Wednesday, September 8, 2010

Debt for Equity Swaps by FIEs in China

[The meat's a few paragraphs down under "In China" header. I just wanted to do the comparative law thing first.]

Given the prevailing gloomy economic climate in the developed world, and market volatility in the developing world, debt for equity swaps have received a lot of coverage over the past couple of years. Debt for equity swaps can be by contract or under a bankruptcy statute, and if in bankruptcy then they can be voluntary or involuntary. The possibility of debt for equity swaps can encourage creditors to lend to riskier borrowers, and involuntary debt for equity swaps in bankruptcy can theoretically help keep interest rates down by allowing creditors the opportunity to take control of, or at least a significant stake in a company if it is forced into bankruptcy.

The most famous debt for equity swap is GM's reorganization in bankruptcy. GM was nudged into filing for chapter 11 bankruptcy which allows for the restructuring of a company's debt-holder's interests into equity interests. And if the most senior creditor of a debtor corporation has at least a 33% or higher equity interest in that company following the chapter 11 reorganization, then the reorganization is tax free to the company, shareholders, and creditors. In GM's case, secured creditors received the requisite amount of equity to keep the reorganization tax free. Chapter 11 is a useful mechanism for a debt to equity swap because it allows for a corporation to receive a fresh start while giving the creditors a judicial forum to protect their interests.

In China
Cagman Palmer of Shanghai Nan Guang Law Firm recently wrote an interesting paper on debt for equity swaps in China, Debt-for-Equity Swap and Reorganisation Law in the People's Republic of China. As in the US, there are three types of situations where there might be a debt for equity swap: 1) contractual, out-of-court swaps; 2) voluntary reorganizations in bankruptcy; and 3) involuntary reorganizations in bankruptcy. Mr. Palmer explains each in extreme detail. I'd like to briefly summarize his description of contractual, out-of-court debt for equity swaps by foreign invested enterprises in China.

Contractual Debt for Equity Swaps by FIEs in China
The key component of these swaps is that 1) they must comply with any laws, regulations and administrative rules of the PRC, and 2) they must be registered and approved by the SAIC in Beijing, or the SAIC's "local or provincial counterpart at the debtor company's domicile." The swaps must be registered and approved because the swap increases a company's level of registered capital. And since this is Chinese law, you should be asking where is the catch-22? It is in enforcement.

Provisions on restructuring say that contractual debt for equity swaps will be recognized in civil disputes if 1) they are purely consensual, and 2) in compliance with compulsory laws and administrative rules. However, the Supreme Court of the PRC has also ruled that the recognition provisions only apply to domestic enterprises, and not to FIEs. This means that since the laws, regulations and administrative rules do not explicitly allow for debt to equity swaps in FIEs, the approving bodies may not approve them. In effect, an FIE debt to equity swap may not be forced because regulations may not cover them because they may not be able to be enforced. D'oh!

Enter Shanghai. Last year Shanghai introduced measures allowing for debt to equity swaps by FIEs, which should, as long as Shanghai is the domicile of the FIE debtor, make debt to equity swaps in FIEs enforceable in a civil dispute. The Shanghai Department of Commerce should approve a debt to equity swap if the following elements are satisfied:
  1. The swap is a conversion of a registered foreign shareholder loan into the registered capital of the same FIE;
  2. The registered capital of the FIE has been paid in full and on schedule;
  3. It has been unanimously approved by all shareholders;
  4. It meets the requirements of the State Administration of Foreign Exchange (SAFE);
  5. The swap agreement state the amount of debt to be canceled in exchange for equity;
  6. The proper documents proving that the debt meets SAFE requirements has been attached; and
  7. The change in registered and paid-in capital were processed at the same time.
I think the comparative aspects are interesting. And I'm sure we'll see a national expansion of these rules over time.

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