It is a common arrangement for major shareholders and de facto controllers of listed companies to make a guaranteed yield and principal commitment to private placement investors. With financial supervision tightened up in recent years, however, the judicial stance towards the validity of guarantee commitment has shifted towards denial.
This may, for some time, shift the focus of disputes over listed companies’ guarantee commitments from validity to the legal consequences of invalidity.
Shifting judicial stance
In recent years, the China Securities Regulatory Commission (CSRC) has revised the Administrative Measures on Issue and Underwriting of Securities several times, while issuing a series of supervisory rules for listed companies’ private placement of shares and companies listed on the ChiNext, Star Market or Beijing Stock Exchange, gradually expanding the scope of issuers prohibited from making any guarantee commitments.
At present, regulators explicitly prohibit listed companies and their controlling shareholders, de facto controllers and major shareholders from making any direct or disguised guarantee commitment to investors.
Accordingly, the Supreme People’s Court (SPC) has also issued judicial safeguard opinions for the ChiNext, Star Market and NEEQ, making it clear that the court could draw reference from applicable supervisory rules in trials.
Because relevant supervisory rules are mostly ministerial-level and less enforceable, however, many local courts have continued to affirm the validity of guarantee commitments, principally on the ground that these supervisory rules are not laws or administrative regulations and therefore not mandatory, enforceable or retroactive.
In June 2022, the SPC made it clear for the first time, in the Opinions on Providing Judicial Safeguards for Deepening the Reform of the NEEQ and Establishing the Beijing Stock Exchange, that, “where investors use their advantageous position to enter into any terms on ‘guaranteed yield and principal on private placements’ with listed companies and their controlling shareholders, actual controllers or major shareholders, because such terms give investors a special right to guaranteed yields that creates superiority to other shareholders of the same class, such arrangement will push up the financing cost of small and medium-sized enterprises in a disguised way and thus violate the principle of equity set forth in the Securities Law and relevant supervisory rules. The people’s court should invalidate such terms in accordance with the law.”
In early 2023, the SPC once again pointed out, in article 1 of the Minutes of the National Courts’ Work Conference for Financial Trials (Draft for Comment), that “the act of issuing a guarantee commitment distorts the securities market’s pricing mechanism based on supply and demand reaction, and the wrong price information released by it will affect other investors’ decisions and disrupt the securities market order. It should be identified as an invalid act that violates public order and good morals.”
Judging from recent court judgments, the judgment criteria are essentially consistent with these SPC opinions, indicating that the judicial stance towards guarantee commitment has shifted to invalidation.
Consequences of invalidity
Liability sharing between investor and commitment maker. In a civil juristic act, the party at fault shall compensate the innocent party for losses incurred. If both parties are at fault, liability shall be shared pro rata between them in proportion to their faults.
In judicial practice, the court usually assesses the fault of investors according to their business scope and knowledge level. In particular, the investor experienced in capital market business may be deemed aware that the guarantee committee violates the supervisory rules, and equally at default with the guarantee commitment maker. In such circumstances, losses shall be equally shared between the two sides.
Determining loss amount. A basic point of view in judicial practice is that if the investor sells shares at a price lower than the purchase price, the price difference can be identified as the investor’s loss, but fixed income derived from the guarantee commitment does not fall under this category.
The underlying logic is that, after the guarantee commitment is found invalid, the investor’s loss becomes a reliance loss. The reliance loss usually includes the direct loss and indirect loss.
The former refers to direct reduction in the value of existing property caused by occurrence of the impairing act. The latter means a loss where the value of the relying person’s property has not been increased as promised, as a result of the impairing act that renders the contract invalid.
If both parties willfully violate public order and good morals, or are equally at fault, neither may claim compensation for indirect losses.
In addition, it should be noted that if the investor has not sold all the shares before filing a lawsuit, there may be a risk that the court will dismiss the claim due to uncertainty in whether the loss has occurred, or impossibility to determine the loss amount.
Liability of guarantor. Performance of the guarantee commitment may involve a third-party guarantee. There may be different views on what liability the guarantor should bear when the guarantee commitment is found invalid.
First, if the guarantee commitment is invalid, the guarantee contract as an accessory contract is also invalid in principle. The guarantor is not liable to pay damages if not at fault; otherwise, the guarantor’s liability shall not exceed one-third of the amount the debtor fails to pay off.
Second, according to the main idea behind the SPC judgment of China Huarong Asset Management Yunnan branch v Chenggang Industry & Trade (2020), when the contract is found invalid, civil liability shall be reasonably shared between the parties under the principle of good faith, so the dishonest party cannot benefit from invalidation of the contract.
Despite the invalidity of the guarantee commitment, the investor still may require the guarantor at default to assume the guarantee liability for the corresponding debt owed by the party making the invalid commitment.
Investors may need to consider adjusting their litigation strategy, and shift their focus from seeking court affirmation of the validity of the guarantee commitment to requesting the court to order that the other party be primarily liable for the loss caused by invalidity of the guarantee commitment, and assume the relevant guarantee liability.
Therefore, the investor may consider asserting that: the guarantee commitment was offered by the other party voluntarily and at that time the investor did not know and should not have known that it violated supervisory rules; the listed company is actually managed and controlled by the other party, who shall be primarily liable for the decline in stock price; and the guarantor is appointed by and related to the other party, and is obviously at fault.
Investors also need to pick the most appropriate time to file the lawsuit to avoid “procedural idling” due to uncertainty of losses.
Chen Zhuo is a partner at Tian Yuan Law Firm. He can be contacted at +86 138 1041 7260 or by e-mail at firstname.lastname@example.org
Yin Yutong is an associate at Tian Yuan Law Firm. She can be contacted at +86 138 1139 4158 or by e-mail at email@example.com