The case Haifu Investment Co., Ltd, vs. Gansu Shiheng
Non-Ferrous Recycling Co., Ltd and Hong Kong Diya Limited for the
defendants' failure to perform the investment compensation
clause under the "valuation adjustment mechanism"
("VAM"), which has drawn high public attention, was
finally determined. After its retrial, the PRC Supreme People's
Court (the "Supreme Court") rendered the final judgment
ruling that the old shareholder, Hong Kong Diya Limited, shall bear
the compensation liability for the investor. It is beyond doubt
that this judgment will play a significant role in guiding the
courts' rulings of similar cases in the future. We believe the
following points are worthy of attention:
The Supreme Court's reasoning suggests its inclination to
decide the validity of VAM (also known as "bet-on
agreement" or "ratchet clauses") by operation of the
doctrines of the corporate law, which is essentially a protection
of legitimate rights and interests of companies and the
companies' creditors, rather than to mechanically apply the
test whether the contract is a "loan arrangement shammed with
business cooperation". It sets a milestone on the legality
review of VAM in similar cases in the future.
The judgment also indicates that the Supreme Court acknowledges
the reasonableness and legitimacy of VAM, but only for those
entered between shareholders. There still exists the risk that VAM
agreed between the new shareholder who subscribes the capital and
the target company is void per se, or to be challenged under the
court's strict scrutiny. PE investors need to pay special
attention to such risks.
It is also noteworthy for the potential commercial risks caused
by the Supreme Court retrial judgment. The VAM disputed in this
case is between the new shareholder and the target company. Leaving
alone the reasonableness of the valuation adjustment set forth in
the terms, the agreement provides that the company shall be
obligated to pay the compensation, while the old shareholder is
more like a guarantor for the company's liabilities. Therefore,
if the Supreme Court determines the VAM to be invalid, the guaranty
to secure such invalid agreement is accordingly invalid. Thus, the
liabilities should be allocated between the parties depending on
the legal consequences of the invalid agreement and guarantee, but
not the old shareholder being held responsible for the full
It is possible that the Supreme Court's opinion of holding
old shareholder responsible for the full compensation was based on
its valuing of the doctrine of estoppel and its tendency to
encourage the investment by safeguarding the investors' entire
interests and rights. According to such judging opinions, however,
in similar cases in future, whether the investors could allocate
the inherent commercial risks to the old shareholder by agreement
during the initial period of investments? In other words, whether
the investors could still recover full compensation when the
investment fails, which was made solely based on the
representations and warranties of the old shareholders or the
company without considering the reasonableness in setting the
structure of the VAM? This is another issue worthy to be highly
considered by PE investors and company shareholders.
Thanks for your reading. An in-depth analysis and follow-up
report on this judgment will be released soon.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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