in the field of investment, financing and M&A, the VAM (valuation adjustment mechanism) clause often appears in transaction documents, becomes the focus of the game between the parties, and frequently causes disputes in the performance process. The mainstream view of academia and judicial practice is that the VAM clause has the function of valuation adjustment, and the parties concerned can solve the problems of uncertainty of the target company’s future development, information asymmetry and agency cost through the mechanism agreed in the contract, so as to actively promote the transaction.
The Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts, issued by the Supreme People’s Court (SPC) on 8 November 2019, has to a certain extent corrected the deviation in previous trial practice, unified the legal understanding and trial on the validity, nature and operability of the VAM clause, and is more in line with commercial practice. However, the minutes are not exhaustive.
(1) VAM with shareholders or actual controllers of the company. In the post-minutes era, there is no doubt about the validity of VAM clauses concluded with shareholders or actual controllers of the target company. In nature, they are also clearly contract clauses with payment content, rather than clauses on liabilities for breach of contract. In practice, investors or acquirers should pay attention to issues such as the declaration letter of knowing and agreeing to bear responsibility, issued by the spouses of the company’s shareholders or actual controllers, and pay more attention to the property of the company’s shareholders or actual controllers.
(2) VAM with entities other than the company. In the case of a VAM with entities other than the company, as long as the entities are parties to VAM clauses, they can be required to assume the VAM obligation in which there is no obstacle for requiring them to pay performance compensation, but in terms of equity/share repurchase relevant procedures should be performed pursuant to the provisions of the Company Law. The above-mentioned opinions are consistent with the trial thinking of the minutes regarding a VAM with shareholders or actual controllers of the company, and are confirmed in the judgment of Beijing High People’s Court on a dispute over equity transfer ( Gao Min (Shang) Zhong Zi No. 1017).
(3) VAM with shareholders or actual controllers, and secured by the target company. Pursuant to the provisions of article 16 of the Company Law, when the company provides security for shareholders or actual controllers, it must go through the resolution procedure according to law and make a legal and effective resolution of the general shareholders meeting. In the case of a VAM with shareholders or actual controllers, and secured by the target company, when and only when the provision of security by the target company is based on a legal and effective resolution of the general shareholders meeting, will the investor or acquirer have the right to require the target company to perform the responsibility of the VAM for its shareholders or actual controllers.
Certainly, a legal and effective resolution of the general shareholders meeting is not sufficient. If the VAM obligation requires cash compensation, the target company must have profits available for distribution; if the VAM obligation requires equity/share compensation or repurchase, based on the trial gist in article 5 of the minutes, the target company should perform the capital reduction procedure pursuant to the Company Law.
(4) VAM with the target company. According to the general theory of academia, the principle of capital maintenance under the Company Law is to restrain the opportunistic behaviour of shareholders and the company, and mediate the conflict of interest between shareholders and creditors of the company. The Company Law establishes the following capital maintenance standards based on the registered capital: Prohibiting shareholders from withdrawing their capital contributions; specifying the procedures for reducing the registered capital; restricting the company from acquiring its own equity or shares; and specifying the conditions and order of profit distribution.
For example, articles 74 and 142 of the Company Law provide that a limited liability company and a company limited by shares can only repurchase equity/shares of the company under specific circumstances. Article 177 of the Company Law provides that when a company reduces capital, it shall prepare a balance sheet and a list of assets, timely notify creditors and make an announcement. Article 166 of the Company Law provides that, subject to the conditions specified in the Company Law, the target company may distribute profits to shareholders, upon resolution of the general shareholders’ meeting, after making up for losses (if any), withdrawing the reserve fund and paying taxes.
The minutes fully agree with the principle of capital maintenance, and indicate that in the trial of VAM disputes, courts should not only adhere to the principle of encouraging investors to invest in enterprises, especially scientific and technological innovation enterprises, but also implement the principle of capital maintenance, and the principle of protecting the legitimate rights and interests of creditors, so as to balance the interests of investors, creditors and the company according to law.
In the post-minutes era, the trial rules no longer deny the validity of the clauses of a VAM with the company on the ground of damaging the interests of the company, but pay attention to the operability of the clauses under the Company Law, on the basis of recognizing the validity of the clauses of the VAM with the company. If the investor, or acquirer, and the target company enter into a VAM clause on cash compensation, the validity of the clause is not in doubt, but the target company can only be required to actually fulfil the performance compensation obligation when the target company has profits to distribute.
If the investor, or the acquirer, and the target company enter into a VAM clause on equity/share compensation or repurchase, the target company shall first reduce its capital according to the Company Law. It should be noted that since the capital reduction procedure is a matter of internal self-governance of the company, it is inappropriate for the court to intervene in the procedure compulsorily by judicial power.
This view was confirmed in the judgment of the SPC on a surplus distribution dispute ( Zui Gao Fa Min Zhong No. 528), and is reflected in the Understanding and Application of the Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts, compiled by the Second Civil Division of the SPC.
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