Legal Regime of Equity Contribution in China and its Implications for Direct Investment

After the Company Law became effective, Shanghai, Zhejiang and Jiangsu AICs first issued measures governing Equity Contribution at the end of 2007. Guangdong, Shandong, Fujian and other AICs followed suit. As of October 19 2008, eight provisional level AICs¹ have implemented measures codifying Equity Contribution. However, the State Administration of Industry and Commerce (SAIC) has not issued any such regulations at a national level².

Brief Introduction of the Legal Regime

Despite some delicate differences, the local measures lay out similar principles regarding Equity Contribution. These principles may likely be referred to by the SAIC in its codification of the national regulation. These principles are discussed below.

1.Elements of Equity Contribution

In an Equity Contribution, an investor (Investor) will contribute its equity or shares (Investor Equity) in an existing company (Investor Company) in exchange for equity or shares in a new company (Investee Company).

The requirements regarding Investors, Investor Equity, Investor Company and Investee Company are restrictive in the local measures.

(i) Investors

Only PRC enterprises or individuals are recognised as qualified Investors. Foreign citizens and enterprises are not eligible to be Investors. However foreign invested enterprises in China are considered eligible.

(ii) Investor Equity

Investor Equity is subject to the following major restrictions: (i) The registered capital corresponding to the Investor Equity must be fully contributed. (ii) The Investor Equity must be free from any encumbrances, such as pledge, seizure or transfer barriers imposed by law or constitutional documents. (iii) All shareholders in the Investor Company must have waived their rights of first refusal regarding the transfer of Investor Equity.

(iii) Investor Company

Local AICs all require that any Investor Company be locally registered companies but restrictions do differ. In Chongqing and Shandong, both limited liability companies and joint stock companies are eligible Investor Companies while in Shanghai, Zhejiang, Jiangsu, Guangdong and Fujian, only limited liability companies are eligible. Most AICs have no requirements on the history of the Investor Company but Shandong AIC has a five year history requirement on the Investor Company.

(iv) Investee Company

The most distinct restriction on any Investee Company is that it cannot be a foreign invested company. This restriction rules out the possibility that domestic or foreign investors invest in foreign invested companies by Equity Contribution.

2.Contribution Procedure

(i) Subscription and Contribution

Most AICs³ permit an Investor to register as a shareholder of the Investee Company before it transfers the Investor Equity to the Investee Company. If the Investor fails to transfer the Investor Equity according to the schedule in the articles of association of the Investee Company, it will be liable to the Investee Company and other shareholders. In addition, the Investor will not be entitled to dividends before it contributes the Investor Equity.

(ii) Assets Appraisal and Capital Verification

The Investor Equity must be appraised by a qualified assets appraisal firm and verified by a qualified accounting firm. If the registration of the Investor as a shareholder and the contribution of Investor Equity are not filed simultaneously, the AIC may require a capital verification report at each filing.

Implications for Direct Investment

The advantages of Equity Contribution are obvious. It enables investors to invest into new companies with significantly less cash commitment. It is also innovative means to centralise scattered equity or achieve equity swaps.

Despite the advantages, local AICs have been cautious in endorsing Equity Contribution. The standards on Investors, Investor Equity, Investor Company and Investee Company are restrictive. Further, foreign investors have not been given direct access to Equity Contributions, possibly due to the difficulty to reconcile the regime governing Equity Contribution with existing Chinese legal regimes for inbound and outbound investments. In addition, due to the local nature of the measures, investors are not able to consolidate their equities scattered at different localities in China.

Local measures governing Equity Contribution have helped to mobilise capital and may boost direct investments in the long run. However, the value of Equity Contribution in direct investments may be limited until the measures are unified and loosened at national level.

Endnotes

1. Zhejiang, Jiangsu, Guangdong, Fujian, Shandong, Shanghai, Tianjin and Chongqing AICs

2. SAIC did publish a draft measure for the registration of equity contribution on its website for public comments in July 2008.

3. However, Guangdong AIC requires that an Investor must first transfer the Investor Equity to the Investee Company before it can register as a shareholder of the Investee Company.