1. Background

In 2011, a valuation adjustment mechanism (“VAM”)(4) agreement between a private equity firm and a foreign-invested company was held invalid by the High People’s Court of Gansu. The case was then accepted by and set for retrial before the Supreme People’s Court. This is the first time a VAM arrangement has been tested in a court in China. Because there are no laws or regulations regarding such arrangements in China, the modified final judgment could greatly impact the investment practices of private equity firms in China.

In October 2007, Suzhou Industrial Park Haifu Investment Ltd. (“Haifu”), a private equity firm, invested RMB 20 million in Gansu Shiheng Non-Ferrous Metal Recycling Ltd (“Shiheng”), a foreign-invested company, and signed a VAM agreement with Shiheng. Of the RMB 20 million total investment, RMB 1,147,717 went into Shiheng’s registered capital, representing a 3.85% equity interest in Shiheng. The remaining RMB 18,852,283 was recorded as capital surplus. According to the agreement, Shiheng was required to earn a net profit of not less than RMB 30 million in 2008, otherwise Shiheng or its affiliates would be required to compensate Haifu.

Shiheng made almost no profit in 2008. However, Shiheng refused to abide by the VAM agreement, forcing Haifu to take Shiheng to court. Both the trial court and the appellate court found the VAM arrangement to be invalid, although their decisions were based on different legal grounds. The trial court recognized and treated Haifu’s entire RMB 20 million investment as an equity investment and dismissed Haifu’s claim for compensation. In contrast, the appellate court held that the RMB 18,852,283 capital surplus portion of Haifu’s investment was not an equity investment, but rather should be treated as a loan to Shiheng. The Court ordered Shiheng and its Hong Kong Parent to repay the funds to Haifu, together with interest accrued.

  1. Legal Effect of VAM Arrangements in China

VAM arrangements are often used in mature capital markets as a mechanism for adjusting uncertain business valuations. As China has no laws or administrative regulations prohibiting VAM arrangements and because there are no other means available to protect investor interests, VAM arrangements have increasingly been adopted in China, though they have been the subject of some criticism. Nonetheless, prior to this case, it was generally believed that VAM arrangements were legally binding and therefore were regularly implemented.

Although court decisions in China do not have the precedential value that they do in common law jurisdictions, the business and legal communities in China are keeping a close eye on this case. Specifically, the position of the Supreme People’s Court in this case may be adopted by other courts and influence the attitude of Chinese courts generally towards such VAM arrangements.

  1. Structuring VAM Arrangements Carefully

Many of the details of the Haifu/Shiheng case are still unclear, but it appears that Haifu relied upon and trusted the person who made the introduction to Shiheng instead of conducting sufficient due diligence in the company. Based on publicly available information, it took Haifu less than two weeks before it made the decision to invest in Shiheng based on the VAM. This decision turned out to be a costly mistake. This case highlights the importance of private equity firms conducting extensive due diligence before signing VAM agreements and making investments.

Given that both the trial court and the appellate court found the VAM arrangement in this case invalid, private equity firms in China should be more careful in structuring VAM agreements in the future. In practice, a VAM agreement between investors and the founders or shareholders of the invested company rather than the invested company itself is relatively common. If, for any reason, the protection of a VAM arrangement must come from the invested company, the funding could, via careful planning, be structured as a loan which could be repaid or converted into equity, depending on whether the invested company meets its business target.

Private equity firms should also note that, in the existing legal framework in China, a company must clean up its existing VAM agreement before listing, otherwise uncertainty regarding equity ownership and conflicts with its current undertakings on lockups may lead to violations of listing rules.