I.Key Features of Valuation Adjustment Mechanism Agreements
A valuation adjustment mechanism agreement (“VAM agreement”), commonly known as “bet-on agreement”, as referred to in the Minutes of the National Court’s Work Concerning Civil and Commercial Trials (the "Minutes"), is an agreement entered into between an investor and a party seeking financing (the “investee company”), agreeing upon certain terms of equity repurchase and monetary compensation (the “VAM terms”), with an intention to adjust the valuation of the investee company if it fails to achieve certain goals described therein.
A VAM agreement is customarily adopted in private equity investment aiming to manage the risk of uncertainties in forecasts of business development, information asymmetry as well as conflicts of interest concerning the investee company, by which an investor may exercise its contractual rights against the obligor, usually the original shareholders of the investee company or the investee company itself.
VAM terms will take effect only upon pre-determined conditions described in the VAM agreement are met. Such conditions generally include: (i) shares of the investee company fail to be listed on a stock exchange within a prescribed time limit; (ii) the investee company fails to achieve prescribed financial performance objectives; (iii) the investee company, its shareholders, directors, supervisors or senior management personnel breach the VAM agreement, (for example, a breach of non-competition obligation by the de facto controller or other shareholders or a breach of commitment of non-fraud by the investee company or its shareholders), and (iv) the investee company fails to achieve certain business goals, such as failure to complete product research and development or to obtain requisite approval or license for certain businesses, etc.
Commonly, the legal effect of a VAM agreement include obligating the investee company or its shareholders (as the case may be) to purchase back equities from the investor or make monetary compensation to the investor, or a combination of both. In addition, some VAM agreements stipulate other protections for the investor, such as shares compensation, a grant of preferred shares, compulsory tag-along rights as well as reversal of control rights.
II.Judicial Opinions about VAM Agreements
Based on our observations of judicial practices concerning VAM agreement disputes, below we summarize the key issues thereof.
(1) The validity of a VAM agreement between an investor and a shareholder of investee company
For a long time, there has been no explicit laws or judicial precedents concerning the validity of a VAM-related agreement. In the first VAM case in China, i.e. HaiFu Investment Co. Ltd. v. ShiHeng Non-ferrous Recourses Recycling Co. Ltd., Hong Kong Diya Limited and LU Bo (the “Haifu Case”)1, the Supreme People’s Court ruled on the re-trial of this case on November 7, 2012 that a VAM agreement between an investor and a shareholder of investee company is valid. This judicial rule is followed by subsequent judicial practices and finally recognized by the Minutes. According to the Minutes, a VAM agreement concluded between an investor and a shareholder or de facto controller of investee company shall be valid and enforceable unless there is any statutory circumstance that renders it invalid. Given the foregoing, there is no controversy in judicial practice concerning the validity of a VAM agreement between an investor and a shareholder of investee company.
(2) The validity of a VAM agreement between an investor and an investee company
Regarding a VAM agreement between an investor and an investee company, however, the Supreme People’s Court in Haifu Case completely denied its validity on the grounds that it violates mandatory laws and regulations. Following the Haifu Case, courts gradually converged on the standpoint that a VAM agreement is invalid if it is concluded between an investor and an investee company, as such an agreement shall be deemed as a violation of the mandatory laws or regulations governing the validity of any agreement. According to relevant judicial cases, the “mandatory laws or regulations governing the validity of any agreement” include the provisions prohibiting shareholders from illegally withdrawing their capital contributions, the provisions concerning repurchasing of its own equity by a company and the provisions concerning profit distribution under the Company Law, as well as the provisions of proportionate profit distribution as stipulated by the Sino-Foreign Equity Joint Venture Law of the People’s Republic of China.
Another case delivered by Jiangsu Higher People's Court on April 3, 2019, known as the "Huagong Case" (see (2019) Su Civil Re-trail No.62 Civil Award), reversed the judicial rule established by the Haifu Case. The Jiangsu Higher People’s Court held that such VAM agreement should be valid since: (i) it does not violate the principle of capital maintenance because the investee company performs its repurchase-of-equity obligation after completion of mandatory capital reduction procedure; and (ii) the payment of the repurchase price by the investee company will not result in impairment of the company’s assets or its solvency, thereby not damaging the interests of its creditors. The court further ordered the investee company to pay the equity repurchase price to the investor. As the first case that the court recognizes validity of a VAM agreement between an investor and an investee company, Huagong Case has a positive impact on resolving later disputes brought to the courts. However, it is at once argued that ordering the investee company to pay the equity repurchase price to the investor without ordering it to perform relevant capital reduction procedure may result in an impairment of its solvency, thereby causing damages to the interests of creditors of the investee company.
The Minutes incorporate the opinions in the verdict of the Huagong Case with certain adjustments. Specifically, the Minutes recognize and reiterate the judicial rule that the court should not uphold an investee company’s claim for invalidity of a VAM agreement it entered into with an investor only on a basis that such agreement contains an equity repurchase or monetary compensation clause, if there is no other statutory circumstance that would render such agreement invalid. The Minutes further stipulate that (i) in the event that an investor requests an investee company to purchase back equities, the court should dismiss its claim if the investee company has not completed capital reduction procedure; (ii) in the event that a monetary compensation lawsuit is brought by an investor against an investee company, the court should proportionately dismiss its claim if the investee company has no profit or its profit is not sufficient for compensation, but the investor shall be entitled to file another lawsuit once the investee company becomes profitable.
Although the Minutes explicitly confirm the validity and enforceability of a VAM agreement, the actual performance of these VAM terms are still subject to strict examination, which exposes an investor to great uncertainties. For example, being a minority shareholder of an investee company, an investor may be unable to facilitate passing the capital reduction resolution, which must be examined as a precondition for the court to recognize the investor’s claim for equity repurchase, or the relevant implementation of capital reduction and equity repurchase from the investor may be intervened by creditors; in addition, in a monetary compensation situation, given the Minutes set evidentiary barriers for an investor, it is difficult for a financial investor, who has no control of the investee company’s operations, to access sufficient financial and profitability information about the investee company to demonstrate that the company has distributable profits under the Company Law.
(3) Considerations in the situation that an investee company provides guarantee for performance of the VAM agreement
Based on judicial practices, the validity and enforceability of such a guarantee shall be simultaneously examined from two aspects. Firstly, it shall be determined whether the investee company’s undertaking to guarantee complies with the Company Law. According to the Company Law, the provision for guarantee shall be approved by way of a resolution of the board of directors or the shareholder’s meeting as prescribed by the Articles of Association, while in the event of providing guarantee for the company’s shareholder(s) or de facto controller, such matter must be submitted to the shareholder’s meeting for approval. Hence, in determining the validity of a guarantee, a court shall examine whether the investee company has passed relevant resolution, as well as whether the creditor is accountable when the investee company undertakes to guarantee without prior resolution(s); Secondly, it shall be also determined from a pure “VAM agreement” perspective, that is, if the company’s decision-making mechanism mentioned-above has passed a resolution on the guarantee and the guarantee obligation is actually triggered due to a default of the contractual obligor of the VAM agreement, then the court shall determine whether the VAM agreement is valid, because the performance of a guarantee obligation by the investee company shall be in effect a performance of the concerned VAM agreement. (2) Accordingly, the court shall refer to the Minutes for determining the validity of a VAM agreement as mentioned in Part II of this briefing.
(4) Considerations in claiming payment of the equity repurchase price/compensation for poor performance
Regarding how courts will treat the provisions of equity repurchase or poor performance compensation, the prevailing opinion of courts is that either payment for equity repurchase price or compensation for poor performance is a contractual obligation in its nature, rather than a liability for breach of contract, so the liquidated damages adjustment rule (i.e., the court may at its discretion adjust the amount of liquidated damages determined by the contractual parties in advance if it is decidedly not proportionate to the actual losses suffered by the non-defaulting party) does not apply. However, we observed that in some cases the court determined the nature of compensation for poor performance as liquidated damages and thus subjecting it to the liquidated damages adjustment rule.
Moreover, with respect to whether an equity repurchase provision and a poor performance compensation provision can be enforced simultaneously, opinions vary greatly in judicial practices. Some courts allow an investor to seek the payment for both the equity repurchase price and poor performance compensation. In their view, they are two independent and valid provisions that serve different compensatory functions. Nevertheless, some courts dismiss investor’s claim as they believe that the purposes of the two provisions are the same as to obligate the investee company/original shareholders to assume liability for breach of contract, hence, if enforcement of one provision would be sufficient to compensate losses resulting from a broken contract, another one should not be recognized. In addition, other courts may award the payment or compensation at the same time. However, they may adjust the calculation method and the amount of compensation for poor performance on a fair basis. In light of the above, it remains to be seen how a court may determine a specific case.
(5) Influence on the performance of VAM agreement if an investor participates in operations of an investee company
Where parties bet on future performance of an investee company, it is undoubtable that the investor will not be held accountable for triggering VAM terms as a result of the investee company’s failure in realizing a specific performance goal if the investee company is still operated by its original management team. However, if an investor, through exercising shareholder’s rights or by investment agreement, appoints one or more directors to the investee company to have influence on the decision-making of daily operations of the investee company, there are different opinions in judicial practice as to whether the investor has contributed to the realization of the preconditions of VAM terms.
According to the prevailing judicial opinion, investors’ participation in operations of the investee company shall not be deemed to be a promotion factor influencing realization of the preconditions of VAM terms, as it is the statutory shareholder’s right enjoyed by the investor. To demonstrate that the investor is a cause to the investee company’s failure in achieving the performance goal, the investee company or the founding shareholders shall take a relatively high burden of proof.
Notwithstanding the foregoing, we note there were precedents that an investor is held liable for a decline in the investee company’s performance, thus the court ruled a pro rata amount of compensation payable by the investee company based on the parties’ proportion of responsibilities of their management conducts; there were also precedents that an investor removes the person-in-charge of the investee company elected by the original shareholders from his position, the court then held that the original shareholders shall not bear the compensation liability arising after the removal of the person-in-charge. It can be inferred that, in determining whether an investee company or its original shareholder’s compensation liability is affected by, and thus needs to be adjusted due to, an investor’s participation in the operations of the investee company, a court may give consideration of the facts of whether the investor has over intervened the operations of the investee company, or whether the original shareholders’ taking compensation liability may result in an imbalance between rights and obligations, moral hazard or other adverse effects, in the situation that they have been deprived of the right to operate the investee company.（Translator: Luo Dan Chen）
- See Suzhou Industrial Park HaiFu Investment Co. Ltd. v. Gansu ShiHeng Non-ferrous Recourses Recycling Co. Ltd., Hong Kong Diya Limited and LU Bo, the Supreme People’s Court, (2012) Civil Re-trial Zi No.11 Civil Award.