Invalidation of ‘minimum income for private placements’ on BSE

The Supreme People’s Court’s invalidation of “guaranteed minimum income for private placements” clauses of listed companies on the Beijing Stock Exchange (BSE) has riveted the attention of capital markets.

The issue arose in article 8 of Several Opinions on Providing Judicial Assurance for Intensification of the Reform of the New Third Board (NTB) and Establishment of the Beijing Stock Exchange, announced on 23 June 2022.

This column discusses the implications and impact of the article on the companies listed on the Shanghai Stock Exchange (SSE) and Shenzhen Stock Exchange (SZSE).

Article 9 of the opinions specifies: “Upholding the principles of impartiality, fairness and openness for capital markets reduces the financing transaction costs of small and medium enterprises by the law. Making direct financing on capital markets accessible is an effective means to solve the difficulties and high costs in financing experienced by small and medium enterprises.

“Concerning the listing and subsequent financings of innovative small and medium enterprises, it is necessary to open up the multi-level capital markets and uphold the principles of openness, fairness and impartiality.

“In the course of private placements and other subsequent financings of listed companies, investors take advantage of their dominant position to enter into the guaranteed minimum income clauses with the listed company and its controlling shareholder, actual controller or a major shareholder, which push up the financing costs of small and medium enterprises in a disguised manner, and violate the fairness principle of the Securities Law and related regulatory provisions by granting the investors special rights to get more guaranteed returns than other shareholders of the same class. Accordingly, People’s Courts shall determine such clauses invalid by law”.

Practical Application

(1) Legal effect. In practice, neither judicial interpretations nor documents in the nature of judicial interpretations, such as the opinions, can create law because in essence they interpret law in a narrow sense. The legal basis for invalidating the guaranteed minimum income clauses is that they violate the fairness principle of the Securities Law and related regulatory provisions.

In past judicial practice, disputes over the validity of capital market contracts often cited the legal grounds for invalidating contracts, such as “violating public order and good customs”, or “harming public interest”.

This time, the court emphasises violation of the fairness principle in the Securities Law, mainly based on the objective of the opinions, namely ensuring reform of the NTB and establishing the BSE’s smooth progress.

If investors of BSE listings mount their defence on the validity of the guaranteed minimum income clauses based on the opinions’ legal effect, the courts will reject it.

(2) Only BSE-listings? The opinions statement that “we specify the following opinions regarding such issues as People’s Courts correctly trying cases relating to companies listed on NTB and BSE, etc.” identifies the scope of its applicability.

In terms of fostering enterprises, the opinions are tailor-made for the BSE. Article 8 specifies differences in the treatment of companies listed at their startup and mature stages. BSE-listed companies were formerly quoted on the NTB Select, and the objective of establishing the BSE is “creating the main platform for serving innovative small and medium enterprises”.

Article 9 mentions the necessity to assist such enterprises in listing and developing, reducing their financing costs. Accordingly, this article applies solely to BSE-listed companies.

(3) Impact on SSE and SZSE. The guaranteed minimum income clauses are in the nature of the valuation adjustment. In past judicial practice, it was common to draw on the adjudication rules of valuation adjustment mechanisms (VAMs) to handle the validity issue of guaranteed minimum income clauses. The difference between them is that the VAM generally involves closed companies, whereas the guaranteed minimum income clauses involve public companies, bearing on the interests of numerous small and medium shareholders.

The guaranteed minimum income clauses between investors and the shareholder or actual controller do not affect the interests of other shareholders, and will generally be deemed valid. However, such clauses between investors and the listed company may be deemed invalid.

Article 29 of the newly revised Detailed Implementing Rules for the Private Offering of Stock by Listed Companies, by the China Securities Regulatory Commission (CSRC) in 2020, expressly prohibits listed companies, controlling shareholders, major shareholders and actual controllers from offering a guaranteed return to targets of such offerings. Investors were concerned that the prohibition would affect the validity of “minimum income” clauses, however, no such effect has been seen from judicial practice (see ETI v China Fortune International Trust).

Arguably, although the opinions apply solely related to the BSE, the legal logic clarified therein may have implications for other cases. The fairness principle of the Securities Law and related regulatory provisions serving as the grounds for the opinions is not formulated specifically for companies listed on the BSE, and the conclusion that guaranteed minimum income for private placements pushes up the cost of enterprise financing is not only for the BSE.

Furthermore, with the law as a superstructure, consideration needs to be given to the economic foundation. Initially, the basic economic logic of changing VAMs from being invalid to valid was to encourage capital investment in startups and foster innovative scientific and technological enterprises. By the same token, if the guaranteed minimum income clauses begin to deviate from the logic of capital market development, they could be abandoned.

Investors are advised to pay greater attention to the study of investment value when participating in private placements of listed companies, particularly those of innovative small and medium enterprises.

To reassure the market, the Supreme Court is expected to clarify the issue of the validity of the guaranteed minimum income clauses of companies listed on the SSE and SZSE.

Sun Junxia is an associate at Zhilin Law Firm