Share buyback agreements are common in equity investment in target companies. However, investors often encounter challenges in enforcing these agreements during disputes. Proactive planning during the investment phase can help mitigate future risks.
Execution challenges
Challenge 1: Clearance and restrictions on share buyback agreements in IPO filing. During the IPO filing process, target companies must clear valuation adjustment mechanism agreements according to regulations. Even if a share buyback agreement is not terminated, it must adhere to strict limits: the buyback cannot be tied to market value, and the company cannot be the buyback obligor.
Additionally, if certain share buyback agreements are not cleared before the IPO filing, investors’ claims based on clauses that violate regulatory requirements will not be supported by the courts.
For instance, in Nanjing Gaoke Xinchuang Investment v Fang and Liang (2021), the investor demanded the actual controller to buy back the shares of a partnership holding the target company’s stock. However, this indirect method was deemed invalid as the price was linked to market value.
Challenge 2: Judicial practice generally prohibits share buyback before capital reduction. Even if a target company is not listed and the share buyback agreement remains, investors often struggle to gain court support for buyback claims.
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The Minutes of the National Courts’ Civil and Commercial Trial Work Conference indicate that courts generally dismiss such claims until the capital reduction process is complete. Consequently, although the share buyback agreement may be legally valid, obtaining court support can be challenging in practice.
Challenge 3: Impact of the new Company Law on investors’ claims for capital reduction through share buybacks. Investors already face difficulties in litigation when pushing a target company for a directed capital reduction resolution, often leading to the dismissal of share buyback requests.
Before revision of the Company Law, there was still controversy in judicial practice over whether a company’s directed capital reduction resolution required a two-thirds majority or unanimous consent from all shareholders.
Paragraph 3 of article 224 of the new Company Law stipulates: “When a company reduces its registered capital, it must proportionally reduce the capital contributions or shares according to the shareholders’ holdings. Exceptions apply if otherwise provided by law, agreed by all shareholders of a limited liability company, or stipulated in the articles of association of a joint-stock company.”
According to these provisions, directed capital reduction is generally prohibited and, in exceptional cases, unanimous consent from all shareholders is required, making it even more difficult for investors to claim capital reduction via buyback through litigation.
Although judicial practice has yet to resolve the challenges of capital reduction and share repurchase for target companies – and the new Company Law requires further interpretation – there is flexibility in the legal provisions.
Investors can make proactive arrangements during the investment stage to minimise risks.
To address obstacles in the capital reduction process, investors can require a special resolution from the target company’s shareholders’ meeting, ensuring all shareholders agree in advance that the company will buy back the investors’ equity when certain conditions are met.
Additionally, the company’s articles of association can stipulate the obligation to perform share buybacks and implement directed capital reduction procedures, confirming unanimous consent from all shareholders.
Arbitration practice
Arbitration practice offers a certain degree of flexibility in handling disputes related to share buyback agreements. To gain the tribunal’s approval in arbitration cases, investors can argue that the target company’s share buyback does not violate mandatory provisions or face performance obstacles.
Some arbitrators currently believe that completing the capital reduction process is not necessarily a prerequisite for the target company to pay the share buyback price to investors as agreed. Therefore, the target company should fulfil the share buyback obligation once conditions are met. Reasons include:
- Investment documents containing share buyback agreements, signed by all shareholders of the target company, effectively serve as a capital reduction resolution. Once the buyback conditions are triggered, the share buyback by the target company is simply execution of the agreement, without requiring further shareholder consent.
- The share buyback agreement imposes a contractual obligation on all shareholders to co-operate and assist in completing the share buyback and change of equity ownership. Based on the legal binding force of valid contractual agreements on all parties, shareholders should vote to pass the capital reduction resolution at the shareholders’ meeting to achieve the applicant’s buyback right as agreed. Therefore, the target company’s share buyback is legally and factually feasible.
- The essence of the share buyback obligation is the target company’s obligation to pay funds to the investor, which should be judged based on contract law rather than company law. The company’s performance of the obligation and payment to the investor is reasonable and legitimate, not constituting a withdrawal of capital contributions by shareholders, and does not violate the mandatory provisions of the Company Law.
Takeaway
Overall, investors face numerous obstacles in enforcing share buyback agreements. To make share buyback an effective exit strategy, investors should focus on choosing appropriate dispute resolution methods.
Additionally, making arrangements during the investment stage to address potential share buyback difficulties can help reduce subsequent risks.
Cui Qiang is a partner at Commerce & Finance Law Offices. He can be contacted at 86 10 6563 7181 or by e-mail at cuiqiang@tongshang.com
