The valuation adjustment mechanism (VAM) is widely used in the private equity and equity investment sectors in China. The transaction structure of a VAM agreement mainly involves the investors making a premium investment in a company and setting certain performance or listing targets for the company. If the targets are not achieved, original shareholders or the company will compensate investors or repurchase their equity.
According to the Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts issued by the Supreme People’s Court, VAM clauses between investors and original shareholders regarding repurchasing equity or the making up of difference in performance should be recognised as valid and supported if there are no other grounds for invalidity.
However, a significant percentage of VAM clauses do not specify whether original shareholders should assume proportionate or joint and several liability. Judicial practices have made different interpretations. This article describes practical observations on the mitigation or exemption of liability of original shareholders after a failed VAM, and sorts out the remedies for all parties.
The contract does not clearly stipulate that original shareholders should assume joint and several liability. Many VAM clauses generally agree only that original shareholders should repurchase investors’ equity within a certain time if the VAM fails, and do not specify the manner of assuming liability among original shareholders.
The Civil Code provides clearly that joint and several liability applies only when there are adequate legal or contractual provisions. Accordingly, some courts hold that the general principle for shared debts is proportionate liability, with joint liability being an exception.
This principle applies unless the contract or the law expressly provides otherwise. If the investment agreement specifies only the repurchase obligation of original shareholders
without specifying the joint liability among the original shareholders, the original shareholders should assume several liability according to their shareholding percentages.
The contractual provision of joint liability does not necessarily apply to shareholders other than the controlling shareholder. For example, some investment agreements stipulate that the controlling shareholder or founder of the company commits to repurchasing equity, while concurrently outlining in the “breach of duty” section that original shareholders will be jointly and severally liable for the breaches of other shareholders.
As there is no clear stipulation that the other shareholders should be jointly and severally liable to the investors for the controlling shareholder’s repurchase obligation, the court is inclined to determine that the other shareholders are not obliged to repurchase the investors’ equity. Refer to the second-instance civil judgment in Guo Wei, et al v Shenzhen CLOU Electronics.
Investors maliciously trigger repurchase or difference making-up conditions. The triggering conditions typically involve the company’s failure to get listed as scheduled or to achieve profit targets. The investors’ improper actions influencing the company include, without limitation, withdrawal of capital contribution, equity pledge, undue influence on the management of the company such as dismissing the original management or even filing lawsuits, and arbitration against the company.
Original shareholders must provide evidence of such misconduct and demonstrate a direct causal relationship between the investors’ actions and the failure to list or meet profit targets. Courts sometimes also consider the industry where the company operates to assess how much the investors’ alleged misconduct contributed to the company’s failure.
Factors such as the target company’s reliance on the investors’ funds and whether the investors made a written commitment to actively support the target company’s development are considerations for courts when determining whether the investors maliciously facilitated the onset of repurchase conditions.
The company’s operating rights are entirely held by the investors. In this case, original shareholders have completely lost operating rights, and the consequences of the company’s performance failure should be partly attributed to the investors. It would be contrary to fairness to require original shareholders to repurchase the investors’ equity in full, or assume the difference making-up liability.
For example, if an investor owns 100% of the equity in the company and appoints six of the seven directors, with the remaining director suspended in a shareholder meeting and the general manager appointed by the board of directors, courts will generally hold that the investor exercises complete control over the company.
In such a scenario, original shareholders are relieved of the adverse consequences of a failed VAM, as they have lost the managerial rights. However, if original shareholders voluntarily waive their controlling positions or board seats under the contract or articles of association and sign a VAM clause, such waiver of rights while still assuming the liability to repurchase equity is generally considered a voluntarily agreed upon transaction arrangement, and thus original shareholders cannot defend their non-performance of the repurchase obligation on that basis.
Original shareholders are solely state-owned enterprises. If the original shareholder was a state-owned entity, the fulfilment of the original shareholder’s repurchase obligation requires the approval of the state-owned assets supervision and administration authority. Otherwise, the repurchase clause is unenforceable.
The controlling shareholders of the company have paid a portion of the repurchase price to the investors. Deduction of the portion paid is the most direct defence of original shareholders, with a higher probability of success against the investors’ claim. However, original shareholders of the company should prove that the payment was specifically for the repurchase of equity or the difference making-up, and not for other debt obligations, and if the repurchase price was paid by the company, it had completed the capital reduction procedure when the payment was made.
In summary, the Civil Code further clarifies that joint and several liability must be expressly agreed upon or provided by law. This provision is reflected in practice by the judicial authorities emphasising the protection of investors’ interest while balancing the interests of original shareholders, especially minority shareholders.
Judicial authorities will examine specific wording in repurchase and difference making-up provisions, the true intent of the parties, the investors’ controlling interests and good faith, whether the repurchase requires approval, and whether part of repurchase price has been paid. Therefore, under the background of the Civil Code coming into force, courts do not adopt a one-size-fits-all approach on VAM clauses. Investors still face challenges in holding original shareholders jointly and severally liable for repurchasing investors’ shares, and original shareholders have the opportunity to find case-specific factors within the rules to achieve relief of liability.
Lu Yichen is a partner at Anli Partners