Capital contributions using equity are welcome

“There was a discussion draft that was issued last year, even before the financial crisis hit,” he says.

The measures will not positively affect domestic companies' ability to set up subsidiaries, either. The capital requirement needed to set up a subsidiary is low, and is probably not an issue for them. The regulation also does not address deals by listed companies, which, according to Hans-Günther Herrmann, counsel at Paul Weiss Rifkind Wharton & Garrison, are the companies most likely to be interested in using acquisition currency.

Lawyers familiar with Chinese corporate law say that the new measures do not say anything new. Since the amended PRC Company Law (中华人民共和国公司法) came into effect in 2006 it has been possible to contribute assets other than cash or real property to a company. (That law says a shareholder can make capital contribution by means of “cash, tangible objects, IP rights, land-use rights and other kinds of properties that can be appraised in terms of currency and are entitled to be legally transferred.”)

So, even before the new measures came into play, investors could register equity as a capital contribution in a company, based on implications in the Company Law (中华人民共和国公司法), and some specific local rules: the Shanghai Administration for Industry and Commerce's Trial Measures for Registration of Capital Contribution to Companies promulgated on December 25 2007, for example. However, in most cases companies had to do the transactions on an ad hoc basis – a more time-consuming and less certain process. The latest measures achieve the formalisation and codification of previous methods, across the country.

“The main thing [the measures] do is expand nationwide the ability to make capital contributions using equity interests,” says Herrmann.

Worries for foreign investors
Although the measures are not groundbreaking, commentators agree that they are reasonably clear and straightforward, and provide the necessary details to help smooth transactions. However, for foreign investors, the rules will raise some concerns.

In certain transactions a capital contribution using equity could result in a change of nature of both the company originally owned by a foreign investor and the company to which the contribution is being made.

“There may be a business scope issue,” says Wang.

If a foreign investor doing an equity contribution swaps its shares in a FIE for shares in a Chinese company, then the foreign investor will become a shareholder in the purely domestic company. That previously domestic company will become an FIE; the company the foreign investor used to own will become a domestic company and the subsidiary of a new foreign holding company (see Chart 1). Depending on the number of shares contributed, the FIE may become primarily a holder of shares in another company – a holding company – which is very likely to violate the original business scope of the FIE, and require it to go through a new approval process.

“In an extreme circumstance,” says Hubert Tse of Yuan Tai PRC Attorneys, “when a foreign investor uses [its] entire equity in a Sino-foreign joint venture as capital contribution to a domestic enterprise, the foreign invested equity in the Sino-foreign joint venture will be changed into the domestic-funded equity and the equity company will become a domestic company.”

And vice versa: if the foreign investor uses its equity as capital contribution to a company which is wholly domestic-funded, the nature of this company will change to a Sino-foreign joint venture, since one of the shareholders is now a foreign investor.

In situations such as these, where an FIE changes its nature, new procedures for approval and registration will have to be followed. A Sino-foreign joint venture or a wholly foreign-invested enterprise needs Ministry of Commerce approval (while a domestic-funded company does not). Companies will also need to go through amendment procedures with the local or state Administration for Industry and Commerce.

Sheng Ping, a corporate lawyer with Hao Li Wen PRC Attorneys argues that companies will not change their nature if an equity investment could result in a prohibited investment. This is because investment within China by foreign investment enterprises is handled in accordance with the Tentative Provisions for Directing of Foreign Investment and the Foreign Investment Industrial Guidance Catalogue which clearly state that FIEs may not invest in fields in which foreign investment is prohibited.

“If company A invested within China by FIEs in a certain area [is] deemed as a Chinese entity, then the target Chinese company will not be turned into an FIE after the equity contribution is made by company A,” she says.

Access to state-owned assets cheaper, but not easier
Using equity for capital contributions applies to both incorporation and capital increase (pursuant to Article 6 of the measures). As capital increase can be one of the methods for doing mergers and acquisitions, capital increase in the form of equity will soon become a practical way for investment in state-owned enterprises, says Tse.

Investing in a state-owned enterprise is likely to become cheaper and require less cash. But it will not be much easier: such investments will still need to be approved by the appropriate authorities. The Tentative Measures for the Supervision and Administration of Enterprise State-owned Assets, issued by the State Council in May 2003, say that in the case of a wholly state-owned enterprise, mergers and acquisitions and capital increase transactions must be approved by the State-owned Assets Supervision and Administration Commission of the State Council or its local authority. If the Commission holds only part of the equity of the enterprise, the transaction must be approved by a resolution of the shareholders' meeting.

Something missing
Although the rules generally seem clear, there are still details missing, and practitioners say they are worried about issues which might arise when companies actually try to execute a contribution.

Although Article 4 refers to “valuated equity” and “non-monetary property”, there is no description of the methodology which should be used to calculate the value.

“It is not stated clearly whether this is a statutory valuation, who can do it and what valuation methods should be followed,” says Michael Jiang, a corporate finance partner of KPMG in Shanghai. “This may leave a lot of room for interpretation and manipulation.”

For foreign investors, there may be complexities related to the requirement in Article 5 for appraisal of equity by “a lawfully-established appraisal firm”. Some lawyers say this will actually make transactions more difficult. There are also no hints in the measures as to how the regulator will treat foreign investors in practice when it comes to using shares as capital contributions.

Some companies may also be thinking of contributing shares as a means of creating a new joint venture using an existing business. Herrmann points out that this was possible already, by round-tripping – contributing cash which is then used to buy shares – but that using equity contribution is a more efficient means. Share swaps between domestic and foreign parties are allowed under the 2006 M&A Rules, but these transactions need specific approval from Mofcom and can only be conducted within one year before a planned listing of the offshore holding company. Few private equity investors or domestic founders have been interested in this onerous option (see box: Doubts over swaps for a notable exception).

Despite some worries and calls for more implementing details, particularly among foreign investors or their advisers, the overall response to the measures has been good. Companies which wish to do a simple restructuring or those that want to make an acquisition through capital increase will be happy to see the promulgation of the measures. And expanding domestic companies, who want to consolidate in the market, should find things becoming easier.

“This is positive and encouraging news for investors,” says Tse. “With the promulgation of the measures, the State Administration for Industry and Commerce has provided a detailed route to make [capital contributions] effective nationwide.”

[Click here to download a chart showing how capital contributions can affect conmpany structures.]

Capital contributions in the form of equity: Using equity interests (shares) in limited liability companies and joint stock companies to invest in other limited liability or joint stock companies. Depending on the number of shares contributed, this kind of capital contribution can significantly change the structure and status of all the companies involved.

Doubts over swaps

Although China's 2006 M&A rules allow share swaps in theory, they contain one significant untested provision, Chapter 4, which says that share swaps can only occur if the acquiring offshore company is listed in a “recognised stock exchange”.

What “recognised” means is so far unclear, but it seems the well-respected Hong Kong exchange is regarded as safe and is unlikely to raise any eyebrows among the regulators. The first share swap in China after the promulgation of the M&A rules occurred in 2008, when Poly Investment's Hong Kong-listed company acquired the equity interest of its sister company, Shenzhen Poly Investments. The Ministry of Commerce did not raise any objection; it seems that only when a company listed on a smaller, less developed exchange attempts a share swap will Mofcom's interpretation be tested.

This story uses parts of an article which first appeared in IFLR in June 2008.