PE funds: check your buyback terms have the PRC’s seal of approval

As a common international practice, private equity (PE) funds will regularly write equity or share buyback terms into the investment agreements they execute with investee enterprises. The reason for these terms is that in the investment process, PE funds seldom have a sufficient understanding and knowledge of the investee enterprises so the investment decisions they make face numerous uncertainties and risks. Another reason is that the analysis of, and judgment on, the enterprises by their management generally lean toward the optimistic.

As potential investment risks exist, the main intention of investors to include such terms is to reserve for themselves the opportunity to revise the valuation of an investee enterprise and add a channel for withdrawing from it when specific circumstances arise. In other words, when a company’s performance does not reach the promised value, or another circumstance arises (e.g. mass departure by senior management and core technical personnel, failure to list by the specified date, discovery of an existing error in the enterprise’s operations and management, etc.) the investor has the right to request to sell its equity to the company, recover its initial investment costs and obtain a certain premium pursuant to the specified buyback provisions.

Furthermore, the conditions set by the equity buyback terms incentivise the existing shareholders to use their best efforts to realise their undertakings initially given to the investor.

Numerous PRC and international PE funds are continuing their rapid growth on China’s capital markets. We regularly receive inquiries from PE funds asking whether the aforementioned equity or share buyback terms are valid and binding under the PRC’s legal framework. This question needs to be addressed differently, depending on the type of company.

Equity buybacks

Article 75 of the PRC Company Law addresses equity buybacks by limited liability companies. Under this article, a shareholder who votes against a relevant resolution at a shareholders’ meeting may request the company to purchase his equity at a reasonable price in any of the following three circumstances: (1) the company has not distributed profits to the shareholder for five consecutive years, where the company has been profitable during those five years and the shareholder satisfies the conditions for the distribution of profits specified in the Company Law; (2) the company merges, is divided, or transfers its main property; (3) the term of operation specified in the company’s articles of association expires or other grounds for dissolution as specified in the articles of association arise, and the shareholders’ meeting resolves to amend the articles of association to extend the life of the company.

Article 75 of the Company Law sets conditions under which a limited liability company must buy back the equity of an opposing shareholder. The Company Law doesn’t contain any other provisions that prohibit a limited liability company from buying back its equity. Based on the principle of “what is not expressly prohibited is not a violation of the law”, we are of the opinion that equity buyback provisions in the articles of association of a limited liability company are valid and binding.

However, Article 143 of the Company Law specifies that a joint stock limited company may not, in principle, buy back its shares unless any of the following conditions is satisfied: (1) it is reducing its registered capital; (2) it is merging with another company that holds its shares; (3) it is to grant the shares as an incentive to its employees; (4) a shareholder who opposes a resolution on the merger or division of the company adopted at a shareholders’ general meeting requests that the company purchase his shares.

From this it can be seen that the Company Law places more stringent restrictions on share buybacks by joint stock limited companies – such buybacks are not permitted in principle.

Supplementary agreements

In practice, some PE funds have included so-called “investment protection terms” in the form of supplementary agreements – either because they do not wish to disclose some terms or to avoid their being questioned or rejected by the competent administrative authority – and do not submit such agreement or undertaking with the master agreement to the competent administrative authority for approval or registration. However, the issue of the validity of such a supplementary agreement or undertaking cannot be ignored. In the case of a renminbi PE fund investing in a wholly Chinese-owned enterprise, pursuant to relevant regulations it must record the change in the registered particulars of the enterprise with the local administration for industry and commerce on the strength of the capital increase or equity transfer agreement relating to the investment.

However, the signing and sealing of the agreement documents relating to the investment by the parties are the conditions for their entry into effect. Accordingly, even if the documents are not submitted to the administration for industry and commerce, their effectiveness is not affected.

However, if the investor is a foreign-funded PE fund or the target company is a foreign-invested enterprise, since the equity transfer or capital increase agreement of a foreign-invested enterprise and the amendment of its articles of association require the approval of the commerce authority to enter into effect, if the supplementary agreement or undertaking is not submitted to the approval authority, their validity is impossible to ensure.

Conflict with listing rules

Generally, the first choice of PE funds for withdrawal from a PRC investment at present is an IPO. However, when reviewing an enterprise’s IPO application, the China Securities Regulatory Commission, in seeking to protect the interests of retail investors and the stability of the enterprise’s equity structure, does not wish to see provisions in the relevant investment agreement or the company’s articles of association that offer protection to a specific investor and violate the regulation that shares of the same class carry the same rights.

Accordingly, in practice, it may be specified in the investment agreement that in the event that such investment protection terms contain provisions that are in conflict with applicable listing laws, regulations and regulatory documents at the time the investee enterprise initiates its IPO application, such provisions will automatically be suspended, and if the investee enterprise’s IPO application is denied or withdrawn, the aforementioned provisions will automatically recover their validity.

Zhang Yichi is a partner at Concord & Partners, and Zuo Kun is the firm’s associate