Jan 11, 2013 02:03 PM

Supreme Court Helps Clear the Air for PE Investors

The legal ambiguity over whether a Chinese private equity investor can sue its investee for failing to live up to its promise finally cleared up a bit after the Supreme People's Court supported a private equity company's claim for compensation.

The verdict in December overruled two lower court decisions and sent a heartening signal to PE investors across China, though it may not necessarily apply to similar cases in the future under the nation's judicial system.

The dispute centered on the legitimacy of a contractual provision known as Value Adjustment Mechanism (VAM). The arrangement allows an investor to request a previously agreed upon compensation when the firm it invested in fails to deliver promised results. It can also require the investor to double down on its investment when the acquired firm performs better than expected.

The clause has often been written into PE contracts abroad to provide an extra layer of protection for investors, who supposedly always suffer information asymmetry in acquisition deals.

Many Chinese investors have used VAMs as well, but Chinese laws remain vague on the issue and no one had taken it to court until Jiangsu PE firm Haifu Investment Co. Ltd. did.

Haifu acquired a 3.85 percent stake in Gansu Shiheng Nonferrous Metals Recycling Co. Ltd. for 20 million yuan in 2007. Their contract included a VAM, which said that Haifu was entitled to compensation if Shiheng's net profit in the next year fell below 30 million yuan.

In case Shiheng failed to pay, the agreement stated, its Hong Kong parent, Diya Co. Ltd., was obligated to pay.

Shiheng's net profit for 2008 turned out to be lower than 30,000 yuan. According to the contract, it should pay Haifu nearly 20 million yuan in compensation, but both Shiheng and Diya refused.

Haifu was rejected by Lanzhou city's intermediate court and lost its appeal to the provincial higher court because the judges ruled that the VAM was not valid.

The top court also ruled against the VAM on the grounds that it would hurt the interests of other Shiheng shareholders. It decided, however, to support the claim for compensation from Diya, thus acknowledging the validity of VAMs to some extent.

The ruling ought to go down in history. It will be a reference for similar cases to follow and serve as a foundation for ongoing efforts to refine the scope and regulations of VAMs in China.

It is also a thrilling message for investors, including CDH Investments Chairman Wu Shangzhi. The alternative asset fund manager is fond of using VAMs, regarding them as an important means to learn the real conditions of the company he plans to invest in.

"It's an integral part of price negotiations, a method to exchange opinions and a tool to facilitate communications when problems arise," he said.

VAMs are also often used in areas outside PE investment. In acquisitions by public companies, for example, the acquired firm would sometimes be asked to compensate the public company if it cannot meet certain goals.

Admittedly, not everyone has a high opinion of VAMs. Hony Capital's president, Zhao Linghuan, said he does not like them because they create an illusion that investors can enjoy locked-in returns.

But in general VAMs are thought of positively because they keep the investee diligent and the investor protected. After all, if a potential investment is dropped because the investor fears a lack of protection, both sides will suffer real misfortune.

The author is the secretary general of Peking University's Research Center of Financial and Industrial Development

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