Repurchase under the VAM (valuation adjustment mechanism) is a common arrangement in private equity investments. However, when investors exercise repurchase rights, a target company or its founding shareholders often defend against the obligation. This article selects three issues that recently concerned investors to make an analysis of current judicial practice.
Failure to fulfil
Is it feasible to directly file a lawsuit if an agreement’s notification and negotiation procedures are not fulfilled after repurchase conditions are triggered? Aside from the substantive conditions for repurchase, two common procedural conditions for repurchase are:
- If repurchase is triggered, the investor shall send a repurchase notice to the repurchase obligor who shall fulfil the repurchase obligation within a certain period (e.g. 30 days); and
- Where a dispute arises, the parties shall settle by amicable consultation. If consultation fails within a certain period (e.g. 30 days), each party may request a court/arbitration settlement.
For the procedural conditions in (1), is it feasible to directly file a lawsuit if an investor fails to send a repurchase notice, or the 30-day period does not expire after sending the repurchase notice?
In the authors’ opinion, filing a case is not affected unless the agreement specifically provides otherwise. However, support of the investor’s claim is still subject to expiration of the 30 days.
In current judicial practice, there are cases where courts consider that even if an investor does not specifically send a repurchase notice, it sends a de facto repurchase request to the repurchase obligor by filing a lawsuit. Therefore, the time for serving a repurchase notice becomes the day when a plaintiff files a lawsuit, or a statement of claim is served on defendant.
If the repurchase period expires during the trial, the investor’s repurchase claim shall be upheld, as in Ningbo Ruanyin Tianyuan et al v Resolute Wisdom et al (2020), and Jiangxi Chuban Group Lanhai International Investment v Chen Xiaodong et al (2020).
Therefore, unless an agreement specifically provides otherwise, sending a repurchase notice is not a prerequisite to initiating a lawsuit or arbitration. However, if the agreement stipulates a long period (e.g. 180 days) and the repurchase performance period does not expire during trial, there will be a risk that the investor’s claim is rejected.
For the procedural conditions in (2), is it feasible to directly file a lawsuit if the investor and the repurchase obligor fail to negotiate, or the negotiation does not last for 30 days? The authors believe that filing a lawsuit is the legal right of the parties; failed negotiations do not affect a court’s acceptance of a case.
However, there are cases where parties apply to the court for not executing an arbitral award because there was no negotiation between the parties, or because of non-compliance with the agreement’s arbitration procedures.
In this regard, there have been changing court views. In the 2005 case of Sichuan Pepsi Cola Beverage Company applying for recognition and execution of foreign arbitral award, Chengdu
Intermediate Court held that PepsiCo’s evidence was insufficient to prove that it had negotiated with Sichuan Pepsi for 45 days before initiating arbitration. The court, therefore, did not recognise and execute the arbitral award, and the Supreme People’s Court accepted this view in its reply to the case.
However, in recent years, courts have tended to hold that negotiation procedure is not part of the arbitration procedure, and that failure to perform negotiation procedure does not constitute a flaw in arbitration or affect the validity of an award, as in the cases of Beijing Weiying Technology v Tianjin Maoyan Microfilm Culture Media (2021), and Cui Ming v Shanghai Guochun Venture Capital (2019).
On 24 January 2022, the Supreme People’s Court issued the Minutes of the National Symposium on the Foreign-related Commercial and Maritime Trial Work of Courts; article 107 makes it clear that failure to follow a negotiation procedure is no reason to not recognise and execute an arbitral award.
New arbitration rules from the China International Economic and Trade Arbitration Commission (CIETAC) add provisions that, “if the arbitration agreement stipulates that arbitration should be preceded by negotiation and conciliation procedures, application for arbitration may be submitted after these procedures, but failure for negotiation and conciliation does not affect the applicant’s application and acceptance by the Arbitration Commission”.
Therefore, according to mainstream viewpoints, failure of negotiation normally does not constitute grounds for non-execution of an arbitral award.
Even so, according to the authors’ experience, some arbitration institutions require applicants to submit evidence of negotiation before accepting their application. Therefore, it is recommended that no specific negotiation procedure and negotiation period be stipulated in investment agreements, to:
• Promote the case procedure as soon as possible;
• Minimise the repurchase obligor’s possible defences; and
• Enable the investor to smoothly exercise its right.
What impact does an investment agreement’s repurchase order have on the exercise of rights by investors of a previous series? If a target company conducts multiple rounds of financing, the repurchase conditions for each series of investors may not be the same.
Sometimes repurchase conditions may be triggered for previous-round investors, but not for subsequent-round investors. Investment agreements will stipulate the order of exercising repurchase rights by each round of investors, and the price. In practice, any lack of contractual clarity may lead to final decisions deviating significantly from the parties’ true intentions.
In arbitration between an institutional investor and a well-known e-commerce company on equity repurchase, the investment agreement stipulated that if the assets of the repurchase obligor were insufficient for repurchase of all the shares requested by the investor:
• A redemption price would be paid in priority to the investors of the A-3 round who made the redemption request; and
• If any assets remained, the redemption price would be paid to investors who made a redemption request in the order of A-2 round, A-1 round.
“A” round investors were the applicants in the case, and the repurchase conditions for A round had been triggered. However, the applicants’ arbitration request for exercising their repurchase right was ultimately rejected.
The arbitration tribunal held as follows:
• The investment agreement provisions gave investors of A-3, A-2 and A-1 rounds priority over investors of series A; and
• In the absence of evidence whether assets of the repurchase obligor met the demand of investors of A-3, A-2 and A-1 rounds … the arbitration tribunal would not go beyond the repurchase right order in the investment agreement.
According to the arbitration tribunal’s interpretation, even if repurchase conditions were met for previous-round investors, they still could not demand repurchase until subsequent-round investors exercised their rights. The authors believe this interpretation is open to debate.
According to the arbitration tribunal’s understanding, and notwithstanding the repurchase conditions, previous-round investors could not demand repurchase until subsequent-round investors exercised their rights.
This is obviously against the intent of the repurchase clauses because, as long as any subsequent-round investor did not exercise rights, previous-round investors would not be able to withdraw from the company.
The above-mentioned provisions should be interpreted as follows:
• As long as repurchase conditions are met, investors have the right to demand repurchase; and
• Only when both the previous and subsequent rounds of investors propose repurchase at the same time, and there is evidence to prove that assets of founding shareholders are obviously insufficient to repay the full repurchase price, will the repurchase right order clause be applicable for subsequent-round investors to get paid in priority.
To minimise the risk of disputes, previous-round investors are recommended to further stipulate in the investment agreement that the repurchase demanded by them will not be conditioned on the exercise of rights by subsequent-round investors, and that the repurchase order clause will be applicable only if investors of each round demand repurchase simultaneously.
Conditional limitation of the liability of founding shareholders in investment agreements is an increasingly common transactional arrangement. It may be expressed as “to the extent of equity”, “to the extent of equity value”, “to the extent of fair value of equity”, and “to the extent of realised value of equity”.
Limited in space, this article only selects the more common expressions, “to the extent of equity” and “to the extent of equity value”, for comparative analysis.
Equity. Founding shareholders shall bear liability to the extent of their equity in the target company. That means to limit the liability scope of founding shareholders to the equity; that is, that they do not bear liability with other personal property, except for equity, to realise the segregation of other property of shareholders.
In a dispute between an investor and a unicorn enterprise over the return of investment payment, the investment agreement stipulated that, “all founders shall be jointly and severally liable to the extent of all the shares/equity they directly or indirectly own in the target company at that time, as well as the proceeds they have obtained therefrom”.
The investor won the case and applied to Shenzhen Intermediate Court for execution. Initially, the execution judge did not recognise that founding shareholders were jointly and severally liable with only specific property, and seized other property, such as bank accounts.
One of the founding shareholders then entrusted authors to act as their agents and filed objections to the execution. Eventually, the court revoked its original execution decision and confirmed that, “founding shareholders are jointly and severally liable for the obligation to repay the investment price only with their equity in the target company and their proceeds therefrom, rather than other personal property”.
This recognises that founding shareholders are only liable with “equity”. Other cases holding the same view include Yinian (Shanghai) Asset Management Centre v Zhang Yitao et al (2019) and Shengyu (Shanghai) Asset Management Centre v Zhang Yitao et al (2019).
However, in practice, some courts believe that “to the extent of equity” is equivalent to “to the extent of equity value”, and that founding shareholders should be held liable with all their personal property, and that the upper limit of liability should be the value of equity, as in Beijing Weiying Technology v Shenzhen Baoying Hongsheng Equity Investment Centre (2022).
Equity value. Founding shareholders are liable to the extent of the value of their equity in the target company. This means the upper limit of the founding shareholders’ liability is the equity value of the target company held by them, and that it includes other personal property in addition to equity.
If an investment agreement does not explicitly stipulate the method of determining equity value there will be great uncertainty in practice, such as taking the post-investment valuation of the target company as the basis for calculating “equity value”, as in the ruling of Beijing WeIying Technology et al v Shenzhen Baoying Hongsheng Equity Investment Centre (2022), or taking the time of signing the investment agreement as the time point for determining equity value, as in Fujian Donghui Investment v Shenzhen Huitong Tianxia Technology et al (2019).
Therefore, if the intention is to stipulate a liability limitation clause for founding shareholders in an investment agreement, it is recommended that other interpretation clauses refine and supplement it, such as:
• Clarifying the manner of determining equity value and the method of realising equity;
• Whether it affects other personal property of founding shareholders in addition to equity; and
• The liability limitation clause does not apply if “there are intentional misconduct, gross negligence, or fraudulent circumstances of founding shareholders”.
To sum up, investors face risks when exercising repurchase rights, mostly based on the understanding of the provisions of the investment agreement. Therefore, investors are advised to strictly control the formulation of provisions to minimise the risk of future disputes.
Alex Huang is a partner at Llinks Law Offices. He can be contacted at +86 135 1012 1328 or by e-mail at firstname.lastname@example.org.
Candice Du is a partner at Llinks Law Offices. He can be contacted at +86 159 9952 1596 or by e-mail at email@example.com.
Zheng Yiran, an associate at Llinks Law Offices, also contributed to this article. She can be contacted at +86 138 0885 1630 or by e-mail at firstname.lastname@example.org