Highlights:

Valuation adjustment mechanisms have been often used by private equity firms in their portfolio investments in China, which had never been tested until recently ruled invalid by a Chinese local court.  It remains to be seen if and how this decision will impact the investment practice of private equity firms in China.

Main Article:

Recently, the People’s Court of Gansu Province of China reversed a lower court judgment and held that the valuation adjustment mechanisms (“VAM”) typically adopted by private equity firms were invalid.

Background of the Case

In 2007, Hai Fu Investment Company Ltd., a private equity firm (the “PE Firm”), subscribed 3.85% of the equity interests in Shiheng Non-ferrous Resources Company Ltd. (the “JV”), an equity joint venture formed under Chinese law, with a premium of RMB 18,852,283. 

In the subscription agreement, the JV, the PE Firm, and the majority shareholder of the JV (the “Majority Shareholder”) agreed to a VAM which provides that, should the net profits of the JV for 2008 be less than RMB 30 million, the PE Firm will be entitled to receive, from the JV or the Majority Shareholder, compensation equal to a certain sum as determined according to an agreed formula.  This provision was triggered in 2009, as the JV failed to reach the targeted performance for 2008 and  the PE Firm sued the JV in the local court to seek to exercise its right to the compensation. 

The decision

The post-closing VAM provision (which helps bridge the gap of different projections for the target company) has been widely adopted in private equity investment in China, but had never been tested before a Chinese court. 

The first instance court ruled that, the VAM is an arrangement for the sharing of the JV’s profits rather than a future adjustment to the valuation of the JV, and thus the compensation arrangement violates the Chinese legal principle that the shareholders should share the profits of the JV in accordance with their respective shareholding ratios. 

The second instance court reversed the lower court ruling and held that, the whole purpose of the compensation arrangement (together with the buy-back right of the PE Firm under the agreement) is to safely recoup the PE Firm’s investment regardless of the JV’s performance, which is against the legal principle that investors should bear the risks of their investment and essentially makes the “investment” a loan instead.  Based on this conclusion, the court ruled that the JV and the Majority Shareholder should jointly repay to the PE Firm the funds equal to the sum of the premium together with the interests accrued thereon (while the PE firm continues to own the 3.85% equity interest in the JV).

Some observations

Chinese company law does not allow the issuance of preferred shares, and still insists on the principle that shareholders share risks of their investment in accordance with their respective shareholding ratios.  We think the second instance court is correct in reversing the first instance court ruling by pointing out that the compensation arrangement is not a profit-sharing provision, but the court incorrectly understood the nature of the VAM and wrongly concluded that the “premium” is a loan, ignoring the facts that making/receiving a loan was clearly not the intent of the parties and Chinese law does not prohibit the Majority Shareholder from compensating the PE Firm, the minority shareholder.

As China is not a case law jurisdiction, it remains to be seen if and how this decision will impact other courts in the country and the practice of private equity industry in China.  Nevertheless, before the Supreme Court of China issues any guidance to specifically uphold the validity of the VAM, there exists a risk and an uncertainty that the VAM may have its validity be challenged in courts.    

This decision also reflects the fact that, mainly due to the concerns of taxation and foreign exchange administration, Chinese law currently still does not leave much room for parties to freely negotiate their transaction terms, and subject provisions of a cross-border M&A or investment agreement to various legal and regulatory restrictions (including, among other things, the general requirement that a deal price be fixed rather than adjustable, which makes the legality of such contingent pricing as an earn-out arrangement questionable under Chinese law). 

Investors in China need to be aware of these risks and uncertainties, and understand that the VAM and other terms of their legal documents must be carefully planned and crafted to manage and allocate the risks in a structured manner.  This sometimes requires creativity to address the risks and uncertainties.