On 7 November 2012, the Supreme People’s Court (SPC) rendered a final judgment in the first dispute case in China involving a valuation adjustment mechanism in a private equity (PE) investment. Although China is not a case law country, the SPC’s judgment will, in practice, have a guiding and demonstrative effect on the trial of similar cases.
In 2007, Haifu injected RMB20 million (US$3.2 million) in cash to increase the capital of Shiheng, and executed a capital increase agreement with Diya (Shiheng’s sole investor) and Lu Bo (the actual controller of Diya), which provided for a valuation adjustment mechanism as follows: if Shiheng’s 2008 actual net profit did not reach a target of at least RMB30 million, Haifu would have the right to demand that Shiheng pay it compensation; and if Shiheng failed to perform its compensation obligation, Haifu would have the right to demand that Diya perform the compensation obligation. On 30 December 2009, as Shiheng’s actual net profit for 2008 failed to reach the target, Haifu instituted a legal action pursuant to the valuation adjustment clause, requesting that Shiheng, Diya and Lu Bo be ordered to pay it compensation.
Both the Lanzhou Municipal Intermediate People’s Court in its judgment at first instance, and the Gansu Higher People’s Court in its judgment at appeal, found the valuation adjustment clause invalid, but on different grounds.
In its final judgment, the SPC held that the valuation adjustment clause between Haifu (the investor) and Diya (the original shareholder) was valid, but that the valuation adjustment clause between Haifu and Shiheng (the investee company) was invalid.
The provision that Shiheng was required to bear liability for compensating Haifu meant that Haifu was assured of a relatively fixed return on its investment, deviating from Shiheng’s business performance and harming the interests of Shiheng and its creditors, thus directly violating the provision on the distribution of profits in a joint venture of article 8 of the Law on Sino-Foreign Equity Joint Ventures, and constituting abuse by a shareholder of its shareholder rights as specified in article 20 of the Company Law. The clause was found to be invalid on this basis.
On the other hand, the provision requiring Diya to bear liability for compensating Haifu did not harm the interests of Shiheng and its creditors, did not violate prohibitory provisions of laws or regulations, and was a true expression of the parties’ intent, and thus valid.
The author holds a somewhat different opinion on the issue of the legal validity of valuation adjustment clauses.
The SPC judged that Shiheng violated regulations on profit distribution in a Sino-foreign joint venture.
The formula for calculating the amount of the compensation used by the parties in the case was as follows: (1 – actual net profit in 2008 ÷ RMB30 million) × the investment amount. This compensation mechanism is a mechanism for revising a valuation (or purchase price), making it different from the usual practice of obtaining a fixed return.
Under the valuation revision mechanism, Haifu purchased 3.85% of the equity of Shiheng at a price of RMB20 million, and the valuation requirement was that the net profit of Shiheng in 2008 reach a target of at least RMB30 million, failing which the purchase price would be revised, and Haifu would be refunded the portion that it overpaid.
In contrast, a fixed return usually means the returns obtained at the fixed return rate on the basis of the purchase price (investment cost) as the base figure.
The author is of the opinion that a court should make a detailed analysis of its internal logic based on the actual circumstances, and determine its real nature, not make an undifferentiated simplistic determination.
Special rights arrangement
By citing and applying the first paragraph of article 20 of the Company Law, the SPC could be accused of expanding the scope of application of the provision. The article specifies that, “A company shareholder shall … exercise his shareholder rights in accordance with the law and may not abuse his shareholder rights to harm the interests of the company or those of other shareholders …” Based on Company Law theory and provisions, “shareholder rights” should mean the rights enjoyed in accordance with the law by shareholders as expressly provided in the Company Law, whereas special rights specially provided for between shareholders or between a company and its shareholders should not be included among the “shareholder rights” as generally meant by the Company Law.
With respect to Haifu’s right to demand that Shiheng pay it compensation, the author strongly believes that it is a special rights arrangement in respect of financing arrived at between Haifu, as an investor, and Shiheng and its original shareholder, and a right of claim arising in the course of the transaction by virtue of which Haifu became a shareholder of Shiheng, not a statutory “shareholder right” naturally enjoyed by Haifu upon becoming a shareholder.
It is not a “shareholder right” naturally bestowed by the Company Law. That being the case, how can there be an “abuse of shareholder rights”?
Even ignoring the issue of shareholder rights, does Haifu’s right to demand that Shiheng pay it compensation genuinely harm the interests of Shiheng and its creditors? Not necessarily.
As mentioned above, the compensation mechanism is a means by which the investor recovers money that it overpaid.
That the investor needs to be compensated for the money it overpaid is the point confirmed by the SPC in rendering a judgment specifying that Diya should pay compensation to Haifu.
Considering that Shiheng’s actual profitability was terrible, the money overpaid by the investor was unreasonable extra income obtained by Shiheng on the basis of an overly high valuation; that being so, how could the investor recovering this portion of its money harm the interests of Shiheng and its creditors?
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