In many disputes arising from equity investment transactions, the transaction documents contain a clause stipulating that the founder’s liability shall be limited to the equity (value) they hold.
Disputes easily arise from the different understanding and application of such clauses because, for one thing, the specific provisions vary greatly; for another, there are no unified standards in judicial practice for judging them.
Application and exclusion
The first issue that comes under dispute is often the validity of the clause, and whether the founder can claim its application and thus reduce liability. Some transaction documents stipulate not only the limitation of liability clauses, but also conditions under which their application can be excluded.
For example, the liability for breach of contract caused by “intentional or gross negligence, or illegal conduct”, or failure to adopt rectifying measures within a reasonable time after being notified, have been deemed exceptions to the limitation of liability clause.
At this point, applicability will in principle depend on whether the investor can fulfill the burden of proof regarding the existence of exceptions.
In addition, the validity and application of such clauses also involve another basic issue, namely the validity of the exemption clause. According to article 506 of the Civil Code, an exemption clause shall be invalid in case of any property damage to the other party due to intentional or gross negligence. Therefore, even if the contract does not provide explicit exclusion to the limitation of liability clause, the investor may still claim invalidity based on the above article.
Determining the limit
Where such a clause is confirmed to be applicable, the next step is to determine the extent of the liability of each relevant party. In practice, factors that need to be determined may vary depending on the specific circumstances and differences between the agreements.
Basis for determining the limit of liability. In some limitation of liability clauses, the limit is determined by “equity” in the company held by the party, while in others it is described as “equity value”. The author has not found any case in judicial practice that explicitly differentiates the two. In the literal sense, the key difference may be that equity limits the scope of property that bears liability, while equity value only limits the amount.
Calculation time point. If no calculation time point is agreed on in the contract, or vague expressions such as “by then” are used, it becomes another issue that may cause considerable debate. In time point-related disputes, the investor usually wishes to interpret it as when the investment is completed, while the founder prefers the time when the investor seeks to have their equity repurchased, or when the equity is monetised during enforcement.
In the absence of an explicit agreement to calculate based on the time of investment, courts tend to adopt the time when the investor claims their rights. However, some courts do not specify the calculation time in their judgments, but simply follow contract terms such as “liability shall be capped by the amount of equity held”, which may result in the defendant being effectively liable to the extent of the assessed auction value of the equity in enforcement.
In the event of an equity repurchase or a dispute over a repurchase, the valuation and equity value of the target company are often significantly lower than when the investor made the equity investment. As a result, this interpretation is unfavourable to the investor.
Determining a specific limit of liability without explicit agreement in the contract essentially comes down to interpretation. Some courts go beyond the literal wording of the contract and interpret it as a whole, focusing on its purpose and taking into account the principles of honesty, credibility and fairness.
Courts may investigate the contract’s objectives based on the nature of the equity investment, and render their decision by taking a more fair and reasonable interpretation consistent with the parties’ original intention.
In a 2020 dispute involving Zhejiang Jinguan and Ruijiu Equity, one of the key disagreements stemmed from the meaning of a clause in the letter of undertaking issued by the defendant to the plaintiff: “After reception, I shall bear obligations to the extent of the equity received.”
The court found it difficult to determine the specific limit of liability based on the text, so opted to further examine factors such as the background and process of the transaction, the breach of contract by the party concerned, the purpose of the transaction, and the current market value of the equity involved. It believed that the contractual purpose of the defendant in issuing the letter was to improve the credit for the investor to share risks and strengthen investment security.
Considering the extremely low market value of the equity at the time, it would be unfair to affirm the defendant’s limit of liability as the assessed auction price of the equity held during enforcement, which would also be contrary to the intention behind the contract.
Furthermore, the court determined the liability to be borne by the defendant based on the equity repurchase price claimed by the plaintiff and with reference to the proportion of the defendant’s received equity. For obvious reasons, this approach proved more beneficial to the investor.
The limitation of liability clause is essentially a compromise struck between negotiating parties in investment and financing. The investor wishes to maximise the security of their investment, while the founder wishes to limit potential liabilities and, in many cases, isolate personal and family property.
When negotiating and finalising the contract, both parties should not only consider their own business goals but also look at the legal provisions in the context of judicial practice to consider whether the text is sufficiently clear and precise and, if disputes arise, whether it can ensure the realisation of their objectives through judicial procedure. It is also advisable to consider countermeasures for possible legal risks, and be prepared to take the initiative when disputes occur.