Exploring Legal Risks in Equity Inheritance Litigation: The Battle for Corporate Control

Introduction

China is on the brink of a significant wealth inheritance, as indicated by the “2023 Hurun Wealth Report”. Over the next decade, an estimated CNY21 trillion of wealth will pass to the next generation, and within 30 years, this figure will soar to CNY84 trillion. This impending wealth transition places a spotlight on the initial cohort of wealth creators, predominantly composed of private entrepreneurs nearing retirement, who must now navigate the transfer of assets to their descendants.

Amidst the rapid development of the Chinese economy over recent decades, the accumulation of wealth among Chinese entrepreneurs has surged. Consequently, many entrepreneurs now possess substantial stakes in their companies, intensifying the importance of equity inheritance. Unfortunately, many entrepreneurs fail to engage in early estate planning, resulting in fierce disputes over equity inheritance, contributing to internal family conflicts over ownership and control of the company, posing significant risks to both company and family stability.

The crux of equity inheritance disputes lies in the battle for control over companies, encompassing both external disputes between heirs and other shareholders and internal disputes among heirs. Internal disputes commonly arise among the deceased’s blood relatives and spouses, with intensity escalating in cases involving multiple marriages or illegitimate children. Below, the author briefly examines two cases exemplifying these dynamics.

In 2020, Lin Qi, founder and 23.99% shareholder of YOOZOO Interactive, a publicly traded electronic gaming company, died and his equity would be jointly inherited by his three underage children based on the notarisation. The battle for control over the company arose when Lin Qi was found to have fathered an illegitimate child, which could result in the wrongfulness of the notarisation. In this case, the complex marital relationships of the deceased and the sudden appearance of an illegitimate child undoubtedly intensified the battle for control over the company. The intensity of the struggle for control over the company can be seen from a series of closely connected actions, from the online post about the illegitimate child, to court litigation, freezing of equity, and reaching agreements.

In addition to internal disputes over company control among heirs, external conflicts may also arise between heirs and other shareholders. The inheritance case that the Dacheng team previously handled, sparked by the murder of an entrepreneur, is a prime example of both internal and external conflicts. This case is extremely complex, involving numerous interested parties, including the deceased’s mother, biological siblings, half-siblings (from the same mother), ex-wife, “current” wife, and children born to the deceased and his “current” wife. Furthermore, the inheritance encompasses a diverse range of assets, ranging from equities in multiple companies to real estate properties, some of which are held in trust by third parties. Lastly, this case involves multiple legal issues including civil, business and criminal matters.

Heirs and other shareholders have initiated over ten lawsuits filed across various jurisdictions over corporate control issues. These lawsuits encompass civil matters such as inheritance and shareholder qualification confirmation, as well as criminal issues like tax evasion, false issuance of invoices, concealing or intentionally destroying accounting vouchers, account books or financial and accounting statements, and embezzlement of corporate assets. Through this case, it can be seen that in equity inheritance disputes, there is a transition period from the death of the deceased to the confirmation of shareholder qualifications by the heirs. During this transition period, when the heirs cannot reach an agreement or when there is conflict between heirs and other shareholders of the company, it often leads to tearing apart the company in a struggle for control, ultimately resulting in governance deadlock and serious damage to the company’s interests.

Drawing from the firm’s past case experience and case data analysis, the team has written a series of articles on legal issues related to equity inheritance. The present article primarily aims to interpret the complexities of equity inheritance and provide practical recommendations, and the author will analyse the legal risks related to the struggle for control over the company in equity inheritance disputes from both legal provisions and judicial practices, and discuss the corresponding strategies.

Legal framework for inheritors obtaining shareholder qualifications and exercising shareholder rights

In the firm’s aforementioned equity inheritance dispute case, some heirs intend to exercise shareholder rights in court before their actual inherited equity stakes are confirmed. However, other heirs and company shareholders argue that the said heir has not actually obtained shareholder qualifications and thus cannot exercise shareholder rights, leading to multiple disputes. Therefore, when shareholder qualifications are actually obtained and whether heirs can exercise shareholder rights before acquiring company equity are two important factors in such disputes.

According to Article 1121 of the Civil Code in the Inheritance Chapter, “the inheritance begins at the time of the death of the deceased”, so the time when heirs acquire the rights to the property of the deceased should be traced back to the death of the deceased. In judicial practice, some courts also consider that heirs acquire shareholder qualifications at the time of the deceased’s death. However, due to the dual nature of equity, involving both property and personal attributes, and considering the legal obstacles and disputes that may arise in equity inheritance, whether heirs acquire shareholder qualifications and can exercise shareholder rights at the time of the deceased’s death is controversial.

In equity inheritance disputes, it is necessary to determine whether the deceased left a Will. The court would not simply assume that heirs can directly inherit shareholder qualifications. According to Article 1123 of the Civil Code, after inheritance has commenced, statutory inheritance shall apply; where there is a Will, testamentary inheritance or legacy shall prevail. Additionally, even if there is a Will or other document, the validity of the relevant agreements still needs to be examined. Furthermore, according to Article 1124 of the Civil Code, even if there is a legally effective Will without any defects, heirs and beneficiaries may still renounce the inheritance or legacy.

Secondly, one of the main obstacles in equity inheritance disputes is the issue of confirming the scope of the estate. According to Article 1153 of the Civil Code, “At the time a decedent’s estate is partitioned, half of the joint property owned in common by the spouse shall, unless otherwise agreed upon, be first allotted to the surviving spouse as his or her own property; the remainder shall constitute the decedent’s estate. If the decedent’s estate forms part of the common property of his family, that portion of the property belonging to the other members of his family shall first be separated at the time of the partitioning of the decedent’s estate.” Therefore, before dividing equity, it is necessary to first determine which part of the estate belonged to the deceased, especially in cases where the deceased made equity investments or increased capital in the company during the marriage. The actual situation of the equity as part of the estate needs to be carefully examined. In practice, Dacheng has found that some couples attempt to circumvent national restrictive regulations through fake divorces, stipulating in the divorce agreement that one spouse will hold all the equity. In such cases, the validity of the fake divorce and the related divorce agreement may be flawed, and the actual amount of equity held by one spouse may be disputed. After the death of either spouse, confirming the deceased’s equity and estate becomes a significant challenge.

In addition, confirming the range of heirs is also an important obstacle affecting the final distribution of equity, especially in cases involving complex family structures, such as when the deceased had multiple marriages or children. Therefore, without clarifying the range of heirs, the court cannot simply assume that heirs can directly have shareholder qualifications. As per Articles 1127 and 1155 of the Civil Code, illegitimate children, adopted children, step-children with support relationships, unborn fetuses, and step-parents can all inherit as first-order heirs. However, disputes over the qualification of heirs such as illegitimate children are more likely to arise in practice. The potential heirs are always requested to launch a lawsuit to request confirmation of parent–child relationship to the court, and as per Article 1073 of the Civil Code, the party needs to prove that there is proper reason to confirm or deny such relationship. Nevertheless, in practice, whether the reason is proper is largely under the court’s discretion. In an equity inheritance case Dacheng handled, the firm’s client was the deceased’s daughter, while the opposing party was the deceased’s mother. The opposing party, based on rumours, alleged that the firm’s client was not the deceased’s biological daughter and sought to request a paternity test using the deceased’s remaining body parts in the hospital.

According to Article 39 of the Interpretation of the Supreme People’s Court on the Application of Marriage and Family Part of the Civil Code of the People’s Republic of China (I), after the party has provided necessary evidence to prove such claim and the other party fails to provide evidence to the contrary and refuses to take a paternity test, the People’s Court may affirm the claim filed by the party for confirmation or denial of parenthood.

Additionally, according to Article 1129 of the Civil Code, “widowed daughters-in-law or sons-in-law who have made the predominant contributions in supporting their parents-in-law shall, in relation to their parents-in-law, be regarded as inheritors first in order.” Furthermore, according to Articles 1128 and 1152 of the Civil Code, in cases where there are issues such as inheritance in subrogation or sub-inheritance during equity inheritance disputes, the range of heirs who eventually acquire company equity may change. In practice, those who provided significantly more care to the deceased during his or her lifetime are often considered potential inheritors, even if they are not first-order heirs.

However, even after confirming the range of heirs, it is not straightforward to determine the proportion of equity for each party. According to Articles 1130 and 1151 of the Civil Code, the estate shall generally be equally inherited by heirs of the same order. However, when there are special difficulties in the lives of heirs who lack labour capacity, fulfil primary support obligations, live with the deceased, do not fulfil support obligations, or situations such as embezzlement of the estate, the proportion of equity that each party can actually inherit will be affected. Additionally, according to Article 1125 of the Civil Code, in special circumstances, heirs may not be entitled to the inheritance. In the aforementioned case, disputes arose among some heirs regarding whether the deceased’s mother would lose her right to inherit taking account of her abandonment of the deceased.

Finally, according to Article 90 of the Company Law (revised in 2023 to be effective on 1 July 2024), “after a natural person shareholder dies, his/her lawful inheritor may inherit the qualification of the shareholder, unless it is otherwise provided for in the articles of association.” Though the heirs have the right to inherit, the method of dividing the equity and whether it is appropriate to grant each heir with rights to inherit the shareholder qualifications of the company should be further considered by the court. Based on Article 1156 of the Civil Code, the division of the estate should be conducive to production and living needs, without impairing the effectiveness of the estate. Inappropriate estate division can be dealt with by methods such as discounting, appropriate compensation, or joint ownership. Often, the court simply distributes the estate through basic proportionate division, resulting in heirs who fiercely battled each other in court becoming shareholders in the same company, which is detrimental to the company’s operations and is highly likely to lead to a deadlock.

Certainly, the primary objective of confirming shareholder qualifications is to enable the exercise of shareholder rights, encompassing actions such as equity disposal and participation in shareholder meetings. As outlined in various provisions of the Company Law, the extent of equities held typically determines entitlements in the company, including dividend distributions, the ability to convene meetings, voting rights, initiation of derivative actions, amendment of articles of association, and decision-making regarding mergers, divisions, or dissolution. Moreover, the number of heirs obtaining shareholder qualifications can influence the company’s structure, as highlighted in Article 42 of the revised Company Law (to be effective on 1 July 2024), stipulating the establishment of a limited liability company with contributions from a minimum of one and a maximum of 50 shareholders.

Therefore, in disputes arising from inheritance of shares and contesting control of the company, the court cannot simply rely on Article 1121 of the Civil Code, without fully examining legal issues including but not limited to the existence and validity of Wills or inheritance agreements, the scope of the estate, the range of heirs, and the proportion of inheritance. It is usually inappropriate for the court to make a simple decision recognising the inheritor as a shareholder upon the death of the deceased without fully considering the context of the company and the significant impact to the operation of the company, which could potentially lead to even greater legal disputes and may even adversely affect the normal operation of the company.

Data analysis of cases related to equity inheritance

Based on the considerations of the legal risks related to corporate control disputes in the aforementioned cases represented by the firm’s team, and in order to explore the timeframe in which inheritors actually acquire shareholder qualifications after the death of the deceased, as well as the possible scenarios of corporate control disputes among parties before acquiring shareholder qualifications, on 11 May 2024, the firm’s team conducted a search through Wolters Kluwer, utilised by legal professionals in the PRC to access publicly available cases. Using the keywords “inheritance begins at the death of the decedent”, “company” and “shareholder qualifications”, and using “inheritance disputes” or “disputes related to companies” as causes of action, the firm retrieved civil judgments related to corporate control disputes. There is a total of 123 cases involving disputes over company control rights triggered by equity inheritance, with 45 cases related to company disputes and 78 cases related to inheritance disputes. The analysis of the search results is as follows.

1. Data analysis

Based on the statistical analysis of the adjudication levels of the aforementioned 123 relevant cases, 73 cases were first-instance cases, 49 cases were second-instance cases, and 1 case was a retrial case. The causes of action mainly involved under the category of “disputes related to companies” includes “disputes over equity confirmation”, “disputes over shareholder qualification confirmation”, “disputes over equity transfer”, “disputes over shareholder information rights”, “disputes over the effectiveness of company resolutions”, “liability disputes causing harm to company interests”, and “disputes over company dissolution”.

It can be observed that the disputes between the relevant parties in corporate control disputes are very intense, involving a wide range of disputes, which often lead to prolonged case adjudication periods. For example, over ten lawsuits have been filed by various parties regarding corporate control issues in the case the firm represented and mentioned earlier, and after two years, the disputes related to the contested company are still unresolved.

2. Analysis of transition periods

In order to further explore the time span in which parties in equity inheritance disputes reach a settlement, the firm also analysed the transition period from the death of the deceased to the court’s final judgment on whether the inheritor can exercise shareholder rights. From the firm’s statistical analysis on the 123 cases, it was found that the majority of cases reflected transition periods of more than three years. Among all cases, approximately 20% were settled after five to ten years, and approximately 10% were settled after more than ten years.

Further analysis of cases with transition periods exceeding 20 years revealed that the main reasons for the prolonged dispute resolution periods include the following.

• Difficulty in confirming the identity of inheritors, including difficulties in confirming the identities of illegitimate children or children from multiple marriages in complex families, or special circumstances such as multiple individuals with inheritance relationships dying in the same event or some heirs dying before the division of the estate, leading to difficulties in expanding the scope of inheritors and difficulty in confirming identities.
• Obstruction by other shareholders of the company to prevent inheritors from acquiring shareholder qualifications, such as denying the inheritor’s shareholder qualification or opposing the inheritor’s shareholder status through resolutions of the company’s shareholders’ meeting or board of directors.
• Disputes over the ownership of contested equity, such as cases where the deceased held equity on behalf of others or others held equity on behalf of the deceased.
• Inheritors failing to assert their rights to equity distribution in a timely manner, especially when some inheritors are shareholders of the company or actively manage the contested company, and it may be difficult for other inheritors to claim equity distribution, or they may neglect to exercise their inheritance rights, and relevant parties may also raise defences on the grounds of exceeding the statute of limitations. Given that these situations frequently occur in cases related to equity inheritance disputes, it can be seen that the difficulty of settling cases related to corporate control disputes is significant.

In conclusion, due to the uniqueness of equity inheritance disputes and the practical difficulties such as the inability to confirm the identities of inheritors, obstruction by other shareholders, and defects in the ownership of contested equity, there is a long transition period from the death of the deceased to the confirmation of shareholder qualifications. Based on the firm’s case analysis, even after the court confirms the shareholder qualifications of the inheritors, disputes over corporate control rights among the parties may still arise. Additionally, in practice, after the court makes a final decision on equity distribution and shareholder qualifications, a party may reject to comply with the judgment, which costs more time for settling disputes related to corporate control rights. Prolonged disputes over equity inheritance and related corporate control rights inevitably lead to a longer period of uncertainty regarding equity ownership, leaving the rights corresponding to the inherited equity in a state of limbo, which undoubtedly severely affects the management of the company, contributes to governance deadlock, and may even result in scenarios such as dissolution being applied for.

Furthermore, Dacheng found that in cases where the secondary cause of action was “inheritance disputes”, the majority of cases involved disputes over corporate control rights triggered by internal conflicts among inheritors, and the relationships between the parties involved in the internal conflicts were also quite complex, including disputes among blood relatives and in-laws of the deceased, siblings, children from multiple marriages, and illegitimate children and legitimate children of the deceased, with the most contentious cases mainly arising in situations where the deceased was involved in multiple marriages or emotional relationships.

Legal risks and lawyer recommendations regarding equity inheritance

Reflecting on a series of intertwined disputes over inheritance and corporate control rights triggered by the unexpected death of entrepreneurs represented by the firm’s team, it is distressing to witness the lack of proper estate planning by the deceased and instead wrongly choosing equity entrustment agreements to temporarily isolate some risks, leading to family rifts, sibling conflicts, and heartbreaking scenarios upon their demise. When disputes among heirs arise, the associated companies often face turmoil due to internal family conflicts, leading to governance deadlock, operational difficulties, and even the risk of bankruptcy. Thus, equity inheritance not only affects family harmony and the preservation of family wealth but profoundly impacts the development of enterprises, the livelihoods of employees and their families, and societal stability.

Complex issues such as the verification of Wills, determination of the scope of the estate, range of heirs, methods of equity allocation, and confirmation of allocation proportions exacerbate the difficulty to the court. Hence, inheritors cannot simply rely on Article 1121 of the Civil Code to obtain corresponding equity interests upon the death of the deceased.

In disputes over equity inheritance, the complexity of issues such as verification of Wills, the determination of the scope of the estate, identification of heirs, and confirmation of equity distribution methods and proportions increases the difficulty for courts in handling these cases. As a result, heirs are effectively unable to simply acquire the corresponding equity rights and shareholder qualification at the time of the decedent’s death in accordance with Article 1121 of the Civil Code.

During the prolonged period of equity inheritance, heirs, and other shareholders of the contested company, may engage in prolonged and fierce battles for control over the company. In this transitional period, the parties involved may employ various strategies to contest control, challenging the identity of the heirs, the deceased shareholder’s qualifications, and the validity of Wills. Other tactics may include intentionally omitting heirs in prior distributions, forging the deceased’s signature to secretly divide or transfer the contested equity, depriving heirs of their entitlement through shareholder resolutions, and implementing coercive measures to control the company. As a result, disputes over equity inheritance and related control rights are inevitably prolonged and unresolved, leading to persistent turmoil, potential governance deadlock, and significant risks such as bankruptcy or dissolution.

The present era marks a pivotal moment in China’s transition from the first generation to the second generation of wealth creators. Prioritising and methodically executing estate planning is crucial, given its dual impact on the endurance of family fortunes and the continuity of family businesses. The smooth transition of a substantial portion of Chinese family businesses is vital for maintaining the overall stability and orderly growth of the Chinese economy. Hence, the firm emphasises the importance of early estate planning, particularly for ultra-high-net-worth individuals, notably entrepreneurs. Anticipating and strategising for wealth inheritance, especially regarding equity inheritance, is essential for mitigating potential risks.