Designing an effective VAM clause

By Zhu Zhitong and Zhang Yang, Hylands Law Firm

The valuation adjustment mechanism (VAM), an investment tool, is often seen in investments in entertainment and sports projects. In judicial practice, disputes relating to these projects mainly arise out of the VAM between the investors and investees. The so-called VAM refers to an agreement between the investor and the investee, through which the investee will buy back the shares held by the investor in the way agreed in advance, or be liable for cash compensation if the investee fails to realize the preset target within the agreed period.

Previous cases

Xhu Zhitong
Hylands Law Firm

(1) Haifu Investment Co. Ltd. of Suzhou Industrial Park v Gansu Shiheng Non-ferrous Metal Resources Recycling Co. Ltd., Lu Bo, etc. (dispute over capital increase): Invalid VAM.

Reason for judgment: “When the clause of the VAM is triggered, Haifu will obtain fixed returns on its investment, which, however, is separate from the business performance of Shiheng, and damages its interests and the interests of its creditors.”

(2) Tianjin Silicon Valley Paradise Heying Equity Investment Partnership v Cao Wubo and Shandong Hilead Biotechnology Co. Ltd. (dispute over partnership agreement): The VAM for share repurchase was invalid but the investee was required to repay the investment recorded as the capital reserve.

Reason for judgment: “The registered capital will not be reduced or drawn back without statutory procedures once the registered capital of a limited liability company is determined. The Company Law provides the special circumstances where a shareholder may request the company to repurchase its shares, and the clause regarding Hilead repurchasing the shares is invalid for violation of the said mandatory provision. The rest of the agreement should be valid for it does not violate the provisions of the Company Law.”

Zhang Yang
Hylands Law Firm

(3) Qiang Jingyan v Cao Wubo (dispute over share transfer): The investee provided guarantee for its shareholders’ repurchase and such guarantee was valid.

Reason for judgment: “Qiang Jingyan has fulfilled his duties of due care and formal examination for the resolution of shareholders’ meeting on Hilead providing guarantee. Hilead’s provision of guarantee benefits its business operation and development without any damage to its own interests or the interests of its minority shareholders. Therefore, it should be decided that the clauses regarding provision of guarantee are legal and valid.”

(4) Jiangsu Huagong Venture Capital Co. Ltd. v Yangzhou Metalforming Machine Tool Co. Ltd. (dispute over share repurchase): The VAM was not necessarily invalid and attention was turned to the performance of the VAM.

Reason for judgment: “The Company Law does not prohibit a limited liability company from repurchasing its shares, and such a repurchase does not necessarily violate the mandatory provisions of the Company Law; The limited liability company’s repurchase of its shares as per statutory procedures will not damage the interests of its shareholders or creditors, or violate the capital maintenance doctrine; In the VAM, both the clauses on the investment reckoned in registered capital, and the agreements on repurchase of investment that is reckoned into capital reserve, are legally capable of performance.”

In August 2019, the Supreme People’s Court released the Minutes of the National Working Conference on the Trial of Civil and Commercial Cases (draft for comment), which specifies the effect of the VAM. The decision on enforcement of the mechanism, however, depends on “whether the mechanism conforms to the mandatory provisions of the Company Law on share repurchase or profit distribution”.

Based on the above-mentioned judicial practice and the contents of the minutes, the author gives the following advice on the VAM:

The repurchase price, or the cash compensation amount, should be reasonable. Although the minutes acknowledge the validity of the VAM, in judicial practice, the court should pay attention to whether the repurchase price deviates from the actual business status of the investee, and whether there is material departure of the repurchase price from the general rate of return of the investment market. Therefore, the reasonability of the repurchase price, or the cash compensation amount, is not just the outcome of gaming between the investor and founder shareholders. Judicial support should also be considered.

The VAM should be designed to be enforceable. The minutes distinguish the effectiveness of the VAM from its performance, but fail to provide guidance on the possibility of de facto performance. The minutes provide that the court will not support the investor’s claim regarding share purchase for violation of article 110 of the Contract Law if the investee fails to fulfil its obligation for capital reduction.

In view of this, the author suggests that the VAM contains the provisions of capital reduction procedures. For example: (1) the VAM of the investment agreement may specify the obligation of founding shareholder for co-operation in completion of capital reduction procedures, and distribution of the capital reduction amount and the related default liabilities; and (2) the VAM may specify that when the capital reduction procedures are initiated, the founding shareholder will be liable for the creditor’s claim for pay-off, to ensure legality of the capital reduction procedures and protect the investor from the risk of being subject to the liability for damages claimed by the creditor for improper capital reduction.

The VAM should be harmonized with the liquidation procedure of the investee. If the VAM contains the provision that the investor has the right to initiate the investee liquidation procedure when the investee or founding shareholder fails to perform the investment agreement, the provision should be consistent with the provision of the Company Law on dissolution, especially with the articles of association.

Zhu Zhitong is a partner and Zhang Yang is an associate at Hylands Law Firm


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