Examining market-oriented debt-for-equity swaps

The State Council issued the Opinions on Actively and Steadily Reducing the Leverage Ratio of Enterprises on 10 October, which put forward seven main ways to reduce the leverage ratio of enterprises, including actively promoting corporate mergers and acquisitions, implementing market-oriented debt-for-equity swaps for banks in an orderly manner, etc. The State Council simultaneously issued the Guiding Opinions on Market-oriented Debt-for-Equity Swaps for Banks to further clarify the mode of implementation for debt-for-equity swaps, which marked the official launch of a new round of swaps.

THE LEGAL BASIS

Debt and equity are the two major ways of obtaining the external funds to realize the financing for enterprises. The two ways are complementary to each other as there are significant differences in their financing risk, financing cost, influence on corporate governance, etc. Enterprises may select either of the above financing methods or both, based on their development and specific circumstances.

Respecting the freedom of contract is the basic principle of civil and commercial laws. The debt and equity can be swapped for each other as long as it is the free will of the parties to the transaction and meets the constituent elements of the equity or debt, and does not violate the provisions of mandatory laws and regulations.

In the case of debt-for-equity swaps, there are two legal consequences: the debtor-creditor relationship ends and an equity relationship forms, coherent in time; as far as the same investment is concerned, the above two legal relationships do not exist at the same time and are not interrupted either. Therefore, from the legal point of view, there are no legal obstacles in debt-for-equity swaps. Provisions of the Supreme People’s Court on Several Issues concerning the Trial of Civil Disputes Relating to Enterprise Restructuring (2003) further confirmed the effectiveness of the debt-for-equity swap agreement voluntarily concluded by the creditor and the debtor. However, in practice, the provisions of the local administration for industry and commerce should be complied with to complete the registration of the new equity. Meanwhile, moving bank assets out of the balance sheet should also comply with relevant regulatory requirements of China Banking Regulatory Commission.

ASSET MANAGEMENT PARTIES

Debt-for-equity swaps refer to the creditor cancelling some or all of its legitimate debt in exchange for equity in its debtor in accordance with the laws and thus becomes a shareholder of its debtor. Through the implementation of debt-for-equity swaps, enterprises may reduce their debt, ease the short-term capital pressure, and reduce the risk of bankruptcy, thus better ensuring the recovery of previous debt. Meanwhile, as the shareholders, creditors will have the chance to get dividends from the long-term development of the enterprises. The new round of debt-for-equity swaps take marketization and legalization as the core principles, and the proposed debt for equity swap, the price, the targeted enterprises and financing etc., should be determined by the marketers themselves through negotiation. Relevant market players will make decisions themselves and assume sole responsibilities for their own profits and losses, which will greatly stimulate the initiative of the parties involved and bring valuable development opportunities to enterprises of good prospects, industrial trend and sound credit status that encounter cyclical difficulties and high debt.

The guiding opinions clarify the “swap-after-sale” mode for debt-for-equity swaps based on past experience. The banks transfer the debt to asset management companies, insurance asset management institutions, state-owned capital operating companies and other enforcement bodies first, rather than directly exchanging debt for equity, and the enforcement bodies will exchange the debt for equity and get involved in the management of the company and exercise their rights as shareholders.

China has formally entered the era of pan-asset management after years of development. As of the end of 2015, the total assets managed by various asset management institutions reached about RMB93 trillion (US$13.5 trillion). As the enforcement bodies have strong fund-raising capacity and rich asset management experience, they are able to offer value-added services to enterprises in terms of specialized operation, capital operation, business resources, etc., after becoming the shareholders, which will improve corporate governance and standardization. So the current market-oriented debt-for-equity swaps aim to reduce corporate debt in the short term and promote the long-term healthy development of enterprises with the help of professional investment management institutions by using the concept of pan-asset management.

FURTHER OPTIMIZATION

The introduction of the guiding opinions offers policy guidance for the implementation of current debt-for-equity swaps. However, more detailed supporting measures and implementation regulations need to be introduced by the government during the implementation of market-oriented debt-for-equity swaps.

The State Administration for Industry and Commerce (SAIC) promulgated Administrative Measures for the Debt-for-Equity Swap Registration of Companies in 2011, and clarified the registration issues during the implementation of the debt-for-equity swaps by enterprises, which ended the awkward situation of “no law can be employed” during business registration of debt-for-equity swaps. However, the administrative measures became invalid on 1 March 2014, and the Administrative Provisions on the Registration of Companies’ Registered Capital, promulgated by the SAIC on 20 February 2014, limited the object of debt-for-equity swaps to the debt of “companies incorporated within the territory of China”, and excluded state-owned enterprises and other non-corporate legal person. Moreover, the administrative provisions did not specify the specific procedures, capital contribution, registration and other practical operation problems of debt-for-equity swaps. Therefore, to truly promote the implementation of debt-for-equity swaps, administrations for industry and commerce need to introduce standardized operating guidelines based on the characteristics of current market-oriented debt-for-equity swaps. Meanwhile, the financial sectors and tax authorities need to further clarify the fiscal and taxation policies during the process of debt-for-equity swaps, thus safeguarding the upcoming debt-for-equity swaps.

Jiang Fengtao is the managing partner and Liu Bing is a partner at Hengdu Law Firm