Legal risks of VAM agreements on IPO

By Ma Chenguang, Co-effort Law Firm
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Valuation adjustment mechanism (VAM) agreements, usually adopted in financing or investing activities, are concluded between an investor and an invested company (the target) regarding future uncertain conditions which, if satisfied, will entitle the investor to exercise its right to recover losses resulting from overvaluation of the target. A “VAM agreement on IPO” is used by the investor to bet on the time that the target goes public.

In practice, the legal validity and actual performance of a VAM agreement on IPO is affected by factors that include, but are not limited to, parties to the agreement, compensation mechanism, terms and conditions of the agreement, and regulatory policies.

Ma Chenguang Senior Partner Co-effort Law Firm
Ma Chenguang
Senior Partner
Co-effort Law Firm

Invalidity ruling. A ruling issued in 2012 by the Supreme People’s Court (SPC) established a principle that VAM clauses between investors and targets are invalid (refer to the Civil Judgment [2012] Min Ti Zi No.11). From then on, courts of various levels across the PRC followed in the footsteps of this ruling to find VAM clauses concluded with targets invalid.

However, in the arbitration cases known to date, all VAM clauses where the target undertook to provide cash compensation or repurchase shares were upheld by arbitration tribunals, and all petitions to revoke such arbitration awards were rejected by courts on the ground that courts were not in a position to review substantive issues of arbitration cases pursuant to article 58 of the Arbitration Law. Therefore, in the near term, it seems unlikely that courts will take the same stand as arbitration tribunals on cases involving VAM agreements on IPO, in which the target is a party.

Even if the target is not a party to such bet-on agreements, a bet-on IPO timing is highly likely to be held invalid on the ground of “covering up illegal purposes in a legitimate form”, because the bet, generally not linked to financial performance of the target, allows the investor to take back principal together with interest at expiry, whether the target makes a profit or not – in other words, the investor does not take any risk in the target’s performance. However, it is notable that after the release of the above-mentioned SPC ruling, VAM agreements on IPO concluded by investors with existing shareholders or actual controllers of the targets (instead of the targets themselves), as a means of risk control, started to win support from judicial bodies in Shanghai and other places.

Fake equity, real debt. In VAM agreements on IPO, the compensation is often not linked with financial performance of the target, not to mention the formula for calculating an amount of compensation, which appears scarcely different from the formula for principal and interest payments at maturity of entrusted loans or lending agreements. If there is no further evidence of equity investment, the capital injected under, or in connection with, a VAM agreement on IPO is highly likely to be considered a loan.

According to the SPC Provisions on Several Issues Concerning the Application of Law in the Trial of Private Lending Cases, issued in 2015, the validity of lending agreements between enterprises for the purpose of meeting production or operation needs should be affirmed except under prescribed circumstances. Therefore, VAM provisions in a VAM agreement on IPO should not be held null and void simply because there is an assurance of minimum return.

Nevertheless, to avoid compensation under a VAM agreement on IPO being ordered to be adjusted as per private lending rate, the author suggests that the relevant investment agreement and its supplementary agreements be drafted in a manner that, in addition to provisions showing the investor’s explicit intent to make equity investment in the target, there are provisions on investment protection (i.e., provisions on injection, maintenance and withdrawal of capital) instead of those on principal and interest payment at maturity, as typically seen in private lending agreements. The purpose of these provisions is to highlight the investment agreement and its supplementary agreements as investment documents so that they are not considered to be intended for lending transactions.

Preventing VAM conditions from being satisfied. In practice, the party with cash compensation or share repurchase obligation usually cites the following reasons to defend its failure to honour the VAM agreement: (1) IPO review procedure being suspended by the CSRC; (2) failure to meet IPO conditions due to declining profit attributable to any terrorist incident in the place of the target; (3) failure to meet IPO conditions due to declining profit attributable to anti-dumping and countervailing investigations initiated in European or American countries; and (4) financial performance of the target being directly affected by the investor’s restriction, intervention or even deprivation of the target’s operation and management powers. In deciding whether the defence is justified, the court examines, among other things, whether these reasons are foreseeable business risks and whether they are causes of the target’s failure to go public as scheduled.

The author suggests that the VAM agreement on IPO should contain a force majeure clause or prescribed exceptions in order to prevent dispute arising out of the target’s failure to go public as scheduled.

Mandatory termination. According to the Measures for the Administration of IPO and Share Listing, the CSRC review mainly focuses on authenticity and stability of equity holding in issuers. A VAM agreement, which is likely to cause change in equity structure, exposes the target to significant uncertainty. That is why VAM agreements must be cleaned away before IPO filing is submitted.

In contrast to the CSRC’s attitude, VAM agreements are acceptable, though not to the full extent, to the National Equites Exchange and Quotations (NEEQ). A VAM agreement on IPO is conditionally acceptable provided that it contains no special provisions imposing obligations on the listed company that are detrimental to legitimate rights and interests of either the listed company or its shareholders.

In view of the risk of mandatory termination, we suggest that the VAM agreement be designed to contain a solution and appropriate compensation in case of mandatory termination of the agreement.

VAM deals should be cautiously addressed since all investments involve risks. To avoid exposing their VAM agreement on IPO to legal risks, investors and investees should work together to ensure that its provisions are valid, reasonable and practicable by following regulatory guidelines, legal stipulations and their prediction of commercial performance.

Ma Chenguang is a senior partner of Co-effort Law Firm

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