Cyclical adjustments in the capital market have made it harder for investors to exit target companies, sparking a surge in repurchase disputes in recent years. Amid this ongoing controversy, the repurchase rights of investors in private equity investment remain a heated topic in both legal theory and operational practice.
This article outlines two different ways for investors to exercise their repurchase rights, namely, the contractual approach and the statutory approach.
Contractual repurchase
Partner
Han Kun Law Offices
Tel: +86 10 8516 4149
E-mail: qimin.zhu@hankunlaw.com
Equity repurchase clauses are common between investors and other parties in private equity deals. The clauses grant investors the right to demand that obligors repurchase their shares in the target company at a predetermined price in the event of specific circumstances, such as the company’s failure to go public by a specified date, failure to achieve performance targets, or the founders’ breach of contract. The obligors may include the target company itself and/or its shareholders and founders.
The legal validity of equity repurchase clauses agreed by the investor and shareholders or founders of the target company is generally recognised in judicial practice. However, for those clauses between the investor and target company, judicial rulings used to be inconsistent in deciding their validity.
But this changed on 8 November 2019, when the Supreme People’s Court issued the Minutes of the National Courts’ Civil and Commercial Trial Work Conference. This clearly stated that, barring statutory invalidity, the courts will not support claims by a target company that equity repurchase clauses with the investor are invalid.
Meanwhile, if the target company fails to complete the capital reduction process, the courts should find the equity repurchase clauses unenforceable on the grounds of the Company Law – which prohibits shareholders from illegal withdrawal of capital contributions – and thus dismiss the investor’s lawsuit.
Notably, the new Company Law (2023 Revision) now mandates, in paragraph 3 of article 224, the principle of a proportionate capital reduction among all shareholders. As a result, it is often challenging for the investor to reach consensus with the target company and other shareholders on the targeted reduction procedures required for equity repurchase.
In this sense, even though the legality and validity of equity repurchase clauses between the investor and target company are recognised, the investor’s request for the target company’s repurchase of shares is unlikely to be supported in judgment.
The business community has reacted fast. For example, more equity repurchase clauses designate the founders and controlling shareholders as repurchase obligors, with the target company taking a joint liability guarantee for their obligation to pay the equity repurchase price.
Also, when the target company serves as repurchase obligor, its articles of association now often include procedures for a proportionate capital reduction under equity repurchase conditions, with shareholders making prior resolutions on the targeted capital reduction.
Statutory repurchase
Associate
Han Kun Law Offices
Tel: +86 8525 5540
E-mail: shi.yin@hankunlaw.com
There are two types of statutory repurchase rights, respectively, for dissenting shareholders, and for minority shareholders having their rights infringed.
The Company Law mandates, in paragraph 1 of article 89, that dissenting shareholders who vote against specific resolutions at the shareholders’ meeting shall have the right to request the company to buy back their shares at a fair price.
Paragraph 3 of the same article also stipulates that minority shareholders are entitled to request the company’s repurchase of their shares at a fair price in the event of controlling shareholders abusing their rights, causing significant harm to the company or other shareholders.
The above-mentioned provisions provide new exit strategies for investors when there is no repurchase right agreed in the equity deal, or when agreed repurchase conditions have not been fulfilled. An increasing number of investors have been exploring exit options in this regard recently, as evidenced by observations.
In judicial practice, the exercise of statutory repurchase rights hinges on sufficient evidence for fulfilment of the repurchase conditions. Notably, the stipulation regarding “controlling shareholders’ abuse their rights, causing significant harm to the company or other shareholders” is somewhat abstract, leaving considerable discretion to the adjudicating body.
Investors, as dissenting or minority shareholders, often face situations where the controlling shareholders conceal the company’s actual operational and financial status, and thus may need to initiate a series of lawsuits – including those for shareholder information rights and for damages to the company’s interests – either independently or on behalf of the target company. This process inevitably entails significant time and financial costs.
Additionally, when investors exercise their statutory repurchase rights, the repurchase should be at a “fair price” of their shares. In judicial practice, this fair price is generally considered to be the market fair value of the shares in question. In most cases, courts refer to the judicial appraisal for such fair value.
Takeaways
The exercise of repurchase rights by investors is often due to the poor performance of the target company, with the agreed repurchase price typically far exceeding fair market value of the shares. Invoking equity repurchase clauses is therefore preferred by most investors.
However, challenges arise when the investor fails to agree on the equity repurchase clauses with relevant parties, the repurchase conditions fail to be met, or the target company fails to execute the targeted capital reduction procedures.
Notably, in the Selected Q&A (Series 9) session published in the People’s Court Daily on 29 August 2024, the Supreme People’s Court mentioned that investors should exercise their repurchase rights within a maximum period of six months to anchor business expectations of the target company, even without prior agreement.
If this judicial standard is retroactive, the repurchase rights of a considerable number of equity deals may soon expire, or have already expired. Therefore, investors are advised to pay close attention to the conditions and timeframes for exercising repurchase rights set out in the clauses, as well as utilising statutory repurchase rights in a timely manner to achieve optimal business performance.
Zhu Qimin is a partner at Han Kun Law Offices. She can be contacted by phone at +86 10 8516 4149 and by email at qimin.zhu@hankunlaw.com
Yin Shi is an associate at Han Kun Law Offices. He can be contacted by phone at +86 10 8525 5540 and by email at shi.yin@hankunlaw.com
