The Haifu Case(1) caused the Private Equity industry consternation until a clarifying judgment from the Supreme People's Court of China (the "Supreme Court") in December 2012. The Supreme Court overruled the second instance court's opinion that PE investments are "joint risk sharing" and investors are not entitled to a guaranteed profit without regard to the performance of the business. The Supreme Court (i) recognized the legitimacy of the PE investment model, (ii) fully considered all the various interests of the project company, the creditors of the project company and the shareholders of the project company, (iii) distinguished VAM (Valuation Adjustment Mechanism) agreements between the project company and the shareholders from VAM agreements between the company shareholders, and affirmed the validity of the latter with certain prerequisites.
The Haifu Case has significant implications not only for PE firms, but also for the investment industry which may find guidance from it when designing equity investment structures.
I. How to withdraw capital from an equity investment?
How to withdraw capital from a project company in a safe and appropriate manner is a key process in an equity investment scheme. In practice, the investment company will sign repurchase agreements with the shareholders of the project company whereby the shareholders are required to purchase for a premium the equity of the financier at the closing date of the project. This process is advantageous because it is common and companies are familiar with it. As for the shortcomings:
- It is difficult to distinguish between a "regular equity repurchase for a premium" and a "loan arrangement under the name of an investment". According to the Guidelines for Trust Companies to Operate a Private Equity Investment Trust Business(2) , a trust investor company can withdraw from an equity investment by the presale of its capital investment". However, in the case of a real estate investment, this "withdraw capital" model may be deemed a "loan arrangement under the name of investment" and the investor company may be considered to be attempting to intentionally avoid the regulations of the "four three two" provision (a qualified real estate developer must have four kinds of permission from the relevant government agencies, i.e., State-owned Land Use Permit, Land Use Permit, Building Permit and Building Construction Permit, and must possess a 30% equity fund and a second grade development qualification) implemented by banking regulation authorities.
- The "withdraw capital" model leads to great uncertainty in the outcome of the judicial process. Based on years of experience engaging with judges of commercial courts at all levels, including the Supreme Court, in cases involving trust plan disputes, most judges are not very familiar with trust laws and prefer instead to adopt traditional civil law theory in their judgments. This leads to a different interpretation, i.e. – that the trust company invests capital but in fact, does not involve itself in the management of the business and also demands the repurchasing of its equity when it becomes due, and charges fixed returns (premium). All this brings the validity of the equity investment structure into question.
- If a trust company adopts a "withdraw capital" model, documents such as the Equity Repurchase Agreement will be signed in advance with a financing party. However, if disputes arise, the financing party may deny the validity of related agreements by insisting that these agreements are not based on true intentions, thereby rendering the equity repurchase impracticable.
Apart from repurchase, there are other options available for withdrawing capital from equity investments, For instance a company can transfer its equity to third parties or by agreeing upon tag along rights. However, except by transferring the outstanding shares issued by listing companies, there is no certainty that an investing company can dispose of its equity or recover the trust fund successfully. In short, a VAM gives the equity investor certainty over the return of its investment. Without the VAM, the investor can only get a return of its investment by transfer of its shares to a third party by way of a tag along right, or an IPO or a negotiated sale—all of which are uncertain exits.
II. The feasibility of VAM as a method to withdraw capital from an equity investment.
Applying VAM to equity investments: the investing company may set VAM terms depending on performance, cash flow and profit objectives with the project company. When such conditions are satisfied, the investing company demands cash compensation or the repurchase of equity by the shareholders of the project company. There is no clear and definite legislation regarding the terms of VAM agreements, but following the judgment in the Haifu Case, the courts should support similar agreements as long as they do not adversely affect the interests of project companies or their creditors.
In theory, a VAM agreement is a valuation adjustment mechanism of a project company. It aims at (i) reducing the risk of the investors' miscalculation of the equity value, and (ii) incentivising and binding the finance party to the investors. If the project company cannot achieve the profit objectives under the VAM agreement, the shareholders of the project company must compensate the investors. This will not cause any damage to the interests of the company, other shareholders or creditors or violate any mandatory provision of any laws, regulations, rules or policies. In addition, because of the uncertainty of realization of the assumed and pre-stated conditions, the VAM agreement differs greatly from the "regular repurchase" clause and to a certain extent helps the investing company reduce the risk of it being held that it is a "loan arrangement under the name of investment".
In fact, situations where VAM was applied to investment structures occurred long before the Haifu Case. In the Trust Plan of Energy Investment Collection of CITIC Rongjin(3), CITIC Trust made an arrangement with China Oceanwide Corporation ("China Oceanwide") whereby: if the project company cannot obtain a mining permit and sell 8 million tons of ore a year, China Oceanwide will repurchase all the equity of the project company held by CITIC Trust as trust assets. Although this arrangement mainly aimed to recover the trust fund when the purpose of trust could not be realized, it could also be used when the project succeeded for the "normal" withdrawal of trust funds.
A fact worth emphasizing is that Chinese courtsdo not need to follow the precedents set by earlier cases or higher courts and different local people's courts may hold different opinions and interpret VAM agreements differently. Considering the possibility that the Supreme Court may give a different judgment in a future case, the Haifu Case can therefore only be considered as a reference for investor companies.
III. Facts worth noting when VAM is used in withdrawing from an equity investment scheme.
A few points investor companies should note when signing a VAM agreement:
- The terms of a VAM must not violate any mandatory provision of any laws, regulations, rules and policies or damage the legitimate rights of any other person.
In the Haifu Case, the Supreme Court ruled that the VAM agreement between the investors and the target company was invalid because it violates Article 8 of the PRC Sino-Foreign Equity Joint Venture Law (4) on profit distribution, which in turn abused shareholders' rights prohibited by Article 20 of the Company Law and jeopardized the interest of other shareholders and creditors of the company. Since China lacks specific laws regulating VAM agreements, investor companies must bear in mind the impact of potentially relevant provisions of the general law, as well as judicial decisions involving VAM agreements so as to mitigate the risk of a VAM agreement being invalidated.
- Avoid gambling with the project company
It is recommended that the investor company should try to avoid entering into VAM agreements with the project company, otherwise, the investor company may expose itself to the court finding that the VAM agreement is invalid. In order to avoid this risk, the investor should instead consider entering into VAM agreements with the actual controller, the management board or other shareholders of the project company.
- The VAM agreement must be fair and reasonable
The court will focus on the fairness and reasonableness of the VAM agreement whenever disputes arise. Therefore, it is advisable that the investor company explicitly identifies the basis for the investment pricing by reference to the target company's operational status, industry key performance indicators, etc. The parties should also set fair and reasonable VAM terms and list clearly the method for calculating compensation or repurchase so as to avoid putting the VAM in danger of being recognized by courts as invalid or partially invalid due to its obvious unfair terms.
- Consider a combination of an equity repurchase agreement, a tag along right and a VAM.
When designing the method of withdrawing capital from an equity investment, an investing company can combine a VAM agreement and an equity repurchase agreement with a tag along right. For instance, the trust company may set the conditions in the VAM agreement to trigger the equity repurchase. Once the conditions are satisfied, the equity repurchase agreement signed in advance will become effective and the financing company can then recover its investment.