The Chinese Supreme Court has upheld a valuation adjustment mechanism (“VAM”) provision. In a much awaited ruling, the Chinese Supreme Court overturned trial and appeal court judgments in the Gansu Haifu investment case on 7 November 2012. The Gansu Haifu investment case drew significant public attention when a trial court and on appeal the appeal court in Gansu held that a VAM provision contained in a capital increase agreement was invalid as a matter of Chinese law. This ruling threw into question whether VAM provisions (known in Chinese as “Gambling Agreements”) would be enforceable in China. These types of provisions are commonly used in private equity and venture capital investments to protect against a portfolio company's failing to reach specified performance targets.
In the Gansu Haifu case, Haifu Investment Co., Ltd. of the Suzhou Industrial Park (“Haifu”) invested RMB ¥20,000,000 in Gansu Shiheng Non-Ferrous Metals Recycling Co., Ltd. (“Shiheng”) through a capital increase. As a consequence of Haifu's investment, Shiheng, which had been a WFOE owned by Diya Co., Ltd. of Hong Kong (“Diya”), was transformed into a sino-foreign equity joint venture. Pursuant to the capital increase agreement, Diya which at that point owned 100% of the equity of Shiheng, agreed to compensate Haifu pursuant to valuation adjustment formula if Shiheng's profits in 2009 failed to reach RMB ¥30,000,000. Further compensation and a put right were provided for in the event that Shiheng failed to achieve a qualified listing on a national stock exchange within a designated time frame.
The purpose of the Haifu investment was to allow Shiheng to reorganise and develop a track record that would permit a listing. For the RMB ¥20,000,000 investment, Haifu received a 3.85% interest in Shiheng. The Agreement provided that in the event Shiheng failed to reach the designated profit level, it would compensate Haifu pursuant to the formula:
|1-||x investment amount|
Should Shiheng fail to make the compensation payment, Haifu had the right to pursue Diya for the payment. In the event, Shiheng failed to achieve RMB ¥30,000,000 in profits and instead had profits of only RMB ¥26,858. Haifu consequently made a claim for compensation in the amount of RMB ¥19,980,095 against Shiheng, Diya and the controlling shareholder of Diya, Ms. Li Bo, who had not been a signatory to the Agreement. Haifu sought to have the Agreement enforced by the Court.
The original trial court held that the VAM Agreement violated the PRC Sino-Foreign Equity Joint Venture Law and PRC Company Law, since it provided for distributions unrelated to the parties' relevant capital contributions to the enterprise or its success. The trial court held any distribution must be based on the parties' relative equity holding in the joint venture. On appeal, the appeal court held that the capital contribution was a loan and ordered it refunded to Haifu, which Haifu had not requested, and affirmed that the VAM Agreements was invalid. These rulings threw into question the validity of VAM provisions, which compensate investors with cash or additional equity when performance targets are not reached.
The Supreme Court in ruling on this case overturned the lower court's rulings and established the validity of VAM agreements in China. In making the ruling, it held that while such a contract provision would be void against the portfolio company as the provision would violate the profit distributed provisions of the Sino-Foreign Joint Venture Law and creditor's right under the Company Law, such agreement could be entered into between the shareholders of such companies. The Supreme Court found nothing in the provisions of the VAM that would violate Chinese law if it were entered into between the shareholders of a portfolio company. The Supreme Court held that the VAM provisions reflected the intention of the parties.
The Supreme Court upheld the right of Haifu to exercise the VAM right against Diya, the controlling shareholder, and invalidated the appeal court's classification of the investment as a loan. It however found no basis for a claim against Ms. Li Bo, who had not been a party to the Agreement.
Based on this case, it is very important to set out the basis for including a VAM in any agreement and to provide for a clear method of making the calculation. This validation of a VAM provision should be of considerable interest to private equity investors in China as there is now official confirmation, even though enforcement was against a foreign shareholder, that this important investment tool is valid in China. While it is clear that these agreements cannot be entered into directly with a portfolio company, shareholders do appear to be able to agree amongst themselves and this should give private equity investors comfort to the extent that such shareholders have resources to settle a claim.