What is “clean hands rule”?

The “clean hands rule” that came from the UK equity law deprives a person acting in an improperway of the right to seek remedies for their acts. A person acting in a way that violates theprinciples of “justice, conscientiousness, fairness, etc.” in equity law cannot seek remedies in acourt under an equity law jurisdiction. The clean hands rule is generally accepted in internationalbusiness arbitration and reflected by provisions of the Chinese Civil Code. For example, Article591 provides that if a party violates the contract, the other party should take appropriate actionto prevent loss increase or otherwise could not claim for the loss increase. Based on this provision,if a party does nothing to prevent the increase in damages caused by the other party breachingthe contract, the non-breaching party will have no right to win the action for the loss increasewith its hands not clean. In addition, articles 680 and 1125 of Civil Code implicitly follow the cleanhands rule which for example is applied in Chinese cases of buying false products deliberatelywhere the buyer will not be awarded a refund for and damages of three times the price of falseproducts they bought because their hands are not clean and their acts are not protectable by law.

The clean hands rule is referred to in the interpretation of Article 24 of the Company Law in thebook “the Explanation and Application of the Minutes of the National Court Meeting on Trials ofCivil and Business Cases” by the Civil Court 2 of the Supreme People’s Court. There areincreasingly more cases decided by legal authorities referring to the clean hands rule. In the caseof Shanghai Zhi Qu Business Information Consulting Co., Ltd. and Lin Zhuoran damaging thecompany’s interests (Case No. (2020) H02MZ1245) decided by Shanghai No.2 IntermediatePeople’s Court and the company interests damage case between Kuang Wensheng, Liang Wenge,Zhang Zhifen and Liao Qihao and Guangzhou Meishan Car Driver Training Co., Ltd. (CaseNo.(2015)SZFM2ZZ886) decided by Guangzhou Intermediate People’s Court, both courts cited the clean hands rule. 

Application of the clean hands rule: a shareholder who has not paid capital contributions hasno right to oust other shareholders.

In the confirmation of the effect of the company’s resolution case between Shen Moufeng andShanghai Baizhen Property Co., Ltd., Shen Mouyi, etc (Case No. (2022)H0113MC24619), ShanghaiBaoshan People’s Court decided the case by following the clean hands rule. Shanghai BaizhenProperty Co., Ltd. was established by three natural people with registered capital of RMB 38million, of which Shen Moufeng, Xu Mou and Shen Mouyi held 60%, 30% and 10% respectively.On March 25th, 2022, the company convened an ad hoc shareholder meeting and made aresolution to ousted the shareholder Shen Mouyi on the ground that she did not fulfill theobligation to pay the capital contribution. In this case I was lawyer of the shareholder Shen Mouyi.In the trial it was found that shares held by Shen Moufeng and Shen Mouyi were acquired fromother people with their consent and other shareholders except Shen Mouyi admitted to havingwithdrawn all their contributed capital illegally.

One of the key issues in this case is whether the shareholder who has not paid subscribed capitalor has withdrawn all contributed capital illegally can exercise the right to ousted othershareholder. I argued that based on the clean hands rule, the shareholder status terminationclause in Article 17 of the Legal Interpretation III of the Company Law should mean that othershareholders who have paid subscribed capital (non-breaching shareholder) may ousted theshareholder who has not paid subscribed capital in the legal process. The purport of the cleanhands rule is to prevent a party from obtaining legal remedies for its improper behavior. In thiscase, if as the plaintiff stated, all the company’s registered capital were withdrawn illegally andneither Shen Moufeng nor Xu Mou paid the subscribed capital, it is contrary to law and a violationof the clean hands rule and the good faith principle that the shareholders who did not pay thesubscribed capital could dismiss other shareholder who did not pay the subscribed capital.Therefore, only the non-breaching party can ousted other shareholder under Article 17 of the Legal Interpretation III of the Company Law and the breaching party has no right  to dismiss other shareholder.

In the trial the court held that although the third person Shen Mouyi did not fulfill the obligationto pay for shares she held in the company, the plaintiff Shen Moufeng and the third person Xuwho did not fully pay their subscribed capital as well were breaching shareholders with no legalinterests harmed and no right to convene a shareholder meeting to ousted other shareholdersbecause the payment certificate they presented after the case arose could not make up for thedefective fact that they had no voting rights when the company made the solution or be usedalone as adequate proof of having fulfilled their obligation to pay the subscribed capital.Therefore, on November 26th, 2022 Baoshan People’s Court decided the shareholder resolutionwas void and the court decision is in legal force.

Application of the clean hands rule: a shareholder should have clean hands when bringing aderivative action

A mechanism against malicious actions must be established to prevent abuse of the shareholder’sright to bring actions. The clean hands rule requires that the shareholder bringing a derivativeaction must not support, approve or subsequently confirm harmful acts of the board of directors,etc. and must be able to impartially and fully represent the company’s interests when bringingthe action. Upon awareness of an illegal act against the company, the shareholder should file anopposition or take active action to protect the company’s interests if they have powers to do so.A shareholder will no longer have the right to bring a derivative action against an illegal act theyhave voted for, approved, acquiesced in or subsequently confirmed.

In the case of Shanghai Zhiqu Business Information Consulting Co., Ltd. and Lin Zhuoran damagedthe company’s interests, Shanghai No.2 Intermediate Court held that Yu Lei failed to performsupervisor’s duties and took active part in rather than stop planning and performing illegal actsagainst the company; she brought the derivative action by violating the clean hands rule inbusiness and investment areas that the shareholder should not explicitly approve, agree to oracquiesce in illegal acts of a director or senior manager or have rights and benefits arising from improper or illegal acts; she approved and agreed to the improper or illegal acts in dispute andcould not impartially, sincerely and fully represent the company’s interests; therefore we rejectedYu Lei’s claims because she violated the clean hands rule by claiming on behalf of the companythat Lin Zhuoran should be solely responsible for paying damages arising from acts of violatingtax collection and management laws that the company’s shareholders jointly decided to do.

Restrictions on the application of the “clean hands rule”. In shareholder capital contributioncases, the plaintiff has the right to bring the action whether they have clean hands.

Can shareholders with defects in their capital contributions bring an action by claiming that othershareholders with defects in their capital contributions should pay in full capital contributions? InArticle 14.1 of the Legal Interpretation III of Company Law, if a shareholder withdraws theircontributed capital illegally, the court should decide in favor of other shareholder claiming theshareholder returns the withdrawn capital with interests on it. Should “other shareholder” benarrowed down to “non-breaching shareholder”? If yes, shareholders with defects in their capitalcontributions have no right to require other shareholders with defects in their capitalcontributions pay in full capital contributions.

In the shareholder capital contribution case between Ma Wei and Shanghai Weishen MedicalTechnology Ltd., Hefei Ruimai Medical Investment Management Ltd., etc. decided by ShanghaiNo.2 Intermediate Court [Case No. (2021) H02MZ6428], one of key issues is whether Ma Wei,one of shareholders who paid no subscribed capital could bring an action on behalf of thecompany claiming that other shareholder should fully perform to pay subscribed capital.

Someone believe that based on the clean hands rule, a shareholder who has not fully performedtheir obligation to pay subscribed capital is infringing the company’s rights and can not bring anaction on behalf of the company by claiming that other shareholder should fully perform theirobligation to pay subscribed capital. The clean hands rule requires rights of shareholders whoviolated the good faith principle be restricted. This requirement is reflected in the existingCompany Law. For the same reason, the right of shareholders with defects in their capital contributions should also be restricted.

Shanghai No.2 Intermediate Court held that the clean hands rules should not be applied inshareholder capital contribution cases because it is the company, not the shareholder withdefects in their capital contributions that directly benefits from capital contributions paid byshareholders. The main reason why the clean hands rule does not apply in shareholder capitalcontribution cases is that the person acting improperly, i.e. shareholder with defects in theircapital contributions is different from the beneficiary, i.e. the target company. In the legalinterpretation, in shareholder capital contribution cases, the shareholder has the right to directlybring an action and the company benefits from the action. Shareholders have indirect interestssuch as rights to obtain dividends and surplus assets. Therefore, shareholders with defects in theircapital contributions could not directly benefit from the repayment of illegally withdrawn capitalby other shareholder to the company. In this case conditions on which the clean hands ruleapplies are not met.