Executive Summary

  • China’s Supreme Court allowed an investor in a Sino-foreign equity joint venture (“EJV”) to enforce a cash-based performance ratchet against the controlling shareholder of the EJV.
  • However, the Supreme Court held that the investor could not enforce the same performance ratchet against the EJV.
  • This decision finally shed light on the type of performance ratchets that are enforceable in onshore private equity investments after years of uncertainty and inconsistent judgments.

Performance Ratchet

A performance ratchet1 (also commonly referred to as “valuation adjustment mechanism” or “对赌协议” in Chinese) is a contractual arrangement among an investor, the target company and typically the company’s largest shareholder or founder to lower the target company’s pre-money valuation if it fails to achieve certain performance targets upon which the pre-money valuation is based. Typical performance targets include minimum revenues or earnings in the financial years following the investment.2

When the target company fails to achieve a performance target, the performance ratchet would commonly:

  • increase the investor’s equity interest in the target company without a new capital injection (commonly referred to as “equity-based performance ratchet”);3 or
  • return a part of the investor’s investment through a cash compensation that is payable by the controlling shareholder and/or the target company without affecting the investor’s equity interest in the target company (commonly referred to as “cash-based performance ratchet”).

The performance ratchet may provide the investor with protection from aggressive projections of the future performance of the target company by its management or existing shareholders, especially where the pre-money valuation of the target company is largely based on such projections. The performance ratchet may also protect the investor in times of a business downturn during which the target company underperforms for an extended period of time.

The Haifu Case


In Haifu Investment Co., Ltd. vs. Gansu Shiheng Nonferrous Resources Recycle Company Limited (the “Haifu case”), Haifu Investment Co., Ltd., a private equity investment company based in Suzhou, China (“Haifu”), entered into a capital increase agreement (the “Capital Increase Agreement”) with Gansu Shiheng Nonferrous Resources Recycle Company Limited, a company based in Gansu, China (the “Gansu Shiheng”),4 Wisdom Asia, a Hong Kong company (“Wisdom Asia”) and Ms. Lu Bo, the general manager and legal representative of Gansu Shiheng (“Lu Bo”) in 2007. Haifu and Wisdom Asia also entered into an Equity Joint Venture Agreement. The Capital Increase Agreement, the Equity Joint Venture Agreement and the new Articles of Association of Gansu Shiheng were approved by the Gansu branch of the Ministry of Commerce on February 29, 2008.5

Pursuant to the Capital Increase Agreement, Haifu invested RMB20 million for 3.85% of the equity interest in Gansu Shiheng, with the remaining 96.15% of the equity interest held by Wisdom Asia.

Cash-Based Performance Ratchet

The main issue in the Haifu case was the legal enforceability of the cash-based performance ratchet provision (“Cash Performance Ratchet”) in the Capital Increase Agreement. According to the Cash Performance Ratchet, Haifu would receive cash compensation from Gansu Shiheng if Gansu Shiheng’s net profit for 2008 was less than RMB30 million. If Gansu Shiheng failed to pay such compensation, Haifu could then demand Wisdom Asia to pay the same compensation.

The net profit of Gansu Shiheng for 2008 was only RMB26,858.13, which was far lower than the target net profit. Despite the Cash Performance Ratchet, Gansu Shiheng and Wisdom Asia both refused to pay the cash compensation, so Haifu sued Gansu Shiheng, Wisdom Asia and Lu Bo in Lanzhou for cash compensation and court fees. The case was heard and decided by the Lanzhou Intermediary Court and the Gansu High Court, and ultimately appealed to the Supreme Court.

The Supreme Court Decision

The Supreme People’s Court of China (the “Supreme Court”) issued its judgment on the Haifu case on November 7, 2012. In the judgment, the Supreme Court made the following rulings:

  • The claim against Gansu Shiheng was unenforceable. It constituted a promise by Gansu Shiheng of a “relatively fixed or guaranteed return” to Haifu irrespective of Gansu Shiheng’s actual business performance and profits. Such guaranteed return was a violation of the requirement under Sino-foreign Equity Joint Venture Law that the shareholders in an EJV are only entitled to share the net profits of the EJV pro rata to their respective equity interests in the EJV.
  • The claim against Lu Bo was also unenforceable. The Cash Performance Ratchet did not require Lu Bo to be jointly liable for the payment of any compensation to Haifu.
  • On the other hand, the claim against Wisdom Asia was enforceable. Haifu’s claim did not harm the interests of Gansu Shiheng and its creditors, nor did it violate any applicable law. In addition, Wisdom Asia did not challenge either the amount or the basis for determining the amount of the claim. As a result, Wisdom Asia was ordered to perform its obligation under the Cash Performance Ratchet by paying a cash compensation of RMB19,982,095 and court fees to Haifu.
  • The fact that the Gansu branch of the Ministry of Commerce approved the Capital Increase Agreement containing the Cash Performance Ratchet was an important factor in the Supreme Court’s decision in favor of Haifu. Although the written judgment did not directly address this issue, the importance of such approval can be deduced from the lower court’s decision6 and Chinese law.7

Considerations in Structuring Performance Ratchet

The Supreme Court’s decision in the Haifu case provides valuable guidance in structuring performance ratchets in onshore private equity transactions in China. Nevertheless, investors should consult legal counsel before agreeing to terms as there are no one-size-fits-all solutions, especially because the law is still evolving and there are numerous factors to consider in structuring an enforceable performance ratchet. Below are some of the factors that investors should consider:

  • Offshore structure. If an investor could make its investment in a target Chinese company through acquiring shares in an offshore target company (typically incorporated in the Cayman Islands, the British Virgin Islands or Hong Kong), the enforceability of a performance ratchet in such an offshore transaction would be more certain. However, Chinese law has recently made it increasingly more difficult to set up an offshore holding company to hold and control Chinese companies, so investors may have no choice but to invest directly in Chinese companies. Nevertheless, given the advantages offered by investing in an offshore structure,8 investors may want to first explore the viability of investing offshore by having a thorough understanding of the target Chinese company and its existing shareholders before deciding on the final investment structure.9
  • Onshore structure. In the event that an investment is made directly in a Chinese company, the following factors may increase the likelihood of a performance ratchet being upheld by a Chinese court in light of the Haifu case:
    • Adopt a cash-based performance ratchet that makes the controlling shareholder responsible for paying the cash compensation.
    • Avoid an equity-based performance ratchet because its enforceability in China remains uncertain.
    • Avoid imposing liabilities on the target Chinese company because it may be unenforceable.
    • Get the appropriate Chinese government office to approve the agreement that contains the cash-based performance ratchet.

The Haifu case is a good example of China’s judicial system’s responsiveness to the ever-changing landscape of private equity-style investments. The courts have shown a willingness to analyze different terms of commonly-used investment structures and investor protections, and to interpret such terms’ enforceability under the existing legal regime in China. Investors should closely monitor such developments to ensure that their investment terms are consistent with the latest court decisions in China.