The valuation adjustment mechanism (VAM) clause is crucial for equity investment deals. A VAM arrangement serves both roles of a security tool to the investors and a motivation tool to the founding team. From the perspective of protecting investors, this article discusses who should assume the share redemption obligation (SRO) and how this obligation may be fulfilled in the context of Chinese judicial practice.
Instead of imposing the SRO directly on the target companies, investors may require the existing shareholders of the targets to take this obligation. In practice, many investors agree with the existing shareholders and the targets that when certain conditions are met, the targets should be obliged to redeem shares from the investors, with the existing shareholders held jointly and severally liable for fulfilling this obligation.
However, in the final decision dated 2012 for Haifu Investment v Gansu Shiheng Non-ferrous Metal Resources Recycling, the Supreme People’s Court (SPC) held that the agreement imposing the SRO on Shiheng was invalid, arguing that “the agreement was detrimental to the interests of the target and its creditors because it allowed Haifu to receive relatively fixed income independent of Shiheng’s business results through the investment”. This has become a consensus opinion of judges.
Based particularly on the doctrine of capital maintenance under the company law in a civil law system, the SPC’s argument reflects its opinion that by imposing the SRO or compensation obligation directly on the target, the VAM agreement has gone beyond the permitted scope within which companies were allowed to repurchase shares from their shareholders, as defined in articles 74 and 142 of the Company Law; the agreement also violated article 35 of the Company Law, because it virtually provided for withdrawal of capital that was detrimental to the interests of the target and its creditors.
But there have been controversies over the SPC’s argument. One arbitration body even ordered the target to indemnify the investor because paying indemnity would not cause damage to the target or its creditors due to the target’s ability to make profit for the current year in excess of the amount of the indemnity.
The targets are held jointly and severally liable as guarantor for the SRO. Below are highlights from the SPC’s civil judgment for a retrial case dated 7 September 2018 ( Zui Gao Fa Min Zai No. 128):
“The judges of the second instance of the case invalidated the target’s guarantee clause mainly because they thought the clause, enabling shareholders to receive income independent of the target’s business results, deviated from the legal doctrines of company legislation by allowing the investor to avoid transaction risks in a way that was detrimental to the interests of other shareholders and creditors. However, for two reasons – firstly, by obtaining approval resolution from the general meeting, the investor has exercised due care and fulfilled the obligation of formal examination before getting the guarantee from the target (for example, relevant transaction document evidence that the general meeting has resolved to approve the capital increase via a private placement); secondly, all the investment amount from the investor was fully used for the operation and development activities of the target to the benefit of all shareholders – we finally decide that the guarantee clause is legal and valid and the target shall be jointly and severally liable for the payment of share transfer price by the existing shareholders.”
In the above judgment the SPC found the clause requiring the target to be jointly and severally liable as guarantor for the SRO of its existing shareholders valid and binding. Obviously, the court of the second instance of the case, being the Higher People’s Court of Sichuan, held a view that was different. The higher court found the guarantee clause of the target invalid on the same ground that the SPC invalidated the target’s SRO in the Haifu case.
In the author’s opinion, it is reasonable that the guarantee clause under case No. 128 was held valid, while the one under the Haifu case was not. In the Haifu case, the guarantee clause violated the capital maintenance doctrine because: First, the rights and obligations among the target, its existing shareholders and the investor relating to the share redemption terminated once the target fulfilled its SRO to the investor; and second, the target was the final assumer of this liability.
As for case No. 128, the target was not the principal debtor. After fulfilling obligations to the investor, it may take recourse action against its existing shareholders according to the Guarantee Law. Given that the target was not the final assumer of the liability, the doctrine of capital maintenance was not violated.
Preconditions for the target to fully assume joint and several guarantee for the SRO, and the specific approaches of partial assumption. According to article 16 of the Company Law, prescribed procedures, i.e., obtaining approval as the law requires from the resolution made by general meeting, must be completed before a company provides any security in favour of any shareholder. However, pursuant to the civil judgment ( Zui Gao Fa Min Zai No. 258), failure of the target to complete such prescribed procedures does not necessarily invalidate the provisions requiring the target to assume joint and several liability as guarantor, although the target’s scope of liabilities may be affected.
The judgment found the target liable for 50% of the principal debt unable to be repaid, although it was not held jointly and severally liable as guarantor, because both the target and the investor had fault in failing to obtain shareholder resolution for the guarantee provided by the target for its shareholder. The court cited article 7 of the Interpretations to the Guarantee Law: “If both the creditor and the guarantor are at fault, the portion of civil liability assumed by the guarantor shall not exceed one half of the amount for which the debtor is unable to repay.” Therefore, when failing to obtain shareholders’ resolution of approval, or complete any other prescribed procedures, the target may be set free from liabilities, or only be held liable for a portion of the liabilities.
In summary, in judicial practice there is still much controversy about who should assume the SRO, and the manner of its fulfillment. The results are uncertain – even courts of the SPC make different rulings. Based on existing rulings, the author proposes arrangements that: (1) require the existing shareholders to assume the SRO; (2) require the target to be jointly and severally liable as a guarantor for the SRO of its existing shareholders; and (3) incorporate provisions that the target has obtained shareholders’ resolution approving the guarantee, or request such shareholders’ resolution to be provided as an appendix to the contract.
Ren Shanshan is a partner at Merits & Tree
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