In November, 2012, the Supreme People's Court entered into the decision of retrial for HaiFu Investment Co. Ltd. v. ShiHeng Non-ferrous Recourses Recycling Co. Ltd. (hereafter referred to as the "HaiFu Investment Case"). This judgment made a distinction between signing a valuation adjustment mechanism (hereafter referred to as "VAM") agreement with the target company and signing a VAM agreement with the shareholder. In essence, it confirms that a VAM Agreement between the investor and the shareholder is valid, whereas a VAM Agreement between the investor and the target company is invalid because such agreement would harm the interests of the company and its creditors. After that, the Supreme People's Court, various People's Courts at the local level, and arbitration institutions dealt with a number of cases related to issues of VAM agreements under the Private Equity (hereafter referred to as "PE") framework. A select number of such typical cases are summarized below:
Cases from the Supreme People's Court
1. Shenzhen ZhongKeHuiShang Venture Capital Investment Co., Ltd. and Daqing ZhongKeHuiYin Venture Capital Investment Co., Ltd. v. Shareholders of ChaoYangFeiMa Wang Zhaohai and Yang Naiyi et al. for Dispute over Equity Transfer
In this case, when the stock buy-back provision was triggered, the parties entered into a separate equity transfer agreement, but a dispute arose thereafter because the original shareholders failed to fulfill the terms of the equity transfer agreement. The Supreme People's Court found in its decision of second instance that the two agreements, namely the equity transfer agreement that parties signed after the conditions of stock buy-back provision was triggered, and the VAM agreement signed when making the investment, are independent of each other. Where the investors claim for their rights based on the stock transfer agreement rather than the VAM agreement, the court should review the stock transfer agreement independently and need not review the validity of the VAM Agreement. As a result, the court ruled that the original shareholders of the target company were to perform the equity transfer agreement and pay the stock transfer price.
2. Suzhou ZhouYuanJiuDing Investment Center (Limited Partnership) v. Lan Zeqiao, Yidu TianXia Special-type Fishing Co., Ltd. and Hubei TianXia Sturgeon Co., Ltd. for Dispute over other kinds of contract
The main issue of this case was the validity of the stock buy-back VAM agreement entered into by the shareholders. Both the court of first instance (Hubei Higher People's Court) and the court of second instance (the Supreme People's Court) confirmed the validity of the stock buy-back VAM Agreement in this case. Moreover, the Supreme People's Court confirmed the validity of this stock buy-back VAM Agreement on the grounds that: first, the agreement is based on the true intention of all parties; second, the terms of the buy-back provision do not violate any mandatory provisions of laws or administrative regulations; third, the process of signing the terms of buy-back VAM agreement was not obviously unfair.
Cases from Local People's Courts
1. LengShan Investment Center v. Shandong HanLin Biotechnology Co., Ltd. for Dispute over Original Shareholder's Equity Transfer
In this case, the Beijing No. 1 Intermediate People's Court found the stock buy-back VAM agreement between the investors and the original shareholders of the target company to be lawful and valid.
2. Shanghai RuiFeng Equity Investment Limited Partnership Company v. Lianyungang DingFa Investment Co., Ltd. for Dispute over Contract of Equity Transfer
In this case, the plaintiff and the defendant entered into two separate VAM agreements. The first agreement was executed by the investor (the plaintiff), the original shareholders, the target company, and many other PE investors; the second agreement was executed by the investor (the plaintiff), the original shareholders, and the target company only, and stipulated a higher stock buy-back price. Based on the principles of encouraging transactions, respecting the party autonomy, upholding public interests, and protecting procedural justice of business transactions, the Shanghai No.1 Intermediate People's Court found the first VAM agreement to be valid, but the second one invalid because it harmed the interests of other PE investors.
3. Shanghai ShanRong Industrial Co., Ltd. v. Yan Xiaoming, etc. for Company-related Dispute
In this case, Shanghai ShanRong Industrial Co., Ltd. and Yan Xiaoming, the shareholder of the target company, signed an agreement which stipulated the terms of stock buy-back and the price of buy-back based on their shareholding ratio. Thereafter, one of the original shareholders transferred a part of the stock of the target company that he held to another subject, which led to a change in the other parties' shareholding ratio in the target company. During the trial, there was dispute among the parties over whether the stock buy-back terms and the buy-back price could harm the new shareholders' interests. The Shanghai No. 1 Intermediate People's Court ruled that a new shareholder joining the target company would not render the stock buy-back terms invalid. Even if the new shareholder's interest was harmed, he or she should make claim against the transfer party rather than against the other investors.
4. GuoHua Industrial Co., Ltd. v. Xi'an XiangYang Space Industry Corporation for Dispute over Equity Transfer
In this case, the target company was a Sino-foreign joint venture (hereafter referred to as "JV"), and the shareholder that was liable for stock buy-back (i.e. Xi'an XiangYang Space Industry Corporation) was a state-owned enterprise (hereafter referred to as "SOE"). Therefore, this case involved having buy-back terms against an SOE and against shareholders of a JV at the same time.
During trial at the first instance, the Jiangsu Province Changzhou Intermediate People's Court found that Xi'an XiangYang Space Industry Corporation was to strictly abide by the relevant laws and regulations concerning state-owned asset disposal in handling the equity of the target company. Without approval from the competent authorities of state-owned assets, the stock buy-back terms involved in the case were considered damaging to the public interests and therefore invalid. On appeal, the Jiangsu Higher People's Court found that the equity transfer agreement involved in the case included two legal relations, which are the PE investor's acceptance of the equity of the target company, and the PE investor's conditional transfer of his equity to the original shareholder (i.e. the stock buy-back provision). Both of these two legal actions need to be approved by the competent authority of foreign investment. According to the approval documents provided by the parties, the authorities only approved the PE investor's acceptance of the equity of the target company. Therefore, the stock buy-back agreement in this case was to be considered as an agreement that had not yet come into force.
5. Investors v. Lianyungang JiaYu Electronic Material Technologies Co., Ltd. for Dispute over Equity Transfer
The investment agreement in this case stipulated both the performance-based compensation terms and stock buy-back terms. Where another court had already ruled that the original shareholders were to give performance-based compensation to the investors, both the court of first instance (Lianyungang Intermediate People's Court) and the court of second instance (Jiangsu Higher People's Court) also found in favor of the investor's request for the original shareholders of the target company buy back his stock. As for the validity of the stock buy-back terms, both courts found the stock buy-back terms between the investor and the target company to be invalid as such terms violated the principle of constant corporate capital and regulations related to company stock buy-back, but the same terms between the investor and the original shareholders to be legal and valid.
6. Tianjin GuiGuTianTangHeYing Equity Investment Partnership (Limited Partnership) v. Shandong HanLin Biotechnology Co., Ltd. and Cao Wubo for Company-related Dispute
In this case, the Shandong Higher People's Court ruled that the stock buy-back agreement between the shareholders and the target company was invalid as it violated relevant provisions regarding stock buy-back in the PRC Company Law, but the stock buy-back agreement among the shareholders was valid.
Cases from Arbitration Institutions
Compared to courts, arbitration institutions focus more on protecting the party autonomy, therefore their decisions are by comparison more flexible. Before the retrial judgment of the HaiFu Investment Case became public, in many cases heard by the China International Economic and Trade Arbitration Commission (hereafter referred to as "CIETAC"), the arbitral tribunal fully respected the party autonomy, and ruled that VAM agreements should be found valid as long as they do not harm the public interests, do not violate laws and regulations, and/or do not give rise to any obviously unfair circumstances. After the retrial judgment of HaiFu Investment Case became public, cases from CIETAC set forth below are worthy of our attention:
1. A PE Fund v. the Target Company for Dispute over Capital Increase
In this case, a PE fund entered into an investment agreement with the target company with performance-based VAM terms. In January, 2014, the arbitral tribunal found such terms to be legal and valid, and therefore the target company had the obligation to pay cash compensation to the investor.
The final award of this case is different from the judgment in the HaiFu Investment Case, where the court denied the validity of the VAM Agreement between the investor and the target company. However, the performance-based VAM terms in this case were particular for the following reasons: (1) the parties to the agreement based the price of capital increase on the provisional estimate of the future performance of the company. Only when the results of the company's actual performance resulted could the parties ultimately fix the value estimate of the company and calculate the capital increase actually payable in accordance with the agreement on cash compensation (i.e. the VAM terms of this particular case); (2) the actual profit of the target company did not vary significantly from the promised performance, i.e. the promised performance did not severely deviate from the company's actual operations; (3) the target company would still hold a net profit of RMB 51 million Yuan after paying the cash compensation, which means it will not harm the interests of the company and its other creditors.
2. A PE Fund and an Individual v. the Target Company and its Original Shareholders for Dispute over Capital Increase Agreement
The capital increase agreement in this case stipulated both performance-based compensation terms and stock buy-back terms. Specifically, if the annual net profit in 2011 of the target company could not meet the promised performance, the target company and its original shareholders were to give cash compensation to the investors; and if the annual net profit of the target company in any year was lower than 80% of the promised performance, or by the end of 2011 the target company had not obtained the dealership of a specific business, the original shareholders had the obligation to buy back the investor's equity of the target company at an annualized yield of 20%, and the target company was to bear unlimited joint and several liability.
The arbitral tribunal ultimately took a step further than courts in rendering the award, and found that: (1) the investor's estimate of the target company's value relies upon the promise made by the original shareholders of the company's anticipated performance, and the performance-based compensation terms are a mechanism to incentivize and restrain the target company and its original shareholders, which conformed to the principles of equality, voluntariness, fairness, and reasonableness. Therefore, the performance-based compensation terms between the investor and the target company, as well as between the investor and the original shareholders are legal and valid. As the target company did not achieve its promised profit amount, both the target company and its original shareholders had the obligation to pay cash compensation to the investor; (2) the function and nature of the stock buy-back terms are in accord with those of the performance-based compensation terms, and should be deemed as legal and valid. The original shareholders should buy back the investor's equity in accordance with the specific agreements in the stock buy-back terms; however, the arbitral tribunal did not find for the target company to bear unlimited joint and several liability.
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