Tackling repurchase performance in VAMs

The validity of valuation adjustment mechanisms (VAMs) between investors and target companies has long been a subject of judicial contention. In 2019, the Minutes of the National Courts’ Civil and Commercial Trial Work Conference, issued by the Supreme People’s Court (SPC), lent a long-awaited authoritative voice: “Without any statutory cause of invalidity, the people’s court will not support a claim for invalidity of the VAM solely on the grounds of having share repurchase or monetary compensation arrangements with the target company.”

However, an acknowledgement of the repurchase VAMs with the target company merely from the perspective of contract validity is far from enough to address investors’ dilemmas in such disputes.

Article 5 of the above-mentioned minutes also states that if an investor requests the target company to fulfill the obligation of the repurchase, “the people’s court shall conduct an examination in accordance with article 35 (limit shareholders’ withdrawal of capital contributions) or article 142 (mandatory provisions on share repurchase) of the Company Law. If the court examination finds that the target company has not completed the capital reduction process, the claim shall be rejected.”

In practice, if the target company has no intention of performing the repurchase obligation, it will likely show little initiative to complete, or even begin, the capital reduction process. As a result, although the repurchase VAMs made by the target company are, in most cases, valid, the investors often find obstacles when requesting the target company to fulfill the repurchase obligation thus far neglected, for such a request cannot be legally supported until the target company has completed its capital reduction process.

Unfortunately, the minutes did not offer investors a clear path to seek further judicial relief. Therefore, based on relevant rules set out in the minutes, the authors have summarised three main approaches to addressing investors’ dilemmas in repurchase VAMs with target companies, combined with the authors’ professional experience gained since the minutes’ issuance.

Capital reduction process

If the agreement under which the target company makes the repurchase bet-on commitment meets certain conditions, it is possible for the investor to prove that the agreement constitutes, in essence, the shareholders’ decision to reduce capital, which facilitates the completion of the target company’s capital reduction process and eventual requirement to fulfill the repurchase obligation effectively.

If the target company refuses to initiate the capital reduction, it would generally delay or refuse to adopt a shareholders’ meeting resolution on capital reduction after the repurchase conditions are triggered so that the investor requests the repurchase, which is necessary for the capital reduction process.

Article 37.2 of the Company Law provides that if all shareholders consent to any matter within the rights of the shareholders’ meeting (including capital reduction) in written form, it would not be a mandatory requirement to hold a shareholders’ meeting, and such decisions may proceed if signed and sealed by all shareholders. Hence, the Company Law acknowledges the unanimous written decision of the shareholders to reduce capital in lieu of a resolution of the shareholders’ meeting.

If all shareholders have signed and sealed the relevant agreement under which the target company makes the repurchase bet-on commitment, consenting to its content, and no new shareholders have joined the target company since then, or the new shareholders have likewise expressed their consent in written form, it is deemed that the target company’s repurchase bet-on commitments have received the unanimous consent of all shareholders. Thus, it is possible to argue that all shareholders have unanimously decided to reduce capital in written form.

However, it should be noted that this approach must meet strict conditions to become applicable. On the one hand, article 37 of the Company Law requires shareholders’ unanimous consent as a condition precedent to the application of shareholders’ written decisions.

On the other hand, the capital reduction and share repurchase of such target companies are often targeted at investors only. In judicial practice, to protect minority shareholders and keep the corporate equity structure stable, some courts may impose even stricter voting requirements, i.e. require the unanimous consent of all shareholders, instead of the two-thirds votes for conventional capital reduction resolutions.

In addition, two major issues linger before the final exit goal can be achieved. First, the shareholders’ decision to reduce capital is far from the end of the reduction process. The to-do list also includes, at a minimum, routine items prescribed by article 177 of the Company Law, such as preparing the balance sheet and property list, notifying creditors and making public announcements.

If the target company refuses to carry out these tasks, it would be difficult to sue and demand it to do so in most mainstream venues. It may be further necessary to enforce capital reduction by requiring the senior management of the target company to perform their duties and implement shareholders’ decisions.

Second, the target companies involved in such disputes are often operating in a poor state. Even if the repurchase bet-on commitment, approved by all shareholders, is determined to be a shareholders’ collective decision to reduce capital, whether the repurchase price, which usually warrants the investors a certain rate of return on investment, may be suspected of withdrawing capital contributions or seriously affecting the target company’s capability of stable operation and debt service may also come under intense court scrutiny. Consequently, the exit amount may not receive full support.

Liability for losses

As long as the repurchase VAMs made by the target company are valid, even if the investors may find it challenging to enforce the capital reduction and repurchase, the target company’s failure to fulfill its obligation may still be held as a breach of contract. Investors can pursue the target company’s liability based on the violation of the contract, seek to reduce losses from the tied-up capital, and thereby urge the target company to repurchase.

According to article 577 of the Civil Code, the ways to bear the liability for breach of contract include continuing to perform the contract, taking remedial measures, or compensating for losses.

If the investors request the court to order the target company to perform the obligation of the repurchase, this request is unlikely to be supported as the above-mentioned issues such as an incomplete capital reduction process may still be in the way. Therefore, a more pragmatic approach is to hold the target company liable to compensate for the investors’ losses.

However, if the loss claimed by investors is the entire receivable consideration of a capital reduction, it may still be heavily suspected of dodging the review standards for requesting the target company to repurchase shares and asking for the capital reduction in a disguised form, which is unlikely to be supported. Therefore, investors may consider requiring the target company to repay losses from tied-up capital due to having not received the agreed-on consideration of capital reduction.

For example, the loss can be calculated using similar methods for calculating liquidated damages under relevant agreements. Or, using the agreed capital reduction consideration or investment amount as the basis, the loss on capital utilisation can be calculated from the date of non-payment of the due capital reduction consideration by the target company to the date of actual payment in the future, multiplied by an applicable rate such as loan prime rate (LPR).

However, it should be noted that this approach remains controversial in judicial practice. For example, when it comes to the liability for the loss from tied-up capital, certain courts may draw reference to article 5 of the above-mentioned minutes and consider whether the company has sufficient profit to cover the loss as a basis for supporting the claim or not, similar to when shareholders require the company to pay compensation.

Nevertheless, if they are able to gain support through this approach, the investors would see instant relief for the losses arising from tied-up capital. As the debt keeps increasing, the target company may be encouraged to fulfill the repurchase obligation.

Demand for repurchase

Analysis should be made on whether the target company’s repurchase valuation adjustment arrangements are in essence made by the de-facto controller, with the target company merely the obligor of the repurchase. Under this framework, if the target company fails to fulfill the repurchase obligation, the investor may consider directly requiring the de-facto controller to assume the repurchase obligation.

In practice, agreements providing the repurchase valuation adjustment arrangements of the target company can take many forms. In some cases, the de-facto controller of the target company is the offeree of the commitment, while the target company is only the entity tasked with conducting the repurchase.

Specifically, based on the agreement’s clauses, it can be deduced from the repurchase trigger conditions that the commitments – such as performance or IPO commitments – are actually made by the de-facto controller of the target company.

Certain commitments can only be made by the de-facto controller, such as their own appointments or non-competition promises. Under this structure, the legal nature of the target company may only be a third party that the de-facto controller arranges to perform the repurchase, rather than the entity that commits to the repurchase.

According to article 523 of the Civil Code, when the agreement states that a third party is agreed to perform the debt to the creditor, but fails to do so, the debtor shall bear the liability for breach of contract to the creditor. If the target company, as the third party, fails to fulfill the repurchase obligation, the entity liable for breach of contract should be the de-facto controller who actually made the repurchase commitment.

The investor may consider pursuing the de-facto controller’s liability for breach of contract. As a manner of bearing such liability, the investor may require the de-facto controller to assume and perform the obligation of the repurchase. This approach effectively avoids the obstacles existing under the Company Law, which hinder the target company from conducting the repurchase.

In addition, there are a few more routes available for investors to safeguard their rights. For example, if the investors acquired an equity interest in the target company by a share transfer, they can consider the possibility of requiring a refund of the equity consideration by terminating the contract.

Also, if the target company is a limited liability company with interests that may have been impaired by the de-facto controller, senior management or others, the investor may consider the possibility of exercising the shareholders’ right to know, collecting evidence and then filing an action of subrogation to safeguard their rights.

Each of the above-mentioned approaches has its own strengths and disadvantages. It is necessary to conduct a case-by-case analysis and flexibly select the most suitable path forward, in order to defuse the repurchase performance dilemma in valuation adjustment mechanisms.

Chen Zhuo is a partner at Tian Yuan Law Firm. He can be contacted at +86 138 1041 7260 or by e-mail at chenzhuo@tylaw.com.cn

Wang Hao is an associate at Tian Yuan Law Firm. He can be contacted at +86 136 5118 1449 or by e-mail at wanghao@tylaw.com.cn