Authors:Guanglei Zhang & Jinhui Zhang

The article was first published on China Law & Practice at www.chinalawandpractice.com.

Guanglei Zhang and Jinhui Zhang of Jingtian & Gongcheng examine the first decision of a Chinese court in which a secret pre-IPO agreement containing a valuation adjustment mechanism based on stock market price was declared invalid.

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Summary

Pre-IPO value adjustment mechanism agreements are contractual arrangements which are used by investors to attempt to mitigate against the uncertainty of the target company’s future financial performance.

They have been widely used in corporate financing transactions in China and were recognized as valid by the Chinese courts in 2012.

Judicial opinion has evolved since then, and the Chinese stock market regulator requires companies to terminate such agreements before going public.

A Shanghai court has recently held such an agreement to be invalid, raising concerns about their enforceability in future.

A secret pre-IPO agreement containing a valuation adjustment mechanism (VAM) has been declared invalid by the Shanghai High People’s Court lately, arousing concerns in the capital markets about the enforceability of pre-IPO VAM agreements. This is the first case where a VAM agreement based on the stock market price was declared invalid in China, although capital market regulators had expressly prohibited the use of such a VAM previously.

1. What is a VAM Agreement

A VAM agreement is a contractual arrangement that allows for the adjustment of the target company’s valuation based on certain conditions, so that investors can seek recovery of their equity interests and/or indemnities from the financing parties. VAM is designed to mitigate against the uncertainty of the target company’s future financial performance, and is widely used by private equity investors in corporate financing transactions in China.

Examples of typical VAM arrangements include those that provide, among other conditions, that should the target company fail to reach an agreed performance target, or go public within an agreed period of time or at a minimum offering price, etc.:

(1) the founding shareholders or actual controllers of the target company must, upon request, repurchase the investors’ equity interests in the target company;

(2) investors may purchase additional equity interests in the target company from the founding shareholders or actual controllers of the target company; or

(3) the founding shareholders or actual controllers of the target company must compensate or indemnify the investors when a VAM event occurs.

Since the first recognition of the validity of a VAM agreement inHaifu Investment Co., Ltd. v. Gansu Non-ferrous Metal Resources Recycling Co., Ltd.et. al(2012 SPC Min Ti No.11) in 2012, the Chinese courts have received more and more requests for enforcement of VAM agreements, and the courts’ opinions have evolved over time. As with the guidelines set out in theMinutes of the National Courts’ Civil and Commercial Trial Work Conference(Jiu Min Minutes) issued by the Supreme People’s Court in late 2019, Chinese courts are generally in favor of VAM agreements that are entered into by and between shareholders and investors.

2. Regulatory Rules on Pre-IPO VAM Agreements

Capital market regulators in China are highly prudent with the use of VAM arrangements by companies going public or their shareholders, because they may bring unpredictable changes to such companies and shareholders, and even jeopardize the transparency and stability of the company’s shareholding and control structure. Therefore, the China Securities Regulatory Commission (CSRC) and stock exchanges in China have expressly required companies to terminate all VAM agreements (with only a few exemptions), and making them public, prior to their IPO.

For example, the Department of Public Offering Supervision of CSRC clarified in itsQuestions and Answers on IPO(first issued in March 2019 and revised in June 2020) as follows:

Some institutional investors entered into a VAM agreement when investing in the issuer. What shall an issuer or intermediary do with it?

Answer：If any private equity, venture capital, or other institutions enter into a VAM agreement when investing in the issuer, as a matter of principle, the issuer shall terminate such agreement before applying for IPO, unless the VAM agreement meets all of the following criteria:

(1) the issuer is not a party to the VAM agreement;

(2) the VAM agreement is free of any provision that may lead to any change in the control of the issuer;

(3) the VAM agreement is not based on the market price; and

(4) the VAM does not seriously affect the issuer’ capacity as a going concern or otherwise seriously affect the rights and interests of investors.

……

The issuer shall disclose the details of the VAM agreement, its potential implication on the issuer, etc., and flag risk alerts in the prospectus.

The above rules have also been adopted by the Shanghai Stock Exchange in itsQuestions and Answers on Examination of the Issuance and Listing of Stock on the Science and Technology Innovation Board (II)issued in March 2019, and by Shenzhen Stock Exchange in itsQuestions and Answers on Examination of the Issuance and Listing of Stock on ChiNextissued in June 2020.

In response to the above listing rules, the following approaches have been developed:

(1) termination of the VAM agreement as required by the listing rules;

(2) conditional termination of the VAM agreement – that is, the VAM agreement will terminate upon the company’s successful IPO, but will survive if the company’s IPO attempt fails – this has been proven acceptable to regulators; and

(3) declaration that there is no VAM agreement or that the VAM agreement has been terminated while a VAM agreement is kept in secret – this is unacceptable to regulators who require a full and truthful disclosure.

The Chinese courts have now been requested to enforce VAM agreements containing a conditional survival clause or secret VAM agreements.

3. Courts’ Opinions on Pre-IPO VAM Agreements

3.1 VAM agreements containing a conditional survival clause

In a number of cases, investors have sought recovery from shareholders or actual controllers pursuant to a VAM agreement containing a conditional survival clause, after the IPO attempt failed. In such cases, the prevailing opinion of the Chinese courts is that such VAM agreements will be valid and enforceable, including for example,Chengdu China Railway High-End Transport Facilities Venture Capital LLP v. Hu Xiufang(2019 SPC Min Shen No.1982),Shenzhen Zhongnan Growth Investment LLP v. Liao Zhiqiang(2014 Xiang Gao Fa Min 2 Chu No.4),Hangzhou Huyue Yuexia Investment Management LLP v. Huang Zhenwu et. al(2020 Zhe 01 Min Zhong No.11166), etc.

In the above cases, the courts unanimously decided that, on the basis of party autonomy and in the absence of any violation of mandatory provisions provided by laws or administrative regulations, the VAM agreements at issue were valid and enforceable. The rationale behind the courts’ opinions is probably that the enforcement of such VAM agreements will not give rise to any regulatory concerns associated with listed companies.

3.2 Secret VAM agreements

Unlike the regulators’ express requirements about pre-IPO VAM agreements, PRC law is silent on the effect of secret VAM agreements that should have been terminated or disclosed. What would be the legal consequences if a party sought to enforce such a secret VAM agreement? In a limited number of cases, a split of court opinions is observed:

3.2.1 Valid and enforceable

InZhuhai Orbita Aerospace Science & Technology Co., Ltd. v. Huang Hua(2020 Yue 01 Min Zhong No.9783; “Orbita Case”), the Guangzhou Intermediate People’s Court declared the secret VAM commitment made by Mr. Huang, the actual controller of a listed company, was valid and binding on him, although the intermediaries and other investors expressly denied the existence of any VAM arrangement on various occasions during the listed company’s IPO process. The decision was affirmed by the Guangdong High People’s Court in the re-trial proceeding filed by Mr. Huang in 2020. The courts did not address the policy concerns raised by Mr. Huang.

3.2.2 Invalid and unenforceable

Contrary to theOrbita Case, recent decisions of the Shanghai High People’s Court and the Maoming Intermediate People’s Court (Maoming Court) suggest that secret VAM agreements could be invalid and unenforceable.

InNanjing Gaoke Xinchuang Investment Co., Ltd. v. Fang Yongsheng et. al(Case No.2021 Hu Min Zhong No.569) andNanjing Gaoke Xinjun Growth I Equity Investment LLP v. Fang Yongsheng et. al(2021 Hu Min Zhong No.745) (collectively the “Gaoke Cases”), the secret VAM agreement at issue, which provided for a pricing mechanism directly based on the stock price in the secondary market, was declared invalid by Shanghai Second Intermediate People’s Court (Shanghai No.2 Court). In the subsequent appeal proceedings, the decisions of the Shanghai No.2 Court were affirmed by the Shanghai High People’s Court.

The Shanghai No.2 Court began by revisiting the prevailing judicial opinions on VAM agreements, and admitted that VAM agreements between shareholders and investors, like one in this case, would be valid as a matter of principle. However, after analyzing the following peculiarities of the case, Shanghai No.2 Court decided otherwise:

(1) the secret VAM agreement, which provides for a pricing mechanism directly based on the stock price in the secondary market, should have been terminated prior to the target company’s IPO pursuant to regulatory requirements;

(2) the rationale behind the required termination is to prevent investors from manipulating the stock price in the secondary market, which would otherwise jeopardize public interests, financial security, public policy and good morals; and

(3) the stock market prices of the target company before and after the investors’ notice revealed the possibility of manipulation (the target company’ stock price rose drastically prior to investors’ repurchase notice).

Eventually, the court denied the validity of the VAM agreement at issue on the ground that it was detrimental to the order of the securities market and social and public interests, and violated public policy and good morals.

Similarly, inChenbiao v.Guangdong Gaoci Technology Corporation Limited and Zou Guokui(2021 Yue 09 Min Zhong No.36; the “Gaoci Case”), the Maoming Court also declared a secret VAM agreement invalid and unenforceable. Taking a slightly different approach from theGaoke Cases, the Maoming Court emphasized that the secret VAM agreement should have been “disclosed” rather than “terminated”, prior to the target company’s IPO:

(1) the target company should have disclosed truthful and full information about VAM arrangements according to the listing rule of the National Equities Exchange and Quotations (FAQs on Stock Issuance by Listed Companies (III)), whereas the target company made misrepresentations in this regard, as a result of the dishonesty of its shareholders and investors;

(2) as a result of the above, the truthfulness and transparency of the target company’s shareholding structure was in question, damaging the interests of vast investors, financial security and stability, and public policy of China; and

(3) the VAM agreement is invalid for violation of public policy and good morals, although the above listing rule amounts to no more than the department rules in effect.

Both the Shanghai No.2 Court and Maoming Court highlighted the violation of listing rules by the parties to the VAM agreements at issue, and concluded that the VAM agreements were invalid for violation of “public policy and good morals”.

While the legal authorities for invalidating these VAM agreements are not yet known, the courts are likely to have relied on Article 153(2) of theGeneral Provisions of the Civil Law(民法总则), which states “civil juristic acts that are contrary to public policy and good morals shall be invalid”. The courts were less likely to have relied on Article 153(1) of theGeneral Provisions of the Civil Law, which states “civil juristic acts that violate mandatory provisions on validity provided by laws and administrative regulations shall be invalid”, because the listing rules referred to in these cases are merely department rules, rather than laws and administrative regulations. The courts’ analysis is also consistent with Article 31 ofJiu Min Minutes, which states “the violation of department rules will not affect the validity of contracts in general, unless such department rules concern financial security, market order, macro policies of the state and otherpublic policy and good morals”.

Both cases have highlighted the risk of non-conformity with regulatory norms even if they are not laws or administrative regulations.

4. Conclusion

Pre-IPO agreements containing a conditional survival clause will be valid and enforceable according to the prevailing opinion of the Chinese courts. The validity of pre-IPO agreements that violate regulatory provisions, such as the listing rules of the CSRC or stock exchanges, is in question and likely to be denied by the Chinese courts. In particular, theGaoke CasesandGaoci Caseare signs that court decisions are aligning with regulatory rules with respect to IPO-related VAM agreements. Therefore, investors are advised to navigate the dynamic regulatory rules with prudence when designing and negotiating pre-IPO VAM agreements.

争议解决专栏往期文章

作者介绍

张光磊律师毕业于中国政法大学，获法学学士、民法学硕士和商法学博士学位。此外，张律师获美国乔治华盛顿大学法学硕士学位，为哥伦比亚大学法学院访问学者。张律师拥有中国及美国纽约州律师资格，为香港国际仲裁中心、上海国际仲裁中心、深圳国际仲裁院等仲裁机构在册仲裁员，中国政法大学法律硕士学院和对外经济贸易大学法学院兼职导师。

张律师的主要业务领域为争议解决，在民商事诉讼、仲裁、调解等领域拥有丰富的经验和良好的声誉，于2018年被CLECSS评选为“中国十大杰出青年律师”，于2020年被《商法》（CBLJ）评选为“A-List法律精英100强”，于2021年被《亚洲法律杂志》（ALB）评选为“中国十五佳诉讼律师”，于2022年被《亚太法律500强》（The Legal 500）评为仲裁领域“重点推荐律师”，并入选“2022年度LEGALBAND风云榜：仲裁律师15强”。在香港国际仲裁中心主办的2019国际仲裁中文赛中，张律师带领竞天公诚律师事务所获得北京赛区冠军和全国亚军，其个人在所有场次比赛中均被评为最佳律师。

张律师曾代表境内外客户处理中国国际经济贸易仲裁委员会及其分会、北京仲裁委员会、上海国际仲裁中心、深圳国际仲裁院、珠海国际仲裁院、香港国际仲裁中心、国际商会国际仲裁院等仲裁机构及中国不同层级法院的数百宗民商事案件，涉及行业领域包括房地产、金融、证券、国际贸易、医药、融资租赁、环保、文旅、教育、电信、征信、互联网、工业制造等。

张律师特别擅长处理投融资领域的争议，曾为客户成功处理业绩对赌、股权转让、公司控制权、董事和高管责任、员工股权激励、基金募集管理等投融资领域的多种争议。张律师也擅长在跨境交易纠纷中为客户制定整体解决方案，并多次在美国、新加坡、香港等地的诉讼和仲裁程序中担任中国法顾问及专家证人。

张光磊律师历史文章

张金辉律师的主要执业领域为争议解决与合规业务，曾代理国内外客户处理多起诉讼和仲裁案件，擅长处理涉外纠纷。张律师毕业于中国对外经济贸易大学，获得国际法硕士学位。张律师拥有中国律师资格。

张金辉律师历史文章

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