When a company intends to go public, it will bring investors in for capital increase. In the transaction documents, a valuation adjustment mechanism (VAM, also known as a “bet-on agreement” in China) clause is often included, under which the investors have the right to sell back their shares.
To satisfy the share issuance requirement for a clear equity structure, most prospective listcos would enter into an agreement with the investors before submitting their listing applications. Under this agreement, they are released unconditionally from the obligation of share buyback by requiring all parties to confirm irrevocably that the relevant VAM clauses are deemed void from the outset, and that there is no arrangement to restore the validity of such clauses.
This article analyses the issue of retroactively voiding the VAM clause during an IPO process in the context of recent regulatory rules and the Minutes of the National Courts’ Civil and Commercial Trial Work Conference.
Partner
Grandway Law Offices
Not all parties may approve of voiding the clause. Most companies, as the principal parties to buy back their shares, will require investors to execute an agreement amid listing application to clarify that the relevant buyback clauses will be deemed void from the beginning, and this request is often proposed during share reform.
Voiding the clause just before making a listing application, when the company’s listing intention was crystal clear, is acceptable to most, but to do this during share reform is another matter entirely, and investors may not go along with it quite so easily.
Many companies argue that if investors refuse to sign relevant agreements that retroactively void the buyback clause, their investment funds may be recognised as financial liabilities, which may, in turn, affect the investors’ shareholder equity, thus prompting them to void the VAM clause. This is generally acceptable for most investors before the listing application, but whether it must be done during share reform is the subject of much debate.
Contradictions between rules for accounting classification of investment funds, regulatory requirements and the above-mentioned minutes. According to the prevailing accounting classification rules for investment funds, a prospective listco should recognise the investment funds carrying buyback obligations as financial liabilities upon their receipt. After the buyback clause has been cancelled, these investment funds will be derecognised as financial liabilities and recognised as equity instruments instead.
It should be noted that the Accounting Department of the Ministry of Finance published, on 13 September 2022, the Cases for Application of Distinguishing Financial Liabilities and Equity Instruments – Changes in Issuer Obligations as a Result of Supplementary Agreements, which clearly states that the accounting classification from prior years cannot be adjusted retroactively.
Salaried Partner
Grandway Law Offices
This means a prospective listco can start recognising investment funds as equity instruments instead of as financial liabilities only after an agreement to cancel its buyback obligations has been concluded.
However, different rules were made in the Guidelines for the Application of Regulatory Rules – Issuance Category No. 4, published by the China Securities Regulatory Commission (CSRC) on 17 February 2023, which clarified that the “void from the beginning” clause made for the sell-back liability prior to the publishing date of the financial report can be seen as that the issuer has no buyback obligations during the reporting period.
This means the relevant investment funds will be recognised as equity instruments rather than as financial liabilities during the reporting period, clarifying that the accounting classification for prior years can be adjusted retroactively under certain circumstances.
According to the above-mentioned minutes, the bet-on agreement between the concerned investors and the company should be valid if there is no legal cause for invalidity. However, investors should first carry out capital reduction before requesting that the company actually fulfil the buyback obligation. This means the minutes recognise the investors’ equity rights in the company, regardless of whether their investment funds are recognised as equity instruments or financial liabilities in the accounting books.
Issues raised from interpreting the above-mentioned guidelines. According to the Civil Code, an invalid or revoked civil legal act is deemed to have had no legally binding force from the beginning. However, the supplementary agreement that retroactively voids the buyback clause between the investor and issuer does not fall into the category of invalid or revoked civil legal acts under the Civil Code.
Therefore, these regulatory rules may be interpreted in accordance not with the Civil Code provisions on retroactive voiding, but instead with the provisions on the rescission of contracts by consensus, making it a rescission of retroactive clauses.
Based on autonomy of will, investors and issuers may agree to cancel the bet-on clause with retroactive effect up to the time of signing. On the other hand, they may also agree that buyback exercises conducted during the contract performance period would be restored to their original status, or not, depending on the actual performance.
Conclusion and advice
With more light shed on regulatory rules surrounding the cancellation of issuers’ bet-on clauses, our understanding of how to handle these clauses effectively has improved. However, in terms of determining legal relationships, there is still much debate over whether the bet-on clause between issuer and investor becomes void retroactively at the time of signing the clause itself, or rather a separate cancellation agreement.
If the latter prevails, we may face the issue that the accounting classification of investors’ investment funds for the prior years cannot be retroactively adjusted accounting-wise.
Therefore, the authors suggest that when a prospective listco concludes an agreement with its investors to terminate the bet-on clause, the agreement should specify that such termination be retroactive, and the clause is to be deemed void from the beginning.
The authors also advise regulators to adhere to upper-tier laws in legal hierarchy when making the rules, as well as take into consideration accounting treatment requirements and other relevant laws and regulations, to minimise conflicts in the application of regulatory requirements.
Li Ling is a partner and Wu Jinfeng is a salaried partner at Grandway Law Offices
Grandway Law Offices
7-8/F News Plaza
No. 26, Jianguomennei Avenue
Beijing, 100005, China
Tel: +86 10 8800 4488
Fax: +86 10 6609 0016
E-mail:
liling@grandwaylaw.com
wujinfeng@grandwaylaw.com
