into several newly established corporations in exchange for stock in the new entities. (30) In considering whether to apply the DFA Rule, the SPC held that the Rule did not apply because the transactions were ordinary investments and not "restructuring" transactions by the debtor. (31) So far, the SPC has not made clear how an investment can be distinguished from a restructuring transaction.

      One possible rationale for applying the DFA Rule in the asset-transfer scenario is fraudulent conveyance. When the value of the equity interests acquired clearly is smaller than the value of the assets transferred, courts may support the creditors' claim. The empirical evidence reflects that even when a creditor fails to prove the value deficiency, courts may still apply the DFA Rule, concluding that the transaction would harm the interests of creditors based solely on the fact that the debtor has invested its assets into a new corporation, even without evidence the value of the exchange is unfair to the debtor and its creditors. (32) The concept of fraudulent conveyance, thus, does not explain fully why some investments trigger the DFA Rule and others do not.

      Some scholars argue that the DFA Rule should not be applied when the debtor invests its assets in a new corporation. (33) They argue that doing so may lead to negative consequences such as disrupting the stability of transactions and violating the...

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