Valuation adjustment mechanism in China’s capital markets
Abstract:
Valuation adjustment mechanism (VAM) is widespread in China’s capital markets, but is rarely discussed at either the practical or the academic level. This chapter reviews the development of VAM in China’s capital markets and analyzes the reasons for its popularity in China. It discusses the first argued VAM case, focusing on the risks and validity of VAM in China. A case study on the legitimacy and disputes of VAM in mainland China is undertaken, and the judgments of courts at different levels are analyzed and discussed in detail. Since there is no special regulation for managing VAM clauses, the first and only judgment by the highest court is significant and deserves consideration.
What is valuation adjustment mechanism (VAM)?
VAM has been a hot topic in Chinese investment field, such as in the PE industry, for the past several years. VAM is often called a gambling agreement or bet-on agreement in China. It is also known as “ratchet clauses.” It has been widely used for business investment in growth firms in China. VAM is a kind of contract between investors and investees to regulate their obligations and rights based on their different judgments of the future performance of an operating company. It is a way to handle the future’s uncertainty in investment. If the operating company achieves a performance target, its management team will be given some benefits by investors, such as shares of the company. Otherwise, the investors will receive some benefits (Figure 8.1).
For investors, VAM is an option embodied in binding contracts to protect their interests and a way for investors to handle future uncertainty of their investment. Different corporate performances bring different valuations of the company, which affects investors’ interests. For example, a VAM contract between the management team of a company and investors can be like the following:
The management team guarantees that its company will generate revenue of no less than $1 million each year for the first 3 years of the business operations (“Performance Target”). If the company fails to achieve the performance target, the post-money valuation on a fully diluted basis will be adjusted.
Those companies involving VAM normally have professional and excellent management teams. They normally have high risk preference. The value of the company can be judged by forecasting corporate performance. More importantly, investors and investee have different judgments and expectations of corporate performance. For the management team of the operating company, VAM can be a kind of incentive mechanism to encourage the management team to work hard to achieve good corporate performance.
In Western countries, VAM is mainly used to reduce investment risk and protect investors’ interest, while in China there are many cases of VAM being used as a means to take over or control the operating company. For example, if the company fails to achieve the performance target, the management team might choose to transfer 5 percent of the total shares of the company to the investors for compensation; while, if the company achieves the performance target, the investors might choose to transfer their 5 percent of shares to the management team. The performance target of VAM can be various, including financial performance or non-financial performance such as IPO. The benefits and compensation may be equity, board direction membership, next round of investment and stock options.
If the company cannot achieve the set financial performance (performance target), the company will transfer some shares of the company to investors, or give investors more positions as board directors.
If the company develops a new Intellectual Property Right (performance target), investors will provide another round of financing.
IPO can be a performance target. Investors ask the company to be listed on the stock exchange within the given period. Otherwise, investors will sell the shares they hold, or are given some compensation by the operating company.
If the management team leave the company, their stock option must be given up; or further investment will depend on the operation of the management team. For example, if they leave the company, further investment will be cancelled.
In fact, VAM is a kind of cliquet option or ratchet option, which consists of a series of consecutive forward start options. Each option is struck at-the-money when it becomes active. VAM can be used in start-up companies, mature companies and M&A. A start-up company often lacks financing and needs capital. Thus, investors often have strong bargaining power in negotiations. The conditions for exercising rights may be favorable to the investor.
VAM in China
The first VAM case debated in China
VAM first became known to the public in China in 2005, when a US-based PE, Carlyle Group, invested in a large Chinese SOE, and the largest maker of construction equipment, XCMG (Xuzhou Construction Machinery Group). On 25 October 2005, they signed an investment contract with VAM clauses. The main points of the agreement were as follows:
Carlyle would pay RMB 2.069125 billion Yuan (about US$252 million) to purchase an 82.11 percent stake of XCM (Xuzhou Construction Machinery Co. Ltd.), a subsidiary of XCMG. After this deal Carlyle would hold 82.11 percent stakes of XCM, while XCMG would hold 17.89 percent.
Carlyle would spend US$60 million to purchase the new issued 16.17 percent shares of the new XCM. Both Carlyle and XCMG agreed the VAM, which was that if, in 2006, XCM achieved the financial target of RMB 1.08 billion (Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)), Carlyle would pay $60 million more, amounting to $120 million in total for the purchase. After the purchase, Carlyle would spend about US$ 375 in total to acquire 85 percent of stakes and XCMG would only hold 15 percent of the stakes of the new XCM. Thus, CXM would be changed from a SOE to a foreign investor controlled joint venture.
The deal caused fierce arguments over involving national security and selling off state assets cheaply to foreign investors. In particular, it seemed unacceptable for the public to see state assets being used for gambling (VAM). A competitor of XCM, SANY Group, which is a Chinese private firm, also wanted to purchase the stakes of XCM, while XCMG preferred to cooperate with Carlyle. SANY then became heavily involved in arguments against Carlyle’s acquisition. The transaction was finally blocked by the Chinese government. However, since then, VAM has been widely known to many Chinese investors and has been used in investment agreements.
Since 2009, China’s PE industry has developed rapidly due to the launch of GEM. Because China’s unique banking system is favorable to SOEs, Chinese private firms have often had difficulty in obtaining financing from banks and have been in urgent need of funds, which provides PE with many opportunities. When PE firms make investments, VAM is often included in their investing agreements and can be regarded as an optional agreement between an investor and an investee, in which the investor can exercise certain rights if its investment is negatively affected. In a popular case, through VAM agreement, a PE fund can subscribe to the newly issued equity of a company, allowing the PE fund to receive a fixed or lowest investment return. If the return is below the fixed level, the company must compensate the PE fund with cash or equity. If the return is higher, the PE fund needs to make an additional investment or give away some equity to the investee.
Risks in VAM
In an investment agreement with a VAM clause, the performance target is set and agreed by both investors and investees. But it is not always reached by the investees, although they normally should understand the operation and performance of the business better than investors. The risk preferred professional management team or investee is often overconfident and likes to take high risks in signing a VAM clause, in which, contrary to their opinion, the performance target is in fact hard to reach. When the investee fails to achieve the performance target, the investee may lose control of the company.
One such gambler was Changsheng China Property, a property company based in Guangzhou city. In 2006 it signed a VAM agreement with Sachs Strategic Investments (Asia) LLC, a subsidiary of Goldman Sachs and established specially for that investment. Changsheng was confident of its plan for a HK$900 million IPO in Hong Kong scheduled in late 2008. However, the IPO flopped due to the poor economic situation, and Changsheng lost the game. To meet the VAM agreement, Changsheng issued bonds in private placements to those companies that were to be repaid unless an IPO succeeded by 18 December 2008. Since the listing flopped, Changsheng had to sell projects to pay off bonds. For example, it had to undersell China Plaza, a retail–commercial complex in Guangzhou, to pay off company debt in late 2008, after being forced to postpone the IPO. Changsheng is just one of the firms rolling toward restructuring to avoid collapse. Many companies are trying to make ends meet, but often find themselves at the mercy of investors.
Another famous case involving VAM is Hunan Taizinai Group (Taizinai), a leading Chinese yogurt producer and China’s best known maker of yogurt-type drinks. The company had almost three-quarters of China’s yogurt-t ype drinks market. To realize IPO in the US, Taizinai decided to import investors. In 2007, Taizinai signed an investment agreement including VAM clauses with three famous investors: Morgan Stanley, Goldman and Actis Capital. They paid US$73 million for a 31 percent stake of the company, of which Morgan Stanley Principal Investment and Goldman Sachs put in US$15 million and US$18 million respectively, while Actis invested US$40 million. The VAM clause was that, for the first 3 years after the investment, if Taizinai could achieve growth rates of over 50 percent, the three investors would be willing to lower their equities of Taizinai, while if the company’s growth rates were lower than 30 percent the three investors’ equities would be raised. Thus, Mr Li Tuchun, the founder of Taizinai, would lose control of the company. In 2008, the melamine crisis in China made Taizinai perform much more poorly than expected. Taizinai did not reach the growth rates. Mr Li lost control of Taizinai and had to transfer 61.6 percent of equities to the three investors at the end of 2008.
In the disclosure of VAM cases involving Chinese firms and foreign investors, most Chinese firms could not win the gambling games. A famous winning VAM case was the VAM agreements signed between China Mengniu Dairy Company Limited (Mengniu), China’s leading dairy products producer, and three foreign investors: Morgan Stanley Dairy Holdings (“MS Dairy”), CDH China Fund, L.P. (“CDH”) and CGU-CDC China Investment Company Limited (“CIC”) in May 2004. The VAM agreement said that from 2004 to 2006, if Mengniu could achieve compound annual growth rates of 50 percent, the three investors would transfer 78.3 million shares (7.8 percent of the total shares) to Mengniu, which would make Mengniu hold 45.2 percent shares while the three investors only controlled 29.2 percent of Mengniu; if Mengniu could not make the rates, it would transfer the same amount of shares or the same value of cash to the three investors, which would make Mengniu lose control of the company, since the three investors’ shares would increase to 40.6 percent while Mengniu’s shares would decrease to only 33.8 percent. It is obvious that the VAM is about betting on the controlling rights of Mengniu company. Mengniu’s profit in 2003 was RMB 164 million Yuan. For Mengniu to win over the investors, its profits in 2006 must be more than RMB 550 million Yuan. Otherwise, Mengniu faced the possibility of being taken over. In fact, Mengniu achieved unexpected performance. In 2004, Mengniu achieved profits of RMB 319 million Yuan, more than the RMB 300 million required to win the VAM. According to that performance and growth rate, it was obvious that Mengniu would very likely win the VAM. The investors then asked for termination of the VAM in advance. In April 2005, the investors transferred convertible instruments of US$ about 6 million (62.6 million shares) to Mengniu for the termination. Then, Mengniu won the VAM agreement.
Is a VAM clause legal in China?
In PE investment in China, the post-closing VAM provision (which helps bridge the gap of different projections for the target company) has been widely adopted. However, the legitimacy of VAM had been argued for a while, since VAM had never been tested before a Chinese court. It was questionable whether VAM was legal or illegal, since there had been no clause on the legitimacy of VAM in China’s corporate law. In practice, when there was a default of the VAM agreement, few investors or investees would have been willing to go to law to solve the dispute, because many of them felt quite uncertain whether the VAM was valid or not. That situation was changed in 2012, when a VAM lawsuit was closed.
Case study: The first lawsuit involving VAM in China
In October 2007, as an investor, Hoi Fu Investment Co., Ltd, which is based in Suzhou Industrial Park (hereinafter referred to as the “Haifu Company”), signed an investment agreement with an investee named Gansu Shiheng Nonferrous Metals Recycling Co., Ltd, which is based in Dingxi City, Gansu Province (hereinafter referred to as the “Shiheng Company”). According to the agreement, Haifu subscribed for 3.85 percent equity interest of Shiheng with an investment of RMB 200 million Yuan, in which RMB 1,147,710 Yuan was paid as increased registered capital and RMB 18,852,283 Yuan was paid as capital reserve. The subscription agreement contains a VAM and share repurchases provisions as follows:
If the net profit of Shiheng in 2008 is lower than RMB 30 million Yuan, Haifu may claim compensation from Shiheng, which equals a certain sum as determined according to an agreed formula:
If Shiheng is not able to pay the compensation, its mother company, Wisdom Asia Limited (hereinafter referred to as the “Diya Company”), which is based in Hong Kong, will pay Haifu Company the compensation.
If Shiheng is not listed on a stock exchange before October 2010, Haifu may request Diya Company to repurchase all the shares of Shiheng held by Haifu Company. If the annual return of Haifu is less than 10 percent, the repurchase price should be added to by 10 percent interest rates of the original investment.
In 2008, Shiheng’s net profit was only RMB 26,858.13 Yuan, which failed to reach the targeted performance for 2008 and triggered the compensation. Haifu Company claimed compensation from Shiheng Company and Diya Company, but this was rejected. Then, on 30 December 2009, Haifu Company sued Shiheng Company, Diya Company and the legal person of Shiheng, Ms Lu Bo, in the local court, Lanzhou City Intermediate People’s Court, to seek to exercise its right to the compensation of RMB 19.982095 million Yuan and all lawsuit-related fees. It was the first lawsuit in China involving VAM. Because there were no laws and regulations on the legitimacy of VAM in China’s corporate law, the result of this lawsuit would greatly impact the investment practices of PE firms. The lawsuit caused great public attention in China’s investment community and the business community.
The judgment of Lanzhou Intermediate People’s Court
On 31 December 2010, the Intermediate Court ruled that the VAM was invalid in the agreement and dismissed Haifu’s claims. There were two main reasons for the court of first instance to deny the validity of the VAM agreement:
First, Shiheng was a joint venture. According to Article 8 of the Sino-Foreign Equity Joint Venture Law, the net profits of a joint venture shall be distributed to the shareholders in proportion to their respective shares in the registered capital. Paragraph one of Article 8 of the PRC Sino-foreign Equity Joint Venture Law says that “After payment of equity joint venture income tax on an enterprise’s gross profit, pursuant to the tax laws of the People’s Republic of China, and after deductions therefrom as stipulated in its articles of association regarding reserve funds, employee bonus and welfare funds and enterprise development funds, the net profit of an equity joint venture shall be distributed between the equity joint venture partners in proportion to their investment contribution to the enterprise’s registered capital.” The VAM agreement granted Haifu the right to claim the compensation from Shiheng only on the condition that Shiheng’s net profits were less than RMB 30,000,000. The imposition of compensation obligations on Shiheng violates mandatory provisions of the law.
Second, the VAM agreement impaired the interest of Shiheng and Shiheng’s creditors, and so violated Article 20, Paragraph 1of the People’s Republic of China Company Law, which provides that “Shareholders of a company shall exercise shareholders’ rights in accordance with the provisions of laws and administrative regulations and the articles of association of the company and shall not abuse their shareholders’ rights to cause damage to the company or the interests of other shareholders or abuse the independent legal person status of the company and limited liability of the shareholders to cause damage to the interests of the creditors of the company.” In addition, the VAM agreement was also inconsistent with Shiheng’s Articles of Association.
Thus, the first instance court mainly held that the compensation agreement signed between Haifu and Shiheng was invalid, because, according to the provisions of Article VIII of Sino-foreign joint ventures in the People’s Republic of China, corporate net income should be allocated by the proportion of registered capital of the joint venture parties. The compensation requested by Haifu was not supported by the court. The judgment caused great repercussions in China’s investment field. It was debated and questioned.
The Judgment of Gansu Provincial High People’s Court
Haifu Company was not willing to accept this result, and made an appeal to the higher court, Gansu Provincial High People’s Court. On 29 September 2011, the High Court made changes to the first-instance judgment. However, it still ruled that the agreement was invalid and developed different reasoning to deny the agreement. On the other hand, the court judged that, of Haifu’s investment of RMB 200 million in Shiheng, other than the sum of RMB 1,147,710 Yuan paid as increased registered capital, the investment of RMB 18,852,283 paid as capital reserve was an unlawful loan. The High Court ordered Shiheng Company and Diya Company to refund this amount to Haifu together with interest.
The reason for regarding the investment as a loan was based on Article 4 (2) of the Explanations of the Supreme Court Concerning Several Issues on the Trial of Joint Operation Agreement Dispute, which says that “where the enterprises or other entities, as a member of a joint operation who neither participates with the business operation nor bears any risk of the joint operation’s business operation, merely invests in the joint operation and withdraws its investment regularly, or obtains profits regularly, such investment is a loan but in the name of joint operation and violates the relevant financial administrative regulations. This kind of contract shall be void. The investment shall be returned to the investor, the interests which has been paid or has been agreed to be paid to the investor shall be confiscated, and the party who received the loan shall be imposed on penalty equaling to the bank interests”. By reference to Article 4 (2) the court of second instance ruled that the VAM agreement in Clause 7.2 of the Capital Increase Agreement was invalid, because it violated Article 52 (5) of the Contract Law. Article 52 of the PRC Contract Law provides that “In any one of the following situations, a contract shall be without effect: (1) one party concludes the contract through the use of fraudulent or coercive means, causing detriment to the interests of the State; (2) the contract involves a malicious conspiracy which is detrimental to the interests of the State, a collective or a third party; (3) illegal intentions are concealed beneath an appearance of legality; (4) there is detriment to social and public interests; or (5) the mandatory provisions of laws and administrative regulations are violated.”
The High Court of second instance held that the agreement allowing Haifu Company to claim compensation from Shiheng Company and Diya Company violated the principle of joint risk sharing in investment, because it would enable Haifu Company, as an investor, to receive guaranteed profits free of risk, whatever the business performance of Shiheng Company. However, the High Court recognized that the agreement on Shiheng Company’s minimum profit in the fiscal year 2008 was valid because it only concerned the profitability of Shiheng Company and did not involve profit distribution. Further, if the agreed profits were achieved, it would allow Shiheng Company and its shareholders to realize their respective distributions in accordance with the Company Law, the JV Agreement and its Articles of Association, as well as enhancing creditors’ interest.
However, Shiheng Company and Diya did not accept the result of the High Court’s judgment, and made an appeal to the Supreme People’s Court.
The Judgment of the Supreme People’s Court
The Supreme People’s Court accepted the appeal of Shiheng Company and Diya. On 7 November 2012, the Supreme People’s Court made the retrial judgment, which was the final judgment of the lawsuit. It reversed the judgment of the second instance. The Supreme Court judged that it was lacking in sound legal basis for the court of second instance to judge Haifu’s investment of RMB 18,852,283 Yuan, which formed part of Shiheng’s capital reserve, to be an unlawful loan. The judgment of the second instance court ordering Shiheng and Diya to jointly refund Haifu’s investment together with interest was wrong, since it exceeded Haifu’s claim, because Haifu had never claimed the refund of its investment. Finally, the Supreme People’s Court ordered Diya Company to pay compensation of RMB 19,982,095 Yuan to Haifu and all the lawsuit-related fees of the first instance and the second instance, which were RMB 316,924.6 Yuan in total. Meanwhile, it dismissed Haifu’s other claims.
The Supreme Court denied the Gansu Provincial People’s High Court’s judgment in defining Haifu’s investment as a loan by applying the Explanations of the Supreme Court Concerning Several Issues on the Trial of Joint Operation Agreement Dispute, and judged that the VAM agreement between the Haifu Company and Shiheng Company jeopardized the interest of Shiheng Company and its creditors. The VAM clause violated Article 8 of the PRC Sino-Foreign Equity Joint Venture Law on profit distribution, which is in turn abuse of shareholder’s rights, prohibited by Article 20 of the Company Law. The Supreme Court concluded that the VAM agreement between Haifu Company and Shiheng Company violated mandatory provisions of laws and regulations and was therefore invalid. The Supreme Court disagreed with the High Court’s judgment considering Haifu’s investment as a loan but in the name of joint operation only because of the VAM agreement.
Discussing the case
The final judgment ruling that the old shareholder, Diya Company, should bear the compensation liability for the investor, Haifu Company, rather than Shiheng Company bearing the compensation liability, is a milestone for the legality review of VAM in similar cases in the future.
The key point of the lawsuit, and what concerned the public about the lawsuit, was how the Courts judged the validity of VAM, or whether VAM in China was legal. From the Supreme Court’s judgment, it could be seen that the Supreme Court revised the lower courts’ judgment that the VAM agreement was invalid. It distinguishes the VAM agreement between investors and investee and the VAM agreement between investors and investee shareholders. In this case, the VAM agreement between Haifu Company and Shiheng Company was judged to be invalid, while the VAM between Haifu and the shareholder of Shiheng Company, Diya Company, was valid. That is why Diya Company was asked to pay the compensation. It was a case of one shareholder of Shiheng Company, Diya Company, compensating another shareholder of Shiheng, Haifu Company. The compensation is valid and legal. Meanwhile, the agreed formula of calculating the compensation is recognized by the Supreme Court and valid. The Supreme Court confirms the validity of the VAM agreement between the investor and other shareholders, while denying the validity of the VAM agreement between the investor and the target company. The Supreme Court’s retrial judgment may have a great influence on the long-term controversial issue of validity of VAM agreement, and generate significant implications for investors, such as PE investors, regarding how to protect their interests in their investments. It can be concluded that VAM agreement can be applied and is legal between investors and the management team of an investee (target company) or between investors and shareholders of investee (target company), while it cannot be applied, or is invalid, between investors and investee (target company).
However, because China is not a case law jurisdiction, it has not been clear how the Supreme Court’s decision will impact other courts and the practice of investments in mainland China. It is necessary for the Supreme Court to issue a guidance to specifically uphold and clarify the validity of the VAM.
In addition, there is one practical question, which is about taxation. When Haifu Company receives the compensation, what is the taxation policy for the compensation? How much tax should Haifu Company pay for the compensation? Meanwhile, what kind of taxation policy will Diya Company use to deal with the payout of compensation? These questions should be answered by Chinese taxation authorities for dealing with VAM cases. It should also be noted that CSRC does not allow any pre-IPO company to involve VAM. If a company wants to be listed in China’s stock markets, it must give up VAM before its IPO.
Summary
Valuation adjustment mechanism is widespread in Chinese investment, particularly in the PE and VC fields. It is an agreement between investors and an investee that gambles on the performance of the investee. They agree that, when a fixed performance target of the investee cannot be reached, the investors can get compensation. VAM is about valuation of a company based on its performance. It protects the investor’s interest and is an incentive mechanism for the management team of the investee. The nature of VAM is a kind of option to handle future uncertainty. In China, one risk of using VAM is the legal system. China does not have clear regulation or laws related to VAM. Chinese company law insists on the principle that shareholders share risks and returns of their investment in accordance with their respective shareholding ratios. Another risk of VAM is abuse of VAM in investments. There is often gambling with the financial performance and equities of the investee. Some Chinese famous entrepreneurs and firms have borne great losses due to VAM. VAM is actually a double-edged sword. It can bring high returns on investment, but it can also bring high risks to investment and financing.
From the Supreme Court’s judgment of the Haifu case, it can be seen that the Supreme Court recognizes the VAM articles between shareholders, and denies the validity of VAM between investors and the target company. In other words, a VAM agreement between shareholders is valid and legal, while a VAM agreement between investors and the investee is invalid. The judgment indicates that the Supreme Court acknowledges the legitimacy of VAM, but only for those entered into between shareholders. There remains the risk that a VAM agreed between a new shareholder who subscribes the capital and the target company is void. Investors should pay attention to this risk.