Legal effect of minimum guarantee undertaking

When a listed company makes a private placement, the majority shareholder or actual controller will often give an undertaking of minimum guaranteed returns to the placement targets in order to ensure the success of the placement, i.e. if the sales price after the expiration of the lockup period for the privately placed stocks fails to reach the promised price, the majority shareholder or actual controller will be responsible for making up the difference.

The parties executing a minimum guarantee undertaking are usually the subscribers for the private placement and the majority shareholder of the listed company, and the entity liable for damages is also the majority shareholder, not the listed company. This point is quite similar to a valuation adjustment mechanism in a private equity (PE) investment. There are a variety of ways for realizing such an undertaking, such as a buyback at the higher price by the majority shareholder, or the provision of security for the undertaking by the majority shareholder in the form of a mortgage, structured product creation or direct cash compensation.

Minimum guarantee undertakings are usually private agreements. When making the private placement, the listed company usually will not include such an undertaking among the documents it submits to the regulator, keeping mum as to its existence. Such undertakings will generally only come to light in the event of a legal action, and hence have strong confidentiality.

In contrast to a PE investment, although a minimum guarantee undertaking is a contract between the majority shareholder and the subscribers, and the private placement itself also only involves a transaction between the listed company and the subscribers, nevertheless the capital operations of the listed company, particularly such a piece of materially favourable news as a private placement, impinges upon the interests of innumerable small and medium-sized shareholders. Accordingly, it can easily cross over into grey areas of securities law.

AGREEMENT VALIDITY

A minimum guarantee agreement is subject to the Contract Law. Article 52 of the Contract Law specifies that, “A contract is void if: (1) a party uses fraud or coercion to conclude a contract, thereby harming the interests of the state; (2) it involves collusion in bad faith, harming the interests of the state, a collective or a third party; (3) it conceals an illegal objective by giving it a legal form; (4) it harms the public interest; or (5) it violates mandatory provisions of laws or administrative statutes.” In practice, items (3) and (5) are the most commonly cited.

It is commonly held that a minimum guarantee undertaking in a private placement is a contract entered into by two equal entities, the majority shareholder and the subscribers, and that it reflects the true intent of both parties and does not harm the lawful rights and interests of the listed company, investors or creditors. Therefore none of the circumstances in article 52 of the Contract Law that void a contract should be applied, and minimum guarantee undertaking should be found to be valid.

The relatively influential cases known in practice include the Topray Solar minimum guarantee undertaking case and the Dadongnan letter of undertaking incident. In the former case, the courts at first instance and appeal rendered judgments to the effect that the compensation undertaking in the minimum guarantee undertaking was valid on the following grounds: (1) the agreement was an expression of the true intent of the parties and complied with the investment method in the PE investment market; (2) the agreement was a compensation undertaking between shareholders and the listed company was not the entity paying the compensation, so accordingly it would not harm the interests of other shareholders or the creditors of the listed company; and (3) none of the circumstances set forth in article 52 of the Contract Law that void a contract applied.

POTENTIAL CHALLENGES

For a long time the Topray Solar minimum guarantee undertaking, which was handled in a manner similar to a valuation adjustment mechanism in a PE investment, has cemented the attitude of judicial practice. However, a private placement transaction is intimately connected to the interests of innumerable small and medium-sized investors. When determining the validity of a minimum guarantee agreement, the necessary distinction with a PE investment needs to be made and should not be handled in the same manner as for a valuation adjustment mechanism.

At least three challenges may be faced in determining the validity. First, regarding securities market trading, regulation of appropriate information disclosure is an important protection ensuring the interests of investors. However, in a private placement, the non-disclosure of a minimum guarantee agreement could trigger a legal action against the majority shareholder by small and medium-sized investors that suffered investment losses. Although this does not touch upon the issue of the validity of a minimum guarantee agreement, it does pose a major attack on its reasonableness.

Second, when a private placement deal is reached, the majority shareholder also undertakes an obligation of buyback at a higher price. When market sentiment is sliding, the majority shareholder may, in order to circumvent its compensation obligation, use various irregular means to hike the valuation, the ultimate victims again being the listed company and the small and medium-sized investors.

Finally, the judgment in the Topray Solar minimum guarantee undertaking case was rendered on 3 June, 2013. The Administrative Measures for Securities Offering and Underwriting, in effect at the time, only regulated the issuers and underwriters, excluding the majority shareholders of listed companies. Article 16 of the administrative measures, amended in 2014, specifies that, “issuers, underwriters and their relevant personnel may not provide, either directly or through their stakeholders, financial assistance or compensation to investors participating in a subscription”. Whether “relevant personnel” includes majority shareholders or actual controllers has yet to be further clarified by the regulator. If the regulator were to render an interpretation affirming this point, the administrative measures will necessarily have a certain impact on findings in judicial practice, despite the fact that they are ministerial-level regulations formulated by the China Securities Regulatory Commission and not “laws or administrative statutes” as specified in item (5) of article 52 of the Contract Law.

Jiang Fengtao is the managing partner and Liu Bing is a partner at Hengdu Law Firm