Swap shop

Only three types of creditor's rights can be converted into the registered capital of the company: (i) the creditor's right under a contract whereby the creditor has fulfilled its corresponding contractual obligations; (ii) the creditor's right affirmed by an effective judgment of a People's Court; and (iii) where the company is subject to reorganisation or settlement procedures in an insolvency proceeding, the creditor's right enlisted either in the reorganisation plan approved by the People's Court or in the settlement agreement acknowledged by the People's Court. The Measures indicate that a creditor's right which is not a right to receive monetary payment may also be converted into equity. As it could be practically difficult to appraise a non-monetary creditor's right, in practice the vast majority of creditor's rights to be swapped into equity will remain monetary in nature.

The Measures are silent on whether the creditor's right under an entrustment loan is eligible for debt-for-equity swap. PRC law generally prohibits a company to extend a commercial loan to another company unless the loan is an entrustment loan where the entrusted lender is a financial institution. In commercial transactions, particularly in private equity transactions, entrustment loans are not uncommon. As the Measures do not specifically address this concern, it will be within the discretion of the competent AIC whether it will accept and register the creditor's right under an entrustment loan for debt-for-equity swap.

Appraised value and registered capital amount

One of the key questions in all debt-for-equity swaps is how much equity the debt can be converted into. The Measures prescribe two rules to address this question. Firstly, the registered capital amount to which the creditor subscribes must not be higher than the appraised value of the creditor's right. Secondly, to be consistent with the PRC Company Law, the Measures require that the sum of (i) the newly-subscribed registered capital amount from debt-for-equity swap and (ii) the amount of all previously-subscribed non-monetary capital contributions must not exceed 70% of the total registered capital amount of the company.

By way of example, in a debt-for-equity swap transaction, assuming the book value of the creditor's right is Rmb1 million (US$157,900) while the appraised value of such creditor's right is Rmb450,000, the theoretical maximum registered capital amount in consideration of such creditor's right will be Rmb450,000. If the shareholders made non-monetary contribution to the company previously, the maximum possible registered capital amount will be further reduced. If before the debt-for-equity swap, the registered capital of the company is Rmb600,000 among which Rmb300,000 is subscribed through non-monetary assets contribution, the new registered capital amount of the company in consideration of the creditor's rights may not exceed Rmb400,000, in order to meet the 70% ceiling above.

By requiring that the newly-subscribed registered capital amount be “not higher than” the appraised value of the creditor's right, the Measures appear to have taken into account the possibility of a debt-for-equity swap at a premium, that is, the newly subscribed registered capital amount in consideration of the creditor's rights is smaller than the appraised value of the creditor's rights. Where the swap is conducted at a premium, it is anticipated that the AIC will follow the common practice to treat the difference between the appraised value of the creditor's rights and the newly-subscribed registered capital amount of the company as the capital reserve of the company.

Swap procedure

The creditor's right intended for debt-for-equity swap must be evaluated by a lawful asset appraisal firm.

The debt-for-equity swap must be subject to capital verification by a lawful capital verification firm. The purpose of this verification is to ensure that the swap has been duly completed. The capital verification report must cover, among other things, the basic information of the creditor's right, the appraisal of the creditor's right, the swap progress, and the availability of regulatory agency approval (if applicable). The Measures require that the completion of the debt-for-equity swap be evidenced by: (i) the execution of a debt-for-equity agreement; (ii) a creditor's waiver of its right against the company; and (iii) the company's accounting records of the swap, and so on.

After the above two steps, the company must apply to the AIC to register the changes to the registered capital amount and the paid-in capital amount.

Impact

The Measures have been promulgated amidst an uncertain economic situation where the sovereign debt crisis in Europe continues to ferment while economic growth in China begins to slow down. Zhou Bohua, the head of the SAIC, commented in an interview after the issuance of the Measures that the purpose of the Measures is to alleviate corporate debt burdens and improve corporate cash flow. The Measures will be a blessing to those companies suffering heavy debts and insufficient cash flow. On the other hand, the cashless debt-for-equity swap enabled by the Measures can equally benefit financially robust companies, as it provide a new alternative to such companies for financial planning and debt restructuring.

Private equity investors and venture capitalists may also warmly welcome the Measures. With appropriate contractual arrangements, they may now be able to invest into a Chinese limited liability company through a structure similar to a convertible loan, which is frequently used in offshore transactions. In the past, an onshore convertible loan arrangement is often not commercially friendly due to the need of large amount of bridge capital to satisfy capital contribution verification requirement so as to achieve the conversion. Under the Measures, the debt-for-equity swap can be conducted on cashless basis, thus reducing the financial costs for the swap.

The Measures formulate a uniform, national regime for debt-for-equity swaps, but it remains to be seen how the local AICs will react where the Measures conflict with existing local rules. For example, in the rules promulgated by the Tianjin AIC, only a limited liability company (as opposed to a joint-stock company) can carry out debt-for-equity swap; in the Measures, a debt-for-equity swap is available to both types of companies. In each swap transaction, the stakeholders need to seek the opinion from the local AIC if the local rules and the Measures have conflictive provisions.

The Measures were issued by the SAIC alone but, theoretically speaking, are applicable both to a domestic company and a foreign-invested company. From past experience, a Chinese authority may not strictly follow a regulation issued by a peer authority unless it co-signs the regulation. Where a foreign-invested company is concerned, it is uncertain that the commerce authority and the foreign exchange authority will fine tune their current regulations to align with the Measures issued by the SAIC. For example, the foreign exchange authority only accepts the conversion of foreign debt extended to the foreign-invested company by its existing shareholder to the equity of the foreign-invested company. Under the Measures, the creditor is not necessarily an existing shareholder. It remains to be seen whether such discrepancies can be bridged.

Joe Chen, Frank Zhou and Yilin Huang, Jun He Law Offices, Shanghai and New York