Issuing Body: State Administration for Industry and Commerce
Issuing Date: November 23, 2011
Effective Date: January 1, 2012

With many small and medium-sized Chinese companies strapped for cash and unable to get bank financing as a result of tight monetary policies, local governments in Shanghai, Zhejiang, Chongqing and other locales have over the past few years adopted legislation designed to ease pressure on companies by enabling them to convert debt into equity, with a corresponding increase in the company's registered capital. In November 2011, the State Administration for Industry and Commerce (SAIC) followed suit, releasing the Measures for Administration of the Registration of Debt-for-Equity Swaps of Companies (Debt-for-Equity Measures). The new rules went into effect on January 1, 2012.

As capitalization is typically a key indicator reviewed by banks when they review commercial loan applications, the Debt-for-Equity Measures may also help companies indirectly by making them seem more creditworthy.

Application of the Debt-for-Equity Measures

Under previously existing debt-for-equity rules, local governments had instituted very different systems of regulating such swaps. In Shanghai and Chongqing, for example, debt-for-equity rules had focused solely on foreign-invested enterprises (FIEs), allowing—and regulating—the swap of foreign debts for equity (intercompany loans between FIEs and shareholders). In contrast, other local governments, such as those of Zhejiang and Hubei, enacted rules that applied to purely domestic companies. All of those local measures were enacted during the past four years, and had been promulgated on a trial basis. As a result, a limited number of enterprises have been able to successfully restructure their debts.

One major impact of the Debt-for-Equity Measures is they establish nationwide rules that apply to all companies established in China, including FIEs and purely domestic companies.

Definition of Debt-for-Equity Swaps

Article Two of the Debt-for-Equity Measures defines debt-for-equity swaps as transactions in which a creditor agrees to convert a lawful claim against a company established within China into equity of that company, thereby increasing the company's registered capital.

The Debt-for-Equity Measures specify three circumstances under which a debt-for-equity swap may occur:

1. A company owes money to the creditor as a result of a contract, and the creditor has performed all contractual obligations related to this debt.
   
   
2. The debt has been confirmed by an effective judgment of a court in China.
   
   
3. The debt has been listed in a company's court-approved reorganization plan or court-accepted reconciliation agreement.

In addition to limiting debt-for-equity swaps to the above three scenarios, the Debt-for-Equity Measures impose several other key limitations. First, only a creditor's rights against a company may be swapped for the equities of this company, meaning that a capital contribution cannot be exchanged for creditor's right against a third party. Second, debt may only be converted to an increase in registered capital of an existing company, meaning a debt-for-equity swap cannot be used as a capital contribution while a new company is being established.

Evaluation and Verification of Debt

Article Seven of the Debt-for-Equity Measures requires the evaluation of a debt by a qualified Chinese asset appraisal agency before that debt may be swapped for equity. In addition, the amount of the capital contribution should not be higher than the appraised debt amount, which accords with current Chinese rules on non-monetary capital contributions to companies. The Debt-for-Equity Measures likewise reiterates existing caps on the ratio of non-monetary investment, limiting  the total amount of debt that may  be contributed for equity and other non-monetary contributions to a maximum of  70 percent of the company's registered capital.

When an agreement for a debt-for-equity swap has been completed, the company should engage a local accounting firm to verify the amount of contributed debt and ensure the authenticity of the capital increase. The accounting firm makes the verification in  a capital verification certificate, which is required to be submitted when the company applies to its local registration authority (local AIC for domestic companies, local commerce authorities  for FIEs) to modify its registered capital amount.

Required Documentation

Any creditor and company applying for a debt-for-equity swap should enter into a specific agreement concerning the swap. In addition, the parties should provide documents showing that the underlying debt qualifies for a swap in accordance with one of the three circumstances described above. If there is an existing court judgment, court-approved reorganization plan or court-accepted reconciliation agreement, the relevant  documents should be submitted to the local AIC. For debts that arise out of a contractual obligation, where no court or other third party is involved, the creditor and the company should enter into a separate letter of undertaking that details the debt-for-equity swap, with a commitment to comply fully with the Debt-for-Equity Measures.

Conclusion

The intent of the Debt-for-Equity Measures is to help companies reduce their debt burden and enhance their capitalization. The new rules appear to be workable  for purely domestic companies. In the case of  FIEs, however, the resulting capital increase will require the approval of local commerce authorities. Since the Ministry of Commerce is not an issuing body of the measures, it remains to be seen how local commerce authorities (which are the local counterparts of the Ministry of Commerce) will deal with this approval requirement .

Another issue that remains unclear is whether an FIE's foreign debt is covered by  the Debt-for-Equity Measures—e.g., whether money borrowed by an FIE from a foreign shareholder will be regarded as contractual debt eligible for a swap, as mentioned in the first circumstance above. Even if it is covered, it should be noted that since China's State Administration of Foreign Exchange is not an issuing body of the measures, swaps of foreign debt for capital increases may still be difficult to execute when the measures  take effect.

Finally, we note that since  the SAIC is regulating debt-for-equity swaps for the first time, local registration authorities (local counterparts of the SAIC) may find it difficult to prevent fraudulent  debt swaps. We understand that the SAIC is working on implementing rules to fill in gaps in the Debt-for-Equity Measures and better regulate debt-for-equity swaps, and we expect that there will  be provisions regarding coordination with authorities in other government agencies.