The Haifu Case is the first case in China where a court has denied the validity of an agreement containing a valuation adjustment mechanism (“VAM Agreement”). It has caused drastic reactions in the PE industry, and not surprisingly, the retrial of this case by the Supreme People’s Court of China (the “Supreme Court”) has also attracted intense public attention. Recently, the Supreme Court has given its retrial judgment, where the Supreme Court (i) corrects the lower courts’ decisions that completely deny the validity of the VAM agreement, and (ii) distinguishes VAM agreements between shareholders and the company from that between the shareholders only, and affirms the validity of the latter. This retrial judgment can be expected to have considerable influence on the controversial issue of validity of VAM agreement, and to generate significant implications for PE investors as for how to protect their interest.
I. Case Overview
- Factual Background
In 2007, Haifu Investment Co., Ltd. of Suzhou Industrial Park (“Haifu”), as investor, entered into a Capital Increase Agreement with Gansu Zhongxing Zinc Industry Co., Ltd. (which subsequently changed its name to Gansu Shiheng Nonferrous Metals Recycling Co., Ltd., “Shiheng”), Hong Kong Diya Co., Ltd. (“Diya”) which was the sole shareholder of Shiheng prior to the investment deal, and Mr. Lu Bo who controlled Diya.
In accordance with the Capital Increase Agreement, Haifu invested RMB 20,000,000 in cash to increase Shiheng’s capital. Clause 7.2 of the Capital Increase Agreement provided that if in fiscal year 2008, the net profits of Shiheng are lower than RMB 30,000,000, Haifu has the right to claim compensation from Shiheng, or, if Shiheng fails to compensate Haifu, to claim the same from Diya. The formula for calculating the compensation payable was (1 – the actual net profits of 2008 / RMB 30,000,000) × the invested amount.
Further to the above investment arrangement, Haifu and Diya also executed a Joint Venture Agreement (“JV Agreement”) and re-formulated Shiheng’s Articles of Association. The JV Agreement provided that: the registered capital of Shiheng will be increased from USD 3,480,000 to USD 3,993,800 with Haifu contributing USD 153,800 which was 3.85% of Shiheng’s shares, and Diya contributing USD 3,840,000 which was 96.15% of Shiheng’s shares; the surplus of the RMB 20,000,000 paid by Haifu over the portion of Shiheng’s registered capital subscribed by Haifu became part of Shiheng’s capital reserve; and the balance of Shiheng’s net profits after paying enterprise income tax and deductions for statutory reserves will be distributed to the shareholders in proportion to their respective shares.
In performance of the JV Agreement, Haifu paid RMB 20,000,000 to Shiheng, RMB 1,147,717 of which formed part of Shiheng’s increased registered capital and the remaining RMB 18,852,283 went to Shiheng’s capital reserve.
Shiheng’s net profits in the fiscal year 2008 were RMB 26,858.13, which failed to satisfy the net profits undertaking in the Capital Increase Agreement. On 30 December 2009, Haifu sued Shiheng, Diya and Mr. Lu Bo, seeking a judgment ordering them to compensate Haifu to the amount of RMB 19,982,095.
- The Reasoning and Judgments of the Lower Courts
The key issue was whether the cash compensation provision in clause 7.2 of the Capital Increase Agreement is valid under Chinese law. Such provision is commonly known in PE investments as a ‘VAM agreement’.
The court of first instance denied the validity of the VAM agreement in its entirety on the basis that the imposition of compensation obligations on Shiheng violates mandatory provisions of law and administrative regulations. That is, the VAM agreement granted Haifu the right to claim compensation from Shiheng merely on the condition that Shiheng’s net profits were less than RMB 30,000,000. Whereas Article 8[i] of the Sino-Foreign Equity Joint Venture Law provides that the net profits of a joint venture shall be distributed to the shareholders in proportion to their respective shares in the registered capital. Further, The VAM agreement was considered invalid because it was inconsistent with Shiheng’s Articles of Association and it impaired the interest of Shiheng and Shiheng’s creditors, and so violated Article 20, Paragraph 1[ii] of the Company Law. Finally, the Court held that the VAM agreement was inconsistent with the JV Agreement, and according to the law, the provisions of the JV Agreement prevail to the extent of inconsistency. Accordingly, the court of first instance dismissed Haifu’s claims.
The court of second instance developed different reasoning on the same issues. On the one hand, it held that the agreement on Shiheng’s minimum profit in the fiscal year 2008 is valid because it only concerns the profitability of Shiheng and not profit distribution. Further, if the agreed profits were achieved, this would allow Shiheng and its shareholders to realize their respective distributions in accordance with the Company Law, the JV Agreement and its Articles of Association, as well as, enhance creditors’ interest.
On the other hand, the court of second instance held that the agreement allowing Haifu to claim compensation from Shiheng and Diya violated the principle of joint risk sharing in the investment industry because it would enable Haifu, as an investor, to obtain guaranteed profits free of risk and without regard to Shiheng’s business performance. By reference to Article 4 (2)[iii] of the Explanations of the Supreme Court Concerning Several Issues on the Trial of Joint Operation Agreement Dispute, the court of second instance ruled that the VAM agreement in Clause 7.2 of the Capital Increase Agreement was invalid because it violated Article 52 (5)[iv] of the Contract Law. The court then held that Haifu’s investment in Shiheng, other than the sum of RMB 1,147,710 paid as increased registered capital, of RMB 18,852,283 paid as capital reserve, was an unlawful loan. Accordingly, the court of second instance ordered Shiheng and Diya to refund this amount to Haifu together with interest.
II. The Reasoning and Judgment of the Supreme Court
Shiheng and Diya disagreed with the second instance judgment and applied for retrial with the Supreme Court. Recently, the Supreme Court has given the retrial judgment and ruled on the validity of the VAM agreement.
Regarding the validity of the agreement on Haifu’s right to claim compensation against Shiheng, that is the VAM agreement between a company and its shareholder, the Supreme Court concluded that: Shiheng became a joint venture company due to Haifu’s investment in and joint operation of it with Diya. The Capital Increase Agreement among Shiheng, Haifu, Diya and Mr. Lu Bo provides that if the net profit of Shiheng is lower than RMB 30,000,000, Haifu is entitled to obtain compensation from Shiheng according to the agreed formula. The VAM agreement effectively guaranteed a fixed profit for Haifu’s investment isolated from the actual business performance of Shiheng; thus, it impaired the interest of Shiheng and its creditors contrary to Article 20 of the Company Law and Article 8 of Sino-Foreign Equity Joint Venture Law. The lower courts therefore correctly invalidated this part of the VAM agreement.
The Supreme Court also found that the court of second instance had no legal basis for deciding that Haifu’s investment of RMB 18,852,283 which formed part of Shiheng’s capital reserve was as unlawful loan. As to whether Haifu’s investment should be refunded, the Supreme Court explained that: in the beginning of this action, Haifu’s key claim was for compensation from Shiheng, Diya and Mr. Lu Do of RMB 19,982,095 in accordance with the Capital Increase Agreement. Haifu has never claimed the refund of its investment. Therefore, the judgment of the second instance court ordering Shiheng and Diya to jointly refund Haifu’s investment together with interest is wrong as it exceeded Haifu’s claim.
When considering the validity of the VAM agreement between shareholders, the Supreme Court held that: Diya’s promise of compensation to Haifu in the Capital Increase Agreement neither jeopardizes the interests of the company or its creditors, nor violated the prohibitive provisions of laws or regulations; such agreement is the parties’ true intention and is valid. Diya made an undertaking to Haifu that Shiheng should achieve a certain net profit in 2008 and the parties agreed on the formula for calculating the compensation. Since Shiheng failed to achieve the agreed net profit in 2008, Diya should pay compensation to Haifu in accordance with the agreement. Since Diya did not object to the amount of compensation or the calculation formula claimed by Haifu, such claim should be supported.
Furthermore, the Supreme Court ruled that since the Capital Increase Agreement does not require Lu Bo to compensate Haifu, there was no contractual basis for Haifu to claim compensation against Lu Bo.
In sum, the Supreme Court reversed the judgment of the second instance in part, and ordered Diya to pay compensation of RMB 19,982,095 to Haifu whilst dismissing Haifu’s other claims.
III. Analysis of the Retrial Judgment of the Supreme Court
- The Supreme Court denies the validity of the VAM agreement between the PE investor and the target company.
The retrial judgment crystallized the Supreme Court’s attitude towards the validity of the VAM agreement between the PE investor and the target company. That is, such agreement is invalid. In developing its reasoning, the Supreme Court corrected the court of second instance’s error in defining Haifu’s investment as a loan by applying the Explanations of the Supreme Court Concerning Several Issues on the Trial of Joint Operation Agreement Dispute. Instead, the Supreme Court held that the VAM agreement between the PE investor and the target company substantially jeopardized the interest of the company and its creditors, and violated Article 8 of the PRC Sino-Foreign Equity Joint Venture Law on profit distribution, which is in turn abuse of shareholder’s rights prohibited by Article 20 of the Company Law. Hence, the Supreme Court opined that this VAM agreement violated mandatory provisions of laws and regulations and therefore is invalid.
It can be seen from the above that the Supreme Court disagrees with the court of second instance’s oversimplified reasoning, namely considering the PE investment as “a loan but in the name of joint operation” merely due to the existence of a VAM agreement. The Supreme Court’s approach assures the legality of the PE investment, and takes into account the interest of the company, its creditors and the other shareholders of the company when deciding the validity of the VAM agreement. The Explanations of the Supreme Court Concerning Several Issues on the Trial of Joint Operation Agreement Dispute was promulgated in 1990, when the so-called “joint operation” was the legitimate form of economic association between companies and other entities. Joint operation became less and less common following promulgation of new laws such as the Company Law and the Contract Law. Thus, the court of second instance’s interpretation and application of joint operation in a PE investment dispute was inappropriate, and is contrary to the merits of PE investment.
According to the Company Law, the principles of “maintenance of the company’s capital” and “independence of the legal entity’s property” must be complied with, and during the existence of a company, the shareholders can only obtain property from the company by profit distribution or withdrawal of their investment through capital decreases. Otherwise the shareholders have no right to directly take property from the company. Attempts to obtain company property outside of these means are likely to be regarded as abuse of rights and damaging to the interest of the company and its creditors.
In this case, Article 7.2 of the Capital Increase Agreement provided that Haifu was entitled to request Shiheng to pay compensation when Shiheng failed to achieve a net profit of RMB 30,000,000 in 2008. That provision granted a shareholder the right to directly obtain property from the company without going through the statutory proceeding of profit distribution, and thereby enabled the shareholder to obtain benefits while bearing no risks of the company’s operation. Thus, that provision not only injured the interests of the company, its other shareholders and its creditors, but also directly violated Article 8[v] of the PRC Sino-Foreign Equity Joint Venture Law. For these reasons the Supreme Court ruled the provision invalid.
In view of the above, we believe that shareholders in limited liability companies and companies limited by shares that are not Sino-foreign equity joint venture, should also comply with Articles 35[vi] and 167[vii] of the Company Law allowing distribution of profits following a shareholder’s resolution, payment of taxes, allowance for losses and allocation of a percentage of profits to the statutory surplus reserve. For those companies, if the shareholder and the company reach an agreement obliging the company to pay compensation to the shareholder when the company fails to achieve a minimum profit, such agreement will constitute abuse of shareholder’s rights, damaging to the interests of the company and its creditors and thus will be invalid.
- The Supreme Court confirms the validity of the VAM agreement between the PE investor and other shareholders.
The Supreme Court corrected the lower courts’ completely negative attitude towards the VAM agreement, and confirmed that Diya’s undertaking (as a shareholder) to compensate Haifu (as PE investor) was the parties’ true intention. This agreement neither injures the interest of the company or its creditors, nor violates the mandatory provisions of laws or regulations, thus it is valid.
This part of the Supreme Court’s finding confirms the reasonableness and validity of a VAM agreement or valuation estimation clause to a certain extent – when between a PE investor and other shareholders. In part, this decision is based upon contractual parties’ autonomy.
In PE investment practice, investors usually use the VAM agreement when they subscribe the target company’s shares at a premium price. In these circumstances, the original shareholders share proportionately the beneficial interest in the capital exceeding the original price of their shares before the investment. If the company fails to achieve the target profit, the natural outcome is that the actual share value is much lower than the stipulated one.
In our experience, PE investors and the original shareholders reach a VAM agreement for two purposes. Firstly, to mitigate the risk that the PE investor has over-valued the shares being purchased. Secondly, to encourage yet restrict the original shareholders. For example, if the parties agree that when the target company fails to achieve the target profit, the original shareholders will compensate the PE investor using their own property (usually cash), this agreement does not injure the interests of the company or its other shareholders or creditors, nor does it violate mandatory provisions of law or regulations. Conversely, in these circumstances, through use of a VAM agreement to balance a PE investor’s risk of increasing contribution at a premium price against potential compensation in cash from the original shareholders for over-valuation of the shares, the parties can ensure the fairness and reasonableness of the deal.
- The Supreme Court’s recognition of the validity of VAM agreement balances the principle of party autonomy and protection of relevant parties’ interest.
VAM agreements have been recognized for a long time by western capital markets and legal regimes, and the respective legal rules thereof are relatively mature. In China, due to the absence of clear statutory rules, direct and simple adoption of the practice of western capital markets is not completely accepted, especially considering China’s company law system and strict financial supervision and regulation. Fortunately, rather than uniformly denying the validity of VAM agreements, the Supreme Court comprehensively considered the issues, balancing the principle of party autonomy, the interest of the company, its creditors and shareholders, as well as, maintenance of transaction order and security. The retrial judgment of the Supreme Court indicates a spirit of maximum respect for party autonomy so long as this does not harm third party or public interest. Upon the release of the retrial judgment of the Supreme Court, the media commented that it has the effect of “rectification of name” for the PE industry.
IV. Implications for PE Investors
The Supreme Court’s ruling on the nature of PE investment and validity of the VAM agreement will have referential significance for PE dispute resolution in future judicial practice. For PE investors, the principle and spirit of judicial evaluation reflected in the Haifu case should be instrumental in determination of the transaction mode and structure, especially use of a VAM. Based on the implications of the Haifu case and our experience, we consider it advisable for PE investors to keep in mind, among others, the following issues when negotiating a VAM agreement:
- The VAM agreement must not violate mandatory provisions of Chinese laws and regulations.
According to the Supreme Court’s opinion in the Haifu case and the position reflected thereby, PE investors are advised to refrain from violating mandatory provisions of laws and regulations when negotiating a VAM agreement. For instance, if the parties reach an agreement obliging the target company to compensate the shareholder when the company fails to reach certain targets, this agreement will violate the Company Law requirement on profit distribution and is likely to be ruled invalid by a Chinese court. Therefore, it is advisable for investors to achieve the purpose of VAM through other means. For instance, it is better to bet with the management team of the target company (as the case of Morgan Stanley’s investment in Mengniu) or the original shareholders of the target company (the founder in most occasions), and not to get the target company involved so as to avoid putting the VAM agreement into danger of invalidation.
- The VAM agreement should explicitly explain the overall commercial arrangement and safeguard the fairness and reasonableness thereof.
The fairness and reasonableness of the overall commercial arrangement of the VAM was an important factor in the retrial judgment of the Supreme Court. Therefore, it is advisable to explicitly identify the basis for investment pricing on which the PE investor makes the investment decision, such as the target company’s operational status, financial statistics and industry forecast etc., commitment to the business performance made by the target company and its shareholders, and to specify the method or formula for determining the investment pricing. This will help the court to comprehensively consider and recognize the fairness and reasonableness of the VAM agreement, and therefore help to mitigate the risk of the VAM agreement being invalidated.