Most registered capital in China is done with illegal sham transactions that create a fictional record of non-existent assets, a kind of fraud that can only be pursued in civil litigation. A leading PRC criminal law attorney recently said (in Chinese), the government isn’t going to enforce the law against registered capital, because the government’s minimum registered capital requirements are often extremely high and it would hurt business and the economy to expect people to actually follow the law.
Nonetheless, Chinese law does treat registered capital a lot like a security deposit and allows finding expansive personal liability against defendants who failed to maintain it. In this CBL explainer, we’ll explain what registered capital really is, why fictional registered capital is so common, and how to use this law to your advantage.
Contents
What China’s Registered Capital Really Is
What Constitutes “Sham” Registered Capital
Judicial Discretion to Penalize Round-tripping Transactions
Litigation Procedure in Registered Capital Disputes
Finding Personal Liability Against Bad Actors
Revised China Companies Act of 2024 Updates
What China’s Registered Capital Really Is
China adopted the idea of registered capital from Germany nearly a century ago, but introduced “Chinese characteristics” that make it in practice behave a lot more like mezzanine capital—specifically, a security deposit in the form of equity. To understand the security deposit mentality, we need to take a quick look at its backstory. When it was initially adopted in China, it was grafted on to the Qing Dynasty practices of merchant guilds, which required massive cash deposits (押金) of often 2,000 (silk) to 5,000 taels (salt), about 50-100 years’ salary for a typical worker.
This policy was preserved all the way through the 1990s. Consider that with an annual monthly salary of 200CNY, this was required to register a company under the first Companies Act:
Manufacturing: 500,000CNY
Wholesalers: 500,000CNY
Retailers: 300,000CNY
At a typical monthly salary in the 1990s, a worker would need to save for over 100 years to get into the manufacturing business, just like in the Qing Dynasty. Its modern incarnation in the context of a modern bank transfers, and not stacks of silver, led to an explosion of criminal falsification and fraud.
Registered capital finds its origin in the 1993 Chinese Communist Party’s Decisions on Building a Socialist Market Economy, which sought to convert its centrally planned state owned enterprises into a system of corporations. The China Companies Act of 1994 heeded the call to action to create a law that has “Chinese characteristics.” The aforementioned massive capital requirements were adopted when forming a company, largely because legislators were afraid of what businesses may do if shielded from personal liability.
Nonetheless, entrepreneurs and local regulators colluded to devise a variety of registered capital misrepresentation techniques that would make starting companies possible. And, as legislators expected, it immediately led to an explosion of fraud as scammers used it to trick partners into thinking they had fictional assets. Legislators feared that rampant fraud was hollowing out the Companies Act, therefore a 1995 decision was issued to establish penalties for registered capital misrepresentation in the Criminal Law Act, and brought several thousand prosecutions against fraudsters.
The China Companies Act of 2005 whittled the subscribed registered capital filing policy down into a simple subscribed capital filing policy, recognizing that requiring massive capital reserves would merely result in waste.
Now, the initial capital contribution would be just 20% with the remainder contributed within 2-5 years, reducing limited liability company minimum registered capital to just 30,000CNY, and criminal cases dropped.
A full subscribed capital filing policy was adopted in the China Companies Act of 2013, which sought to encourage entrepreneurship, and new regulations decriminalized most forms of sham registered capital misrepresentation. Criminal liability was limited to critical industries.
Fraud is still rampant, but it’s now pursued primarily through civil litigation and debtor-creditor law.
What Constitutes Sham Registered Capital
Sham registered capital in China is closely connected to fraud; the Chinese word for it “choutao chuzi”, literally “contribute then remove capital,” is a metaphor that describes something like Enron-style round-tripping.
In a lawsuit, a finding of sham capitalization is controlled by the China Companies Act Judicial Interpretation #3 §12, which describes sham transactions such as distributing fictitious profits, payment of fictitious debt, and anything else that may be a round-trip transaction. A party can be liable for sham transactions involving themselves or a related party. The following case summaries will show how this typically occurs.
Common §12 sham transaction types
Distributing fictitious profits resulted in liability in Civil Appeal No. 1904 (Supreme Court, 2016) (in Mandarin) where a company with unpaid social security liabilities used falsified accounting statements showing past profits in order to support dividends.
In another fictitious profits case, Civil Appeal No. 1207 (Fujian Higher Appeals 2019) (in Mandarin), the court held that distributing surplus as dividends impaired creditor rights when the company accrued significant losses of almost 300,000CNY for previous years, but nonetheless distributed dividends based on current year profits, totaling 175,000CNY. This made the registered capital contributions a §12 sham transaction, because China’s corporate law requires these funds be held as a capital reserve.
A fictitious debt was used as part of a round-tripping scheme in Civil Appeal No. 324 (Supreme Court, 2016) (in Mandarin) where “pre-production expenses” were paid to an offshore entity documented by a Collaboration Agreement and business records, but the court found those expenses never actually occurred. This round-tripping scheme was a §12 sham transaction.
A related party transaction was used to round-trip registered capital contributions in Civil Appeal No. 790 (Supreme Court, 2018) (in Mandarin), where the promoter was the largest shareholder and other major shareholders and executives were affiliates and the company was making large transactions totaling 96 million CNY into affiliates of one of the shareholders. The court found persuasive evidence to show promoter and other major shareholders knew that the payee of these transfers was an affiliate of a major shareholder, and rejected arguments that the payee was an independently controlled entity with a fully separate legal personality.
Rather, the China Supreme Court found it persuasive that within a month of the major shareholder’s registered capital contribution and filed capital verification report, the company made a 36.6 million CNY transfer to that shareholder’s affiliate. As a fictitious debt scenario, this round-tripping scheme was a §12 sham transaction. Other circumstantial evidence the court pointed out was the lack of legitimate reasons for making that large transaction, especially shortly after the company’s formation.
Judicial Discretion to Hold Round-tripping Transaction is Sham Registered Capital
Judges are given broad discretion to find sham transactions under §12, which captures any kind of sham registered capital contribution achieved through round tripping methods.
In Civil Appeal No. 226 (Supreme Court, 2013) (in Mandarin) a capital reserve was withdrawn to the detriment of creditors when sham debts were used to achieve round-trip transactions. In this case, the capital reserve was used to make a loan from the company to its shareholders, which was then settled with payment in kind involving company assets, and upon investigating the substance of the transaction, the China Supreme Court held the transactions part of a disguised round-tripping scheme designed to record fictitious registered capital. The court invalidated the entire loan and repayment scheme.
Note that if the transfer from the company does not remove capital, a Chinese court will not find it constitutes sham capitalization.
This rule is illustrated in Civil Appeal No. 4680 (China Supreme Court, 2018) (in Mandarin), where the court did not find sham capitalization, based on the principle that the company’s capital and assets are fundamentally different; in Chinese law, the capital is merely the shareholder registered capital contribution. The judge reasoned, the funds at question in this case were litigation proceeds, which constituted earnings that are part of company assets that were unlawfully transferred to the detriment of the company, however since they did not impair the company capital reserves, the transfer did not culminate in unlawful sham capitalization.
Civil Appeal No. 435 (China Supreme Court, 2015), rejected sham capitalization allegations surrounding loan repayment amounts to a shareholder, totaling 120 million CNY. The dispositive facts in the court’s view were how the company offset part of settled funds in a way that did not impair the company’s capital, or reduce registered capital reserves. Secondly, the purpose of the loan was to support a fixed income stream; third, there was no evidence that the company’s management was improperly manipulated.
Litigation Procedure in Registered Capital Disputes
Claims for sham capitalization are subject to ordinary court jurisdiction and forum selection rules, as announced in Civil Appeal No. 414 (China Supreme Court, 2017) (in Mandarin), which held the appropriate forum for the sham capitalization dispute to be the court in the company’s local jurisdiction, rather than the corporate domicile as provided by the subject matter jurisdiction rules of the Litigation Procedure Act. While business organization disputes have a large number of interested parties who will be affected by the outcome, a sham capitalization dispute is limited to the company and shareholder.
A later precedent, Civil Appeal No. 140 (China Supreme Court, 2018) refined this rule, upholding a forum selection clause in a shareholders agreement, holding that a sham registered capital dispute does not fall under any mandatory subject matter jurisdiction rule as it is fundamentally a breach of contract dispute, and therefore the forum selection clause can be given effect.
Sham capitalization gives rise to personal liability against shareholders in debtor-creditor law. A debtor can make sham capitalization allegations in a debtor-creditor suit, where the shareholder is named as a defendant in the lawsuit, and during the execution phase the shareholder is an additional defendant in execution.
If there are multiple shareholders, they can be joint defendants and are held liable to pay compensatory damages to the debtor. Additionally, the China Supreme Court Rules on Judgment Execution Parties at §18 also allows adding a defaulting shareholder in a sham capitalization action as an additional defendant in execution in an enforcement order against a business organization debtor. However, seeking personal liability for the sham registered capital against shareholders during execution is usually too late in the process and judges in enforcement actions are reluctant to grant these motions due to the complexity of the issues involved. Thus, experienced lawyers in China advise finding sham capitalization facts earlier, that is, during substantive debtor-creditor litigation.
The burden of proof to show sham capitalization in China is extremely low, courts typically accept the scintilla of evidence standard as establishing a prima facie case that the defendant has to the burden to rebut. In their reasoning, judges say that such a low standard is necessary because proving sham capitalization requires a plaintiff navigate the dense thicket of a muddy swamp to find evidence, as the defendant has the advantages of low transparency, information asymmetry, and deception. Thus, even a few shreds of evidence that capital was round-tripped out of the company are enough to put the ball in defendant’s court.
Finding Personal Liability Against Shareholders, Directors, Supervisors, and Executives
Judicial Interpretation No. 21 (2020) provides that a debtor may pursue liability for damages against a shareholder involved in sham capitalization, or if the shareholder did not fully perform its registered capital contribution obligations.
Failure to fully perform capitalization obligations is a reliable avenue to pursuing liability, as guidelines by the China Supreme Court (in Mandarin) describe bright-line judicial rules for testing sham capitalization schemes under a failure to provide capital contribution basis. Specifically, the Supreme Court provides causes of action arise for refusal, inability, falsified, and round-trip capitalization scenarios.
The upper appellate courts in various regions throughout China have also consistently upheld findings of personal compensatory damages in sham capitalization cases under this theory that the shareholder did not perform their capital contribution obligations, for example in Civil Appeal No. 1365 (Henan, 2019).
Revised China Companies Act of 2024 Updates
The Revised China Companies Act of 2024 includes a new provision in §53, which imposes joint and several liability on directors, supervisors, and executives of a company for any sham registered capital. The updated §53 leaves intact the prior jurisprudence about identifying what objective acts constitutes a sham capitalization in itself, but greatly broadens who can be held liable for sham capitalization.
As of the 2024 update, a sham capitalization that causes harm to the company imposes joint and several liability on directors, supervisors, and executives in the company who allowed it to happen as a result of conscious disregard for their duty, which a low hurdle for litigants to clear compared to aiding or abetting the practice.
The revised Act §53 in itself does not provide for subjective intent, rather this is found in the §180 provisions on duty of care, which has been interpreted by courts across China quite consistently to require that directors and officers must reasonably perform due diligence. In practice, the concepts in China resemble the Caremark conscious disregard standard from the Delaware. While China has its own cultural practice, it’s still a common frame of reference and a good starting point for understanding how Chinese judges going forward will analyze liability for registered capital regulatory compliance oversight.
Conclusion
The main difficulty litigating sham capitalization is the amount of obfuscation that a party can create around their scheme, that makes a finding of sham capitalization in the courts hard to achieve. Finding adequate evidence to show that there was a course of conduct culminating in a sham capitalization in China is very difficult. However, once these have been proven, courts have shown they are very willing to impose personal liability on doctrinal theories that the shareholder failed to perform capital contribution obligations as required by the Companies Act.