In judicial practice, courts often refer to the "equitable subordination principle" to solve such problems, but the application of this principle may produce opposite results depending on the circumstances.

Editor's note:

In real life, there are many problems in which parent companies (or controlling shareholders) use claims to seize the assets of subsidiaries (enterprises) and harm the interests of external creditors and shareholders of subsidiaries (enterprises). Then, when the claims of external creditors of the company How should one protect his claims when he is damaged? In judicial practice, courts often refer to the "equitable subordination principle" to solve such problems, but the application of this principle may produce opposite results depending on the circumstances. In order to deeply understand how the principle of equitable subordination protects the claims of external creditors of the company, the author studied and understood the source, legislative practice, judicial practice and other aspects of the principle of equitable subordination.

The Deep Stone Principle, also known as the Equitable Subordination Rule, refers to the fact that in an associated enterprise with a relationship of control and subordination, in order to protect the legitimate interests of the creditors of the subordinate company from illegal infringement by the holding company, the law stipulates that in the case of a subordinate company During the company's liquidation, reconciliation, reorganization and other procedures, the principle of deciding whether its claims should be paid less favorably than other creditors or preference shareholders is based on whether the controlling shareholder has committed unfair behavior.

1. The origin of the principle of equitable subordination

The concept of equitable subordination comes from the famous Deep Stone case in the United States, so the principle of equitable subordination is also called the Deep Stone principle. In 1938, the U.S. court made a very famous decision in the case of Taylor v. Standard Electric Oil Company. In this case, when the court ruled on Shenshi Company's debt reorganization plan, it was found that the defendant's parent company, Standard Electric Oil Company, was a huge creditor of Shenshi Company, and these claims all arose from business dealings with Shenshi Company. Although the defendant's parent company made concessions to Shenshi Company's reorganization plan, the plan was still extremely unfavorable to Shenshi Company's preferred shareholders and therefore met with opposition. The reorganization plan was established by the local court and the high court. However, the Supreme Court believed that if the plan was approved, it would be extremely detrimental to the preferred shareholders of Shenshi Company and violate the principle of fairness and reasonableness, so it canceled the reorganization plan. The reason is: Shenshi Company lacked capital at the beginning of its establishment, and its business operations were completely controlled by the defendant company and operated entirely for the benefit of the defendant's parent company. For example, the parent company instructs Shenshi Company to sign a lease contract with another subsidiary that is extremely unfavorable to Shenshi Company, and the other subsidiary then transfers the lease fee received to the parent company; the parent company instructs Shenshi Company to enter into a lease agreement with another subsidiary. A subsidiary signed a management contract, for which Shenshi Company had to pay an extremely unreasonable management fee; the parent company demanded high interest rates through its current account with Shenshi Company; the parent company continued to pay when Shenshi Company was unable to pay. Claim dividends, bonuses, etc. Therefore, it was judged that the claims of the defendant's parent company against Shenshi Company should be inferior to those of Shenshi Company's preferred shareholders.

The principle established in this judgment is widely known as the "deep stone principle", which later evolved into the principle of equitable subordination. The principle of equitable subordination is also often applied in commercial disputes to protect the legal claims of ordinary creditors of the company.

2. Legislative examples of the principle of equitable subordination

1. "Regulations on Several Issues Concerning the Trial of Corporate Dispute Cases" promulgated by the Supreme People's Court on November 4, 2003 (1) (Draft for Comments) Article 52: Control If a company abuses the personality of a subordinate company, the controlling company will not have the right to offset the subordinate company's claims; when the subordinate company goes bankrupt and liquidates, the controlling company will not enjoy separate rights or priority, and its creditor's rights will be allocated second to other creditors of the subordinate company. The draft opinion restricted the "controlling company" to take second place in creditor's rights when abusing its legal personality, but it failed to take effect.

2. The 2008 Supreme People's Court's Regulations on Several Issues Concerning the Application of the "Company Law of the People's Republic of China" (2) Article 14 stipulates that if the creditor's supplementary declaration cannot be paid off in full, the shareholder may claim that the shareholder shall use it in the distribution of the remaining property. The property already acquired shall be paid off. This clause can be understood as indirectly determining the order in which shareholders' claims are inferior to ordinary claims.

3. Article 39 of the Notice of the Supreme People's Court on the issuance of the "Minutes of the Bankruptcy Trial Work Conference of National Courts" in March 2018 stipulates that claims arising from improper use of related relationships between members of affiliated enterprises shall be paid in priority to other ordinary claims. And the inferior creditor shall not receive priority for payment of specific properties provided by other members of the associated enterprise. This provision draws on the equitable subordination rule, extends the application of the principle to affiliated enterprises, and limits the priority of the claims of affiliated enterprises, which has certain guiding significance for judicial practice.

4. Article 369-7 of Taiwan's "Company Law" stipulates: "If the controlling company directly or indirectly causes the subordinate company to become an operator that is inconsistent with business practices or otherwise unprofitable, if the controlling company has claims against the subordinate company, the controlling company will not Within the scope of the liability for damages, no claim for offset shall be made. Regardless of whether there is any right of exclusivity or priority, the subsidiary company shall be subject to bankruptcy or settlement in accordance with the provisions of the Bankruptcy Law, or reorganization or special liquidation in accordance with the provisions of this Law. "

3. Judicial cases on the principle of equitable subordination

1, Shagang Company v. Kaitian Company Objection to Execution of Distribution Plan

On April 1, 2015, the Supreme People's Court issued Among the four typical cases (2015), there is the "Shagang Company v. Kaitian Company's Objection to the Execution of Distribution Plan" that used the Shenshi principle to decide the case (the first-instance judgment of this case took effect). The court in this case held that : This case is a lawsuit against the implementation of the distribution plan. There are two points of dispute between the original (Shagang Company) and the defendant (Rongcheng Company) in this case around the relevant execution distribution plan. The first one is the 450,000 yuan deducted by the court for the false investment of Kaitian Company. Can the company (shareholders of Rongcheng Company) jointly allocate this part of the execution funds with Shagang Company on the grounds that it also has claims on the company? The second question is whether the execution target should include double payment of debt interest during the delayed performance period. Regarding the first focus of dispute, the company law clearly stipulates that shareholders of a limited liability company shall bear liability to the company to the extent of their subscribed capital contributions. The 450,000 yuan deducted from Kaitian Company due to false capital contribution should first be replenished with Rongcheng Company's liability assets and repaid to the plaintiff Shagang Company, which is an external creditor of the company. Kaitian Company requested to participate in the distribution of its own deducted funds because it also had claims against Rongcheng Company, which was unfair to the company's external creditors and was contrary to the legal principle that the company's shareholders bear responsibility for the company based on their capital contributions. The opinion that 450,000 yuan of the 696,505.68 yuan execution payment should be paid first by the plaintiff, and the remaining balance should be distributed proportionally was adopted. Regarding the second focus of controversy, the relevant civil judgments in Case No. 275, Case No. 1436, and Case No. 2084 all ruled that if the debtor fails to perform the monetary debt within the specified period, he must pay double the interest on the debt during the period of delayed performance. Therefore, the claim of the plaintiff Shagang Company that the subject matter of execution should include double payment of interest during the period of delayed payment of debts shall be adopted.

The typical significance of this case is that if shareholders who make false capital contributions are allowed to have the same priority as external creditors for their claims against the company, it will not only lead to unfair results for the company's external creditors, but also conflict with the company law's regulations on capital contributions. False statements are inconsistent with the legal responsibilities imposed on shareholders. Therefore, this case finally denies the claim that shareholders who made false capital contributions should be compensated in the same order. It has good social effects and has good reference significance for the handling of similar cases.

2, Chen Xin and Xinyoulian Company, Sun Lin, Yahe Company and Others Confirm Contract Invalidity Dispute Case

In this case, Yahe Company defaulted on shareholder Chen Xin’s investment funds and loans before 2014, and Yahe Company’s debts to Chen Xin and others were real; at the end of June 2014, Chen Xin and others I knew earlier that Yahe Company had debt problems, and negotiated with Yahe Company representatives, and the company signed a pledge contract for the company's accounts receivable with shareholder Chen Xin.

The Supreme Court’s retrial held that: The pledge contract involved in the case was negotiated by Li Meixiang on behalf of Yahe Company with Chen Xin and others when Yahe Company was involved in other lawsuits, the company’s account had been frozen, and it was unable to make normal payments, and was signed by Li Meixiang on behalf of Yahe Company. The pledge contract involved in the case will be redistributed, and Chen Xin and others will collect the accounts receivable from the outside. After the payment is collected, settlement and negotiation will be carried out to determine the amount of repayment to Chen Xin and others, and the excess amount will be left to the company. It can be seen that the pledge contract involved in the case was not a guarantee established by Yahe Company out of normal business needs. The original judgment found that the purpose of Chen Xin and others signing the pledge contract involved in the case with Yahe Company was to change the order of payment of existing creditors of Yahe Company, to enable Yahe Company to circumvent the court's preservation and enforcement of accounts receivable, and to transfer Yahe Company's assets , and there is no lack of evidence. Since the pledge contract involved in the case objectively caused the other creditors of Yahe Company to be unable to enforce the relevant claims receivable and obtain fair compensation, which obviously harmed the interests of other creditors of Yahe Company, the original judgment was based on Article 52 of the Contract Law. The provisions of Paragraph 2 determined that the pledge contract involved in the case was invalid, and the application of the law was not inappropriate.

When a company encounters a debt crisis and its bank accounts are seized and frozen by law, signing an accounts receivable pledge contract with the company as a shareholder creditor is tantamount to transferring the company's assets, resulting in the company's other creditors being unable to enforce relevant claims receivable and receive fair compensation. , which obviously harmed the interests of other creditors of the company, so the accounts receivable pledge contract is invalid. According to this case, guarantee measures for shareholders’ claims due to unfair behavior can also be invalidated by applying the principle of equitable subordination.

3, "Lending Disputes and Private Lending Disputes between Jiangsu Yueda Trading Co., Ltd. and Chen Weimin, Weibing and other enterprises" [(2015) Su Zhifu Zi No. 00159]

On November 28, 2017, the Jiangsu Provincial Higher People's Court issued an enforcement ruling Book. The court held that Chen Weimin (the applicant for execution and creditor) believed that Yueda Company (the applicant for execution and creditor) was the only legal person shareholder of Jiafeng Company (the person subject to execution and debtor). According to the principle of equitable subordination and the deep stone principle in company law, , the company's assets should first pay off non-shareholder loans. The property seized by Yueda Company as a shareholder of Jiafeng Company should be the property seized by Chen Weimin in the execution case. The reason that the auction proceeds should give priority to repaying Chen Weimin's debts has no legal basis. . According to existing legal provisions, Chen Weimin's claims against Jiafeng Company and Yueda Company's claims against Jiafeng Company should be equal.

4, Hengfeng Company and Lei Ruiping, Xingsheng Company and others dispute over execution of distribution plan

Hengjing Company is a Sino-foreign cooperative enterprise, and Hengfeng Company is its shareholder. The claims that Hengfeng Company applied for execution in this case were based on the "Contract for the Cooperative Development of the Commercial and Residential Building at No. 130 Binjiang West Road" and the "Supplementary Contract for the Cooperative Operation of Hengjing Company" signed between it, Shifangshi Company and Century Company. The investment income obtained by jointly establishing Hengjing Company to develop real estate.

The court held that Hengjing Company was established in 1994, in accordance with the Fourth Regulation of the Implementation Rules of the Law of the People's Republic of China on Sino-foreign Joint Ventures (approved by the State Council on August 7, 1995, and issued by the Ministry of Foreign Trade and Economic Cooperation on September 4, 1995). Paragraph 2 of Article 15 stipulates that "the foreign partner shall not recover the investment before the losses of the cooperative enterprise have been made up." The creditor's rights claimed by Hengfeng Company in this case should be distributed after Hengjing Company makes up for its losses and repays the company's debts. . The other claims participating in this execution of distribution are all debts borne by Hengjing Company. Hengjing Company should first pay them off before distributing the investment income of Hengfeng Company. Therefore, Hengfeng Company should not participate in this execution allocation.

In this case, Hengfeng Company claimed that the source of its claims was compensation for expropriation and demolition, not investment income, but this was not supported by the court. According to this case, the order of repayment of the investment income claims of shareholders of Sino-foreign joint ventures should be after other applications for enforcement of claims. Although the Sino-foreign joint venture was not established in accordance with the Company Law, the theoretical basis of this case was also the principle of equitable subordination, which expanded the scope of subjects to which the principle of equitable subordination applies.

4. Conditions for the application of the principle of equitable subordination

In judicial practice, the principle of equitable subordination cannot be applied arbitrarily in order to protect the claims of individual creditors. Certain conditions must also be met:

1. Time requirement. From the perspective of the time when the creditor's rights are formed, if the controlling shareholder fairly and reasonably obtains the creditor's rights of the bankrupt enterprise before becoming a controlling enterprise, the principle of equitable subordination should not apply to this part of the creditor's rights. In other words, when the controlling shareholder is still an external creditor , if the creditor's rights obtained are fair and reasonable, the creditor's rights can be obtained on the same basis as other creditors, without considering whether the creditor's rights should be inferior.

2, main elements. In judicial practice, the principle of equitable subordination mostly applies to controlling shareholders. However, in addition to controlling shareholders, most courts in the United States affirm that unfair claims between internal subsidiaries of related companies should also be subordinated to ordinary claims. This means that It expands the scope of applicable subjects of the principle of equitable subordination and can better protect the claims of ordinary creditors of the company. The author believes that China can also learn from relevant U.S. precedents and regulations in its legal formulation and judicial practice.

3, behavioral requirements. The principle of equitable subordination does not apply to all situations where the controlling shareholder has claims against the company. It is only applicable when the controlling company abuses its control rights to cause improper conduct, excessive manipulation of corporate behavior , and harms the interests of ordinary creditors. It is advisable to subordinate the claims of the controlling company to other creditors of the subsidiary company. Mainly include the following situations:

(1) The subsidiary company's capital is obviously insufficient. This situation means that the controlling company has investment defects when establishing a subsidiary company, and does not pay the subscribed capital in full or withdraws the capital after making the capital contribution. In this case, the controlling company's claims against the subsidiary company should be treated as capital replenishment, and it should not be allowed to claim claims against the subsidiary company.

(2) Control of company management for breach of fiduciary duty. The essence of is the abuse of control. If the abuse of control is for fraudulent purposes, the theory of piercing the corporate veil can be directly applied to hold the parent company accountable. However, if this abuse of control is limited to the formation of inappropriate claims on the same subsidiary, the Shenshi principle should be applied to make the parent company's claims inferior to ordinary claims.

(3) The assets of the controlling company and its affiliated companies are mixed or transferred improperly. asset commingling means that there is property non-independence between the parent company and its subsidiaries. The parent company can arbitrarily control the subsidiary's property or provide property to the subsidiary. Asset commingling breaks the boundaries between the parent company and the subsidiary company, resulting in the parent company's relationship with the subsidiary. Responsibilities of Subsidiaries. In addition, in order to reduce the assets of the subsidiary company, the controlling company often transfers the assets of the subsidiary company to other member companies through certain improper transactions. This will lead to a reduction in the company's capital and a great threat to the interests of creditors. In this case Under this situation, if the controlling company has claims on the subsidiary company, its claims should be subordinated to other ordinary claims.

(4) The controlling company abuses the independent personality of the subordinate company. controlling companies often ignore the independent existence of the personality of the subordinate companies and impose their own business decision-making rights on the subordinate companies. In many cases, the subordinate companies are just a means of operating the controlling company. In this case, the personality of the subordinate company has actually been ignored, and the economic ties between the controlling company and the subordinate company have become indistinguishable. At this time, the law naturally does not need to regard the two companies as independent legal persons. Instead, it should decide to deny the controlling company's claims against the subsidiary company, or to settle its claims at a later date, depending on the degree to which the subsidiary company's personality has been ignored.

4, cause and effect. means that there should be a causal relationship between the improper behavior of the controlling enterprise to obtain creditor's rights and the damage caused to the ordinary creditors of the subsidiary company. If the controlling shareholder's relevant misconduct does not adversely affect ordinary creditors, or the claims of the controlling shareholder are legal and reasonable, then the claims of ordinary external creditors will not be harmed, and the claims of the controlling shareholder do not need to be subject to equitable subordination. in principle.

5. Overview

From the above content, it can be seen that when applying the "Deep Stone Principle" in practice, factors that should be considered include whether the controlling company directly or indirectly does anything to the subsidiary that is inconsistent with business practices or other unfavorable situations, that is Whether the capital invested by the parent company in the subsidiary is sufficient and whether there is any improper or illegal behavior such as fraud in the parent company's control of the subsidiary. The parent company's claims should not be completely denied simply because the parent company's capital investment in the subsidiary is insufficient. If the parent company acts in good faith, fairly, and fulfills its duty of special care, its claims do not need to be subordinated to the claims of other creditors of the company. Nor should the parent company's claims be denied simply because there is fraud or other improper or illegal behavior in the parent company's control over its subsidiaries. Because when the subsidiary's capital is sufficient, even if the parent company may behave inappropriately towards the subsidiary for its own benefit, the subsidiary is not in danger of bankruptcy and there is no threat of infringement on the interests of other creditors or preference shareholders. There is no need to deny the parent company's claims on its subsidiaries.

In judicial practice, courts often refer to the principle of equitable subordination when hearing corporate cases. However, the principle of equitable subordination should not be automatically applied (i.e., the theory of automatic subordination), but should be applied similar to the right of defense. Creditors can apply when making claims, and, using the theory of inversion of the burden of proof, it is up to shareholders to prove the legitimacy of their claims against the company, instead of a one-sided, one-size-fits-all approach. This will lead to deep The stone principle became the punitive principle.

In reality, the phenomenon of "one share dominating" of controlling shareholders in my country's corporate field is very serious. In order to better protect the interests of creditors of subordinate companies, it is necessary for our country to establish the principle of controlling corporate debt balance in legislative practice. Moreover, the application of this principle mainly applies to the bankruptcy proceedings of subsidiaries. Therefore, the author believes that this principle can be clarified in the judicial interpretation of the bankruptcy law and the provisions on the order of repayment of claims can be revised.

Author: Fu Jialing