Security provided by the target company under VAM

By XuYu and Pang Yuying, Hylands Law Firm
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Taking the National Work Conference on Civil and Commercial Adjudication by Courts minutes as its foundation, this article focuses on the issue of the security provided by the target company for the buyback of the original shareholder’s equity under a valuation adjustment mechanism (VAM).

徐羽, Xu Yu, Partner, Hylands Law Firm
Xu Yu
Partner
Hylands Law Firm

Validity and performance of a VAM in which the target company participates

Before the above-mentioned minutes, there was an ongoing debate on the issue of the validity of a VAM in which target companies are involved in, inter alia, the Haifu Case (Min Ti Zi Case No. 11 [2012]), and a number of arbitration cases, and, in practice, the adjudication criteria were not uniform.

Part 1 of chapter 2 of the minutes describes the common models of VAM, and addresses their validity and performance. That is to say, a VAM in which the target company is involved, and which provides for an equity buyback or monetary compensation, is valid, but in the specific performance of such an agreement, a finding should be rendered based on the circumstances. More specifically:

(1) Where the target company is required to buy back equity, it should do so by carrying out a capital reduction procedure to realise the objective of recovering the investment money, so as not to violate the mandatory provisions of article 35 of the Company Law, prohibiting shareholders from illegally withdrawing their capital contributions, or article 142, on the buyback of shares, failing which the request will be denied; and

(2) Where the target company is required to bear a monetary compensation obligation, the court should adjudicate the investor’s request for compensation based on the company’s profit situation. If it is profitable and can pay compensation, the request should be upheld, or partially upheld. If there is no profit, the request for compensation should be dismissed.

逄玉英, Pang Yuying, Associate, Hylands Law Firm
Pang Yuying
Associate
Hylands Law Firm

Bearing by the target company of security liability for the original shareholder under a VAM

Part 1 of chapter 2 of the Minutes explains that the agreement between the investor (i.e., the shareholder that made the capital injection) and the target company providing for an “equity buyback” or “monetary compensation” is a valuation adjustment, but it does not expressly specify that, in the case of a value adjustment between the investor and the original shareholder, the security liability borne by the target company for the original shareholder’s equity buyback moneys constitutes a value adjustment.

In Zui Gao Fa Min Zai Case No. 128 [2016] (the Hanlin case), the VAM provided that the target company was to bear security liability for the original shareholder’s equity buyback money. In its final judgment, the Supreme People’s Court (SPC) held that the security clause was lawful and valid, and ordered the target company to bear joint and several liability in accordance with the agreement. From this, the SPC’s stance on the issue can be perceived.

Some argue that the security liability borne by the target company for the original shareholder’s equity buyback money falls within the scope of the target company’s “payment of monetary compensation”. The authors believe that the bearing by the target company of security liability for the original shareholder’s equity buyback money, and the performance by the target company of an “equity buyback” or “payment of monetary compensation” directly toward the investor, are fundamentally different. If the provision of the agreement concerning the bearing by the target company of security liability for the original shareholder’s equity buyback money is valid, the target company is required to directly perform the same.

First, they differ in their legal natures. The agreement under which the target company bears security liability for the original shareholder’s equity buyback money is a legal issue concerning the provision by a company of security to a third party, and the target company should consult the relevant procedural constraints for companies that provide security for their shareholders found in the Company Law, its articles of association, the Security Law, etc.

An agreement for the “buyback of equity” or “payment of monetary compensation” by a target company is a general contract into which companies enter, and its validity is mainly determined in light of the Contract Law, which is expressly addressed in the conference minutes.

Second, the entities with the performance obligation differ. In an agreement under which the target company bears security liability, the entity with the obligation of buying back equity or paying monetary compensation is the original shareholder, and the buyback by the original shareholder of the investor’s equity does not involve the issue of taking into account the target company’s capital and creditors’ interests.

In contrast, the target company’s entity with the obligation of “buying back the equity” or “paying monetary compensation” is the target company, directly involving the mandatory provisions of the Company Law, which ban shareholders from illegally withdrawing their capital contributions, and on the buyback of equity by companies.

Finally, the financial treatment by the target company differs. After bearing the security liability, the target company can seek recovery from the original shareholder, and this asset of the target company is converted into an account receivable. In contrast, the target company’s “buying back of equity” or “paying of monetary compensation” directly reduces its assets.

After the minutes were issued, the Jiangsu High Court rendered Civil Judgment Su Min Zhong No. 1362 [2018], which likewise upheld the bearing by the target company of security liability for the original shareholder’s equity buyback money, and ordered performance by the target company. After performance, the target company could seek recovery from the original shareholder.

From the above analysis it can be seen that, since the procedure is complex, when a target company performs an “equity buyback” or “payment of monetary compensation”, the agreement is valid, even though it is difficult to realise in practice, and the target company is a material asset of the original shareholder, when designing a VAM scheme, it is reasonable to provide that the original shareholder bears an equity buyback obligation, and that the target company bears security liability for the original shareholder’s equity buyback obligation.


Xuyu is a partner at Hylands Law Firm. He can be contacted on +86 10 6502 8912 or by email at xuyu@hylandslaw.com

Pang Yuying is an associate at Hylands Law Firm. She can be contacted on +86 10 6502 8716 or email at pangyuying@hylandslaw.com