Countering penetrative trial approaches

The penetrative trial approach is a trial concept put forward by the Supreme People’s Court (SPC) in the Minutes of the National Courts’ Civil and Commercial Trial Work Conference. The approach emphasises establishing a stronger link between civil and commercial trials and administrative regulations, and a more thorough understanding of the parties’ true intention and the nature of the underlying legal relationship.

In investment and finance dispute resolution, a transaction conducted under the new structure, if excessively penetrated and identified as a means of evading the law, may swiftly be deemed void, threatening the stability of the transaction. Therefore, it is advisable to study the logic of the penetrative trial approach and understand countermeasures against it.

Analysis on logic

A valuable tool for regulators. One of the most prominent values of the penetrative trial approach in finance is supporting the regulatory authority in performing its regulatory functions. In practice, if the court considers all relevant facts of a case, suspects the transaction involves circumventing financial regulation, or finds it difficult to accurately determine the legal relationship or related party’s responsibilities, and is unable to expose the violation at the core by examining the legal relationship superficially, it may redetermine the nature and the party to the legal relationship by adopting a penetrative trial approach.

For example, in the civil ruling of Jiangxi Xinxin Jianan Construction et al v China Great Wall Asset Management (2020), the SPC advised that, in terms of the validity of the transaction documents involved in the case, one should adopt a penetrative perspective and substance over form approach, trace upward to the source of funds, and strictly examine for any disguised form of financial activities carried out through illicit borrowing channels and regulation circumvention. Should such acts be established, the relevant contract would have violated the mandatory provisions on effective financial security management, and would therefore be void.

Illustration with inductive conclusions. When judging a case with the penetrative trial approach, one often uses enumeration and induction to present an argument that is embodied in two aspects: (1) the characteristics of a substantive legal relationship and the corresponding facts involved in the case are enumerated in a correlative manner to substantiate the relationship; and (2) the characteristics of the ostensible legal relationship and its contradictions with the facts involved in the case are compared, to prove that such relationship should not be established.

For example, in determining cases of loans named in investment co-operation, the court often holds that investment co-operation is characterised by joint operation and sharing of risks and profits, while a loan is characterised by the collection of fixed income. Suppose the investor does not participate in the actual operation of the company and obtains a fixed return regardless of the company’s operating status or profitability. In this case, the relationship will likely be identified after penetration as one of the loans.

Countermeasures

Legislative necessity. The legitimacy of the penetrative trial approach is based on its benefits in maintaining financial security and market order, but with an acceptable level of impairment to transaction freedom and stability. If we can thoroughly demonstrate a fundamental difference between the legal relationships involved in the case and the substantive legal relationship prejudged by the court, or that the transaction in question did not infringe on any legal interests protected by law or administrative regulations, or that it is a minor offence, it is unnecessary to expose a false declaration of will through penetrative inspection. Therefore, it is no longer necessary.

For example, in sale and leaseback financial lease disputes, a common point of contention is whether the transaction involved is a loan with the name in the financial lease. In practice, it is generally believed that the authenticity of the leased property and the transfer of ownership of the leased property are the essential differences between a sale and leaseback financial lease and a loan, as a legal relationship of the financial lease is established when the leased property is genuinely transacted as an asset.

Another example, in cases of a minor violation deemed as such due to the limited scope, period or amount involved, the court may determine that its actual performance has cured the contractual defects, and that a penetrative determination of substance is no longer necessary to save social costs.

Disassembling the logic. To adopt a penetrative trial approach, one must present the conclusion and then conduct reverse argumentation through enumeration and induction. The downside of this methodology is that it may not always form a completely logical closed-loop and is prone to loopholes. Therefore, if we can refute the inductive conclusions piece by piece, it is possible to strip away the persuasive integrity of the court’s penetrative determination of the legal relationships.

For example, in cases where multiple transaction documents are signed and various legal relationships are formed among several parties, it is necessary to treat these elements when applying a penetrative trial approach. In this regard, we may consider splitting the contract relationship, emphasising the independence of each stage of the transaction, downplaying any concern about their relevance, and pointing out the contradictions between the newly found legal facts and the actual agreement between the parties, or those between the facts themselves, preventing any overt generalisation by the court.

This article is based on the authors’ own practical experience. Under the stringent policies of the current financial regulatory environment, how to counteract the excessive use of the penetrative trial approach and maintain transaction stability may be a subject of long-term consideration. The judicial practices on the penetrative trial approach, while plentiful and diverse, await further research in more detail.

Chen Zhuo is a partner at Tian Yuan Law Firm. He can be contacted at +86 138 1041 7260 or by e-mail at chenzhuo@tylaw.com.cn

Yin Yutong is an associate at Tian Yuan Law Firm. She can be contacted at +86 138 1139 4158 or by e-mail at yinyutong@tylaw.com.cn