The validity of valuation adjustment mechanism (VAM) agreements between investors and target companies and the possibility of their actual performance often become the cause of disputes.
According to the judicial rules under the Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts, the Supreme People’s Court (SPC) makes it clear that VAM agreements shall be valid. But if the investor requests the target company to repurchase its own shares, the court shall review it according to article 35 of the Company Law, which stipulates that “shareholders may not withdraw their capital contributions”, or the mandatory provisions of article 142 on share repurchases.
Claims made by a target company having failed to reduce its capital will be rejected by the court. However, the minutes did not clearly provide for the legal procedures for partnerships to buy back their own partnership interests.
Recently, the authors handled a dispute involving the repurchase of partnership interests, in which the investor requested the repurchase of partnership interests owned by it in order to exit from the investment. During the trial, the procedural prerequisite for a partnership repurchasing its own interests became a furiously debated issue.
This case involved a limited partnership and its three partners, GP, LP1 and LP2. GP is the general partner and managing partner of the limited partnership, while LP1 and LP2 are limited partners. The three partners entered into an investment agreement which provided that – under certain circumstances – LP2 may request GP, LP1 and the limited partnership to repurchase their own interests at a specific price. LP2 later put forward a repurchase request, a request that went unheeded by GP, LP1 and the limited partnership, which led to litigation.
This article discusses whether a partnership should go through certain procedural prerequisites when repurchasing its own partnership interests, with a brief analysis on whether the repurchase request merits support under the special circumstances of this case.
At present, there is a lack of clear regulation or guidance on the validity of repurchasing one’s own partnership interests or whether certain procedural prerequisites are required. The judicial rules of the minutes on companies repurchasing their own shares are based on three principles: Finance serving the real economy; investors bearing certain risks; and the overall balance of interests.
Investment in business entities is to be encouraged, but we should likewise strive for a balance of interests among investors, shareholders, creditors and companies. When it comes to creditors and investors, the SPC believes that the interests of the former should be given priority over those of the latter, thus capital reduction must be completed first and foremost.
As for the investors, they should set out terms on these matters in the investment agreements according to the aforementioned principles. Repurchase of partnerships is also a tricky act of balancing the interests of multiple parties.
The authors believe that a partnership differs from a company mainly in that the relationship between partners is more personal than that between shareholders. The partnership by itself does not own independent property. Its debts are paid off by the partners with their own property according to the proportion of capital contribution or their agreement. General partners bear unlimited joint and several liability for the debts of the partnership. When a partner transfers all its interests to the partnership, it inevitably means more liability for the rest of the partners. Balance of interests among partners should be taken into consideration in cases of repurchase by the partnership.
If the contingent liabilities of certain partners are to increase, a procedural prerequisite ought to be in place. To be specific, all partners should vote on a formal proposal in agreement to the repurchase of interests.
In this case, all three partners in the limited partnership have signed the investment agreement in question, thus committing themselves to the obligation of repurchasing their partnership interests, should that be requested. Each partner has clearly been aware of and in agreement to the potential increase in liability brought by the repurchase agreement. The indication is that they would have voted in favour of a repurchase proposal.
Under such circumstances, to mandate a proposal as a precondition for repurchase, regardless of commitments made by voting partners in other related agreements, such a repurchase agreement cannot be performed in case of dispute, and the interests of investors cannot be safeguarded. Therefore, the author believes that, by refusing to make a proposal when LP2 requested a repurchase, with all other conditions for such a repurchase satisfied, GP and LP1 violated their commitments in their agreement and improperly hindered the thorough fulfillment of repurchase conditions. Accordingly, the repurchase conditions should be deemed fulfilled.
To sum up, the authors believe that in general, when a partnership repurchases its own interests, it should be required that all partners give their go-ahead in the form of a proposal. In this particular case, however, because all partners of the limited partnership have clearly agreed to the limited partnership’s repurchase obligations in the agreement, they have made explicit their consent to a repurchase, which is as good as undertaking to make the required proposal in the event of a repurchase request.
Therefore, if the limited partnership has sufficient repurchasing power, its default by way of refusing to make a proposal should not be regarded as a valid basis of defence, and the court should not reject the investor’s request for repurchase on this ground. Otherwise, the defaulting parties will be allowed to benefit from their breach of contract, which obviously goes against the principle of good faith.
Hu Zhiyong is a partner and Zhu Jingmin is an associate at Grandway Law Offices. Wang Mengmegn, an associate at the firm, also contributed to this article
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