Legal Risk Prevention and Control of Valuation Adjustment Mechanisms (VAMs) and Investment Methods from the Perspective of Judicial Adjudication and Listing Supervision
Recently, the Shanghai Higher People's Court has made a ruling to uphold the first-instance judgment of the Shanghai No. 2 Intermediate People's Court (hereinafter referred to as "Shanghai No. 2 Intermediate Court") in China's first case involving the validity determination of a post-listing Valuation Adjustment Mechanism (VAM) agreement. The case is a VAM dispute between Nanjing High-Tech Xinchuang Investment Co., Ltd. and Gaoke Xinjun Phase I Fund (collectively referred to as "Nanjing High-Tech Group" hereinafter) and Jiangsu Shuoshi Biotechnology Co., Ltd. (hereinafter referred to as "Shuoshi Biotechnology") (hereinafter referred to as "Nanjing High-Tech Case"). The effective judgment indicates that: for the "post-listing repurchase clause" stipulated in the VAM that was not disclosed by the invested enterprise and the investor during the listing review, if the repurchase price is linked to the stock trading price of the invested enterprise in the secondary market, this clause shall be invalid. After this judgment was made, issues related to "VAM agreements" in judicial practice have triggered extensive discussions in the industry.
According to the definition of relevant scholars, a VAM agreement, also known as a valuation adjustment agreement, refers to an arrangement where an investor invests in a target company to become a shareholder and obtain equity, while agreeing on matters such as the target company's future operating performance and listing. If the agreed targets are not met or achieved, the target company or its shareholders shall provide equity compensation, cash compensation to the investor, or repurchase the investor's equity in accordance with the agreed ratio or amount. 1 The establishment of VAM conditions can help investors control risks caused by information asymmetry, improve decision-making efficiency, and to a certain extent bridge the value divergence between investors and financiers due to valuation flexibility. In the field of private equity investment, VAM agreements are widely used due to the above advantages.
However, at the same time, VAM agreements also bring uncertainty of legal risks to all parties involved in investment and financing transactions. Firstly, since VAM agreements themselves are non-standard commercial legal relationship arrangements in commercial activities with high uniqueness in individual cases and may involve a wide range of interest relationships, the determination result of judicial adjudication will have a significant impact on the interests of all investment and financing parties if a judicial dispute arises. In addition, during the process of an invested enterprise applying for listing, the review opinions of regulatory authorities on VAM agreements during the listing review also have variable factors due to the different circumstances of individual cases. This article intends to discuss issues related to VAM agreements from the perspectives of judicial adjudication and listing supervision, and on this basis, put forward ideas on how investors can prevent and control legal risks.
Among various types of VAM agreements, according to the different subjects performing the equity repurchase obligation, they can be roughly divided into two types: VAM with the target company and VAM with the shareholders or actual controllers of the target company. In judicial practice, there are also different views on the validity determination of VAM agreements under different circumstances:
Regarding such circumstances, the Minutes of the National Courts' Civil and Commercial Trial Work Conference (hereinafter referred to as "Minutes of the Ninth Civil and Commercial Court Meeting") holds that: "For VAM agreements concluded between investors and the shareholders or actual controllers of the target company, if there are no other invalid circumstances, their validity shall be recognized and their actual performance shall be supported, and there is no dispute in practice." It can be seen that the current judicial field holds that VAM between investors and the shareholders or actual controllers of the target company should be valid in principle, but the premise is that there are no circumstances under which the contract is determined to be invalid in accordance with the relevant provisions of laws such as the Civil Code of the People's Republic of China (hereinafter referred to as "'s Republic of China* (hereinafter referred to as "Civil Code"). For example, in the "Dispute Case, in the "Dispute Case over Equity Transfer Contract between Shanghai Ruifeng Equity Investment Partnership and Lianyungang Dingfa Investment Co., Ltd." 2 before the implementation or issuance of the Civil Code and the Minutes of the Ninth Civil and Commercial Court Meeting, the VAM clause was determined to be invalid by the court because it violated the main contract and damaged the interests of other investors.
Among various circumstances of contract invalidity, the invalidity caused by violation of mandatory legal provisions often attracts special attention from all parties to the VAM agreement. Article 153 of the Civil Code stipulates: "A civil juristic act that violates the mandatory provisions of laws or administrative regulations shall be invalid. However, this does not apply if the mandatory provisions do not lead to the invalidity of the civil juristic act." The above-mentioned "mandatory provisions" shall only include "validity-related mandatory provisions". However, when distinguishing between "mandatory provisions", it is necessary to confirm the purpose of the mandatory provisions, which is inevitably highly subjective and makes it difficult to ensure the uniformity of adjudication. 3 For this reason, the Minutes of the Ninth Civil and Commercial Court Meeting further clarifies: "The following mandatory provisions shall be recognized as 'validity-related mandatory provisions': mandatory provisions involving financial security, market order, national macro-policies, and other public order and good customs; provisions prohibiting the sale of transaction objects, such as the prohibition of the sale of human organs, drugs, firearms, etc.; provisions violating franchise management, such as over-the-counter financing contracts; provisions involving seriously illegal transaction methods, such as contracts concluded in violation of competitive contracting methods such as bidding and tendering; provisions involving illegal transaction venues, such as futures transactions conducted outside the approved trading venues. Mandatory provisions of an administrative management nature regarding business scope, transaction time, transaction quantity, etc. shall generally be recognized as 'management-related mandatory provisions'."
In addition, on June 24, 2022, the Supreme People's Court put forward 14 measures 4 on issues related to companies listed on the National Equities Exchange and Quotations (NEEQ, also known as the "New Third Board") and listed companies on the Beijing Stock Exchange. Among them, Measure 9 mentions that in the process of refinancing such as private placement of listed companies, the "private placement floor price" clauses concluded by investors with listed companies, their controlling shareholders, actual controllers, or major shareholders by taking advantage of their dominant position shall be invalid. This is because such clauses endow investors with special rights to guaranteed returns that are superior to other shareholders of the same type, which indirectly increases the financing costs of small and medium-sized enterprises and violates the fairness principle of the Securities Law and relevant regulatory provisions. Although this measure is proposed for the private placement business of listed companies on the Beijing Stock Exchange, it also reflects the judicial tendency of courts in recent years from the perspective of financial transaction supervision and market order maintenance.
Compared with the aforementioned circumstances, regarding the validity of VAM agreements between investors and the target company, the views held by judicial adjudication have varied in different periods, generally going through the following development stages:
Denying the validity of VAM with the target company
In 2012, the Supreme People's Court determined in the "Haifu Case" 5 that the relevant VAM performance compensation clauses were invalid because they allowed investors to obtain fixed returns regardless of the company's performance, damaging the interests of the company and its creditors. After this case, judicial practice generally adopted the "dichotomy" adjudication rule in determining the validity of VAM agreements, that is, VAM with the shareholders or actual controllers of the target company is valid, while VAM with the target company is invalid.
Validity of guarantees provided by the target company for VAM
In the "Hanlin Case" 6 in 2016, the parties agreed that if the target company failed to complete the listing target within the agreed time limit, the original shareholders would repurchase the investor's equity, and the target company would assume joint and several guarantee liability for the repurchase obligation. In this case, the Supreme People's Court held that the act of the company providing guarantee for the original shareholders' repurchase obligation had gone through an effective internal decision-making process and did not damage the interests of other shareholders, thus determining that the guarantee provided by the target company for the VAM was valid.
Affirming the validity of VAM with the target company
With changes in the market environment and economic situation, and the deepening of judicial practice's understanding of VAM agreement issues, relevant adjudication rules have also changed. For example, in the representative "Huagong Case" 7, both the court of first instance and the court of second instance held in their judgments that the stipulation of the VAM clause was invalid because it violated the prohibitive provisions of the Company Law on the company's repurchase of shareholders' equity and was contrary to the principle of capital maintenance. The court of retrial, however, held that: (1) The disputed VAM clause was the true intention of all parties and a normal commercial arrangement, and all shareholders were aware of its consequences and risks; (2) The Company Law did not explicitly prohibit companies from repurchasing their own shares, and it was procedurally feasible for the company to repurchase shares to realize the investor's exit, which would not violate the principle of capital maintenance; (3) The investor had both the status of a shareholder and a creditor of the target company, and these two statuses did not conflict. Therefore, the VAM clause between the investor and the company was legally valid and could be made enforceable through the company's capital reduction procedure. The "Huagong Case" made a breakthrough in the validity determination of VAM agreements compared with previous precedents, and some of its views were also recognized in the Minutes of the Ninth Civil and Commercial Court Meeting issued later. 8
Shift of the focus of dispute from contract validity to contract performance
After the issuance of the Minutes of the Ninth Civil and Commercial Court Meeting, Article 5 specifically elaborates on VAM issues, with the main contents as follows: (1) It summarizes and determines the nature of VAM agreements; (2) For disputes over "VAM" between investors and target companies, the focus of the dispute mainly lies in whether the performance of the contract can comply with the mandatory provisions of the Company Law on "shareholders shall not withdraw their capital contributions" and share repurchase. Specifically: 1) If an investor requests the target company to repurchase equity, the people's court shall review it in accordance with Article 35 of the Company Law on "shareholders shall not withdraw their capital contributions" or Article 142 on the mandatory provisions of share repurchase. After review, if the target company has not completed the capital reduction procedure, the people's court shall dismiss its claim; 2) If an investor requests the target company to assume the obligation of monetary compensation, the people's court shall review it in accordance with Article 35 of the Company Law on "shareholders shall not withdraw their capital contributions" and Article 166 on the mandatory provisions of profit distribution. After review, if the target company has no profits or the profits are insufficient to compensate the investor, the people's court shall dismiss or partially support its claim. If the target company has profits in the future, the investor may file another lawsuit based on this fact. In addition, the investor shall also bear the burden of proving whether the target company has distributable profits. 9 If it cannot prove that the target company has distributable profits, the court will not support its claim for the target company to provide cash compensation.
To sum up, under the guidance of the Minutes of the Ninth Civil and Commercial Court Meeting, the current adjudication rules for VAM agreements can be summarized as follows: The validity of VAM agreements is generally recognized. When the agreement stipulates that the target company is the VAM obligor, the court will strictly review whether it complies with the mandatory provisions of the Company Law on "no withdrawal of capital contributions" and share repurchase, and will also conduct a strict review on the performance level. If the capital reduction procedure has not been completed, the investor's claim may be dismissed. For example, in the "Retrial Case of Equity Transfer Dispute between Beijing Yinhaitong Investment Center and Xinjiang Xilong Geosynthetic New Materials Co., Ltd." 10 in 2020, the court ruled that the VAM agreement for the target company to repurchase equity was legally valid, but dismissed the investor's claim because the target company had not completed the capital reduction procedure.
At present, the relevant provisions involving VAM agreements in China's company listing review mainly include the Several Q&A on Initial Public Offering (IPO) Business issued by the China Securities Regulatory Commission (CSRC), Article 13 of the Q&A on the Review of Initial Public Offerings and Listings of Stocks on the ChiNext Board of the Shenzhen Stock Exchange (referred to as "Review Q&A"), and Article 10 of the Q&A on the Listing Review of Stocks on the STAR Market of the Shanghai Stock Exchange (II) (referred to as "Review Q&A (II)"). The review requirements put forward in the above provisions can be summarized as follows: VAM agreements shall be cleaned up in principle, and may be retained if they meet certain conditions. Regarding the prerequisites for retaining VAM agreements, the contents of the aforementioned provisions are roughly the same: first, the target company shall not be a party to the VAM agreement; second, the VAM agreement shall not contain provisions that may lead to changes in the company's actual control; third, the VAM agreement shall not be linked to market value; fourth, the VAM agreement shall not contain provisions that seriously affect the issuer's sustainable operating capacity or other circumstances that seriously affect the interests of investors (collectively referred to as "retention conditions" hereinafter). In addition, the sponsor and the issuer's lawyer shall issue a special verification opinion on whether the VAM agreement meets the above requirements, and the issuer shall disclose the specific content of the VAM agreement and its possible impact on the issuer in the prospectus, and provide risk warnings.
The relevant provisions of the New Third Board on VAM of the New Third Board on VAM agreements are mainly found in the Q&A on Common Issues Concerning Stock Issuance of Listed Companies (III) and the Guidelines for the Application of Rules for Private Placement of Stocks on the National Equities Exchange and Quotations (No. 1), with the main contents as follows:
"If the share subscription agreement for stock issuance of a listed company contains special clauses, it shall not include the following circumstances: the listed company is the obligor or signatory of the special clauses, of the special clauses, except in cases where the issuer has rights and interests in circumstances such as the subscriber subscribing with non-cash assets; restricting the price or subscribers of the listed company's future stock issuance and financing; forcing the listed company to make equity distributions or prohibiting it from making equity distributions; if the listed company has new financing in the future and the new investor has agreed with the listed company on terms that are more favorable than those of this issuance, the relevant terms shall automatically apply to the subscribers of this issuance; the subscribers of the issuance have the right to assign directors to the listed company directly without going through the internal decision-making procedure of the listed company, or the assigned directors have the right to veto the business decisions of the listed company; preferential liquidation right clauses that do not comply with the provisions of relevant laws and regulations, as well as provisions on the distribution of residual assets, access to information, and other related rights; trigger conditions linked to the issuer's market value; other special clauses that damage the legitimate rights and interests of the listed company or its shareholders; other circumstances recognized by the CSRC or the National Equities Exchange and Quotations Co., Ltd."
It can be seen that the principles reflected in this provision are basically the same as those in the aforementioned provisions of the Shanghai Stock Exchange and Shenzhen Stock Exchange, but have been refined to a certain extent. In addition, although the Beijing Stock Exchange has not yet clearly responded to the review requirements for VAM agreements, it has made a principled provision in Article 2.1.4 of the Listing Rules of the Beijing Stock Exchange (Trial Implementation), that is, companies that have a significant adverse impact on the stability of the listed company's operations, its independent and sustainable operating capacity directly facing the market, or other circumstances where the interests of the listed company are damaged shall not be admitted to the Select Layer or publicly issued and listed on the Beijing Stock Exchange.
Through data search, the author found that from January 1 to November 1, 2022, the Shanghai Stock Exchange's STAR Market accepted a total of 123 IPO application enterprises, among which 52 had received inquiries, and 14 of the enterprises that had received inquiries were involved in VAM matters (accounting for approximately 26.9%). This data shows that the regulatory authorities attach great importance to VAM agreement issues. The inquiry content and specific disclosure requirements of regulatory authorities for issuers involved in VAM matters vary, but their focus can be roughly summarized as follows: 1. If the company planning to list has institutional shareholders or indirect shareholdings when applying for listing, it shall explain whether there are special arrangements such as VAM; 2. If the company planning to list has experienced multiple capital increases/reductions in history, the regulatory authorities will focus on requiring the disclosure of the specific content of historical VAM agreements; 3. If the company planning to list has clearly disclosed the existence of VAM arrangements, the regulatory authorities will require the issuer to disclose the VAM arrangements in detail and explain their rationality and cleanup status, including whether there are potential disputes and whether they affect the issuer's equity structure and the stability of control rights.
After checking public information, the author found that in the current regulatory environment, if the VAM clauses of enterprises can meet the review conditions or be adjusted accordingly during the listing process, they may still pass the review of regulatory authorities and successfully list. Some of the cases are as follows:
In October 2020, Zhang Rongming, the actual controller of Aimer Co., Ltd., signed a Supplementary Agreement with six of its shareholders, including Zhonghai its shareholders, including Zhonghai Jiaxin, Shiyue Haichang, and Jiangsu Chenhui. The agreement stipulated matters related to the protection of investors’ rights, including repurchase clauses and some preferential right clauses. The inquiry from the Shanghai Stock Exchange (SSE) required the issuer to explain: whether the suspension arrangement of the VAM agreement was genuine, whether the preferential rights granted to some whether the preferential rights granted to some shareholders had been lifted, and whether there was a risk of changes in the issuer’s equity or potential disputes. In response, Aimer Co., Ltd. stated that the VAM clauses were only between shareholders, representing the true and accurate intentions of all parties; the company was not a party to the VAM clauses, and there were no provisions that might lead to changes in the company’s controlling rights or involve the company’s interests. If the triggering conditions of the VAM clauses stipulated in the aforementioned agreement were met, it would trigger the repurchase or compensation obligations of Zhang Rongming (the controlling shareholder and actual controller of the company) to the aforementioned investors, which would pose risks of changes to the company’s existing equity structure and potential disputes between Zhang Rongming and the relevant shareholders. Aimer Co., Ltd. successfully listed on the Shanghai Main Board on May 31, 2021.
Caina Technology signed VAM agreements with investors Xinguolian and CITIC Prudential in May 2019 and June 2020 respectively. The inquiry from the Shenzhen Stock Exchange (SZSE) required Caina Technology to explain: the rationality of the target company not being a party to the VAM arrangement and whether it complied with the relevant provisions of Article 13 of the Review Q&A; and to supplement the disclosure on whether the VAM arrangement with Xinguolian contained reinstatement clauses and whether it would lead the issuer to bear repurchase liabilities. In response, Caina Technology stated that CITIC Prudential had issued a letter in 2021 confirming the complete termination of the VAM arrangement, with no reinstatement clauses, which complied with regulatory requirements; the VAM arrangement with Xinguolian was attached with reinstatement clauses, but such clauses would only be triggered if the listing application failed, and the issuer was not the obligor of the VAM obligations, which would not constitute a material obstacle to the issuer’s listing application and complied with regulatory requirements. Caina Technology was successfully registered on the SZSE ChiNext Board on January 26, 2022.
Opumay and its actual controller Xiao Zhihua once signed a VAM agreement with investors, stipulating that if the target company failed to list before December 31, 2022, the investors would have the right to require the company to repurchase the equity. In September 2021, all parties signed the Agreement on Termination of Special Shareholder Rights, which stipulated the termination of the special shareholder rights clauses related to the issuer and also included reinstatement clauses for validity. In this regard, the SSE conducted an inquiry, requiring the issuer to: comprehensively sort out the historical VAM agreements signed, as well as their existence and cleanup status; confirm whether the remaining valid VAM agreements complied with regulatory provisions and whether they would remain valid after listing; and explain the impact of the validity reinstatement clauses on the current listing application and whether they would constitute a material obstacle to the listing. The key points of Opumay’s response were as follows: the VAM provisions where the issuer was a signatory had been completely terminated through the Agreement on Termination of Special Shareholder Rights; the VAM provisions where the actual controller was a signatory had been suspended, and if the issuer’s current application was rejected by the SSE or voluntarily withdrawn, the validity of the VAM clauses would be automatically reinstated; after the aforementioned VAM cleanup, the existing VAM agreements with validity reinstatement clauses complied with the requirements of Article 10 of the Review Q&A (II), and the probability of causing changes in the issuer’s controlling rights was extremely low, which would not constitute a material obstacle to the current issuance and listing. Opumay successfully listed on the STAR Market in August 2022.
When Keda Automatic Control was listed on the New Third Board (NEEQ), it signed VAM agreements with Huifeng Hesheng and Zhejiang Rongteng respectively, and these VAM agreements violated relevant business rules such as those on private placement. In this regard, the regulatory authority conducted an inquiry, requiring the issuer to supplement the disclosure on: the triggering conditions for repurchase and whether repurchase had been actually implemented; if implemented, the source of funds for repurchasing shares and paying compensation; if not implemented, whether repurchase needed to be continued; the existence of other undisclosed VAM agreements or "drawer agreements" (undisclosed side agreements), and whether there were disputes or potential disputes; the adverse impacts on the stability of the issuer’s controlling rights, business decision-making, corporate governance, production and operation, and financial status; and whether the repurchase obligations stipulated in the supplementary agreements of the VAM would affect the stability of controlling rights. The key points of Keda Automatic Control’s response were as follows: although the issuer had unresolved VAM agreements, the following conditions were met: (1) the issuer was not the subject of the VAM; (2) the issuer’s controlling shareholder and actual controller, as the repurchase obligors, had sufficient assets to fulfill the repurchase obligations, which would not affect the stability of the issuer; (3) after the clause cleanup, the agreements complied with the regulatory requirements for special investment clauses on the NEEQ and would not cause material adverse impacts on the issuer’s corporate governance. Keda Automatic Control was successfully registered on the Beijing Stock Exchange on October 15, 2021.
As mentioned earlier, after the issuance of the Minutes of the Ninth Civil and Commercial Court Meeting, when adjudicating VAM disputes, courts generally recognize the validity of VAM agreements in the absence of other invalid circumstances. However, considering factors such as the protection of third-party interests, incomplete capital reduction procedures, and the principle of capital maintenance, courts may still dismiss investors’ claims. Therefore, from the perspective of the enforceability of VAM agreements, investors may refer to the following ideas when signing VAM agreements:
(1) In VAM agreements involving equity repurchase, prioritize selecting the shareholders and/or actual controllers of the target company as the repurchase obligors. According to relevant judicial adjudication rules, the prerequisite for an investor’s claim for the target company to repurchase equity to be supported is that the target company has completed the relevant capital reduction procedures. Considering that in practice, the smooth implementation of the company’s capital reduction procedures is unlikely when shareholder disputes occur, investors may prioritize selecting shareholders and/or actual controllers as repurchase obligors to ensure the enforceability of the VAM repurchase obligations.
When assessing the performance capacity of the target company’s shareholders and/or actual controllers as repurchase obligors, investors may also consider requiring the target company to provide joint and several liability guarantees for the payment of equity repurchase proceeds to the investors. Here, attention should be paid to the validity of the company’s guarantee for its shareholders. Article 16 of the Company Law stipulates: "If a company provides a guarantee for its shareholder or actual controller, it must be resolved by the shareholders’ meeting or general meeting of shareholders. The shareholder specified in the preceding paragraph or the shareholder controlled by the actual controller specified in the preceding paragraph shall not participate in the voting on the matter specified in the preceding paragraph. The voting on this matter shall be approved by more than half of the voting rights held by other shareholders present at the meeting." According to this article, the guarantee must be approved by the company’s shareholders’ meeting or general meeting of shareholders. If the legal representative of the target company provides a guarantee to a third party without authorization, it constitutes an without authorization, it constitutes an ultra vires representation. In such cases, if the counterparty ( if the counterparty (investor) is in good faith, the guarantee is valid; otherwise, the guarantee is invalid. Therefore, if an investor requires the target company to provide a joint and several liability guarantee for the payment of equity repurchase proceeds, the investor shall also review the target company’s shareholders’ meeting or general meeting resolution on the guarantee when concluding the contract. 11 In addition, if the guarantee is invalid due to the target company’s fault in the external guarantee process, the investor may also claim liability for breach of pre-contractual obligations against the target company.
(2) In VAM agreements where the target company is the equity repurchase obligor, if necessary, require the target company’s shareholders and/or actual controllers to bear joint and several liability for the repurchase obligations. At the same time, clearly stipulate in the VAM agreement the obligation of other shareholders of the target company to cooperate with the company’s capital reduction procedures and the corresponding liability for breach of contract. In commercial practice, there may be situations where the target company’s shareholders and/or founders refuse to directly act as repurchase obligors. In such cases, investors may consider requiring them to bear joint and several liability for the target company’s repurchase obligations as a supplementary measure. It should be noted that although there are cases where the Supreme People’s Court supported investors’ claims for shareholders to bear joint and several liability for the target company’s repurchase obligations (e.g., "Case of Dispute over Capital Increase of Guangdong Southern Radio, Film and Television Media Group Co., Ltd. and Guangdong Southern Pilot Film and Television Communication Co., Ltd." 12), during the same period, some other cases denied the validity of such clauses. For example, in the "Case of Disputes Related to the Company Involving Lei Yutian and Xiao Nan" 13, the court held that the target company and its shareholders have different implementation procedures and legal consequences in performing repurchase obligations, which cannot replace each other and thus cannot be the subject of joint and several liability.
In VAM agreements where the target company is the repurchase entity, it is recommended that investors stipulate with other shareholders of the target company in the VAM agreement that the latter have the obligation to cooperate with the investor in completing the company’s capital reduction procedures when the repurchase conditions are triggered. At the same time, set corresponding breach of contract clauses, such as stipulating that if other shareholders fail to cooperate or the capital reduction procedures cannot be completed due to other circumstances, other shareholders or the target company shall compensate the investor for damages. In addition, the VAM agreement should also clearly stipulate the amount of liquidated damages or the method for calculating them as much as possible, which can be reasonably determined with reference to the amount of equity repurchase proceeds. This will help the court to confirm the liability for breach of contract in case of disputes. If the parties only vaguely stipulate in the agreement that "the breaching party shall compensate the non-breaching party for losses", the investor will then bear the burden of proving the losses and face the risk of not being fully compensated for the losses.
(3) The content of VAM clauses should be designed with full consideration of legality and compliance, and shall not violate laws, regulations, or financial regulatory provisions. In the aforementioned "Nanjing High-Tech Case", the Shanghai No. 2 Intermediate Court discussed the validity of VAM acts and specific clauses separately in its article National First Case: VAM Agreement Linked to Market Value Not Cleaned Up Before IPO Is Invalid | Zhizheng - Case Discussion 14. The article stated: "In general judicial practice, if Shaoxing Runkang has made procedural arrangements such as agreeing to withdrawal from the partnership and capital reduction liquidation for the partnership shares that Gaoke Xinjun claims to repurchase, and there are no other invalid circumstances, the repurchase matters agreed upon by Gaoke Xinjun with Fang XX, Liang XX, and Shaoxing Runkang in the agreement shall be recognized as valid and ordered to be performed." However, the problem in this case was that "whether Gaoke Xinjun’s act of transferring and profiting from the equity interests of Jiangsu Shuoshi in advance during the lock-up period would seriously affect the issuer’s sustainable operating capacity and other circumstances. More importantly, the calculation method of the repurchase price claimed by Gaoke Xinjun is directly linked to the stock trading market value of Jiangsu Shuoshi after its issuance and listing, and the repurchase timing is completely controlled by the repurchase right holder. This pricing method is likely to cause the stock trading price in the secondary market to deviate from the company’s normal valuation and fluctuate in the short term due to profit-seeking, which affects the order of financial market transactions and national financial security." Therefore, "the price calculation method stipulated in Article 4.2 of the Amended Partnership Agreement, which is directly linked to the short-term stock trading market value in the secondary market, involves disrupting the securities market order, harming public interests, and violating public order and good customs, and shall be deemed an invalid clause."
Based on this, the court in this case held that although the VAM act itself was valid, the aforementioned repurchase price calculation clause was invalid due to violating legal provisions. The parties may renegotiate the repurchase price; if negotiations fail, the Nanjing High-Tech Group may determine the price in accordance with the "unlisted repurchase right" clause or the "post-lock-up repurchase" clause (i.e., the sale of Jiangsu Shuoshi’s shares held by Shaoxing Runkang after the lock-up period expires). This case shows that even if the VAM act itself is valid, each specific VAM clause in the agreement must comply with laws and regulations, including financial regulatory provisions. This is also consistent with the judicial concept of judicial authorities in recent years of "fully respecting regulatory provisions and transaction rules, and legally supporting the effective exercise of regulatory functions by administrative regulatory authorities". 15
To comply with relevant regulatory provisions, invested enterprises usually clean up VAM agreements in accordance with the requirements of regulatory authorities during the IPO application process. Currently, the main cleanup methods adopted by all parties involved in investment and financing are as follows:
Unconditionally terminate or rescind the VAM agreement: This method can meet regulatory requirements to the greatest extent, but for investors, it will undoubtedly lead to the loss of their rights under the original VAM mechanism and increase their investment risks.
Suspend the VAM agreement with validity reinstatement clauses: VAM agreements cleaned up in this way are often referred to as "frozen clauses". The common arrangement is that the agreement is temporarily suspended, and if the IPO application is rejected or voluntarily withdrawn, the validity of the VAM clauses will be automatically reinstated. As mentioned earlier, from the cases of successful listing with existing VAM agreements, the general attitude of regulatory authorities is: if the content of the VAM agreement meets the retention conditions, it will be recognized in principle; otherwise, it shall be completely terminated. Under this cleanup method, for investors, due to the high uncertainty of the invested enterprise’s IPO, the validity of the VAM agreement may also be in a pending state.
Formally terminate the VAM agreement while signing a "VAM drawer agreement" separately: In practice, to ensure the target company’s successful listing while protecting the investors’ existing rights, all parties may formally cooperate in cleaning up the VAM clauses while signing a "VAM drawer agreement" (undisclosed side agreement) with the counterparty of the VAM agreement in private. Common forms include:
(1) Formally agreeing to unconditionally terminate/rescind the VAM arrangement, while stipulating in the drawer agreement that the VAM agreement will be reinstated if the IPO fails. In terms of contract legal relations, this situation is similar to the cleanup method of "suspending the VAM agreement with validity reinstatement clauses". At this time, the clauses of the drawer agreement only bind the parties involved and do not violate the regulatory requirements on VAM arrangements for listing. From the perspective of judicial adjudication, if there are no other violations of validity-related mandatory provisions, such drawer agreements are generally deemed legally valid. However, it is worth noting that according to Article 7 of the Guidelines for the Supervision of Listed Companies No. 4 - Commitments of Listed Companies and Relevant Parties: "【Information Disclosure Requirements for Commitments】When a commitment is made, all relevant parties must disclose or provide relevant information in a timely and fair manner, ensure that the disclosed or provided information is true, accurate, and complete, and shall not have false records, misleading statements, or material omissions." If investors or invested enterprises fail to truthfully disclose information about VAM arrangements and drawer agreements and evade the inquiries and disclosure requirements of regulatory authorities, they cannot be exempted from the risk of being subject to regulatory measures.
(2) Formally agreeing to unconditionally terminate/rescind the VAM arrangement or terminate it with conditional reinstatement, while stipulating in the drawer agreement that the VAM agreement remains valid from the beginning to the end. Unlike the above situation, this cleanup method essentially conflicts with relevant regulatory provisions. The author believes that, combined with the relevant judicial spirit of judicial authorities and the views in cases of similar similar nature such as the "Nanjing High-Tech Case", in such cases, the court is highly likely to determine that the parties signed the drawer agreement to evade financial supervision, which is detrimental to the security and stability of the financial market, harms the transaction order and transaction security of the capital market, and violates public order and good customs, thus deeming the agreement invalid.
To sum up, in the cleanup of VAM agreements during the invested enterprise’s IPO process, the author believes that the following risk prevention and control principles should be followed: (1) Always comply with regulatory provisions, design cleanup plans on the premise of ensuring the validity of VAM agreements, and ensure that relevant VAM clauses meet the requirements of retention conditions; (2) Adopt a cautious attitude towards "VAM drawer agreements" and avoid signing "drawer agreements" that stipulate "the VAM agreement is valid from the beginning to the end" as much as possible.
"Gambling" usually implies "high risk and high return", but in the context of "valuation adjustment mechanism (VAM)" in corporate investment, the way both parties involved obtain returns is to pursue win-win cooperation rather than a zero-sum game. Whether from the perspective of supervision or judicial adjudication, the purpose of regulating VAM agreements is to safeguard the healthy operation of the capital market. By balancing and protecting the interests of all parties, it encourages innovation and enhances economic vitality. If both parties to a "VAM agreement" can make good use of this mechanism, motivate and cooperate with each other, it can provide impetus for promoting the sound development of enterprises.
Zhao Xudong. The Third Type of Investment: Legislative Response and Institutional Innovation of Valuation Adjustment Mechanism (VAM) [J]. East China Law Review, 2022(04): 90-103. (2022.04.007)
Civil Judgment of Shanghai No. 1 Intermediate People's Court (2014) Hu Yi Zhong Min Si (Shang) Zhong Zi No. 730.
Liu Guixiang, Wu Guangrong. Several Issues Concerning the Validity of Contracts [J]. China Journal of Applied Jurisprudence, 2021(06): 12.
Supreme People's Court. Several Opinions on Providing Judicial Protection for Deepening the Reform of the National Equities Exchange and Quotations (NEEQ) and Establishing the Beijing Stock Exchange (Fa Fa 〔2022〕 No. 17).
Civil Retrial Judgment of Supreme People's Court (2012) Min Ti Zi No. 11 (Case of Dispute over Capital Increase between Suzhou Industrial Park Haifu Investment Co., Ltd., Gansu Shiheng Nonferrous Resources Recycling Co., Ltd., Hong Kong Diya Co., Ltd., and Lu Bo).
Civil Retrial Judgment of Supreme People's Court (2016) Zui Gao Fa Min Zai No. 128 (Case of Retrial of Equity Transfer Dispute between Qiang Jingyan and Cao Wubo, et al.).
Civil Retrial Judgment of Jiangsu Higher People's Court (2019) Su Min Zai No. 62 (Case of Retrial of Dispute over Claiming Company Share Repurchase between Jiangsu Huagong Venture Capital Co., Ltd., Yangzhou Forging Machine Tool Co., Ltd., Pan Yunhu, et al.).
Chapter "VAM with Target Company" in Minutes of the National Courts' Civil and Commercial Trial Work Conference ("Minutes of the Ninth Civil and Commercial Court Meeting"): "Where there are no statutory invalid circumstances for a 'VAM agreement' concluded between an investor and a target company, if the target company claims the 'VAM agreement' is invalid solely on the ground that there are provisions on equity repurchase or monetary compensation, the people's court shall not support such claim. However, if the investor claims actual performance, the people's court shall review whether it complies with the mandatory provisions of the Company Law on 'shareholders shall not withdraw their capital contributions' and share repurchase, and decide whether to support the investor's claim."
Second Civil Tribunal of the Supreme People's Court (Ed.). Understanding and Application of the Minutes of the National Courts' Civil and Commercial Trial Work Conference [M]. Beijing: People's Court Press, 2019: 120.
(2020) Zui Gao Fa Min Shen No. 2957
Article 7 of the Supreme People's Court's Interpretation on the Application of the Guarantee System in the Civil Code of the People's Republic of China (Fa Shi 〔2020〕 No. 28).
(2020) Zui Gao Fa Min Shen No. 6234
(2021) Jin Min Zhong No. 6950
See the article "National First Case: VAM Agreement Linked to Market Value Not Cleaned Market Value Not Cleaned Up Before IPO Is Invalid | Zhizheng - Case Discussion" published on November 10, 2022, in Shanghai by the official WeChat account of "Shanghai No. 2 Intermediate People's Court".
Speech by Liu Guixiang, Member of the Judicial Committee of the Supreme People's Court, at the 2019 National Conference on Civil and Commercial Trial Work of Courts.
