This summary discusses the following points:  

  • Are valuation adjustment mechanism (VAM) provisions commonly used by PE/VC in investment agreements in the People’s Republic of China (PRC) still valid after the recent Gan Su High Court judgment?
  • How can investors protect their interests if the VAM provision is not valid?
  • Can investors adopt a different type of structure in PE/VC investments in PRC to avoid this risk?  


Gan Su Shi Heng Nonferrous Metals Recycle Co., Ltd. (Shi Heng) was a wholly owned subsidiary of Wisdom Asia Limited (Wisdom), a Hong Kong company. In November 2007, Hai Fu Investment Co. Ltd (Hai Fu) entered into a Subscription Agreement with Shi Heng, Wisdom and Lu Bo (Wisdom’s legal representative) to subscribe for 3.85 percent equity interest in Shi Heng by investing RMB20 million in Shi Heng. After the completion of the investment, Hai Fu held 3.85 percent of Shi Heng’s equity interest and the remaining equity interest is held by Wisdom.  

The Subscription Agreement contains a standard VAM and share repurchases provisions as follows:  

  1. If Shi Heng’s 2008 net profit was lower than RMB30 million Hai Fu may claim compensation from Shi Heng and Wisdom through a formula stipulated in the Subscription Agreement (VAM Compensation).  
  2. If Shi Heng was not listed on a stock exchange before October 2010, Hai Fu may request Wisdom to repurchase all its shares in Shi Heng.  

Hai Fu and Wisdom also entered into an Equity Joint Venture Contract (EJV Contract) specifying their rights and obligations in Shi Heng. Both the Subscription Agreement and the EJV Contract are approved by the Gan Su government authorities.  

After the investment, Shi Heng continued to lose money and refused to provide VAM Compensation to Hai Fu. Hai Fu sued all three parties (Shi Heng, Wisdom and Lu Bo) for VAM Compensation due to their breach of the Subscription Agreement in December 2009.  

Summary of Court Decisions

Gan Su High Court

Gan Su High Court held that the VAM provision was invalid for the reason that VAM provision leads to a consequence where Hai Fu needs not bear any investment risk in Shi Heng as a shareholder. Based on a Supreme Court guidance note, the High Court found that such an investment by Hai Fu is a de facto loan if the investor neither participates in the operation of the joint venture nor bears any responsibility or risk, and receives principal and interests after a fixed term or fixed profit at regular intervals regardless whether the joint venture is making profit or not. The Subscription Agreement for such investment shall be deemed to be invalid for the violation of relevant financial regulations. The Gan Su High Court therefore rejected Hai Fu’s claims and ordered Shi Heng and Wisdom to return the investment amount with interest to Hai Fu.  

According to information from local press, this case is currently under the review by the Supreme Court in Beijing. The final result is yet to be announced.  

What Does the Courts’ Decisions Tell Us?

Subject to the review decision by the Supreme Court in Beijing, the Gan Su High Court judgment does post challenge and risk on the enforcement of VAM provision/arrangement of the PE/ VC investment cases in PRC. According to the Gan Su High Court judgment, such PE/VC investment with VAM provision may be considered as a loan and is invalid.  

How to Protect Investor’s Interests if the VAM Provision is Not Valid  

There may be two situations where the court may have different view on this type of VAM provision:  

  1. The original shareholder provides for personal/corporate guarantee to the investor for the enforcement of such VAM provision; or  
  2. The Subscription Agreement is a framework agreement that is governed by law in other jurisdiction, e.g., Hong Kong law.  

Further, as Wisdom is a Hong Kong company and Shi Heng is a wholly owned foreign investment company in PRC, so it is possible that Hai Fu can use a special investment vehicle in Hong Kong or other offshore jurisdictions to form a joint venture with Hai Fu in overseas. Such offshore investment or cooperation will not be governed by PRC law, provided it complies with certain PRC regulations, e.g., tax regulation.  

Conclusion – Avoiding the Risk Altogether

The Gan Su High Court judgment reminds the PE/VC investors that may be time to reconsider the validity of the VAM provision in their investment agreements or even restructure its investment in PRC in order to reduce the potential risk that their PE/VC investments with VAM provision may be considered as a loan and is invalid in PRC. Proper legal advice in this type of PE/VC investment is therefore recommended.