Gansu case helps with design of a valuation adjustment mechanism

In recent years, valuation adjustment mechanisms have gradually been accepted and used by transaction parties in private equity (PE) investments in China. In a PE transaction, “value adjustment” means revision, at some time after closing, of the valuation of the investee company based on its actual operations, whereupon the investment price, post-investment equity and other rights and obligations of the investor, the investee company and the original shareholders are redefined.

The reason for adopting a valuation adjustment mechanism lies in the asymmetry of the information on the operations of the enterprise that is available to the investor, and to the investee company and the original shareholders, when negotiating the valuation of the investee company, with the investor never as clear on the investee company’s operations as the investee company itself.

The case

In the Gansu valuation adjustment case, the investor, Haifu, the investee company, Shiheng (originally Zhongxing), and the Shiheng shareholders executed a capital increase agreement providing that Haifu and Shiheng would carry out a valuation adjustment in light of Shiheng’s performance.

If Shiheng made a profit of less than RMB30 million (US$4.7 million) in 2008, Haifu would have the right to demand that Shiheng pay it compensation, and if Shiheng did not pay the compensation, Shiheng’s shareholder, Diya, would.

At the end of 2008, Shiheng’s net profit failed to reach the target of RMB30 million, which gave rise to the legal action. At appeal, the Gansu High Court held that “the provision specifying that if Shiheng fails to make a net profit of at least RMB30 million in 2008, Haifu has the right to demand that Shiheng and Diya compensate it by certain means breaches the principle in the investment field of the sharing of risks by entitling Haifu, as the investor, to obtain the agreed upon returns without bearing any risk, regardless of Shiheng’s business performance”.

Application for retrial

Gansu Shiheng submitted an application for a retrial to the Supreme People’s Court, requesting that the appeal judgment be quashed and the judgment at first instance be upheld. The Supreme People’s Court accepted Gansu Shiheng’s application on 19 December 2011, and has taken up the case, which is still pending.

Elements to consider

Given that the Supreme People’s Court has not yet handed down its final verdict, the possibility remains that other courts, in trying similar cases, will refer to the judgment in this case, notwithstanding the fact that China’s legal system does not fall into the Anglo-American case law system.

We have the following thoughts on the legal issue of valuation adjustments mechanisms triggered by the Gansu valuation adjustment case:

First, in this case, the investee company is the primary liable party and the original shareholder bears supplementary liability.

We believe that a supplementary adjustment mechanism between the investor and the shareholder would be more acceptable to the judges. We would recommend that it should go with the original shareholders bearing primary liability and the company supplementary liability.

Several forms

Second, the valuation adjustment mechanism between the investor and the original shareholders can take several forms, with the common one being that if the company’s performance does not meet the set target, the original shareholders transfer a portion of their equity, or the original shareholders buy back the company equity held by the investor.

In PE transactions, the investor generally acquires its stake by contributing to a capital increase at premium. We believe that, where the investor has not illegally withdrawn the funds or assets, divesting from the company by transferring its equity to the original shareholders of the company to evade operational risks or realise returns is a regular equity transaction permitted by law.

Less risky

Third, an equity valuation adjustment is more acceptable and less risky than a cash valuation adjustment. In this case, the stake in the valuation adjustment mechanism was cash. If the investee company failed to achieve the set performance or other target, the risk that the investee company would be unable to make payment would be relatively great, and if the figure was huge, it would be even less likely to be accepted by the court.

Two-way valuation

Fourth, we would recommend a two-way valuation adjustment mechanism. In the Gansu case, a one-way valuation adjustment mechanism was provided for, namely: if Shiheng made a profit of less than RMB30 million in 2008, Haifu would have the right to demand that Shiheng pay it compensation.

However, Haifu was not similarly required to pay Shiheng any compensation if Shiheng’s profit exceeded RMB30 million. Accordingly, only the investee company and its original shareholder bore the operational risks, with the investor exempt from all risk, which is unfair and breaches the principle of the sharing of risks. The court would find such provisions unacceptable and unreasonable.

Secure seats

Finally, an investor should endeavour to secure seats on the board of directors and supervisory board of the investee company. If it does not have any seats on the board, it could be deemed as “not participating in joint operations”, thereby resulting in the invalidation of the contract.

Accordingly, the investor could demand that the original shareholders give it seats on the board of directors and the supervisory board, based on this reason.

Wang Wei is a partner at Zhonglun W&D Law Firm in Beijing and is the chairman of the Private Equity Fund Practice