Equity repurchases: Fulfilling obligations, mitigating dispute risks

Equity repurchases, in which investors can compel obligated parties to buy back their shares at an agreed price under specific conditions, are a staple of equity financing agreements. Recently, disputes over these clauses have surged, largely centring on the definition of obligated parties and the mechanics of fulfilment. This article examines these issues through the lens of judicial practice and offers strategies for risk mitigation.

Validity and enforceability. Following the issuance of the Minutes of the National Courts’ Civil and Commercial Trial Work Conference 2019, judicial treatment of repurchase agreements has become clearer. Agreements between investors and target company shareholders or actual controllers are generally deemed valid and enforceable, barring other invalidating factors.

Agreements with the target company itself are similarly valid. However, where the investor claims actual performance, such claim is subject to judicial scrutiny to determine whether it complies with the mandatory provisions of the Company Law regarding the prohibition against shareholders’ withdrawal of capital and share buybacks.

Because an equity repurchase effectively reduces a company’s registered capital and its liable assets, courts prioritise capital maintenance and creditor protection. Consequently, a company’s repurchase obligation is unenforceable unless it has completed a formal capital reduction procedure; investor claims for actual performance prior to this will be rejected.

Liability among co-obligors. When multiple shareholders are obligated to repurchase, but the agreement fails to specify the nature of their liability, disputes inevitably follow. Because joint or joint and several liability must be statutorily mandated or explicitly agreed upon, some courts rule that, absent such clauses, shareholders are only proportionally liable based on their stakes at the time of signing.

Conversely, other courts infer joint and several liability by examining the agreement’s broader context, the parties’ true intent and the commercial purpose. Furthermore, as an equity repurchase is, in essence, an equity transfer, there is also a view in practice holding that judicial scrutiny should be further conducted to see whether the right of first refusal (ROFR) of other shareholders is involved, depending on the specific identity of the obligor.

Impact of shareholder status. Does an obligor’s loss of shareholder status extinguish their repurchase obligation? Generally, the contract prevails.

The obligation is not inherently tied to shareholder status. Absent specific clauses, the obligor remains bound. However, if the agreement explicitly identifies the obligors by titles such as “controlling shareholder”, “actual controller” or “all shareholders”, courts will analyse the specific terms, commercial background and true intent to determine if a change in status discharges the obligation.

Special circumstances of repurchase guarantees. Where the target company serves as the primary obligor, and the repurchase agreement is valid but temporarily unenforceable due to unmet statutory conditions, significant controversies usually arise in practice over whether a guarantor should directly perform the guarantee liability.

It should be clarified that, unless otherwise agreed, the assumption of guarantee liability is not contingent upon the performance of the repurchase obligation. In cases where the guarantee agreement is valid and the law contains no special provisions regarding the performance of guarantee liability, the guarantor must bear the guarantee liability, even if the target company, as the repurchase obligor, is temporarily unable to fulfil its repurchase obligation.

Regarding the scenario where a target company provides a guarantee for a repurchase obligation, one view argues that the target company’s assumption of guarantee liability is substantively equivalent to executing the repurchase itself and thus should still be bound by the mandatory provisions of the Company Law regarding the prohibition on shareholders’ withdrawal of capital or share buybacks. Accordingly, if the target company has not completed the capital reduction procedures, such a claim shall not be supported.

An opposing view treats it as no different from a standard corporate guarantee provided for other matters. Provided that the company complies with the relevant corporate resolution requirements under the Company Law regarding external guarantees, and no other grounds exist to negate the validity of the guarantee, the target company should bear the guarantee liability. Judicial practice has not yet formed a unified stance on this issue.

Risk mitigation strategies. While some disputes stem from ambiguous regulations or inconsistent judicial application, the vast majority arise from the improper selection of repurchase transaction models, as well as an outright absence of contractual terms or ambiguous drafting. Addressing the above-mentioned issues by selecting the appropriate transaction model and making targeted contractual covenants within the repurchase agreement can effectively mitigate dispute risks.

First, parties to a transaction must determine the appropriate repurchase obligor based on the transaction’s actual circumstances, and upon fully understanding the statutory conditions and procedures for the actual performance of the repurchase agreement under different obligor profiles.

• Where the repurchase obligor is the target company, the design of the transaction model must simultaneously incorporate the obligation to initiate the corporate capital reduction procedure alongside its specific arrangements, stipulating, where necessary, breach-of-contract liabilities should the capital reduction procedure fail to be initiated in a timely manner.
• Where the obligor consists of multiple shareholders, the contract must explicitly clarify the specific manner in which the repurchase obligation is to be performed, such as several liability, joint and several liability, or joint liability.
• Where the obligor is a third party, the parties must take into account the other shareholders’ ROFR and the procedural requirements for registering the transfer of the repurchased equity, so as to avoid undermining the enforcement of buyback claims due to an inability to deliver the equity interest.

Second, it must be confirmed whether the repurchase obligation is linked to a specific identity of the obligor. Repurchase agreements should avoid using specific identity characteristics to refer to the subject of the repurchase obligation.

If the repurchase obligation is contingent upon shareholder status or actual controller identity, the agreement must explicitly outline the circumstances under which the repurchase obligation is discharged, as well as the corresponding handling mechanisms.

Finally, where the repurchase obligation is backed by a guarantee, the repurchase agreement should distinguish between the respective performance conditions of the repurchase obligation and the guarantee liability, while simultaneously stipulating matters such as the ownership allocation and registration of changes of the repurchased equity after the guarantor has performed the guarantee liability.

Zhou Jian is a senior equity lawyer at Anli Partners