Using nominee shareholders is an extremely common practice in China’s corporate law practice today. Nominee shareholding received legislative blessing with the development of China’s Foreign Investment Act, where the Supreme Court adjudicatory rules describe how it may be used to legally hide a company’s foreign ownership status. Nominee shareholders nonetheless have traditionally posed a variety of major legal risks in ownership disputes; tax, marital community property, and inheritance have been the subject of litigation in China.

Typically, a nominee shareholder and the beneficial owner will have numerous concerns about the nature of the nominee shareholding relationship, because there are numerous risks, potential liability, and operational complexities involved.

This CBL China Law Library explainer will close look at the law governing nominee shareholding in China, along with court judgments respected by jurists.

Contents

Nominee Shareholder’s Lack of Cooperation

Loss of Property Rights to Third Parties

Risks That Cannot Be Contracted Around

Mitigation Strategies in Nominee Shareholder Negotiations

The Beneficial Owner Faces Three Risks Typical of Contract Law

The three risks of using a nominee shareholder revolve around on the nature of the contract for a third party to be in possession of equity on an owner’s behalf:

1. Possible unenforceability of the nominee agreement;
2. The nominee shareholder fails to perform their nominee obligations.
3. The third party’s property is subject to disposition or enforcement;

In China’s corporate law principles, apparent authority and apparent ownership under Company Act §32 may conflict with and can defeat the beneficial owner’s rights under the contract in a variety of contexts. This could be a result of dishonesty on the part of the nominee, who may agree to the contract and fail to follow through. Additionally, ordinary third parties including creditors and spouses not party to the contract, have superior rights to the nominee contract.

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There are also special China law regimes affecting nominee shareholding, but most critical of these is how the Foreign Investment Act’s Supreme Court interpretations authorize using nominee shareholding to circumvent being identified as a foreign owned entity. China Foreign Investment Act compliance when using nominee shareholders is a separated explainer by CBL. The law in this area is complex and daunting. If you need help, we can help you find a lawyer to help you.

The ordinary civil law contexts will be explained below.

The nominee shareholder could refuse to follow the contract through dispute or non-compliance

Unenforceability Claims

The Supreme Court Interpretation #3 at §24 provides a general principle for interpreting nominee shareholding contracts: the nominee shareholder is bound except where in violation of the law. From a judge’s perspective, the nominee shareholder’s obligations are enforced as an ordinary contract law matter. The nominee agreement will bind the nominee shareholder unless there is a rule of law that makes the agreement illegal. The law in this area is well developed around LLCs, and for close corporations, the law governing LLCs is being applied by judges in practice.

That is to say, the agreement is assumed to be enforceable unless a specific exception is found, allowing shareholders to ensure enforceability by understanding and planning for each of the exceptions. The list of potential disqualifications for foreign investors is so complex that we have a separate article on the topic. In particular, a key risk is that the foreign investor is seen circumventing an Exceptions List limitation on national treatment. In more general contexts, the law as it is applied by the courts primarily creates enforceability issues for public companies and highly regulated industries (i.e., insurance and commercial banking) because the law very explicitly prohibits this kind of arrangement.

A common fact pattern seen in business law disputes of nominee obligations is where the beneficial owner lacks the legal qualifications to be a shareholder in a highly regulated industry, whereas the nominee shareholder meets all of the requirements.

The law on nominee shareholders is largely judge-made and has been detailed in the Ninth National Civil Judicial Conference Report. For example, §31 expands the scope of mandatory legal provisions to cover the needs of financial security, market order, and national policy.

If the nominee agreement is held unenforceable, then the property issue will be resolved under Civil Code §157, which provides for equitable damages if the property cannot be returned to its owner or is not required to be returned. Judges will weigh three factors and each party’s contribution or fault when determining damages:

1. Whether the beneficial owner has most of the risk in a nominee shareholding arrangement;
2. Whether the nominee shareholder provided transaction information to facilitate the transaction;
3. Whether one party has committed waste or abuse of the property; a classic scenario is where a nominee shareholder causes an enforcement action to be taken against the shares.

Reading each of these scenarios, the owner should observe how the measure of damages is likely going to be monetary restitution and not the return of property, which means that the nominee shareholder may not be financially capable of paying the damages.

Unauthorized Sale or Pledge of the Equity by the Nominee Shareholder Could Be Made to a Bona Fide Holder

China Company Act Interpretation #3 atIf y §25 provides that if the nominee shareholder grants a security interest or sells shares and harms the beneficial owner, then Civil Code §311 on bona fide holders will apply to determine whether the beneficial owner is entitled to damages.

Bona fide holder status is determined by evaluating Civil Code §311 elements:

1. The assignee acted in good faith at the time of the transaction (that is, they did not know the nominee shareholder acted without authority);
2. Reasonable consideration is paid for the shares (note that Chinese corporate law, not civil law, adopts the doctrine of consideration);
3. The sale or security interest is registered with the business registrar.

If all three elements are satisfied, then the sale or security interest will be valid.

A first line of defense against assignment to a bona fide holder is to include provisions in the shareholder agreement and bylaws that the nominee shareholder must follow a defined procedure when assigning or granting a security interest in shares. Nonetheless, there is a risk that the nominee shareholder may simply ignore this sort of minimal protection.

A more vigorous protection would be to make the nominee shareholder grant a security interest in the shares to the beneficial owner or another party of their choice. Under China’s current business organization filing system, shares subject to a security interest are ineligible for further filings to recognize a subsequent transfer. The risk that the nominee shareholder transfers the shares is thus considerably mitigated by that approach.

In the event an unauthorized disposition of the shares occurs and is irreversible, the beneficial owner can make a claim for damages against the nominee shareholder under the nominee agreement. An additional claim for damages on grounds of unauthorized sale or disposition can be added to the original title holder’s claim under Civil Code §311(2), which will grant relief for the loss. Nonetheless, as noted above, the nominee shareholder may lack the ability to pay the damages.

The main solution to this problem, in addition to having a strong nominee agreement, is to evaluate the nominee shareholder’s trustworthiness, creditworthiness, and ability to pay damages. A frequent recommendation made by law firms in China is to entrust a close friend with the nominee shareholder obligations.

The Nominee Shareholder May Refuse to Return the Shares by Exploiting Lack of Clear Agreement

Frequently, a nominee shareholder will refuse to cooperate with filing the declaration of trust that they are holding the nominee shares on behalf of a beneficial owner. This typically occurs where the nominee agreement lacks adequate provisions saying otherwise. Remedies available to the beneficial owner in Chinese courts include seeking declaration of a constructive trust or pursuing claims of unjust enrichment.

This risk can be mitigated by having a well-defined nominee agreement in place to begin with. Also, consider having a majority of other shareholders certify in writing that they are aware of the nominee shareholder relationship and consent to the beneficial owner’s exercise of the shareholding rights. In the event of a dispute, such documentation would ensure that the trust relationship can be constructively declared.

Attaining this result under Company Act Interpretation #3 at §24, requires getting consent from over half of the company’s shareholders, which was further interpreted in §28 of the Ninth Judicial Report, which states that the courts uphold beneficial owners’ claims in this context.

Trustee Duties Are Likely to Be Neglected by the Nominee Shareholder

The nominee agreement will require the nominee shareholder to perform its obligations as a named shareholder. Once the law has recognized the nominee shareholder’s status, the nominee shareholder is empowered to exercise the share rights, in which case the company will generally be unable to take into account the beneficial owner’s intent.

A nominee shareholder could abuse their powers or not be proactive enough as a shareholder when participating in corporate governance, such as when making votes, nominating directors, or deciding on dividends. The beneficial owner may suffer damage as a result; common scenarios involve corporate governance instability or decision-making deadlock, such as when there are three shareholders with equal voting interest and the nominee shareholder fails to break a tie.

In this respect, the beneficial owner should take steps to ensure that the nominee shareholder is exercising shareholder rights as intended, in a manner that will protect the beneficial owner’s interests. A clear plan for corporate governance actions should be laid out and documented as obligations in the nominee agreement. Here are some essential corporate governance provisions every nominee shareholder should be bound by:

• Notifications: Required governance notices such as shareholder meeting notices, corporate notifications, and shareholder meeting decisions, should be forwarded to the beneficial owner.
• Voting: Any decisions or other shareholder powers exercised should be made by the nominee shareholder only after consulting the beneficial owner and obtaining their approval.
• Dividends: Establish a deadline, late fees, and damages to control when the nominee shareholder must remit dividends to the beneficial owner.
• Redundancies: Seek parallel agreement from other shareholders to provide copies of the relevant notices and decision plans to the beneficial owner, thus ensuring that notices can be received by other means if the nominee shareholder is negligent.

Loss of property rights could occur due to creditor enforcement or marital property division

A Creditor’s Enforcement Action Against the Nominee Shareholder Could Result in the Equity Being Seized

Legally, enforcement actions are similar to the unauthorized sale risk described above, so we can make it easier to understand by comparing them. In the unauthorized sale context we just covered, the nominee shareholder’s action is deliberate, but the bona fide purchaser (or subsequent holder) only sees the apparent authority to dispose of the shares. The new context now involves enforcement on assets, which presents two key differences. First, the nominee shareholder is a passive participant, and second, the bona fide holder of the shares will be an ordinary creditor who lacks any specific interest in the shares. The risk now is that judicial enforcement actions involving levy or seizure of the debtor’s assets, including the nominee shares, could result in auction or forced sale to satisfy a debt.

This raises a contentious legal issue that has caused a split in the courts: does the nominee’s apparent ownership of the shares determine whether they can be seized by a creditor to satisfy a debt? The conflicting judgments in the courts can be organized generally into two perspectives:

Group 1: The creditor entered into a transaction with the debtor on the basis of the debtor’s creditworthiness, ability to pay, and total assets. In doing so, the creditor relied reasonably on the apparent ownership in the shares by the nominee shareholder, and therefore should be deemed to have a priority interest in the asset.

The analysis for these kinds of opinions views the contractual relationship between the nominee shareholder and beneficial owner to create a debtor-creditor relationship that is inferior in priority to financial creditors. Therefore, courts are unwilling to refuse a creditor’s right to enforce on the nominee shareholder’s property merely because of a nominee agreement.

Group 2: The creditor is not entitled to priority treatment and the prior nominee shareholding arrangement should prevent the creditor from enforcing on the shares. The reasoning is that the nominee shareholder’s financial creditor is not a party to an equity transaction, nor does their reliance on apparent ownership make them a bona fide third party deserving protection. Secondly, the creditor in this case is an ordinary financial creditor whereas the beneficial owner has a right to the return of the property.

China’s Supreme Court appears to be leaning towards adopting the rule that Group 1 is currently applying. In Supreme Court Appeal No. 397 (2021), on appeal from the Shandong Higher Appeals court acting as the trial court, the Supreme Court overturned a judgment that had upheld a beneficial owner’s petition to block creditor enforcement, reasoning that apparent ownership was insufficient grounds to support enforcement.

The Court reasoned that apparent ownership is not a principle of general law used in China, rather it is limited to specified transactions. On appeal, the Supreme Court overturned the judgment, holding that a third party who relied on apparent ownership of the assets deserves protection under the law, and furthermore that the third party enforcing on the assets is obtaining restitution for its reliance damages.

In sum, the judicial precedent in China says a general creditor is entitled to rely on the apparent ownership of the shares by looking at the public records available at the business registrar, even if the transactions had nothing to do with the nominee shares.

Marital Community Property or an Inheritance Could Result in Family Claims to the Shares

The Company Act §73 and Supreme Court Interpretation on Family Law No.1, §73, provide that shares held by a nominee shareholder can be inherited or subject to marital property division. The family law property context in many ways works very similarly for nominee shareholding disputes to what we’ve covered above.

The addition of these family relationships adds an additional layer of complexity. If the nominee shareholder status is well documented in evidence that shows the nature of the relationship, then the amount owned by the beneficial owner will not pass into inheritance. The beneficial owner’s position in litigation will be compromised if there is no written nominee agreement in evidence and can only indirectly evidence their beneficial ownership through documentation such as payment and assignment receipts.

To mitigate these risks, if using a natural person as the nominee shareholder, the beneficial owner should evaluate the risks associated with the candidate’s personal background and utilize a written nominee agreement. If a review of the candidate nominee shareholder’s background reveals they are married or have children, request that the family members disclaim any rights to the beneficial owner’s shares. To do this, sign an agreement clearly showing their knowledge that the nominee shares are not part of their inheritance or marital community property.

Some Beneficial Owner Risks Cannot Be Contracted Around

Above, we learned how beneficial owners of nominee shares in China can use contractual provisions to mitigate many of the risks and potential liability from nominee shareholding. Next, we will go over the several nominee shareholding risks that cannot be contracted around.

These risks at best can be managed by introducing provisions that reduce the probability that they occur, which will be described in more detail below. Therefore, clearly understanding the obligations in a nominee agreement is essential to successfully using a risk mitigation strategy. Do that by getting an accurate English language version of the contract prepared by professional translators and not unprofessional workers, such as freelancers or in-house staff.

Liability Due to Abuse of Corporate Personality

Chinese corporate law provides that a shareholder’s liability is limited to the extent of their shares in the company, with exception to doctrines such as veil piercing. Company Act §20(3) imposes personal liability on an anonymous shareholder who abuses the independent legal personality of the company in a way that causes severe harm to creditors’ interests.

The Supreme Court also ruled on this matter in Judgment No. 185 (2020). The court held that liability could expand from shareholders to non-shareholders if necessary for the interest of justice. The Supreme Court reasoned that the purpose of veil-piercing laws is to balance creditor interests in collection against corporate investor interests in limited liability. Therefore, affiliates or parties with actual control of the company that abuse their power to the detriment of creditors shall be liable under the veil-piercing approach, in application of Company Act §20(3) to the extent necessary to uphold justice. To put it more plainly, parties other than the shareholders can be liable under veil piercing.

The Ninth Judicial Report also directs judges throughout China to develop more nuanced applications of veil piercing to the facts of cases before them in order to prevent bad actors from using corporate shareholding structures to evade liability for abusing the independent legal personality of business entities. Following the most recent judicial conference, practitioners in China expressed serious doubts that an anonymous beneficial owner would be able to escape liability for abusing corporate governance powers.

Liquidation Obligations Can Imply Joint and Several Liability for the Beneficial Owner

Company Act Interpretation No.2-§§19-20 provide that a creditor may hold a person in actual control of a company jointly and severally liable for several types of acts and omissions.

The omissions include failing to organize a liquidation committee when required by law or failing to perform obligations to ensure that assets are available for liquidation.

The acts include preferential transfers, falsifying liquidation reports to deceive creditors, or refusing to make business filings essential to begin liquidation.

Overall, these include anything that would detriment a creditor. According to the Supreme Court’s Interpretation, a beneficial owner whose ownership of the shares is concealed may nonetheless be held liable under veil-piercing claims.

Debt Collection Enforcement Cannot Be Avoided by Using a Nominee Shareholder

The Supreme Court Rules on Enforcement Actions §2(c) provides that a court may sequester, seize, or freeze assets of a debtor held in the name of a third party if there is written documentation of such arrangement. In the context of nominee shareholders, the Rules provide that a court may freeze equity held by the nominee shareholder when debt enforcement action is taken against the creditor, but does not clearly specify the subsequent enforcement process.

In the absence of binding authority, courts have developed abundant persuasive authority to order enforcement against debtor assets under the name of a nominee shareholder, and practitioners say they expect their jurisdictions to follow the existing persuasive authorities. Therefore, using a nominee shareholder is ineffective in preventing debt collection actions.

Legal Risks to Focus on in Nominee Shareholder Contract Negotiations

Most international companies will be looking at the risks they face as the beneficial owner of the shares. However, during contract negotiations, it’s crucial to consider the perspective of the nominee shareholder. This section will focus on the risks faced by the nominee shareholder, whether in their capacity as a personal or institutional investor.

Capital Calls Can Impose Liability on the Nominee Shareholder, Forcing Them to Pay Out of Their Own Funds

The Supreme Court’s interpretations of the Company Act provide that an insolvent company’s shareholder who fails to make payment during a capital call is jointly and severally liable for the company’s debts to the extent of non-payment. Moreover, a nominee shareholder cannot escape liability for this on the grounds that they are not the beneficial owner.

Thus, if a capital call is made and the beneficial owner omits to prove additional funding, the nominee shareholder is liable to fund the capital call using their own funds.

Given these risks, the nominee shareholder should consider demanding that the contract require the beneficial owner to make capital call payments when required. A provision for damages should be included to cover the scenario where the beneficial owner fails to fund the capital call during the time limit, causing the nominee shareholder to be liable to pay out of their own funds.

Veil Piercing Claims Can Impose Liability on a Nominee Shareholder, Even if They Did Not Participate in Abuse or Fraud

In the above section on veil piercing, we learned that liability against shareholders can be found if they have abused an entity’s independent legal personality. In some cases, nominee shareholders who were genuinely shareholders in name only, exercising no shareholder rights and instead sitting passively by while the company powers were used to the detriment of shareholders and creditors, have been sued under a veil-piercing approach.

In these circumstances, the nominee shareholder may also be deemed to have failed to perform their obligations as a trustee, and on top of the veil-piercing claims, could also be liable to the beneficial owner for violation of trustee duties.

Double Taxation May Affect Nominee Shareholders

The tax administration’s rulemaking progress on nominee shareholding has lagged behind that of the judiciary. As can be seen in the above sections, the judiciary has already issued interpretations and the conference Report establishing a principle that nominee shareholding is presumed to be valid. There is some uncertainty as to whether tax should be assessed during the declaration of trust and assignment of shares back to the beneficial owner.

Tax lawyers in China mostly are of the opinion that when the nominee declares the trust and returns the shares, this merely constitutes an acknowledgment of the nominee relationship. The reassignment of shares back to the beneficial owner in itself does not constitute economic activity which should be taxable as income.

Extra Liability Could Be Incurred by a Nominee Shareholder Who Serves as a Corporate Officer

An individual serving as a nominee shareholder is eligible to serve as the company statutory representative, director, supervisor, or executive.

Chinese corporate law makes the statutory representative a powerful officer of the company, who has special powers and unique obligations. Chinese legal policy imposes this unique liability because of an assumption that the statutory representative has great power over the company.

However, whether the law imposes such liability is not determined by whether the statutory representative is in actual control. Therefore, if a nominee shareholder acting on their behalf faces claims on grounds of their statutory representative status, the common defense that the statutory representative lacked actual control over the company has a significant probability of being ineffective.

The corporate officer positions and statutory representative status implicate liability under corporate law and therefore should be considered in their own context.

Conclusion

In summary, the nominee shareholder structure for equity in Chinese companies is very common and has a legal regime to go along with it. Nonetheless, there are many risks involved and not all of them are adequately addressed by the law. In many cases, using a nominee shareholder arrangement is effective. However, before committing to this course of action, an investor should make sure they adequately understand the applicable business tax and understand the appropriate risks. As we’ve seen, the law in this area is complex and daunting. CBL can help you find a lawyer to help make the best decision for your business.

To learn more about the risks involved with nominee shareholders involving foreign investment law compliance, take a look at the separate article by CBL on that topic.