What do the First Valuation Adjustment Mechanism (VAM) Lawsuits in China Tell Us?

Analysis on the HF Fund’s lawsuits against Gansu Shiheng and Hong Kong Dia

(By Bai Lituan & Zhang Qianlin) In December 2012, HF Fund Management Co., Ltd. (the “HFF”) filed a lawsuit against Gansu Shiheng Nonferrous Metals Co., Ltd (the “GSNM”), and after being heard by the Supreme People’s Court, the Court stated that the valuation adjustment Mechanism (VAM) would be considered partially valid. This particular case has been seen ups and downs, and now that it has finally been heard, we would like to share our opinions on it within a framework of legal analysis, and hope that it will help clarify any issues presented in the case and thus help to reduce the risks investors typically face.

I. Case Summary:

GSNM was originally a fully invested subsidiary company of the Hong Kong Dia Company (the “HK Dia”), with a registered capital of $ 3.84 million; in December 2007, GSNM, HFF, HK Dia and Lu Bo, the latter of whom is the legal representative of GSNM, signed a “Capital Increase Agreement” (the “Agreement”) of GSNM. As stipulated in the Agreement, HFF would invest RMB 20 million in GSNM, among which RMB 1.15 million would be added in addition to the registered capital, and the premium of RMB 18. 85 million yuan would be added into capital reserve.

After the capital increase, GSNM’s share structure changed, with HFF taking 3.85%, and HK Dia taking 96.15%. Simultaneously, the parties involved in the case signed a VAM clause:

The first is to “bet the achievement;” the agreement specifically stated that: “if at the end of 2008, GSNM’s net profit is less than RMB 30 million yuan, HFF will have the right to demand reimbursement from GSNM; and if GSNM fails to do that, HFF reserves the right to demand that HK Dia compensate the losses.”

The second is to “bet the listing;” If by October 20, 2010 GSNM failed to complete its listing, HFF would have the right to demand HK Dia purchase back all shares held by GSNM. The parties involved would negotiate in detail the share purchase price. Later on, the parties involved signed a joint investment contract, and the Articles of Association of the company, and became a Sino-Foreign invested company following approval by the authorities. In 2008, GSNM’s total profit and net margin was RMB 20, 000 yuan, and in December 2009, HFF filed a lawsuit in the court demanding GSNM and HK Dia compensate it RMB 19.98 million yuan.

II. Different awards granted in third level courts

The Lanzhou Intermediate People’s Court (the “Intermediate Court”) determined that the “bet the achievement” clause in the agreement did not conform to the relevant regulations in the Sino-Foreign investment laws, which require that the net margin should be divided among the parties as per the individual investment proportion, because any agreement otherwise could damage the interests of the company and the individual. Moreover, the Court felt the agreement could be considered an abuse of shareholder power. For these reasons, the “bet the achievement” clause was found to have violated the laws and relevant administrative regulations, and was found to be invalid. With that in mind, the court refused HFF’s request.

The Gansu Higher People’s Court (the “Higher Court”) ruled that the “bet the achievement” had violated the principle that the investment risk shall be undertaken by all, in contrast to HFF, who was a principal investor but assumed no real risks when its interests were guaranteed. Therefore, the agreement should be deemed invalid. In addition to HFF’s investment of RMB 1.15 million yuan in GSNM, the Gansu court ruled that the remaining RMB 18.85 million yuan should be considered a loan rather than an investment. Based upon this reasoning, the court ruled that GSNM and HK Dia return HFF’s RMB 18.85 million yuan as well as any interest accrued during HFF’s takeover period.

The Supreme Court heard the case and came to the following determinations: first, that the agreement in the VAM contract enabled HFF to get fixed gains, and those gain were separate and distinct from GSNM’s business achievements, and this would possibly damage GSNM’s interests as well as those of its creditor. The first and second instance courts ruled that the reimbursement articles in the Agreement were invalid pursuant to Article 20 of the Corporate Law and Article 8 of Sino-Foreign Joint Investment Law – a correct legal assertion. But in the Agreement, HK Dia’s compensation to HFF would not damage GSNM’s interests or that of its creditor. Furthermore, this would not be considered a violation of the relevant rules and regulations. Since the agreement reflected the actual intent of the parties involved in the litigation, the Supreme Court believed the agreement should be deemed valid. Finally, the Supreme Court vacated the judgments made in the previous instances, and ruled that HK Dia would individually pay HFF compensation in the amount of RMB 19.98 million yuan.

III. To bet with the target company violates the statutory rules in the law

The VAM agreement is a kind of agreement concluded by the purchaser (including the investor) and seller (including the financing party) when there is uncertainty in the future or when making a transaction (or financing). Once a stipulated and agreed event occurs, an investor can exercise certain rights pursuant to the agreement. When the stipulated event does not happen, the financing party may exercise certain rights. In this case, courts at three different levels all expressed a different understanding of the VAM agreement. Why would this be? This is likely due to inadequate law regulating PE, a relatively new investment method. Therefore, an effective method of evaluation under the Corporate and Contract Law is needed. China’s Corporate Law provides that the shareholder of a company should not abuse its shareholder status or damage a company’s or creditor’s interests. As provided in the Agreement, GSNM compensating HFF when its net profit margin fellow below an agreed upon amount would enable HFF to gain such compensation even though it would not suffer any real losses. Such an arrangement would obviously damage GSNM’s interests and that of its creditors – and also violate regulations in the Corporate Law that deem it invalid.

The Court’s decision reveals the original purpose of the VAM agreement, and agreed that part of the agreement would be deemed valid.  This line of reasoning arises out of two main points: 1) it shall allow the parties involved in the case to freely express their intentions when no laws are violated; and 2) the VAM agreements violating the current law should be corrected.

IV. How to prevent the risks in the VAM agreement.

A VAM agreement should be signed between the investing party and the target company’s original shareholder or its management. In this case, the Agreement provided that if GSNM was not listed, HFF would have the right to demand HK Dia repurchase all shares held by GSNM at any time, and that article was deemed valid. In other cases, we have seen B-Ray Media (the “B-Ray”) sign a share transfer agreement with DSTF Holdings Ltd, a major shareholder of Chenyan Information, and pursuant to that agreement, B-ray would purchase 100% of Chenyan Information’s shares; in this case, the parties involved signed a VAM agreement. As agreed to by both parties, the purchase price would be from RMB 1.2 million yuan to RMB 40 million yuan, and the final price would be tied to Chenyan Information’s business achievements for three years subsequent. This particular type of VAM is one entered into by a share purchase and controlling shareholder, and therefore would be unlikely to damage the interests of the company or its creditor – for this reason, the VAM agreement was considered valid.

Despite the above conclusion, if a company’s goal is IPO, then regardless as to what VAM is adopted, it should be done cautiously. According to China’s Management Measures regarding IPO:

“The publisher shall have a clear share structure, and there should be no major disputes visible between the controller shareholder, the controlled shareholders, and the actual controller’s influence shareholder. This shows to some extent that the authorities would like to see stability in terms of publishing shares. The problem is that the VAM agreement may lead to shareholding disputes or shareholder adjustment. In practice, the listing time, VAM on shares, VAM on achievement, and board vetos,  as well as priority clearance in liquidation has been banned in IPO examinations. Any violations against the five situations stated above would make a company difficult to list. However, these factors should not be considered enough to invalidate on their own, as their effectiveness shall be examined in each particular case.

A VAM or repurchasing agreement is a common measure for PE, and is considered to be one of the main lines of defense. Under the current legal framework, it is obvious that through proper agreements made in regard to VAM or repurchases that the interests of PE investors may be protected, but the flipside is that professional due diligence and thorough investigation is sufficient to gain a deeper understanding of any given company.

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