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Developments and Risk Prevention in Equity Investments in China – Comments on VAM Agreements

2023.06.19 ZHENG, Yanli (Leanne)、LIU, Zhen、CANG, Haitian

The original article is published on the Chambers Expert Focus website (https://chambers.com/legal-trends/overview-of-vam-agreements-in-china)


A valuation adjustment mechanism agreement, also known as a “VAM agreement”, is a critical commercial tool for the protection of investors in equity investments. Investors do not usually directly participate in a target company’s operation and management, which leads to information asymmetry between the investors and the founders regarding the target company. A VAM agreement can permit investors to exercise their redemption rights to withdraw from a target company when its performance or valuation is not ideal, thus protecting the rights and interests of investors, and it encourages the company and its founders to commit to the company's operation.

 

The Validity of VAM Agreement


Over the past decade, China’s judicial practice regarding the validity of VAM agreements has been highly controversial. Disputes have gradually decreased since the release in 2019 of the Minutes of the National Courts’ Civil and Commercial Trial Work Conference (the “Minutes”). According to the Minutes, a VAM agreement will be deemed valid unless it violates mandatory provisions of laws and regulations, no matter whether it is concluded between an investor and shareholders, the actual controller or the target company. 

 

“A VAM agreement can permit investors to exercise their redemption rights to withdraw from a target company when its performance or valuation is not ideal.”

 

Factors that may have influenced the validity of VAM agreements in past judicial practice may or may not currently have an impact in the following situations.

 

The VAM agreement concerns state-owned assets


According to the latest precedent set by the Supreme People’s Court, where shareholders of the target company are state-owned enterprises, whether a VAM agreement has been approved by the competent state-owned assets authority or not will not affect the validity of the agreement. 

 

The VAM agreement involves “disguised debt   in the  form of equity”


According to Chinese court cases, “disguised debt in the form of equity” may render a VAM agreement invalid, but the validity of the embedded loan agreement will not be affected. 

 

The VAM agreement violates mandatory financial   regulations


According to the latest trend in financial trial cases, if a VAM agreement violates mandatory financial regulations involving public interests, the agreement will be invalid.

 

Main Content of VAM Agreements


Conditions for the exercise of redemption rights


Common redemption conditions under VAM agreements include: 


·       failure of the target company to complete an IPO or M&A as scheduled; 

·       major violations of laws and regulations by the target company; 

·       violations of laws or breaches of contract by the actual controller/shareholders/senior officers of the target company; and

·       the exercise of redemption rights by other investors. 

 

Period for the exercise of redemption rights


If there is no exceptional provision in the agreement, an investor who fails to exercise their redemption rights within the exercise period may be deemed as having lost the redemption right and may not exercise it. 


According to current judicial practice, if no exercise period is specified in the agreement, the redemption right-holder may exercise the redemption right within a reasonable exercise period.

 

Common redemption paths and redemption obligations:

 

  • the target company holds a shareholders’ meeting or a board meeting to pass a resolution with respect to share redemption, equity transfer, financing and capital reduction; 

  • the target company pays a redemption fee to the redemption right-holder within the agreed timeframe; this fee may include the investment principal, investment premiums and liquidated damages; and

  • the redemption right-holder may, as agreed in the VAM agreement, make a claim on the target company for payment of performance compensation, and may also require founders (and their spouses) or relevant entities to assume joint and several liabilities. 

 

Common Barriers to Implementing VAM Agreements in Judicial Practice


 

  • The clauses regarding the redemption options are ambiguous, the exercise path is not specified, or the pre-negotiation conditions of the redemption option constitute obstacles. 

  • The redemption conditions are unspecific or ambiguous. 

  • The investor fails to send a written notice or fails to retain records for exercising their redemption rights.

  • The exercise period of redemption rights is not clearly stipulated.

  • The procedure for capital reduction is not duly performed, and other shareholders do not co-operate in passing the resolution on capital reduction.

  • Some investors and shareholders privately agree on the VAM clauses, while such private agreement is prohibited under the shareholder agreement or the articles of association. 

  • The sequence for exercising redemption rights is inferior to that of other investors, and investors with priority have not yet exercised their redemption rights. 

 

Suggestions for Drafting VAM Agreements


 

  • Pay close attention to the mandatory financial provisions and ensure the validity of the VAM agreement. 

  • Clearly stipulate the exercise conditions for redemption options to avoid ambiguity. 

  • Set a clear exercise period as needed and exercise the redemption option in a timely manner. 

  • Place importance on the written notice of claim and properly retain relevant evidence of the exercise of the redemption option.  

  • Clearly stipulate the co-operation obligations and liabilities of the founders and other shareholders. 

  • Negotiate a more preferential sequence for exercising redemption rights. 

  • Require counterparties to provide diversified credit enhancement guarantees and request founders and their spouses to assume joint and several liability.

  • Stipulate the “drag-along” and “liquidation” clauses to ensure an investor can smoothly withdraw from a company under extreme circumstances. 

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