Under PRC law, while an LP partner’s liability is usually limited to their investment, they risk assuming personal financial liability in two ways unique to Chinese law. First is the doctrine under the Supreme Court Rules on Substituting or Adding Execution Parties § 14(b), which provides that a civil debt collection action against an under-capitalized limited partnership may motion to add a limited partner as a defendant in execution liable up to the amount of their capital contribution shortfall. Under the China Partnership Entity Act § 81, a withdrawing limited partner is liable for the partnership’s debts prior to their exit up to the amount of their withdrawal amount.
Since “international lawyers” in China are usually highly bilingual attorneys that don’t specialize in any particular field of law, they often give bad advice about limited partnerships. This article will walk you through the risks so you can make the best strategic decisions.
Contents
Liability for Debts after a Partner Withdraws
Liability Arising from Debts Arising from a Partner’s Withdrawal
Liability for Inadequate Capital Contributions
Enforcement Under the Partnership Act and Court Rules § 14
Liability for Debts after a Partner Withdraws
Under the Act § 53 and § 81, the general partners are jointly and severally liable for partnership debts incurred prior to a partner’s withdrawal, whereas a limited partner is liable only liable up to the value of assets withdrawn from the partnership. Chinese law’s principal reason for the difference is due to its unique perspective on the difference between a partnership and a limited liability company. In Chinese law, unlike western legal systems, an LLC is seen as an aggregate of capital, where the liability is limited to the amount of its capital contribution, but a partnership is not given that treatment because the law sees it as an aggregate of individuals.
A second consequence of this unique perspective is, the legislative intent requires enhanced liability for limited partners to protect creditors who deal with them. As a result, a limited partner withdrawing from a partnership is liable for the partnership debts dually up to the amount of their contribution, and up to the amount of the withdrawn assets. Under China Partnership Entity Act § 81, such liability is limited to obligations incurred prior to withdrawal and limited to those assets withdrawn from the partnership.
When understanding the risks associated with a China LP investment, note that while English as second language lawyers often refer to this as a limited partnership “enterprise,” but this can be very misleading as legal scholars in China have concluded the word qiye actually means what the US and UK call a “business entity.” Legislators also wrote that they added an additional word to the China Partnership Entity Act, to explicitly endorse the USA’s Revised Uniform Partnership Act’s entity approach but with its own unique set of rules described in more detail below.
Liability Arising from Debts Arising from a Partner’s Withdrawal
Liability is imposed for “debts arising from a limited partner’s withdrawal,” an ambiguous rule that different lawyers interpret in one of two ways. First, construed more literally, arising means where the limited partner is at fault or at least liable for events that incurred the debt. Secondly, arising means that the partner’s withdrawal affected whether that debt would be incurred, even if there was no fault. The second interpretation is generally considered more likely for the following reasons.
China Partnership Entity Act § 96-98 governs liability for partners and imposes damages on a partner who causes losses to the partnership, and such conduct should fall under the ambit of the § 81 fault rules.
The judicial precedent for § 81 damages has looked at the timing of when the debt arose relative to when the limited partner exited, and courts have typically held the relevant date is when the underlying contract was executed, not when the creditor brought a claim against the partnership or limited partner, and do not look at subsequent enforcement actions.
Judicial interpretation can vary by region, so get local expert advice before making limited partnership decisions. CBL can help you find a lawyer who has the necessary expertise and is affordable.
Withdrawal of Partnership Assets by a Limited Partner
When a limited partner withdraws from the partnership, the China Partnership Entity Act § 51 provides that the other partners must buy out the withdrawing partner’s interest at its current valuation. The withdrawing partner is liable for damages caused to the partnership. Under § 52, the buyout payment can be made either with cash or if appropriate through payment in kind.
“Withdraw assets from the partnership” in the statute means that a settlement process will be completed resulting in either withdrawal of cash or property from the partnership.
Under Act § 73, a limited partner in China may transfer their interest to a third party in accordance with the partnership agreement with thirty days’ notice to those partners. Withdrawing from a partnership by assigning the interest means the new partner must assume existing partnership debts, which refers to unpaid capital contributions. These payments’ requirements are not defined in the statute, but the partners may agree on when past due capital contributions must be paid. If the deadline is missed, then the purchaser of the partnership interest will be liable to pay in the capital contribution, which is the rule provided under the Act § 77, where a new limited partner is liable for the debts of the prior limited partner up to the capital contribution commitment.
Additionally, in principle and as reflected in most interest assignment agreements, the partnership interest assignor is relieved from liability following the consummation of the assignment, and the assignee is liable up to the amount of the capital contribution.
This raises a concern about prior partnership liabilities where the assignee has fewer assets or inferior creditworthiness to the assignor. Here, a creditor could argue that the assignment unduly prejudices their legal rights, and claim the assignment is void, with the consequence that the original obligor is liable for those debts.
Thus, careful due diligence is warranted where debts have been accrued, because China sees a partnership as being an aggregate of individuals. Furthermore, those debtor-creditor relationships will have only been entered into if that individual’s assets and creditworthiness were adequate.
Liability for Inadequate Capital Contributions
China Limited Partnership Entity Act § 65 provides that a limited partner must be obligated by the partnership agreement to fund their capital contribution commitment. The capital call establishes the other partners’ breach claim against the non-funding limited partner, but does not address whether such rights extend to other creditors. Unlike the China Companies Act, there are no judicial rules addressing consequences for the way a capital contribution is manifested. The China Supreme Court Rules on Substituting or Adding Execution Parties fills this gap in the Limited Partnership Entity Act by enabling external creditors who bring a collection action to add a limited partner who failed to make the capital contribution as a defendant in execution.
Under the Rules, the central focus of the dispute is whether the limited partner subscription term ended, as they will disclaim liability for debts for the partnership entity on grounds that the capital contribution term has ended, entitling them to the benefits of the elapsed capital contribution term.
Two issues are raised in such disputes: (1) whether the capital contribution term can be extended, and (2) the applicability of debt acceleration rules. Under the China Partnership Entity Act, the capital contribution term must be stated in the partnership agreement.
The rule of § 19 allows partners to amend their partnership agreement to extend the capital contribution term and there is no statutory maximum. Thus, the limited partners may provide for an extended capital contribution term and if it is currently short, it can also be extended. However, extended contribution terms must be provided in the partnership agreement, otherwise § 19(b) requires unanimous consent of the partners.
Thus, since Chinese law limits the partner’s liability to the amount committed to their capital contribution, even if the capital contribution term has been extended, the capital contribution liability still applies. Under an acceleration clause, creditors may seek to add limited partners to their claims, which causes capital contribution term due date to be moved forward, and resulting in liability for the limited partner. This acceleration clause appears in China Companies Act § 6, under which outstanding capital contributions must be paid in full in two situations. The first is, whenever the company has been sued resulting in a judgment against its assets that renders the company insolvent and is eligible to declare bankruptcy but has chosen not to.
The second situation is, a shareholder resolution extends the deadline for capital contributions and after the debts had accrued. Here, most Chinese courts have ruled that under the policy espoused by the Companies Act, the acceleration clause applies to these capital contribution commitments. However, some other courts have deferred to the capital contribution term established by the partnership, recognizing partners’ statutory right to use the share subscription policy, which excepts them from the acceleration clause.
When analyzing whether a court may accelerate your capital contribution term deadline, you should weigh your interest against the considerations of whether the partners are acting in subjective bad faith or prejudicing creditors’ rights, in which case the courts will likely rule in favor of creditors.
Enforcement Under the Partnership Act § 81 and Substitution Rules § 14
A minority view among China lawyers holds that a withdrawing partner is only liable for partnership debts up to the amount of their withdrawn assets, and not the amount of their capital commitment. The underlying reasoning is, the two applicable rules are mutually exclusive, where § 81 is applicable only when a limited partner has already withdrawn, and § 14 applies where the limited partner has not yet withdrawn.
However, most Chinese attorneys find this interpretation unconvincing. Nothing in the Party Substitution Rules bars its application to a limited partnership subsequent to a partner’s withdrawal. Second, the China Limited Partnership Act implies that withdrawal from a partnership does not exempt a limited partner from its capital commitments, because § 65 broadly requires the full and timely payment of capital contributions. Consequently, exiting the limited partnership renders the withdrawing partner liable up to the amount of their capital commitment.
Protecting partnership assets by requiring that limited partners are liable to fully subscribe to their shares even if withdrawing ensures that partnership entities’ capital structure will be stable, because otherwise it would create high transaction risks that would hinder a partnership’s ability to secure loans or enter into financing transactions. When a limited partner has withdrawn from the partnership, the most reasonable approach would be to first apply § 14 to determine if the partner has fulfilled their capital contribution obligations and whether they are liable for inadequate capital contributions. Then, apply § 81 to review financial information to determine the amount of any asset withdrawals from the partnership.
Accordingly, a limited partner who did fulfill their capital contribution obligations is liable to creditors up to the amount of the withdrawn amounts, whereas a partner who did not fulfill their capital contribution obligations is liable up to the amount of unpaid capital contributions.
Case Study
In a series of private equity fund transactions, a managing partner committed the partnership to purchase an interest in another fund, and pledged the partnership’s assets as collateral to a third party to buy the shares, providing this guarantee in the name of the partnership. This happened without getting the unanimous consent of the partners. Subsequently, the partnership was unable to pay the purchase price for the fund interests or to satisfy the guarantee requirement. Only then was a lawsuit filed in China against the partnership, and the other limited partners received notice.
The lawsuit found that the business registrar recorded that the governing documents made limited partners’ capital contribution obligations were actually subject to certain conditions precedent. The limited partner refused to perform its capital contribution obligations, asserting that those conditions precedent had not been met, and subsequently sought to withdraw from the partnership after litigation began. Due to the substantial ambiguity described in this article around the liability of limited partners when withdrawing from a partnership under these unusual conditions, the parties chose to settle out of court, leaving all of the parties to suffer a loss. Had the parties more closely considered governance requirements and the law on liability of withdrawing partners, they could have avoided this costly dispute.
Conclusion
In this article, we have learned that liability against limited partners in China is significantly different from other legal systems and can expose you to unexpected liability. When entering into a limited partnership in China, both due diligence and prior planning are needed. To better navigate these issues, CBL can help you find a lawyer with expertise in limited partnerships who is also affordable.