To cope with the economic slowdown resulting from international financial crises, and maintain a steady development of the economy, On January 14th, 2009, the State Administration of Industry and Commerce (the SAIC) announced the Administrative Measure for the Registration of Capital Contribution by Equity Stock (hereinafter refers to the Administrative Measure or the Measures) which has been in force since 1st March 2009.

Legal bases for the Administrative Measure

According to the Company Law of the PRC, investors may make capital contribution in cash, in kind, or intellectual property right, land use right or other non-monetary properties that can be assessed by currency through legal transferration. 
The Regulation for the Registration of Companies also provides that “where stockholders inject the capital that does not take the form of cash, tangible assets, IP rights, land use rights, and other properties, the SAIC and the relevant ministries under the State Council have the authority to prescribe the registration procedure.
The above legal authority specifies the legal rules for use of stock as capital contribution, and delegates the authority to SAIC to formulate the administrative measure for it. However, it does not expressly mention that equity interests are treated as one type of "non-monetary properties”. Besides, in practice, before promulgation of the Measures, making capital contribution by equity interests was not readily accepted by certain PRC government authorities due to lack of detail guidelines.

Application of the Measures

The Measures apply to investments in LLC or LBS ("Invested Company") by investors with equity interests in another LLC or LBS ("Equity Company") held by such investors.
 
Since the Measures do not expressly exclude FIE from being an Invested Company or Equity Company, the Measures apply to both pure PRC domestic companies and FIEs which are also LLC or LBS.

 Legal requirements of equity interests to be contributed
 According to the Measures, equity interests to be used as capital contribution shall satisfy the following criteria:
(1) Equity interest that is to be contributed must have clear title and be legally transferable.
(2) Non-paid up equity interests cannot be used as capital contribution.
(3) The aggregate equity and other non-monetary capital contributions made by all shareholders may not exceed 70% of the registered capital of the investee company;
(4) Actual contribution with equity interests must be made within one year of the incorporation of these companies.
(5) Equity interests must be appraised by a qualified valuation agency.

Besides, equity interests to be used as capital contribution shall not be subject to any of the following circumstances:
(1) The registered capital of the Equity Company has not been paid in full;
(2) The equity interests are subject to a pledge;
(3) The equity interests have been legally frozen;
(4) Transfer of the equity interests is prohibited by the articles of association of the Equity Company; 
(5) The requisite governmental approvals for transferring the equity interests as provided by applicable PRC laws, administrative regulations or decisions of the PRC State Council have not been obtained; or
(6) Transfer of equity interests does not comply with applicable PRC laws, administrative regulations or decisions of the PRC State Council.
Specific contribution process
(1) Make application to set up the Invested Company and register the name of investor using equity interests as contribution, the amount and mode of such contribution and the timing for making such contribution;
(2) Complete contribution of equity interests within one year after establishment of the Invested Company;
(3) Verify the contribution by a qualified capital verification institution and issue capital verification report;
(4) Apply to change registration of paid-up registered capital of the Invested Company to show that the registered capital has been paid by contribution of equity interests;
(5) Apply to change registration of the amount of paid-up registered capital and timing of such contribution etc. of the relevant investor if the Invested Company is a LLC.
If equity interest is used as contribution for increase of the registered capital of an Invested Company, the contribution shall be completed before the Invested Company applies to change its registration for increasing its paid-up registered capital.

Affects of the Measures

Stock equity is an important property right. It is the legal right for the stock contributor to participate in the major decision making of the Company to the extent of the equity brought in, to receive returns on investment and transfer of the equity interest in accordance with the law.
The provision of capital contribution by equity stock can firstly enhance the utilization of the assets as represented by the brought-in capital, increase the ways for using stock capital, reduce the transaction costs in equity transfer, and motivate investors. Secondly, it can facilitate the movement of capital to new market and industry sectors, optimization of industrial structures, mergers, acquisitions and economy of scale. Thirdly, it brings along more employment opportunity as a result of more investment, eases the social pressure arising from unemployment and achieves steady economic growth.
Equity contribution as a new form of capital contribution will help expand capital contribution channels and ease financial difficulties for enterprises.
Issues of Concern for Investors
Apart from the stimulating effect brought by the Measures on investments and corporate restructuring of PRC companies, the Measures also give rise to some issues that investors would need to pay attention to:

Shorter time period for contribution
According to the relevant PRC law, investors of a LLC may complete their capital contribution by installments within two years, except for the first installment which shall not be less than 15% or 20% of the registered capital of the LLC (depending on whether it is a FIE or a pure domestic company).  However, under the Measures, if capital contribution is made by transferring equity interests to the Invested Company, such contribution has to be completed within one year after the establishment of the Invested Company.
 
For increase of registered capital of a FIE, generally speaking, not less than 20% of the newly increased registered capital should be contributed when a FIE applies to register the increase of its registered capital with the local commission of SAIC, and the rest of the increased portion should be contributed within two years. However, under the Measures, the Invested Company cannot apply to increase its registered capital before the newly increased registered capital has been fully contributed.

Undertaking letter for contribution of equity interests
According to the Measures, those investors who would like to make capital contribution by equity interests have to provide the relevant government authority with an undertaking letter confirming that the equity interests to be contributed comply with all those requirements set out above.

Changing the nature of Invested Company and/or Equity Company
As both Invested Company and Equity Company can now be a FIE, a foreign investor may convert the Invested Company into a FIE if it becomes an investor with 25% or more equity interests of the Invested Company. By the same token, a FIE may also be converted into a pure domestic PRC company if all the equity interests of a FIE held by foreign investor(s) are transferred to an Invested Company.  In such circumstances, investors may need to consider the following issues:

- Whether the Sino-foreign shareholding proportion and the requirements for establishment of the Invested Company can still be complied with after it becomes a FIE;

- Since transfer of equity interests of FIE requires approval from competent government authority, investors may need to take into account the time period required for obtaining such approval;

- If an Equity Company ceases to be a FIE, it may lose the benefit of enjoying its preferential treatments (if any) as a FIE.

Conclusion

Despite the above limitations and extra requirements imposed on investors, the Measures will no doubt be welcomed by both domestic and foreign investors.  In a word, the Measures do not only help to ease the cash requirement for new investments and corporate restructuring exercise but also provide an alternative to obtaining financing in merger and acquisition transactions within China.