Should a one-person company and its shareholder be joint defendants?

Company A sued Company B for a dispute over the sales contract and applied to add Company B’s shareholder, Company C, as a joint defendant. Company C defended that Company A had abused its right of prosecution, because the dispute between Company A and Company B had no business with Company C.

Article 63 of the “Company Law” stipulates that, “A shareholder of a one-person limited liability company who is unable to prove that the company’s assets are independent of the shareholder’s personal assets shall bear joint and several liability for the company’s debt.” In addition, Article 20 of the “Regulations of the Supreme People’s Court on Several Issues Concerning Changing and Adding Parties during Enforcement of Civil Cases” prescribes that, “When a single-member limited liability company, as a party subject to enforcement, cannot pay off with its property the debts specified in effective legal documents, and the shareholder cannot prove that the property of the company is independent of its own property, if the petitioner applies to change the party subject to enforcement, or add such shareholder as a party subject to enforcement to be jointly and severally liable for the company’s debts, the people’s court shall uphold the application.”

Therefore, in order to avoid a one-person limited liability company’s shareholder overlaps its will with the will of this company, and to protect the interests of creditors, the burden of proof is inverted to the shareholder, that is, the shareholder should provide evidence to prove that its property is independent of the company’s property, otherwise, the shareholder would bear the legal consequences of not being able to provide evidence.

However, in practice, there are several issues shall be taken into consideration.

Firstly, whether the plaintiff could add the shareholder as a joint defendant in the stage of prosecution or trial? There are different opinions regarding this issue. Some courts may add the shareholder as a joint defendant directly. If the shareholder could prove its property is independent of the company’s property, the court would decide that the shareholder does not have to bear any liabilities. Some courts may require the shareholder to provide preliminary evidence in advance. If the shareholder could prove its property is independent of the company’s property, the court would reject the plaintiff’s claim against the shareholder. In judicial practice, more courts prefer the former opinion.

Secondly, how to prove the independence of shareholder’s property? We have searched for civil cases under Article 63 of the “Company Law” in the past 5 years, and we found the plaintiff’s claims were fully/partially supported by the courts in nearly 80% of these cases. It can be seen that the majority shareholders failed to prove the independence of their property, and bore joint and several liability. However, the law does not explain the methods and degree to prove the independence of shareholder’s property. Regarding this issue, we provide two suggestions.

(1) Refer to the rules of the “Confusion of Personality” as prescribed in the “Notice of the Supreme People’s Court on Issuing the Minutes of the National Court Work Conference for Civil and Commercial Trials” released in 2019, the most fundamental criterion for determining the “Confusion of Personality” is whether the company has independent intention and independent property, and the most important performance is whether the company’s property and the shareholder’s property are confused and cannot be distinguished. For the determination on whether confusion of personality is constituted, the following factors shall be comprehensively considered:①The shareholders use the company’s funds or assets for free and do not keep financial records;②The shareholders use the company’s funds to repay the shareholders’ debts, or provide the company’s funds to affiliated companies for free use, without being recorded on financial books;③The books of the company are not separated from those of the shareholders, as a result of which the properties of the company cannot be distinguished from those of the shareholders;④There is no distinction between the interests of the shareholders and the profits of the company, resulting the benefits of two parties are unclear;⑤The property of the company is recorded in the name of a shareholder and is occupied and used by the shareholder; and⑥Other cases of confusion of personality.

It should be noted that although there are differences between the proof on the determination of the “Confusion of Personality” and the proof of the independence of shareholder’s property, the fundamental criterion is the same, that is, the company has lost its independent intention and independent property, and the shareholder shall assume joint and several liability beyond the limited liability. Therefore, the factors listed above can be served as important references for determining whether shareholder property is independent.

(2) The proof effectiveness of audit reports is various. In judicial practice, an audit report plays an important role in proving property independence for the shareholder. However, it is not the only role, in the minority cases, the courts denied the proof effectiveness of audit reports. There are two main opinions. Some courts held that where a company submitted its audit report, which could be deemed as the preliminary proof, then the burden of proof shifted to the plaintiff. The plaintiff should provide evidence to prove the confusion of property, or point out the problems in the audit report, otherwise, the shareholder would not bear the  joint and several liability. Some courts held that an audit report was not sufficient enough. For example, in the case (2020) Zui Gao Fa Min Zhong No.727, the court held that the audit report and other relevant evidence provided by the defendant in the second instance could only reflect the its debts and profits, which could not reflect the cash flow between it and its shareholder, so such evidence was insufficient to prove that its property was independent of its shareholder.

Thirdly, the scope of a one-person company may be expanded a company with two shareholders with the spouse relationship.

The term “one-person limited liability company” referred to in the “Company Law” refers to a limited liability company with only one natural person shareholder or one legal person shareholder. In practice, some companies have two shareholders with the spouse relationship. Such companies do not belong to the definition of a “one-person limited liability company” in terms of form. However, in judicial practice, many courts held that if the two shareholders invested in the company with the joint property of the husband and wife, it could be deemed as a special “one-person”, therefore, such company shall be deemed as a “one-person limited liability company”. (Such as (2019) Zui Gao Fa Min Zai No. 372 is a typical case).

In summary, in order to reduce the risk of joint and several liability of the shareholder in a “one-person limited liability company” (including the aforementioned situation where two spouses are shareholders), we have several suggestions.

1.To conduct annual audits of a “one-person limited liability company” in a timely manner in accordance with the requirements as stipulated in the “Company Law”. Because it is highly likely that the courts might deny the effectiveness of those audit reports which are commissioned after being sued. In addition, those audit reports shall not have any problems, such as the auditing agency stated that it has reservations about a certain issue in the report and etc.. In order to strengthen the effectiveness of the audit report, it is recommended to describe the cash flow, affiliate transactions between the company and its shareholder in a clearly and comprehensively manner.

2.In order to avoid the circumstances as stipulated in the “Regulations of the Supreme People’s Court on Several Issues Concerning Changing and Adding Parties during Enforcement of Civil Cases”, it is recommended to strengthen financial management. For example, if the shareholder used its subsidiary’s fund to repay its debts, and failed to take a record in its subsidiary’s financial statement, such circumstance would be very risky. Therefore, in the daily operation, the company should retain all basic financial information, such as original vouchers, company books, bank statements, financial statements, etc. If necessary, the company could apply for a special financial audit or judicial accounting assessment during the hearing.

Finally, it is worth noting that both the 2021 Company Law (Revised Draft) and the 2022 Company Law (Revised Draft Second Review) have deleted special provisions on one-person limited liability companies, so there might be some changes in the future.