This article is part of a series by the Bankruptcy and Reorganization Group of Junhe LLP on the subject of investment by foreign investors in domestic reorganization enterprises, and is based on our experience in dealing with similar cases.
An Equity Acquisition Pattern occurs when foreign investors purchase shares in a domestic reorganization enterprise, thus becoming reorganization investors directly holding shares in the reorganization enterprise. During the reorganization process, the specific method of equity acquisition is as follows: the rights of original shareholders are adjusted and transferred to reorganization investors; meanwhile, these investors transmit funds to the reorganization enterprise in order to raise share capital so that the enterprise is able to pay off its debts and pursue other elements of the reorganization plan.
I. Key stages of an Equity Acquisition Plan
1. The investor signs the investment agreement of the reorganization enterprise with the administrator
According to the provisions of the Bankruptcy Law, in the take-over phase, during the period of reorganization, after taking over the reorganization enterprise the administrator shall be responsible for day-to-day business and disposal of property. Therefore, the investor should sign a contractual agreement to invest in the reorganization enterprise with the administrator responsible for the reorganization phase, in order to clarify and define the rights and obligations of both parties during the process of reorganization.
In practice, before the two parties sign the agreement of investment in the reorganization enterprise, there will be several preparatory stages, which will most likely include: (a) the investor receives the preliminary recruitment notice from the administrator and communicates with the administrator; (b) the investor becomes acquainted with the preliminary information about the reorganization enterprise received from the administrator and other parties; (c) the investor signs a confidentiality agreement with the administrator of the reorganization enterprise, pays the deposit and conducts due diligence on the reorganization enterprise; (d) the investor signs a letter of intent to invest in the reorganization enterprise with the administrator and pays therefor; (e) the administrator selects a shortlist of investors in the reorganization enterprise; (f) shortlisted investors submit their investment plans and other bidding materials; (g) shortlisted investors discuss and negotiate with the administrator to refine the investment plan; (h) the administrator evaluates all investment plans and selects the reorganization investor; (i) the administrator prepares a draft reorganization plan according to the contents of the investment plan and the draft is confirmed by investors; (j) the creditor and the investor vote on the draft reorganization plan; (k) the investor signs a formal agreement of investment in the reorganization enterprise with the administrator and implements the reorganization plan.
2. Approval or record-filing by commercial departments
July 30, 2017, the Ministry of Commerce announced the revised "Interim Administrative Measures for the Record-filing of the Incorporation and Change of Foreign-invested Enterprises" (hereinafter referred to as “Interim Measures”), which stipulates that where a non-foreign-invested enterprise changes into a foreign-invested enterprise due to acquisition, consolidation by merger or otherwise, which is subject to record-filing as stipulated in the Interim Measures, it shall complete the record-filing process in accordance with the Interim Measures,1 without further approval.
With regard to the scope of the record-filing, the Interim Measures stipulate that if the incorporation and change of a foreign-invested enterprise does not involve the implementation of special access administrative measures prescribed by the State, these Measures shall apply. If investors purchase a reorganization enterprise involved in a restricted category, it will require approval by the relevant commercial department; if investors purchase a reorganization enterprise involved in an encouraged or otherwise permitted category, it will be subject to record-filing. When foreign investors invest in a reorganization enterprise, they must first assess whether the industry of the reorganization enterprise is encouraged, permitted, restricted or prohibited, and, on that basis, determine whether the merger and acquisition process (M&A) will require approval or record-filing.
In practice, the relevant record-filing procedures can be completed by conducting newly established record-filing for an M&A (part of capital increase M&A) and by uploading the prescribed materials online after logging into the foreign investment comprehensive administration information system.
3. Industry entry restrictions and security review
(a) Industry entry restrictions
The entry restrictions on the industry of foreign investment are mainly governed by the regulations "Provisions for Guiding the Foreign Investment Direction" and "Catalogue for the Guidance of Foreign Investment in Industries". In addition, the "Provisions on the Merger and Acquisition of Domestic Enterprises by Foreign Investors" (hereinafter referred to as " Order No. 6") stipulates that equity M&A by foreign investors shall comply with the requirements stipulated by the laws, administrative regulations and rules of China, and policies concerning industry, land and environment.
According to the Catalogue on the Guidance for Foreign Investment in Industries, for an industry that is not allowed to be wholly operated by foreign investors, its M&A shall not result in foreign investors holding the enterprise's entire equity. For an industry that requires a Chinese party to have holdings or relative holdings, the Chinese party shall continue to maintain its holdings or relative holdings in the enterprise after the enterprise in that industry is merged and acquired. For an industry that is forbidden to be operated by foreign investors, the foreign investors shall not merge or acquire any enterprise in that industry.2
(b) Security review
In addition to industry entry restrictions, equity M&A by foreign investors may also involve a national security review, well-known trademark protection and other requirements. If the reorganization enterprise falls within the scope of the M&A security review3, as determined by the "Circular of the General Office of State Council on Establishing the Security Review System for Merger and Acquisition of Domestic Enterprises by Foreign Investors", the investors shall file an application for an M&A security review with the Ministry of Commerce. In addition, if the M&A results in the transfer of the actual rights of ownership of a domestic well-known trademark or a name with a long history, the person concerned shall submit a report thereof to the Ministry of Commerce4.
4. Vote by the creditors’ meeting
The rights and obligations of the parties in the reorganization process are mainly defined by the reorganization plan. The draft reorganization plan becomes effective when it has been passed by the creditors' meeting and approved by the Court.
According to the Bankruptcy Law, the People’s Court shall convene the creditors' meeting within 30 days of receiving the draft reorganization plan for the purpose of voting by dividing on the reorganization plan. Where more than half of the creditors present at the meeting within the same voting group agree with the draft reorganization plan and their claims amount to more than two-thirds of the sum of group claims, the draft reorganization plan shall be deemed as being adopted by this group.5 The reorganization plan is deemed as being adopted provided each voting group adopts the draft reorganization plan.
5. Approval by the court
According to the provisions of the Bankruptcy Law, the debtor or the Administrator shall petition the People’s Court to approve the reorganization plan within 10 days after the adoption of reorganization plan. The People’s Court shall rule to approve the reorganization plan and terminate the reorganization proceeding within 30 days since receiving the application and ascertaining that the plan meets the requirements stated in this law and make announcement accordingly.6
Where the draft reorganization plan fails to be adopted by some of the voting groups, the debtor or the administrator may negotiate with the voting group that does not adopt the draft reorganization plan. This voting group may vote again after negotiation. Where the draft reorganization plan fails to be adopted on the revote, the debtor or the administrator may petition the People’s Court for approval of the draft reorganization plan so long as the draft conforms with certain conditions.7 In accordance with judicial practice, courts at all levels tend to take a cautious approach to mandating draft reorganization plans, being wary to avoid conflicts with creditors, investors and employees.If the draft reorganization plan is adopted by all creditor groups, with the exception of the investor group, the court is more likely to mandate the draft reorganization plan since the original investors' rights have already been annulled. However, if the draft reorganization plan is not adopted by creditor groups, the court will be more inclined to increase the compensation ratio through further adjusting the investment plan, in order to gain greater support from creditors, rather than enforcing the original draft plan.
6. Implementation of the reorganization plan
According to the provisions of the Bankruptcy Law, the debtor shall implement the agreed reorganization plan. After the People’s Court has ruled to approve the reorganization plan, the administrator shall transfer the property and business to the debtor.8
According to the reorganization plan, the reorganization enterprise should first adjust the rights of shareholders, that is by adjusting the rights of original shareholders and transferring them free-of-charge to the new investors, thereby making the foreign investors shareholders in the reorganization enterprise. In addition, foreign investors shall transmit funds to the account of reorganization enterprise as share capital in accordance with the reorganization plan, and the enterprise shall pay off its debts as per the reorganization plan having received the capital injection funds.
7. Registration for business alteration
According to the provisions of Order No. 6, where a foreign investor merges and acquires equities, the merged or acquired domestic company shall apply to the original registration administration to modify its registration and to acquire a business license for foreign-invested enterprises.
The relevant procedures for alteration of the business registration shall be handled in accordance with the specific provisions stipulated by regional industry and commerce departments. According to the provisions stipulated by the Shanghai Administration for Industry and Commerce, alteration of registration for a change from a domestic to foreign-invested enterprise requires submission of the "foreign company registration (filing) application" and other materials. Specific materials and processes can be found on website of the Shanghai Administration for Industry and Commerce (http://www.sgs.gov.cn/shaic/).
8. Foreign exchange registration and foreign exchange purchase
According to “the Administrative Provisions on Foreign Exchange in Domestic Direct Investment by Foreign Investors”, domestic direct investment by foreign investors is administered by registration, and banks shall handle businesses related to domestic direct investment in accordance with information registered with foreign exchange bureaus.9 In practice, the authority for foreign exchange registration has been delegated to banks, and investors can contact their deposit bank to handle any relevant issues.
If the foreign party is responsible for paying the cost of equity transfer or capital injection, the registration procedures for foreign exchange receipts of equity transfer only require completion of capital entry record-filing for the converting-assets-into-cash account, after which the State Administration of Foreign Exchange will automatically complete the capital verification registration through its business system relating to foreign investors' acquiring Chinese investors' equity interests. If the foreign party covers the costs of equity transfer or capital injection in the form of a non-spot exchange (such as cross-border RMB, lawful RMB income, physical goods and/or intangible assets), the foreign-invested enterprises undertaking the equity transfer shall apply to the administration of foreign exchange in order to complete the confirmation and registration of the capital contributions made by foreign investors to acquire the equity of the Chinese party.
9. Registration for taxation alteration
Along with the "Five-in-One" registration system reform, if a reorganization enterprise changes from domestic to foreign-invested ownership, its registration for taxation alteration will be undertaken by the industry and commerce departments, and taxation departments will only be responsible for maintaining information.
Due to the varying rates of progress in the introduction of these reforms, there are differences in the specific provisions by region. Practical experience indicates that where there are changes to a taxpayer’s ‘one code for one license’ industrial and commercial registration information (excluding changes relating to business premises, person in charge of finance and accounting policies), the enterprise shall apply for the amended registration with the industrial and commercial departments. Having received approval from the industrial and commercial departments, the amended information will be immediately shared to the data exchange platform. Having received the taxpayer’s in-person or online application, the taxation authorities shall update the taxpayer's respective information in the taxation system according to the amended information provided by the industrial and commercial department and the taxpayer.
It should be noted that the "Five-in-One" registration system reform is still in a period of transition. If the reorganization enterprise is not subject to the "Five(three)-in-One" registration system, its registration for taxation alteration should still be in accordance with the provision of “the Administrative Measures for Tax Registration”, under which the enterprise shall first apply for an amended registration with the industrial and commercial departments. Following that, the amended registration with the industry and commerce departments should be undertaken within 30 days.
II. Guarantee of Equity Acquisition Pattern
1. Guaranteeing the safety of investment funds
Firstly, the reorganization investment agreement between the investor and the administrator of the reorganization enterprise is likely to stipulate a clear plan for the use of the funds. The reorganization plan and the agreement of investment in reorganization enterprises will likely stipulate that the total price paid by investors should be used for paying off debts, for the payment of expenses for bankruptcy proceedings and debts of common benefits, and that any remaining funds be used as the working capital required for ongoing production and operation and/or for the purchase of high quality assets.
Second, in general, those funds paid by the investor for paying off creditors shall be transferred into the specified account of the administrator, and the settlement of creditors by the administrator shall be made under the supervision of the court as well, in order to prevent misappropriation of those investment funds.
Finally, as is generally the case for equity acquisition, once investors’ rights have been adjusted, the new investor is likely to have control of the enterprise through ownership of the shares and capitalization of capital reserve, and thus will be able to supervise the use of investment funds.
2. Guaranteeing the efficiency of investment activity
According to the Bankruptcy Law, the debtor or the administrator shall submit the reorganization plan to the People’s Court and to a creditors’ meeting within 6 months of the People’s Court making the ruling to reorganize. The People’s Court may rule to extend by a further 3 months upon the expiration of the initial 6 months prescribed in preceding paragraph on the basis of a request made by the debtor or the Administrator.10
Thus, the longest period that a legal reorganization can take is nine months. In summary, the administrator is required to specify the key components of a reorganization plan within nine months. Having a legal period within which the reorganization must occur ensures a predictable and efficient process for investment in reorganization enterprises.
1. See Article 5 Section 2, Interim Administrative Measures for the Record-filing of the Incorporation and Change of Foreign-invested Enterprises.
2. See Article 4, Provisions on the Merger and Acquisition of Domestic Enterprises by Foreign Investors.
3. "Circular of the General Office of State Council on Establishing the Security Review System for Merger and Acquisition of Domestic Enterprises by Foreign Investors" stipulates that the scope of M&A Security Review is as follows: foreign investors' M&A of domestic military industry enterprises and military industry support enterprises, enterprises around key and sensitive military facilities, and other units which have impact on national defense security; and foreign investors' M&A of domestic enterprises, which have impact on the national security , in fields of important agricultural products, important energy and resources, important infrastructure, important transport service, key technology and major equipment manufacturing, etc and such M&A may result in foreign investors' acquirement of actual control over the enterprises.
4. See Article 12, Provisions on the Merger and Acquisition of Domestic Enterprises by Foreign Investors.
5. See Article 12, Provisions on the Merger and Acquisition of Domestic Enterprises by Foreign Investors.
6. See Article 86, Section 2, Enterprise Bankruptcy Law of the People's Republic of China
7. See Article 87, Section 1 and Section 2, Enterprise Bankruptcy Law of the People's Republic of China.
8. See Article 89, Enterprise Bankruptcy Law of the People's Republic of China.
9. See Article 3, the Administrative Provisions on Foreign Exchange in Domestic Direct Investment by Foreign Investors.
10. See Article 79, Enterprise Bankruptcy Law of the People's Republic of China.