Investors often require that target companies are included as repurchase subjects when designing the repurchase agreement (valuation adjustment mechanism, or VAM) of equity investments due to concerns about the solvency of the founding shareholders and the actual controllers. However, the Company Law sets strict conditions for share repurchases – i.e., capital reduction – by companies as part of its creditor protection, which can create multiple obstacles to performing repurchase agreements.
The first obstacle is that any investor request for share repurchases by target companies must be premised on a resolution for capital reduction made at the target’s shareholders’ meeting, according to the Company Law and the Minutes of the National Courts’ Civil and Commercial Trial Work Conference, among other legal documents.
Some courts may further hold that the repurchase of shares held by a specific investor is a target-specific capital reduction, which must be unanimously agreed by all shareholders, rather than the standard minimum of a two-thirds majority as stipulated in article 43 of the Company Law.
However, most financial investors do not seek to become a controlling shareholder and are less involved in the daily management of the target company after investment. When the majority shareholders or the actual controllers are unwilling to co-operate, it is often difficult for the investors to achieve a capital reduction resolution passed by two-thirds or more of the shareholders.
In the author’s view, the performance of the repurchase agreement is a special case of target-specific capital reduction because, usually, all shareholders would have signed the investment agreement when accepting the investment, which should be regarded as the formation of a unanimous resolution on the repurchase arrangement.
Because the subsequent capital reduction and share repurchase procedures are essentially just the performance of the investment agreement, there should be no need to obtain consensus of the shareholder again. However, under the current law, a valid resolution of the shareholders’ meeting is still a prerequisite for the capital reduction and share repurchase.
The second obstacle comes from the creditor protection proceedings that must be performed for a substantive capital reduction. According to article 177 of the Company Law, a company that plans to conduct capital reduction must prepare a balance sheet and an inventory of property, make a resolution on capital reduction at a shareholders’ meeting, notify known creditors in writing, make an announcement of capital reduction and make debt repayment or provide security for dissenting creditors.
However, investors usually cannot initiate the proceedings without co-operation from the majority shareholders and actual controllers. Moreover, the target companies facing the investors’ repurchase claim often have no intention or capacity to reach the statutory conditions of capital reduction for early debt repayment or provision of security.
There is a doctrinal distinction between substantive capital reduction (such as the performance of a share repurchase agreement by the company) and formal capital reduction (such as deregistration of certain shares to offset losses), depending on whether there is an outflow of the company’s net assets.
Some courts hold that a formal capital reduction can be valid even without notice to creditors because it does not impair the company’s solvency, but almost all courts believe that a substantive capital reduction should be strictly subject to procedural requirements. The minutes stipulate more explicitly that “where the investor requests the target company for a share repurchase, … upon examination, the people’s court shall reject its litigation request if the target company has not completed the capital reduction procedure”.
The third obstacle is that courts will be more cautious in capital reductions by unprofitable companies. In Shanghai Sheng Jiachong E-Commerce company v Hua (2018), the court held that “allowing a company at a loss to return the original investment capital corresponding to part of the equity required for capital reduction to the shareholder was actually a disguised distribution of the company’s remaining assets to individual shareholders through target-specific capital reduction without liquidation procedures, which is not only detrimental to the interests of other shareholders and the company’s property rights but also seriously damages the interests of the company’s creditors, so the request should be invalid”.
In practice, target companies suffering failure in the repurchase agreement are likely to be unprofitable. In such cases, courts may substantially review the financial data and solvency of the target to protect the interests of creditors, and it will be more difficult to implement share repurchase through capital reduction.
The observations on these obstacles are drawn from the theory and practice of the Company Law regarding capital reduction, but are also largely influenced by the conversion of shares and debts in repurchase agreements. An alternative is the convertible bond investment model, in which investors buy convertible bonds to become creditors of a company. When specific conditions are met, they will have the right to request the target company to increase capital, and can use the creditors’ right formed by the target’s borrowings to contribute to the company so as to obtain the equity and become shareholders.
The advantage of this model is that investors’ initial status is as creditors, and after the debt-to-equity swap conditions are met, they can decide whether to convert the creditors’ right into equity. When they enter the target company as new shareholders, the capital increase procedure is mainly completed within the company, and does not involve external creditor objection procedures. The possibility of performance of such an arrangement is higher than the repurchase agreement requiring share repurchase by the target company.
In transaction arrangements of the repurchase agreement, external investors are essentially no different from a company’s creditors. But once they hold the equity, their legal status changes from external creditors protected by the Contract Law to shareholders subject to the Company Law, and the exercise of shareholders’ rights is subject to a series of restrictions on capital reduction, repurchase, and capital withdrawal.
Investors should conduct due diligence before investing and make the shareholders assume the repurchase obligation, or choose other investment models such as using convertible bonds. Whichever model investors choose, they should require all shareholders of the target company to sign an investment agreement to hedge the risk of difficulty in making a resolution on capital reduction.
Cui Qiang is a partner at Commerce & Finance Law Offices. He can be contacted at 86-10-65637181 or by e-mail at firstname.lastname@example.org