Debt for equity swap is not something new to many foreign investors as such swap is widely used as a way of corporate financial restructuring in the west. In China, such practice was once heavily employed in reforms for state-owned enterprises and however China Company Law does not recognize debt as a valid form of capital contribution for incorporating a company. Recently, we have seen local regulations in relation to debt for equity swap in Chongqing city and Zhejiang province with a view to relieving local companies’ financial strain resulting from the financial crisis but such local regulations applies to domestic companies only.

On November 12, 2009, Shanghai Industry and Commerce Bureau and Department of Commerce jointly issued the Interim Approval and Registration Measures on Debt to Equity Swap in respect of Foreign Invested Enterprises in Shanghai (the “Shanghai Regulation”), under which the debt for equity swap is extended to foreign invested enterprises incorporated in Shanghai. Interestingly, Shanghai government so far has not made the swap available to domestic enterprises.

1. Summary of Shanghai Regulation

Scope of Application. Debts denominated in foreign currencies incurred by a foreign invested enterprise can be swapped into equities or stock of the foreign invested enterprise provided however that such debts/loans are granted by the shareholder(s) of such foreign invested enterprise. In other words, other creditors like banks cannot convert their rights to debts into equity interests of the indebted foreign invested enterprise. Also it should be noted that debts under the swap mechanism shall take the form of foreign exchange excluding debts stemming from other transactions.

The debt for equity swap under Shanghai Regulation shall only apply where the foreign invested enterprise, having received in full all its registered capital subscribed by shareholders upon incorporation, increases its initial registered capital. Namely, shareholders can only convert their creditor’s rights to debts into the increased part of equity interests rather than any part of the initial equity interests.

Formalities to be effected. To carry out the debt for equity swap, the foreign invested enterprise shall enter into a swap agreement with its shareholder creditor. Then the foreign invested enterprise shall, after its corporate resolution at the shareholder meeting or board meeting, present required documents to Shanghai Foreign Investment Commission (an agency under Shanghai Department of Commerce) for approval of the swap and related corporate changes in its articles of association or corporate governance. After obtaining the aforesaid approval, the enterprise shall then register all corporate changes with the relevant industry and commerce bureau at its domicile.

2. Significance of Shanghai Regulation

Debt for equity swap is used as bailout method to boost financial conditions of companies that are hit by the financial crisis. Companies that are struggling to meet their debt obligations may resort to such swap to restructure its financial positions. Foreign shareholders may utilize the swap to strengthen its control over its invested enterprises.

Unlike debt for equity swap regulations applicable to domestic enterprises under which non-shareholder creditors may also swap their rights to debt into equity or stock, Shanghai Regulation’s limitation to shareholder creditor undercuts the significance of swap mechanism.

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