The Bankruptcy and Restructuring Group of Junhe LLP will release a series of articles concerning the investment of foreign investors in domestic restructuring enterprises, according to our practical experience in dealing with similar cases.
I. Current Situation of Non-Performing Assets and Investment therein
In recent years, China's economic development has been relatively slow in the context of a weak global economic recovery. The return on all kinds of investment projects decreased significantly, while the business of non-performing assets disposal has gradually gained increasing popularity among various funds.
The popularity of the investment in non-performing assets results not only from its high level of profitability, but to a great extent also results from the Chinese policy of Supply-Side Reform. Under the move to "Address Overcapacity and Deleveraging", enterprises with excessive production capacity accelerate the progress of entering into debt-restructuring or reorganization-by-bankruptcy procedures. Thus the capital demands of these restructuring enterprises and the investment needs of foreign capital neatly coincide.
In comparison with other forms of investment in non-performing assets, the investment in restructuring enterprises stands out with its advantages as follows: (a) the guarantee of judicial power and the relatively high possibility of successful restructuring; (b) well-rounded protection mechanism of the funds; (c) relatively low cost and high return on investment: specifically, the shareholders’ equity and the creditors’ compensation ratio will be adjusted in the restructuring process, so that investors can obtain high returns through low investment.
Moreover, the foreign capital investment in restructuring enterprises may also prove superior with respect to taxation. Although Chinese enterprise income tax of foreign- and domestic-funded companies has been unified, foreign-funded enterprises still win concessions in certain areas, projects, industries and other respects, and the Supreme People’s Court is actively promoting the establishment of tax concession mechanism for bankruptcy as well, to permit a tax deduction for the earnings of the restructuring enterprise from debt exemption and property disposal. It depends, of course, mainly on the attitude of local governments.
II. Investment Patterns for Foreign Investors
In accordance with different methods of investment, the patterns of foreign capital investment in restructuring enterprises divide themselves into three types: equity acquisition, re-investment of a foreign-invested entity, and cross-border loans.
1. Equity Acquisition
The pattern of equity acquisition happens when foreign investors purchase shares of the domestic restructuring enterprise, thus becoming the direct restructuring investors. In the restructuring process, the specific method of equity acquisition is as follows: the rights of original shareholders are adjusted and transferred to new foreign investors; meanwhile, these investors transmit funds to the restructuring enterprise in the name of raising share capital, so that the enterprise is able to pay off its debts and carry out other arrangements in the restructuring plan.
The process of equity acquisition mainly includes: (a) the investor signs a confidentiality agreement with the trustee of the restructuring enterprise and conducts due diligence; (b) the investor signs a letter of intent to invest in restructuring with the trustee and pays therefor; (c) the investor applies to the relevant commercial departments in terms of the equity acquisition for approval (restricted category) or registration (encouraged/permitted category); (d) the investor signs the agreement of investment in restructuring enterprise with the trustee; (e) the restructuring plan is to be voted in the creditors’ meeting; (f) the court approves of the restructuring plan; (g) the trustee transfers the company property and business affairs to the enterprise; (h) the enterprise carries out alteration of the business registration; (i) the investor raises the share capital of the restructuring enterprise in accordance with the restructuring plan; (j) foreign exchange registration shall be conducted.
The creditors are to be divided into different groups in the creditors’ meeting to vote on the draft of the restructuring plan. The court may also enforce its approval in certain circumstances, even though the draft does not go through the vote of several voting groups. In practice, the attitude of the court for this compulsory approval shall be taken into consideration.
In addition, equity acquisition by foreign investors is also subject to industry entry restrictions. The application to commercial departments for security review shall be filed, when the restructuring enterprise falls within the scope of those to be under security review by Mergers and Acquisition according to Chinese law.
2. Re-Investment of a Foreign-Invested Entity
The common method of investment by foreign investors is to set up a foreign-invested enterprise or a foreign-funded partnership (hereinafter collectively referred to as “Foreign-Invested Entity”) first, and then to invest in the territory of China through this foreign-invested entity.
(a) To set up a foreign-invested enterprise: the pre-approval of the enterprise name shall be obtained first; a declaration form of establishing a foreign-invested enterprise and other relevant documents are to be completed and submitted online through the comprehensive management system;1 after getting receipts of establishment registration, business registration, foreign exchange registration, tax registration and other procedures of establishing enterprises are to be completed.
(b) To set up a foreign-funded partnership: compared with foreign-invested enterprises, the establishment of a foreign-funded partnership is simple, flexible and efficient. Furthermore, the structure of a partnership enjoys the advantage of tax exemption on the principle of tax calculation after interest distribution for partnerships. This structure, however, requires ordinary partners to bear unlimited joint liability, which is a risk for investors. There are also some restrictions on setting up a foreign-funded partnership in terms of business areas.
The concrete methods of re-investment of the above mentioned Foreign-Invested Entity can be classified into two categories:
(a) Equity Acquisition by a Foreign-Invested Entity
The pattern of equity acquisition of a foreign-invested entity happens when foreign investors first set up a foreign-invested entity in China as previously mention, and then the very same entity purchases shares of restructuring enterprises. With respect to the specific process thereof, refer to the process of foreign investors’ direct equity acquisition as stated in II. 1..
Apart from that, re-investment of a foreign-invested enterprise is also under industry entry restrictions, and the follow-up investment procedures are also different in different fields of business. If the business scope of the restructuring enterprise belongs to the fields of the encouraged category or the permitted category, the restructuring enterprise shall submit to registration departments the documents listed in the Provisional Regulation on Investment of Foreign-Invested Enterprises (hereinafter referred to as “Provisional Regulation”) and those required by the government. In case the business scope thereof touches upon the fields of the restricted category, these foreign-invested enterprises shall obtain the approval of the provincial-level examination authority according to Provisional Regulation, and then apply to the original registration departments of the restructuring enterprise for registration alteration. Furthermore, these foreign-invested enterprises are also required to report their investment to their own registration departments accordingly.
(b) Assets Acquisition by a Foreign-Invested Entity
The pattern of assets acquisition of a foreign-invested entity happens when foreign investors set up a foreign-invested entity in China, which is the same as the pattern above. The difference, however, is that the foreign-invested entity purchases all or part of the assets of the restructuring enterprise, rather than its equity, and the restructuring enterprise uses the consideration, in other words, the income from the transferred assets, to pay its debts.
The disposal of assets in the insolvency proceedings shall normally be carried out by auction according to law, so the process of assets acquisition mainly includes: (1) the investor signs a confidentiality agreement with the trustee of the restructuring enterprise and conducts due diligence, or signs with the auction institution and pays the deposit; (2) the creditor’s meeting votes on and approves of the assets disposal plan; (3) the assets are to be auctioned; (4) the foreign-invested entity participates in the auction bidding; (5) the rights are to be transferred by virtue of the notification of the bid-winning from the auction institution.
If the auction of that restructuring enterprise’s assets has failed three times, the trustee shall sell these assets. In which case, the foreign-invested entity could directly sign an assets acquisition agreement with the trustee.
3. Cross-Border Loans
Cross-border loans refer to the pattern of foreign investors investing in a restructuring enterprise by means of providing loans directly thereto. The overall process includes: (a) the investor signs the loan agreement with the trustee of the restructuring enterprise; (b) the trustee reports to the creditors’ committee or the court; (c) the trustee applies for the external debts registration and open an external debts account with the form of external debts registration; (d) the parties perform the loan agreement.
With regard to the registration of external debts, China has abolished the previous review of external debts of the domestic enterprises according to the latest provisions of the central bank. The system of previous agreement registration also applies to cross-border financing of domestic enterprises, which is the same as foreign enterprises.2 If the restructuring enterprise borrows mid- and long-term international commercial loans, it will be regulated by the National Development and Reform Commission’s Notice on Promoting the Management and Reform of External Debts’ Registration System (hereinafter referred to as Notice No. 2044). It is required by the Notice No. 2044, that the enterprises with external debts shall have a relatively strong capability to repay its debts and other basic capacity. The question of whether restructuring enterprises meet the requirements, remains unanswered and there is no precedent in practice after the preliminary case retrieval. Thus the relevant supervising authorities’ attitudes shall be taken into consideration. Meanwhile, it remains uncertain according to Chinese law, whether the borrowed external loans can be used to discharge the bank debts of the enterprise, although at present Shanghai SAFE permits this.
III. Guarantee for Foreign Investors
The reason foreign investors invest in restructuring enterprises is not only the considerable return on investment, but also sufficient guarantee for their investment.
First of all, the restructuring process will guarantee the safety of investment funds. The investment agreement between the investor and the trustee of the restructuring enterprise is likely to stipulate the use of the funds clearly. Those funds shall be transferred into the specific account of the trustee, and the management and disposal thereof shall be under the supervision of the court as well, to prevent abuse of those investment funds. In the pattern of equity acquisition, the investor is likely to get control of the enterprise after the adjustment of shareholders’ rights and thus is able to supervise the investment funds on its own. In the pattern of cross-border loans, the debtor or the trustee may, in accordance with the bankruptcy law, set guarantee for the loans with the purpose of continuing business of the restructuring enterprise. Therefore, the investor can enjoy the priority right of compensation with regard to the collateral.
Secondly, the restructuring process will guarantee the efficiency of investment activity. The legal restructuring period is nine months at longest according to the bankruptcy law. That is to say, the trustee has to specify the central contents of the restructuring plan within nine months. That legal period of the restructuring process ensures the efficiency and predictability of the investment in restructuring enterprise.
IV. Exit of Foreign Investors
The main purpose of the foreign investors’ investment in restructuring enterprise is to make profits through the upvaluation of the enterprise. Therefore, the exit mechanism constitutes an important part of investors’ concern. At present, the exit mechanism includes IPO, equity transfer and liquidation.
IPO refers to the exit method that after the enterprise has been publicly listed, the foreign investor may sell its shares through the open-air transaction on the secondary market, bulk transaction or agreement after lock-up period.
Equity transfer means that foreign investors transfer their shares to a third party in accordance with law to exit.
Liquidation is the mechanism of exit by means of liquidation of the insolvent company. This is mainly the case, when the investment plan fails.
1. See Art.5, Provisional Regulation on Establishment and Registration Alteration of Foreign-invested Enterprises.
2. See The Notice of People’s Bank of China on Implementation of Prudential Macro-Management of Cross-Border Financing across the Country.