Claiming share repurchase and cash compensation in VAM

By Xie Yang and Tian Cheng, Zhilin Law Firm
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The Minutes of the National Courts’ Civil and Commercial Trial Work Conference made a detailed analysis on the effectiveness of VAM (valuation adjustment mechanism), which can be summarised as follows: (1) if the investor bets against the shareholder or actual controller of the target company, the VAM should be deemed valid; (2) if the investor bets against the target company, it should be deemed valid. If the investor requires the target company to repurchase its shares, it should be examined whether the target company has completed capital reduction; if the investor requires cash compensation from the target company, it should be examined whether the target company has any profits.

However, the minutes failed to clarify whether share repurchase and cash compensation can be claimed and supported at the same time, or ways to judge whether the claimed amount is too high.

For and against

The arguments supporting the simultaneous claims mainly include:
The conditions and period for share repurchase and cash compensation are different, and the respective terms do not contradict or contravene. In Shandong Hongli Anywhere Environmental Technology Group v Tianjin Pukaitianji Equity Investment Fund Partnership (2019), the Supreme People’s Court noted that the condition for cash compensation was the failure of the net profit of the target company to reach in 2012, and the condition for share repurchase was the failure of the target company to be listed in China’s A share market before 31 December 2014.

As the two claims were conditional on terms occurring at different times, when the condition for cash compensation was met, the condition for share repurchase was not. Additionally, the conditions for the two claims were entirely different, one based on a commitment of performance, while the other was on listing status. Therefore, cash compensation and share repurchase in this case were not contradictory.

Parties to VAM did not agree on choosing one or the other. In Citic Capital v Xie Lixin (2020), the Higher People’s Court of Beijing held that cash compensation and share repurchase were provided for under separate terms in the supplementary agreement in question. In the absence of any stipulated standards of applicability or any conflicts, both claims should be supported simultaneously.

The arguments against the simultaneous claim mainly include:
Overlapping, as the trigger of cash compensation inevitably also leads to share repurchase. In Shenzhen Qianhai Shengshi Mengjin Investment v Kashi Xinghe Venture Capital, et al (2017), the Beijing No.1 Intermediate People’s Court held that a conflict exists in that when an investor requires shareholders for cash compensation, it would itself remain a shareholder; but when requiring a share repurchase, it would lose the status of being a shareholder.

If the commitment of listing cannot be fulfilled, it is likely that the performance of the company has also suffered, indicating that the legal consequences of share repurchase caused by the failure of the target company to be listed by the appointed time already incorporated the consequences of cash compensation caused by underperformance, creating an overlap between the two. For these reasons, the investor’s request for separate cash compensation constitutes duplicate calculation.

谢阳__Xie_Yang__Zhilin-s
Xie Yang
Senior partner
Zhilin Law Firm

Parties to the VAM have agreed to choose only one out of the two, or that overlapping benefits should be deducted when another is claimed.

In Wang Canshou v Hubei Hongrui Smart Industry Equity Investment Fund Partnership (2021), the higher court of Beijing held that the supplementary agreement in question stipulated that if the investor chose to exercise the repurchase right, all dividends or compensation previously received by the investor from the target company would be offset against the repurchase price. Therefore, the investor can only claim either cash compensation or share repurchase.

Amount adjustment

田诚__Tian_Cheng__Zhilin-s
Tian Cheng
Associate
Zhilin Law Firm

In Shanghai Pukai Tianji & Pukai Tianxiang v Shandong Hongli Heat-pump Energy (2019), the SPC held that after consolidating the amount of cash compensation and the annual dividends previously received and apportioning them equally to the return on investment for each year, from the time of investment to the triggering of the share repurchase, the return on investment was not considered too high when taking annual investment income into consideration.

After a rough calculation based on the SPC’s opinion, the return on investment and the standard interest rate on investment costs in this case add up to about 20% per year. In Zhengxiang Baiqi Yihao Mining v Ping An Bank (Beijing branch) (2019), the higher court of Beijing supported cash compensation for interest losses, in addition to share repurchase, return on investment and cash compensation simultaneously.

In a certain sense, a VAM is like an option. Investors take on higher risks in the hope for higher rewards, while resorting to cash compensation, share repurchase and other means to protect their interests. However, for the rights of cash compensation and share repurchase to be supported simultaneously, when signing the agreement, one should clearly distinguish the two in terms of conditions and exercise time, expressly set out that the two rights can be exercised simultaneously, and that benefits already received will not be deducted when the other right is claimed, in order to improve the chances of being simultaneously supported by the court.

As for how to simultaneously claim the two rights without the amount being identified as too high by the court, based on cases retrieved and analysed by the author, most courts adjust the excessive return on investment, in many cases to 24% of the annual interest rate. Since the new judicial interpretation on private lending designated four times the loan prime rate as the interest rate cap, it cannot be ruled out that courts may lower the total return on investment with reference to that limit.

When a VAM is signed, in order to protect the upper limit of investor interest, the author suggests that the interest rate of cash compensation and share repurchase costs should not be excessively high. Instead, reference can be made to 24% of the annual interest rate or four times the LPR. If the interest rate ends up being too high, courts may lower such rates in an effort to balance the interests of both parties.

Xie Yang is a senior partner and Tian Cheng is an associate at Zhilin Law Firm

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