Introduction: The meaning of ‘Equity in Name, Debt in Substance’: As the name suggests, ‘Equity in Name, Debt in Substance’ refers to the practice where real estate companies in need of financing achieve their debt financing goals through the transfer of equity.
‘Equity in Name, Debt in Substance’ appears to be equity on the surface, but is essentially debt. It superficially represents equity investment, but in reality, it is a form of debt investment.
‘Equity in Name, Debt in Substance’ serves as a debt financing tool rather than an equity financing tool. It differs from pure equity or debt investments in that it invests in the target company through equity but obtains fixed returns through mechanisms such as buybacks (full principal buyback or interest buyback), third-party acquisitions, betting agreements, and regular dividends. Essentially, it embodies a rigid repayment characteristic, representing a specific manifestation of capital preservation and guaranteed returns. The essence of ‘Equity in Name, Debt in Substance’ is borrowing, where investors expect to recover their principal and receive fixed interest.
1. Different industry professionals categorize the identification standards of ‘Equity in Name, Debt in Substance’ into two main types based on judicial practice.
First Type: Five Standards
① There are interest-bearing characteristics; after receiving investment, the invested company must pay interest periodically at the rate specified in the investment contract or agreement.
② There are principal repayment characteristics; there is a clear investment term or specific investment conditions, and upon the expiration of the investment period or fulfillment of specific investment conditions, the invested company must redeem the investment or repay the principal.
③ The investing company does not own the net assets of the invested company.
④ The investing company does not have voting rights or the right to be elected.
⑤ The investing company does not participate in the daily production and operation activities of the invested company.
Second Type: Seven Standards
Through the analysis of Supreme Court cases and our experience in handling related cases, these standards include but are not limited to:
|
Serial Number |
Standard |
|
1 |
Whether the investor actually participates in the management of the target company or bears its operational risks |
|
2 |
Whether the returns obtained by the investor are linked to the company’s performance or if a fixed premium is agreed upon above the investment amount |
|
3 |
Whether the investor exits upon the investment’s maturity or exits after meeting certain conditions |
|
4 |
Whether the investment consideration aligns with the market value of the rights transferred to the investor |
|
5 |
Whether the changes in equity have been registered with the industrial and commercial authorities, company bylaws, and shareholder registers |
|
6 |
Whether the investment return rate is close to the borrowing interest rate |
|
7 |
Whether the parties have indicated their legal relationship as a lending relationship through signing a ‘Debt Confirmation Agreement’ or other means |
2. Compilation of Laws and Regulations from a Regulatory Perspective
1Judicial Interpretations:
The ‘Supreme People’s Court’s Provisions on Several Issues Concerning the Application of Law in the Trial of Private Lending Cases’ involves the investment behavior of ‘Equity in Name, Debt in Substance’, which is a typical case affected by the new regulations beyond the literal interpretation.
The ‘New Judicial Interpretation of Private Lending’ or ‘New Regulations’ clearly defines the scope of adjustment of this judicial interpretation in its first article: ‘The private lending referred to in this provision is the act of capital financing between natural persons, legal persons, and unincorporated organizations. Disputes arising from loans and related financial businesses by financial institutions and their branches approved by financial regulatory authorities are not subject to this provision.’ This means that the scope of adjustment of the new judicial interpretation of private lending is limited to certain capital financing behaviors, and non-capital financing behaviors should theoretically not be affected. However, the actual impact of this judicial interpretation extends far beyond the literal provisions of the first article, as investment behaviors involving the qualitative dispute of ‘Equity in Name, Debt in Substance’ are typical cases affected by the new regulations.
2Regulations on Fund Investments:
The Asset Management Association of China (hereinafter referred to as ‘AMAC’) issued the ‘Regulations on the Filing Management of Private Asset Management Plans by Securities and Futures Operating Institutions No. 4’ on February 13, 2017, which stipulates that securities and futures operating institutions establishing private asset management plans to invest in ordinary residential real estate projects in cities with rapidly rising real estate prices, if they engage in ‘acquiring equity of real estate development companies in the form of Equity in Name, Debt in Substance’, will not be filed. Subsequently, AMAC further clarified in the ‘Private Investment Fund Filing Guidelines (2019 Edition)’ that private investment funds should not be lending activities, and private funds with ‘Equity in Name, Debt in Substance’ situations do not conform to the essence of ‘fund’ fundraising and investment activities, and are not within the scope of private investment fund filing.
3Regulations under Company Law:
The non-compliance situation lies in the clear restrictions of the ‘Company Law’ on the company’s own repurchase of equity; only companies that meet certain conditions can repurchase equity. The design of the Company Law in this way is to prevent companies from manipulating stock prices for personal gain and to protect creditors’ interests from the reduction of company assets. If a company repurchases in situations that do not comply with the Company Law, it is clearly illegal. Even if it meets the conditions for repurchase under the Company Law, if it does not follow internal resolution procedures and external notification procedures for creditors, it will also be non-compliant due to procedural illegality or damage to creditors’ interests.
The restrictions on company repurchases in the ‘Company Law’ do not mean that companies cannot repurchase; it merely sets conditions and procedures for repurchase, which can be done if the corresponding conditions are met. However, considering the high risk costs of company repurchases, the general practice is to consider stipulating in the agreement that the actual controller of the invested company, other shareholders, or related parties will repurchase or transfer the equity originally purchased by investors at an excessive interest rate upon the achievement or non-achievement of certain conditions.
4From the Perspective of the Ministry of Finance and the National Development and Reform Commission:
The ‘Interim Measures for the Management of Government Investment Funds’ (Cai Yu [2015] No. 210) requires the government to ‘not promise other investors that the investment principal will not suffer losses, nor promise minimum returns’;
The ‘Notice on Further Jointly Doing a Good Job in Government and Social Capital Cooperation (PPP)’ (Cai Jin [2016] No. 32) clearly states ‘to resolutely eliminate all forms of irrational guarantees or commitments, excessive subsidies or pricing, and to avoid disguised financing through fixed return commitments, Equity in Name, Debt in Substance, etc.’; the ‘Interim Measures for the Management of Government Contributed Industrial Investment Funds’ (Fa Gai Cai Jin Gui [2016] No. 2800) clearly states that government-contributed industrial investment funds must not engage in ‘Equity in Name, Debt in Substance and other disguised behaviors that increase government debt.’
Specific Regulations Overview:
① The ‘Interim Measures for the Management of Government Contributed Industrial Investment Funds’ (Fa Gai Cai Jin Gui [2016] No. 2800) clearly states that government-contributed industrial investment funds must not engage in ‘Equity in Name, Debt in Substance and other disguised behaviors that increase government debt.’
② The ‘Interim Measures for the Supervision of Local Government Debt by Financial Supervisors’ (Cai Yu [2016] No. 175) in Chapter 3 on the supervision of local government and financing platform company financing behaviors requires supervisors to oversee local government financing behaviors, mainly including: (1) Except for issuing local government bonds and external debt transfers, local governments and their affiliated departments must not incur debts in any way, nor provide guarantees for the debts of any units and individuals in any way; (2) When local governments and their affiliated departments participate in social capital cooperation projects, as well as establish venture capital guidance funds, industrial investment guidance funds, and other types of funds, they must not promise to repurchase the investment principal of other investors, bear the losses of other investors’ investment principal, or promise minimum returns to other investors;
③ The ‘Interim Measures for the Financial Management of Government and Social Capital Cooperation Projects’ (Cai Jin [2016] No. 92) requires: ‘All levels of financial departments should work with industry authorities to strengthen the supervision and management of PPP projects, effectively ensure project operation quality, and strictly prohibit incurring government debt under the guise of PPP projects. Financial departments should work with relevant departments to strengthen project compliance review, ensure that projects belong to the public service sector, and fulfill relevant preliminary verification and review procedures according to laws and regulations and related provisions. Project implementation must not adopt the build-transfer method. When the government and social capital jointly establish project companies, they should operate in accordance with the provisions of the ‘Company Law’ and the agreements of the PPP project contract, and must not agree in the shareholder agreement to have government shareholders or other institutions designated by the government repurchase the equity of social capital shareholders.’
④ The ‘Notice on Further Promoting Government and Social Capital Cooperation Models in the Cultural Sector’ (Wen Lyu [2018] No. 96) requires: ‘All levels of cultural and financial departments must fully recognize the connotation and essence of the PPP model, standardize project value-for-money evaluations and financial affordability demonstrations, strictly review the entry into the database, and strictly prohibit projects that exceed financial affordability.’ It is strictly prohibited to illegally and irregularly incur debts through PPP projects, and to engage in disguised financing through repurchase arrangements, minimum return commitments, fixed returns, and other forms of ‘Equity in Name, Debt in Substance’, firmly maintaining the bottom line of preventing regional systemic financial risks.
⑤ The ‘Notice on Further Jointly Doing a Good Job in Government and Social Capital Cooperation Project Demonstration Work’ (Cai Jin [2015] No. 57) requires: ‘To leverage the advantages of government centralized procurement to reduce costs, determine reasonable charging standards, and select a number of capable professional intermediary institutions through the government procurement platform to provide technical support for demonstration project implementation. It is strictly prohibited to engage in disguised financing through minimum return commitments, repurchase arrangements, ‘Equity in Name, Debt in Substance’, etc., packaging projects as PPP projects.’
⑥ The ‘Notice from the China Banking and Insurance Regulatory Commission on Carrying Out Work to Consolidate the Achievements of Governance and Promote Compliance Construction’ (Yin Bao Jian Fa [2019] No. 23)
Prohibits direct financing for real estate development projects with incomplete ‘four certificates’, developers or their controlling shareholders not meeting standards, or insufficient capital contributions, or providing financing directly or indirectly for real estate companies to pay land transfer fees, or providing financing directly or indirectly for real estate companies to issue working capital loans;
5. Other Laws, Regulations, and Judicial Interpretations
① ‘Minutes of the National Court Civil and Commercial Trial Work Conference (Draft for Public Consultation by the Second Civil Division of the Supreme People’s Court)’
In trust disputes involving transaction management, the effectiveness of financing activities conducted and participated in by trust companies, such as multi-layer nesting, channel businesses, and repurchase commitments, should be determined based on the actual legal relationships constituted, and the rights and obligations of all parties should be determined accordingly.
[Nature of Repurchase Business] After the establishment of a capital trust, the trust company uses the raised trust funds to acquire equity, stocks, bonds, notes, debts, real estate, construction projects, and other specific assets or specific asset income rights, which are to be repurchased by the transferor or a designated third party at a fixed price including the transaction principal plus a premium after a certain period, which constitutes the trust company’s behavior of utilizing funds raised in accordance with the law. Disputes arising from this should not be recognized as business trust disputes but should be recognized as financial loan contract disputes between the trust company and the transferor.
② ‘Notice from the China Banking Regulatory Commission on Issues Related to Project Financing Business by Trust Companies Involving Project Capital’ (Yin Jian Fa [2009] No. 84)
Trust companies must not use the funds from debt collective trust plans to supplement project capital to meet the minimum project capital requirements set by the state. The aforementioned debt collective trust plan funds include trust funds utilized in ways that involve equity investments with repurchase commitments (including situations where investments are transferred to related parties or other third parties).
③ ‘Regulations on the Filing Management of Private Asset Management Plans by Securities and Futures Operating Institutions No. 4 (February 14, 2017)’
1. Securities and futures operating institutions establishing private asset management plans to invest in ordinary residential real estate projects in cities with rapidly rising real estate prices will not be filed, including but not limited to the following methods: (4) acquiring equity of real estate development companies in the form of ‘Equity in Name, Debt in Substance’; the term ‘Equity in Name, Debt in Substance’ refers to an investment method where the investment return is not linked to the operating performance of the invested company, and is not distributed based on the company’s investment profits or losses, but provides investors with capital preservation and guaranteed returns, paying fixed returns to investors periodically according to the agreement, and redeeming equity or repaying principal and interest under specific conditions.
④ ‘Private Investment Fund Filing Guidelines (January 12, 2018)’
Private fund investments should not be lending activities. The following activities that do not conform to the essence of ‘investment’ do not fall within the scope of private funds: … 2. Engaging directly or indirectly in lending activities through entrusted loans, trust loans, etc.; 3. Engaging in disguised forms of the above activities through special purpose vehicles, investment enterprises, etc.
⑤ ‘Notice from the China Insurance Regulatory Commission on Matters Related to Establishing Equity Investment Plans with Insurance Funds’ (Bao Jian Zi Jin [2017] No. 282)
The investment returns obtained from equity investment plans should be linked to the operating performance of the invested unlisted companies or the investment returns of private equity investment funds, and must not promise to guarantee principal and investment returns in the following ways: (1) Setting clear expected returns and paying fixed investment returns to investors periodically; (2) Agreeing to redeem the investment principal by the invested company or related third parties at maturity; (3) Other situations recognized by the China Insurance Regulatory Commission.
⑥ ‘Notice from the State Council on the Implementation Plan for Special Rectification of Internet Financial Risks’ (Guo Ban Fa [2016] No. 21)
Equity crowdfunding platforms must not publish false targets, must not self-finance, must not engage in ‘Equity in Name, Debt in Substance’ or disguised fundraising, and must strengthen the information disclosure obligations of fundraisers and the protection of shareholder rights, and must not make false statements or misleading promotions.
⑦ ‘Guiding Opinions from the Ministry of Culture and Tourism and the Ministry of Finance on Promoting Government and Social Capital Cooperation Models in the Cultural Sector’ (Wen Lyu [2018] No. 96)
All levels of cultural and financial departments must fully recognize the connotation and essence of the PPP model, standardize project value-for-money evaluations and financial affordability demonstrations, strictly review the entry into the database, and strictly prohibit projects that exceed financial affordability. It is strictly prohibited to illegally and irregularly incur debts through PPP projects, and to engage in disguised financing through repurchase arrangements, minimum return commitments, fixed returns, and other forms of ‘Equity in Name, Debt in Substance’, firmly maintaining the bottom line of preventing regional systemic financial risks.
⑧ ‘Notice from the Supreme People’s Court on Issuing Answers to Several Issues Concerning the Trial of Joint Venture Contract Disputes’ (Fa [Jing] Fa [1990] No. 27)
When a corporate legal person or institutional legal person invests as one party in a joint venture but does not participate in joint operations and does not bear joint venture risk responsibilities, regardless of profit or loss, they receive fixed returns on principal and interest or fixed profits, this is clearly a joint venture in name but a loan in substance, violating relevant financial regulations, and the contract should be declared invalid. In addition to the return of principal, any interest obtained or agreed to be obtained by the investing party should be confiscated, and the other party should be fined an amount equivalent to bank interest.
⑨ ‘Notice from the Ministry of Finance on Regulating Financial Enterprises’ Financing Behaviors Towards Local Governments and State-Owned Enterprises’ (Cai Jin [2018] No. 23)
State-owned financial enterprises providing financing to state-owned enterprises (including local government financing platform companies) participating in local construction or PPP projects must strengthen capital source reviews according to the ‘penetration principle’, ensuring that the capital sources of financing entities are legal and compliant, and that financing projects meet the prescribed capital ratio requirements. If issues are found involving ‘Equity in Name, Debt in Substance’, shareholder loans, debt funds, and irregular contributions or contributions that do not meet standards, state-owned financial enterprises must not provide financing to them.
⑩ ‘Notice from the National Development and Reform Commission on Issuing the Interim Measures for the Management of Government Contributed Industrial Investment Funds’ (Fa Gai Cai Jin Gui [2016] No. 2800) states that the investment amount of government-contributed industrial investment funds in a single enterprise must not exceed 20% of the total fund assets, and must not engage in the following businesses: (1) ‘Equity in Name, Debt in Substance’ and other disguised behaviors that increase government debt;
11‘Notice from the People’s Government Office of Shibei District, Qingdao on Issuing the Interim Measures for Debt Management of State-Owned Enterprises in Shibei District’ (Qing Bei Zheng Ban Fa [2018] No. 60)
State-owned enterprises in Shibei District are prohibited from financing through ‘Equity in Name, Debt in Substance’, and must not agree to fixed returns, fixed terms, repurchase, and guarantee clauses in transaction terms, nor assume risks that should be borne by other shareholders through introducing ‘Equity in Name, Debt in Substance’ type equity funds or purchasing subordinate shares.
Source: Strengthening Lawyers. For infringement, please contact for deletion. This platform maintains neutrality regarding the content, statements, and opinions shared, and is for the purpose of learning and communication among auditing peers, with no commercial use. If there are copyright issues, please contact the backend for deletion.