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This year has seen a significant rise in equity repurchase disputes due to underperformance or delays in public listings of target companies. In practice, investors typically sign a valuation adjustment mechanism (VAM) agreement with the target company, its controlling shareholders and founders when investing in the company, specifying repurchase obligations at the occurrence of specific events.

However, variations in the design and wording of an agreement often lead to differing interpretations during litigation or arbitration. This article draws on relevant case rulings to analyse the legal implications of different provisions in VAM agreements.

Target company

Investor¡¯s request. The Minutes of the National Courts¡¯ Civil and Commercial Trial Work Conference stipulate that when an investor requests the target company to repurchase equity it holds, the court should review the case pursuant to article 35 of the Company Law, which prohibits shareholders from withdrawing capital contributions, or article 142, which mandates equity repurchase regulations. If the target company has not completed the capital reduction process, the court should dismiss the lawsuit.

Taking a reference from Xinyu Zhentou Yunlian Growth Investment Management Centre v Long Ke and Guangdong Yunhuogui Information Technology Co Ltd (2020), a target company is to complete several steps to finalise the capital reduction process. These steps typically include passing a resolution at the shareholders¡¯ meeting, issuing an announcement and notice to creditors, and completing necessary industrial and commercial registration of changes.

Therefore, following the implementation of the minutes, it is challenging to demand fulfilment of a target company¡¯s repurchase obligations without the support of the company and all its shareholders in the capital reduction process. Even if the investor pursues litigation or arbitration to compel the company to reduce capital, the claim is unlikely to gain support from the court or the arbitration panel.

Rulings on liabilities. While a target company fails to fulfil its repurchase obligations through capital reduction, its liabilities under the VAM agreement are not necessarily exempted. The minutes mandate that in the absence of statutory grounds for invalidity, the court should not support a target company¡¯s claim for invalidating the VAM agreement on the ground of provisions for equity repurchase or financial compensation.

Referring to Zhang Dongju et al v Nanjing Steel Research Venture Capital Partnership (2021), it was held by the court that the Company Law¡¯s prohibition on shareholders¡¯ withdrawal of capital is primarily to protect creditors¡¯ interests based on the capital maintenance rule.

In the Nanjing Steel case, while the target company should have duly anticipated its capacity to fulfil the obligations on signing and executing the investment agreement, its failure to timely complete the capital reduction process breached the subordinated obligations of the agreement, resulting in its inability to pay the redemption price to the investor on time.

Consequently, it was held liable for delayed performance and shall pay the investor overdue performance penalties.

In summary, without the target company¡¯s support in completing the capital reduction process, it is hard for the investor to enforce the company¡¯s repurchase obligations. However, the investor can claim for liquidated damages for overdue performance as stipulated in the investment agreement.

Other obligors

Investors tend to seek flexibility to hold the target company or founding shareholders accountable for repurchase. However, variations in the design and wording of investment agreements often lead to differing rulings in practice.

Supplementary obligations. In Beijing Yinhaitong Investment Centre v Xinjiang Xilong Geotechnical New Materials Co Ltd, the investor required from the start of the investment that the target company¡¯s subsidiary should pay the investor for equity repurchase on the target company¡¯s failure to fulfil its repurchase obligations.

The Supreme People¡¯s Court determined the subsidiary¡¯s obligations to repurchase the equity was a warranty. Given the nature of a warranty, it was held that the subsidiary¡¯s repurchase obligations were not yet established, as the primary obligations had not been satisfied without the target company¡¯s completion of the capital reduction process. Therefore, the subsidiary was not liable for the repurchase.

Shared obligations. In Zhang Dongju et al v Nanjing Steel Research Venture Capital Partnership (2021), the investment agreement stipulated that management shareholders were liable for an equity repurchase. If the investor did not fully recover the investment and returns after issuing a redemption notice to the target company, it could demand an equity repurchase from the management shareholders.

The key issue was the management shareholders¡¯ claim that they were liable for the target company¡¯s equity repurchase as a general guarantee only.

The court ruled that the management shareholders, rather than bearing liabilities only for a repurchase payment, could acquire the equity on payment as agreed on in the VAM agreement with the investor. The principles of fairness and making compensation for equal value were not breached, thus obliging the management shareholders to proceed with the equity repurchase.

Takeaways

In conclusion, when entering into a VAM agreement, investors should avoid structuring other obligors¡¯ liabilities of equity repurchase in a way that implies a sequential or subordinated nature, which could be interpreted as a general guarantee for the repurchase.

Three key aspects should be considered:

• Avoid setting preconditions for other repurchase obligors to perform the repurchase, and clearly state that the investor has the right to directly demand repurchase from these obligors;
• Specify that the investor requires other repurchase obligors to perform their obligations of equity repurchase, and that these obligors shall acquire the investor¡¯s equity in the target company, rather than merely assuming joint and several liability for debt payment; and
• Avoid provisions in the agreement that allow other repurchase obligors to recover against the target company the repurchase price after fulfilling the repurchase obligation.

Chai Xueying is a salaried partner at Grandway Law Offices