China: Impact Of The PRC Supreme Court's Position On The Valuation Adjustment Mechanism

In China, the Valuation Adjustment Mechanism ("VAM") has long been frequently used in corporate financing transactions, especially in PE investments. VAM is a contractual provision that allows for the adjustment of the target entity's valuation on certain conditions, including the right of investors to seek recovery of its equity interests and/or indemnities from the financing parties. The VAM is designed to handle the uncertainty associated with the target entity's future financial performance and business development. Investors tend to add a VAM provision in their transaction documents to mitigate investment risks.

Unlike the practices in some other jurisdictions, the effectiveness and enforcement of VAM provisions have been the subject of disputes in the PRC for years. However, since the Minutes of the National Courts' Civil and Commercial Trial Work Conference (in Chinese characters "全国法院民商事审判工作会议纪要") ("Jiu Min Minutes") was issued on November 14, 2019, we have seen that the judicial opinions of the PRC courts have trended to evolve along with growing market-oriented practices.

Impact of Jiu Min Minutes

The Jiu Min Minutes summarizes the court's previous judicial experience with the twelve (12) types of civil and commercial cases. The Jiu Min Minutes includes a summary of how the court applied the laws and dealt with VAM -and other - disputes, shareholders' pre-emptive rights, and guarantees by companies, all of which are important to investments in the PRC market.

Court decisions in China relating to VAM-related disputes have significantly aligned with the Jiu Min Minutes since it was issued in 2019. China Judgements Online (https://wenshu.court.gov.cn/) shows 76 VAM-related court decisions were handed down by the domestic High Courts and the Supreme Court in 2020 and 2021. In most cases, the judges referred to, analyzed, and considered the Jiu Min Minutes in their judgements.  

Main Observations

In light of the Jiu Min Minutes, the PRC courts are now trying to decide VAM-related cases based on two key factors: (i) the effectiveness of the VAM provision and (ii) the plausibility of the parties being able to carry out the provision, under which the Jiu Min Minutes has held different views and positions on the relevant contractual obligations borne by the target entity and its shareholders.

Among the 76 court cases mentioned above, only four were between the investor and the target company. The remaining cases were brought by the investors against the shareholders/persons with actual control of the target companies. From this, we see a growing trend toward investors exercising a VAM provision against the shareholders, rather than against the company, in order to avoid any potential non-performing risks. On the other hand, shareholders appear to be more reluctant to take obligations and liabilities under a VAM provision in their own capacity. This can leave the parties with challenge of how to fulfill their respective duties under an acquisition agreement.

Ultimately, the VAM provision will be one of many issues in a complicated transaction - it forms part of a suite of transaction-related pitfalls that relevant parties need to consider, and be mindful of, during robust negotiations. Therefore, potential investors, the target company, and its shareholders should be aware of the judiciary's current position towards corporate financing transactions and seek professional guidance on how to build and better formulate their transaction documents.  

Seyfarth Experience

Seyfarth's China team proactively advises our foreign clients in connection with their PRC investments and businesses and can tap into valuable knowledge and connections for additional support when needed.