VAM clause ruling to have huge impact on PE industry

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On 7 November 2012, in the retrial of the high-profile private equity case Suzhou Industrial Park Haifu Investment v Gansu Shiheng Non-Ferrous Recycling and Hong Kong Diya over the validity of the valuation adjustment mechanism (VAM) clause in the capital increase agreement between the parties, the Supreme People’s Court decided that the VAM clause (article 7 (2) in the capital increase agreement) signed between Haifu, a private equity fund, and Shiheng, the target company, was invalid; and the VAM clause signed between Haifu and Diya, the target company’s controlling shareholder, was valid. Based on the above decisions, the court ruled that Diya had to pay RMB19,982,095 (US$3.1 million) to Haifu as compensation based on the agreement.

Arbitration This retrial judgment is the first in which China’s Supreme People’s Court has ruled on the legal validity of the VAM clause between a private equity (PE) firm and a target company. In the past, whether the VAM agreement is legally valid was not clear. This judgment will have a huge impact on the transaction models of the PE industry. According to the principle established by the Supreme People’s Court through this ruling, the VAM clause between a PE firm and the controlling shareholder of a target company is valid, while the VAM clause between a PE firm and a target company is invalid.

The ruling that the VAM clause between a PE firm and the controlling shareholder of a target company is valid upholds the spirit of contract, which consists of the following three elements: freedom of contract; contract justice; and pacta sunt servanda (agreement must be kept). The capital increase agreement between the parties is sufficient reflection of the autonomy of will of both Diya and Haifu.

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The author, Liu Junhai, is an arbitrator at the Beijing Arbitration Commission and a director with the business law centre at the Law School of Renmin University of China. Last month’s article from the BAC, entitled Joint mediation: two heads better than one in international disputes, was incorrectly attributed to Zhang Jishuang. The author was in fact Fang Jian, a case manager with the commission.

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