PRC rules in favour of VAMs

A PRC Supreme Court ruling in favour of profit guarantees is reassuring for PE investors in China, according to a Ropes & Gray report.

The PRC Supreme Court has ruled in favour of private equity value adjustment mechanisms (VAMs) for onshore investments, meaning that profit guarantees written into the original contract will be enforceable by law, according to a Ropes & Gray report.

The case began in 2008, when Haifu Investment, a mainland China fund manager, sued one of its portfolio companies (Gansu Shiheng Nonferrous Metals Recycling) for cash compensation in accordance with their previously established VAM once the company failed to meet its net profit target.

Haifu’s case was rejected by two lower-level courts – the Lanzhou Intermediate People’s Court and the Gansu Provincial High People’s Court – before the appeal reached the PRC Supreme Court in May. In November, the Supreme Court overruled the decisions of the lower courts, ruling that the VAM was legally valid.

“There has been a big cloud over profit guarantees in onshore investments, as it was not clear whether they were enforceable,” said Marcia Ellis, partner at Ropes & Gray. Now, however, that cloud has largely lifted, and some kind of investment protection will be defensible (though not binding) under this new ruling, she said.

The ruling does not explicitly permit put options, as the issue was not raised. However, “given the reasoning of the Supreme Court in the Haifu case, such IPO-related put option could be deemed valid by the court as such put option is between shareholders,” according to the report.

The major qualification to VAMs in onshore investments is that they are only valid between shareholders, said Ellis. In other words, a private equity investor may only chase another shareholder (particularly the majority shareholder) for compensation, not the company itself. Ellis said this is the preferred outcome for private equity, as it is usually the majority shareholder that has cash.

Private equity investors are particularly happy that the Gansu court’s 2011 decision was overruled, Ellis said, because it treated Haifu’s investment as a “de facto loan”. Only when the Supreme Court rejected that view could the VAM arrangement be considered valid as a “contractual agreement between willing parties”, according to the report.

This ruling will allow private equity investments in China to continue more freely, Ellis said, as “not having a VAM option makes it much harder to get an investment through a [private equity] investment committee.” With the leverage provided by the ruling, “as long as [the investor] can negotiate a VAM in the document, there’s no reason not to have it,” Ellis said.

However, Ellis also believes this isn’t the end of this case. With the IPO market in China still chilled, there is a high likelihood that many private equity investments are going to miss their IPO deadline. Thus Ellis has no doubt China will see another court case related to put options specifically, but after this case it may not need to go up to the Supreme Court level, she said.