The Plot of Shadow Shareholder

By William Wang

On May 8th 2010, around ten o’clock in the morning, one Guangzhou guy named Ma Hui and his two friends were having their morning tea in a hotel of downtown, talking about domestic economic situation and the A-share market trend. Suddenly the mobile phone of Ma Hui was ringing. The call was from his 60-year-old father, he asked Ma Hui to come back home immediately, because the court sent him a subpoena. Ma Hui was so much surprised. He had no dispute with any person, and no tort was committed by him, why did the court send him the summons?

Almost at the same time, a Shanghai guy called Zhou Min was in his office, discussing how to expand domestic sales revenue with a couple of the company’s executive, to make up for the international market slide. His secretary suddenly entered into the office without knocking the door, telling him the company had just received a courier from Shanghai Huangpu district people’s court. Zhou Min calmly opened the courier, quickly scanned the letter, and became startled. The content of the courier was the summons and indictments. Two cases were taking place respectively both in Guangzhou and Shanghai. The defendants were Ma Hui and Zhou Min, and the plaintiffs of two cases were the same foreign couple: one Dutch called Leontien and her Bangladeshis husband Kapon.

International players Leontien and Kapon

The Dutch Leontien, 26 years old, was born in a small town of the Netherlands next to Belgium. She is a blond, and nearly 1.80m tall. At the age of 16, she attended an international exchange program held by YFU, and went to the United States. She participated the US domestic SAT examination, and was enrolled to the University of North Carolina. After graduation, she got an internship in a professional design company in New York, where she met her current husband, one Bangladeshis guy Kapon. The United States is mixed with numerous culture, races, ethnics; it is a melting pot, which is likely to accept other cultures. It is also a place with minimum racial discrimination. The Bangladeshis Kapon was engaged in furniture design industry, he was in his 30s. The man had artistic features and temperament with long hair, firm plait and bright clothes. He often wore the sunglasses indoors. Kapon had quite radical views. When he talked about his new design of furniture, he would became very excited and would explain every detail of his design and its implication to others; he would not stop his talking even though his audience were impatient. However his designs were rarely accepted by the clients, thus had little contribution for the company sales. Kapon self-mockery said: the level of his design was too high. After more than ten years in the U.S., Kapon eventually settled himself in New York city, working at a professional design company. It was in that company where Leontien met Kapon and she was attracted by his personal style. From then they lived together.

Leontien and Kapon had a lot of ideas. They hoped to have a great professional career in the industry. Consequently Leontien and Kapon set up their own design company in the US, offering furniture design service to the customers. But the competition in design industry was fierce in the US and their company got very few orders in the whole year. Instead, customers told Leontien and Kapon, they would not only need their design, but the complete products as well. If they could produce the furniture based on their design, there would be a great number of orders. Leontien and Kapon saw the business and finally decided to transform their company from a single design company to a company with production, which could provide the customers with complete products. Leontien and Kapon had the capability to complete product design; however the problem was where to produce the furniture? Leontien was familiar with her hometown, and decided to outsource furniture production to a Dutch manufacturer. After 2 years of operation, their company became insolvent. The fundamental reason was the cost of outsourcing to the Dutch manufacturers was too high. This was a strategic mistake because furniture production was labor intensive industry and labor cost in Europe was even far above that of the US. The company was unable to pay back creditors the debts due. Creditors brought action against both the company and Leontien and Kapon, in the name of “piercing the corporate veil”.

According to the provisions of US company law, company shareholders have limited liability. This means as a shareholder, if he has already paid up capital, he will bear no responsibility to pay back company debts. But the law defines the exception. If the creditors can prove shareholders embezzle company assets and blend their personal assets with company assets, they will be liable to pay company debts under the doctrine of “lifting the company’s veil” and the shareholders behind the company should bear joint responsibility to pay back debts of the company as long as the company is unable to pay debts due. This time, the creditors brought action against Leontien and Kapon in the name of this doctrine. The court made a judgment that Kapon and Leontien shall be jointly liable of company debts. Kapon and Leontien were forced to sell their personal property and pay back debts owed by the company. The couple became almost bankrupt after the lawsuit. After 2 years of rest, they decided to bounce back. A fall into the pit, a gain in your wit! Firstly Kapon and Leontien made a decision to outsource the production in Philippines and Vietnam; secondly they opened a new company, in which they were not shareholders. Leontien let her 60 years old father be the sole shareholder, and they implemented overall management of the company in the shadow as actual investors and controllers.

Develop the markets of Guangzhou and Shanghai

China becomes the world’s manufacturing center. Foreign companies outsource a large number of orders to the Chinese companies who are responsible for production and exporting products to all over the world. The Pearl River Delta and Yangtze River Delta are the areas for these enterprises. Due to the increasing labor cost of Southeast Asia, Kapon and Leontien intended to transfer their outsourcing business to China. They visited furniture enterprises in Dongguan, Shanghai, and Zhejiang. In their opinions, the Chinese companies have more competitive advantage in costs, especially labor cost, which other countries can’t match; on the other hand, China is a vast country, with all kinds of raw materials and semi-finished product suppliers. In addition, Guangdong, Shanghai and Zhejiang are all coastal regions, so transportation cost is relatively low. Hence China is a good furniture production base.

Due to the experience in the United States, Leontien and Kapon drafted a plan in order to deliberately avoid potential legal risk.

First, Leontien and Kapon established Guangzhou TingZhong Trading Co. Ltd, whose shareholders were only Leontien and Kapon and legal representative was a Guangzhou guy called Ma Hui. The company was actually controlled by Leontien and Kapon. The interesting issue is why did Ma Hui agree to become the legal representative of the company?

Ma Hui was a professional trainer, he often went to nightclub and bars. Incidentally he got to know Leontien. Ma Hui was proud of making friend with a white blond, Leontien also thought of using relationship network of Ma Hui in Guangzhou. So the two became friends. Later Leontien expressed her hope to Ma Hui of setting up a trading company in Guangzhou, and she was afraid that Chinese government would impose strict conditions on foreign shareholders in founding such a trading company. She requested Ma Hui to be the legal representative of TingZhong Company, which could become a Chinese company rather than a 100% foreign company. Having no legal consciousness, Ma Hui quickly agreed. Guangzhou TingZhong Trading Co. Ltd specialized in furniture export business. Meanwhile, the couple founded Shanghai TingLiang trading Co. Ltd in Shanghai, which was also engaged in furniture export business. They used the same excuse to successfully persuade a Shanghainese called Zhou Ming as the legal representative of Shanghai TingLiang. Different from Ma Hui, Zhou Ming held 10% stake of Shanghai TingLiang.

Actual investors of the two companies were Kapon and Leontine. Ma Hui didn’t participate in the daily management of Tingzhong; Zhou Ming was involved in daily management of TingLiang as he held 10% of company stakes.

The plot was successfully realized

The business of TingZhong and TingLiang was going quite well after their establishment. In this industry Kapon and Leontien had rich experience about international market, and had a lot of clients available. In addition, labor cost in China was extremely cheap. Both companies had obtained high profit. Leontien and Kapon were gradually familiar with business practice in Guangzhou and Shanghai. In the Guangzhou and Dongguan area, since most companies were private, business owners completed deals based on mutual trust and transactions were completed through oral agreement without written contract. Initially, TingZhong followed traditional trading practice by paying the suppliers on time. But later on, Leontien and Kapon began to postpone the payment to their suppliers with a lot of excuses, i.e. international customers could not timely implement the payment. By the end of 2009, TingZhong owed its suppliers in total of RMB10 million.

In Shanghai there was a different situation. In Shanghai, business managers preferred written contract to oral agreement, so details could be defined. TingLiang had to sign written contract and orders with the suppliers who supplied the goods on time, and required the payment to be carried out on time in return. If TingLiang did not make payment on time, suppliers would generally stop supply. If TingLiang continued non-payment, suppliers would send lawyers letter to the company and consequently brought action to the court. As legal representative, Zhou Ming was involved in the company management. By the end of 2009, its net profit after tax reached the RMB 600 million. With his power in hand as legal representative, Zhou Ming sent his friends and relatives into the company and held some crucial post in various departments of the company. Gradually the whole company was in his control; although Leontien and kapon were majority shareholders, they could not control company and Zhou Ming.

Based on these facts, Leontien and Kapon decided to withdraw from China. Firstly, they let TingZhong continue to delay the payment to the suppliers. They left Guangzhou and gave orders to the managers through telephone. As the company’s legal representative Ma Hui did not know anything about it. Secondly, Leontien and Kapon found an international buyer, who prepared to acquire shareholding of Shanghai TingLiang from Leontien and Kapon. They were ready to transfer 90% of interest of TingLiang to this buyer. However Zhou Ming did not agree to the deal, and refused to cooperate. Leontien and Kapon took an action against Zhou Ming to the court, claiming their position as majority shareholder of TingLiang. In Guangzhou, Leontien and Kapon tried to avoid their legal liability through being the shadow shareholders, while in Shanghai they tried to establish their shareholder status and rights through lawsuit.

Risk for explicit shareholder and ratification of rights for shadow shareholders

In this case there exist two legal issues. First, what is legal risk for explicit shareholder? The names of explicit shareholder and legal representative are recorded in articles of association, shareholder list and bureau of commerce and industry, even though they do not participate in company’s management directly, they need to bear the responsibility as shareholders and legal representative. Creditors may take action by “shareholders have not fully paid the capital” or “lift the corporate veil” against shareholder and legal representative. Ma Hui was the legal representative of TingZhong, and had no legal consciousness, he might take the legal responsibility which did not belong to him.

Secondly, how to determine shadow shareholder rights? Whether shadow shareholder will be treated as other real shareholder? People have different opinions. Some argue that shadow shareholders are not officially registered in bureau of commerce and industry, nor in the articles of association, so that they are not shareholders. Some argue that shadow shareholders should have equal legal position as real shareholders, because they pay share capital and perform their legal obligation objectively as shareholders.

(The author William Wang is a lawyer of Shanghai Hunglong Law Office; if you wish to know more about him, please visit:

webpage: http://www.hl-lawfirm.com/docc/Aboutus.asp?Title=王卫东&types=2

or if you wish to communicate with the author about this article, you can email: wwd55@hotmail.com.)