Most agreements between investors and the founders of companies or projects contain valuation-adjustment mechanisms or repurchase arrangements to protect investors from the potential failure of the investments or failure of the founders to fulfill their commitments. However, investors may nonetheless fail to get their money back if the founders have few assets, or none. One way to solve this is to go after the founders’ spouses by claiming that the commitments or debts of the founders constitutes matrimonial community debt, requiring reimbursement from the spouses. Matrimonial community debt is set out in the Marriage Law of the People’s Republic of China (“Marriage Law”), and in recent years China\s Supreme People’s Court (SPC) has changed its position on how to recognize matrimonial community debt.
The Former Rule: Article 24 and Protection of Creditor Interest
Matrimonial community debt is the debt owed by a couple in union and used for the sake of a couple’s community life. In 2004, the SPC issued its Interpretation of the SPC on Several Issues Concerning the Application of the Marriage Law (II) (“Interpretation II”), Article 24 of which states that during the existence of the marriage, the debt owed to the creditor by one party of the couple shall be treated as the couple’s joint debt unless either the husband or wife is able to prove that the debt is clearly stipulated as a personal debt or that the creditor knows that the couple have agreed to individually and separately own their property during the marriage. Put simply, the presumption is that debt incurred during the marriage should be recognized as matrimonial community debt, and the burden of proof rests on the husband or wife to show that the debt is in fact personal.
The rationale and original purpose of Article 24 is to protect creditors’ interests, based on the understanding that the marital relationship is more intimate than other civil relationships (such as partnerships), and that couples are thus more likely to conspire to transfer their assets to avoid debts. However, Article 24 has generated heated discussion and criticism since its promulgation. One major issue is that sometimes one party of the couple (usually the husband) can secretly borrow money, make investments, or sign contracts for his or her personal use without his or her spouse’s knowledge. Individual debtors unable to repay their debts or fulfill their commitments in investment contracts will often see creditors or investors make claims against the innocent spouses under Article 24, and it is often difficult for that innocent spouse to prove that the debts were clearly stipulated as personal. Therefore, the spouse may suffer enormously to pay off the debts. In some extreme occasions, wives continue to owe huge amount of debts to creditors even after they have divorced their husbands. Consequently, the public has protested strongly against Article 24 and even established a so-called “Anti-Article 24 League.”
The New Change: Shifting of Burden of Proof
In response to the social outcry, in 2017 the SPC issued Supplementary Provisions on Interpretation II, stating that courts should not support creditor claims if one party to the marriage fabricates the debt in collusion with the creditor or if the debt arose from gambling or other unlawful activities. However, these supplementary provisions can help in only limited situations.
Then, in 2018, the SPC promulgated Interpretation of the SPC on Issues Concerning the Application of Law in the Trial of Cases Involving Matrimonial Debt Disputes (the “Interpretation”). The Interpretation is regarded as a change of the SPC’s attitude toward the recognition of matrimonial community debt, as Article 3 of the Interpretation stipulates that the court shall not support a creditor if a debt that arose during the existence of the marriage by a husband or wife exceeds the necessity of the couple’s daily life, unless the creditor is able to prove that the debt was used for the community life or community production and management of business or that the couple agreed to treat the debt as matrimonial community debt.
Compared to Article 24 of Interpretation II, Article 3 of the Interpretation changes the presumption and shifts the burden of proof such that, in the event that the amount of debt exceeds the necessity of the couple’s daily life, it will be regarded as personal debt, and it is the creditor’s obligation to prove that it should be treated as matrimonial community debt. This change reflects a new balance between creditor interests and the property rights of one party of the couple.
How Investors Can Protect Themselves Under the New Rule
Under the former legal framework, investors may file claims for reimbursement for matrimonial community debt against the spouses of the original debtors. However, according to Article 3 of the Interpretation, where the debt owed is likely to exceed the necessity of the couple’s daily life, the investor bears the burden of showing that the debt belongs to the matrimonial community. Although the “necessity of daily life” is not specifically defined, it is generally believed that costs for food and clothes, education, and medical expenses are for daily use may not be included. Therefore, if the investor cannot prove that the debt is used for the couple’s community life or is acknowledged by the couple, the court may not rule in its favor.
One suggestion to investors is to request that both spouses sign the original investment agreement. Article 1 of the Interpretation provides that if both the husband and wife sign on the agreement or the spouse subsequently confirms the debt, then the debt is considered matrimonial community debt. In addition, if the investors seeking reimbursement can prove that the debt was incurred during the common management of business by the couple, it also qualifies as matrimonial community debt. Therefore, investors may consider asking the spouses of the founders to co-sign the investment agreement or acknowledge key terms such as the repurchase arrangement or the valuation adjustment mechanism. Considering the bargaining power between the investors and the founders, this strategy is feasible in most cases and can reduce risks regarding the recognition of matrimonial community debt.
By Wei Sun, Partner, Beijing Zhong Lun Law Firm
This Article was originally published in Issue 5.10 of the CEE Legal Matters Magazine. If you would like to receive a hard copy of the magazine, you can subscribe here.