The case Haifu Investment Co., Ltd, vs. Gansu Shiheng Non-Ferrous Recycling Co., Ltd and Hong Kong Diya Limited for the defendants’ failure to perform the investment compensation clause under the “valuation adjustment mechanism” (“VAM”), which has drawn high public attention, was finally determined. After its retrial, the PRC Supreme People’s Court (the “Supreme Court”) rendered the final judgment ruling that the old shareholder, Hong Kong Diya Limited, shall bear the compensation liability for the investor. It is beyond doubt that this judgment will play a significant role in guiding the courts’ rulings of similar cases in the future. We believe the following points are worthy of attention:

  1. The Supreme Court’s reasoning suggests its inclination to decide the validity of VAM (also known as “bet-on agreement” or “ratchet clauses”) by operation of the doctrines of the corporate law, which is essentially a protection of legitimate rights and interests of companies and the companies’ creditors, rather than to mechanically apply the test whether the contract is a “loan arrangement shammed with business cooperation”. It sets a milestone on the legality review of VAM in similar cases of future.
  2. The judgment also indicates that the Supreme Court acknowledges the reasonableness and legitimacy of VAM, but only for those entered between shareholders. There still exits risk that VAM agreed between the new shareholder who subscribes the capital and the target company is void per se, or to be challenged under the court’s strict scrutiny. PE investors need to pay special attention to such risks.
  3. It is also noteworthy of the potential commercial risks caused by the Supreme Court retrial judgment. The VAM disputed in this case is between the new shareholder and the target company. Leaving alone the reasonableness of the valuation adjustment set forth in the terms, agreement provides that the company shall be obligated to pay the compensation, while the old shareholder is more like a guarantor for the company’s liabilities. Therefore, if the Supreme Court determines the VAM be invalid, the guaranty to secure such invalid agreement is accordingly invalid. Thus, the liabilities should be allocated between the parties depending on the legal consequences of the invalid agreement and guarantee, but not the old shareholder being held responsible for the full compensation.

It is possible that the Supreme Court’s opinion holding old shareholder responsible for the full compensation was bases on its valuing of the doctrine of estoppels and its tendency to encourage the investment by safeguarding the investors’ entire interests and rights. According to such judging opinions, however, in similar cases of future, whether the investors could allocate the inherent commercial risks to the old shareholder by agreement during the initial period of investments? In other words, whether the investors could still recover full compensation when the investment fails, which was made solely based on the representations and warranties of the old shareholders or the company without considering the reasonableness in setting the structure of the VAM? This is another issue worthy to be highly considered by PE investors and company shareholders.