Legality of VAM still in some doubt

By Vincent Mu and Blake Yang, Martin Hu & Partners
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In foreign equity investments as well as mergers and acquisitions, private equity investors are exposed to two major risks – valuation risk and management risk. On one hand, the financing sides often overvalue performance intentionally as they expect to achieve high valuation financing; on the other hand, private equity investors are not able to control the business of a company effectively as they are usually not the controlling shareholders.

Vincent Mu Associate Martin Hu & Partners
Vincent Mu
Associate
Martin Hu & Partners

To avoid these risks and motivate the management of a company, valuation adjustment mechanism (VAM) has become a tool frequently used by foreign investors in making arrangements for complex agreements on financing transactions, to enable them to adjust the valuation of their investment targets and protect their own interests. However, the legality of a VAM has not yet been recognised under Chinese law. This has led to an unresolved issue: can the legal effect of a VAM be judicially sustained if a dispute between an investor and a financing party is referred to a court in China?

The Shiheng case

In 2011, the Higher People’s Court of Gansu province made a ruling of second instance on a dispute over capital increase (the Shiheng case), confirming that the valuation adjustment terms involved in this case were invalid. The ruling immediately provoked a spate of controversies in the financial and legal sectors. Since the Shiheng case is the first case in which a higher people’s court in China made a definitive legal conclusion on the legality of a VAM, it is considered to be indicative to a certain extent, and therefore various parties are trying to interpret the case.

In the Shiheng case, the investor made an equity investment in a company for a consideration at 20 times the equity premium in order to push for the listing of the company, and entered into a capital increase agreement with the company and its existing shareholders and legal representative. The agreement contained two major terms:

  1. The company’s net profit in 2008 shall not be less than RMB30 million (US$4.7 million); if the real net profit is less than RMB30 million, the investor shall have the right to require the company or its existing shareholders to compensate (in case the company fails to fulfil the compensation obligation). The amount of compensation equals 1 minus 2008’s real net profit/RMB3,000, times the amount of the investment.
  2. If it is not able to complete the listing by 20 October 2010 on the part of the company, the investor shall have the right to require the existing shareholders of the company at any time to buy back the entire equity in the company held by the investor then. If the annualised return on the assets of the company is over 10% from 1 January, 2008, the existing shareholders of the company shall buy back the equity in an amount equivalent to the book value of owner’s equity, corresponding to the shares of the company held by the investor. If the annualised return on the net assets of the company is less than 10% from 1 January 2008, the existing shareholders of the company shall buy back the equity in an amount (investor’s original investment amount minus the amount of compensation) times (1 plus 10% times the number of investment days/360).

In its ruling, the Higher People’s Court of Gansu province maintained that the premium on the calls paid by the investor was “an investment in name but was a borrowing in reality”. The court also held that the clause under item 1 above was “a clause with maximum loss guaranteed” under the joint operation contract, pursuant to which the court ruled that the premium on the calls be returned to the investor with interest.

Our views

The relevant clauses of the capital increase agreement were not typical clauses of a VAM. A general VAM usually arranges a VAM betting between an investor and existing shareholders (e.g. the clause in item 2 above). However, the clause in item 1 was a VAM betting between the investor and the company, with the compensation obligations towards maximum loss guaranteed borne by the existing shareholders. This arrangement can easily be identified by the conservative judiciary in China as an infringement of the interests of the company and its creditors. This was exactly one of the grounds on the invalidity of the VAM in the ruling of the first instance. Moreover, the agreement in this case was only focused on the protection of the interests of the investor, without any general incentives offered to the company or its management if specific conditions were satisfied under the VAM. Therefore, the agreement was more akin to unilateral binding, rather than a VAM betting.

Blake Yang Associate Martin Hu & Partners
Blake Yang
Associate
Martin Hu & Partners

However, the clause in item 1 was reasonable and necessary, as the investor took a great risk by making the equity investment for a consideration at 20 times the equity premium. The use of any future cash compensation to balance the real risk was a legitimate protection of the investor itself, because the premium here was much higher than the share price itself. Therefore, the parties to the transaction have made special arrangements for the premium different from those for a general equity transaction.

Furthermore, the clause in item 1 above should not be regarded as “an investment in name but a borrowing in reality”. The “clause with maximum loss guaranteed” under the joint operation contract was widely regarded as a typical invalid clause. The absence of a clear definition of “joint operation” under Chinese law has given rise to a grey concept. Exactly because of this, judges exercise extra caution when determining a specific investment relationship to try to avoid making a relevant determination. However, although a similar conclusion was made in the ruling of the Higher People’s Court of Gansu province, there was a lack of a convincing analysis. This is the main reason why the ruling is being questioned.

Finally, a VAM must be designed to meet the requirements for both incentives and disincentives. Excessively biased clauses for the interests of an investor may be counterproductive after dispute resolution procedures commence, as demonstrated by the unilateral incentive in this case. The retrial procedures of the Supreme People’s Court for the case have already commenced. We will be monitoring the progress of this case closely.

Vincent Mu and Blake Yang are both lawyers at Martin Hu & Partners (MHP Law Firm)

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胡光 Martin Hu

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牟笛 Vincent Mu

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杨奕 Blake Yang

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