Validity of Joint and Several Liabilities for VAM Agreements

By Weiwei Gu / Yin Wu


Ever since the "Haifu Case", i.e. the capital dispute among Haifu Investment Co., Ltd. of Suzhou Industrial Park, Gansu Shiheng Non-ferrous Resources Recycling Co., Ltd., Hong Kong Dia Co., Ltd., Lubo, there have been ongoing discussions over value adjustment mechanism (“VAM”) in the industry. The law firm of the author has undertaken big data research on this issue in 2016 and publishedStudy Report on Judicial Practice Concerning VAM (First Edition) (the “Report”). The author also participated in the writing of the Report. 


From the research results, the court has made a basic conclusion on the common legal issues arising from VAM (mainly about the validity of the VAM agreement signed by investors and original shareholders, and by investors and invested companies). However, in practice, the cases regarding whether invested companies shall bear joint and several liabilities for the VAM agreement signed by investors and original shareholders are rare, and the trial court for the existing cases believed such joint and several liability should be valid. However, as the author has noticed lately, the Supreme People’s Court (the “SPC”) reversed the previous opinion in “Qiang Jingyan Case”, i.e. equity transfer dispute among Qiang Jingyan, Cao Wubo and Shandong Hanlin Biotechnology Co., Ltd..


I. Previous Cases Review


The Report discussed the topic under Item 2.3 (circumstances where it is agreed that the invested company assume joint and several liability) on pages 14-15. The reference case is the equity dispute among Shanghai Lihong Investment Partnership (Ordinary Partnership), Zhejiang Zhongzhou Photoelectricity Co.,Ltd. and other (Case No.:(2014) HuYiZhongMinSi (Shang) ZhongZi No. 1334, hereinafter referred to as the “1334 Case”).


In this case, Shanghai First Intermediate People's Court held such clause shall be invalid based on the following reasons:


In the Capital Increase Agreement and the Supplementary Agreement signed by the parties, there are no clauses clearly demanding the invested company to make compensation to the investors or to repurchase their equity when the agreed performance target conditions fail to appear. However, stipulations endow the investors with the right to withdraw from the invested company, and choose either the controlling shareholder or the actual controller to repurchase their equities. It is also agreed that the invested company, the controlling shareholder, and the actual controller, shall be jointly and severally liable for any event of default of any party. As the first trial court analyzed, such agreement actually resulted in the invested company taking joint and several liability with its own assets for the creditor’s rights of one shareholder to another. According to Paragraph 2 Article 16 of the Company Law, if a company intends to provide guaranty to a shareholder or actual controller of the company, a resolution of the shareholders’ meeting or general meeting of shareholders shall be made. Considering the fact that the invested company had not convened a general meeting to resolve the above-mentioned joint liability, such guarantee obviously lacks the effective requirement. In addition, practically such an agreement will eventually make the invested company replace its controlling shareholder or its actual controller to assume debt, namely the invested company assume indemnification obligations to the investors, which violates the capital maintenance principle in Company Law and infringes the rights and interests of the company, shareholders and creditors as well. Thus, such an agreement shall be deemed invalid. 


II. New Case Express


In “Qiang Yanjing Case”, the SPC believed that the clause is effective and enforceable, which is contradictory to the previous judgements based on the following reasons:


First of all, the investor, Qiang Jingyan, has fulfilled the duty of due diligence and formal examination to the shareholders’ resolution regarding the guarantee provided by the Hanlin, the invested company.


The Capital Increase Agreement involved in this case specified that “Hanlin has passed the resolution of the shareholders' meeting, and the original shareholders agreed to this capital increase; all internal procedures have been fulfilled by the parties to ensure that they all have rights to enter into this agreement; authorized representatives of all parties have obtained formal authorization from the party. The Supplementary Agreement stipulated that “the Party A (Hanlin) approved the capital increase through shareholders’ meeting resolution”. In addition, the above two agreements regulate a package of issues including the amount of capital increase, the purpose of capital increase, the conditions for repurchase, the price of repurchase, and the guarantee provided by Hanlin, etc.. Besides, the two agreements are signed by Hanlin and its legal representative. From the perspective of the creditor Qiang Jingyan capital increase, equity repurchase and company guarantee constitute a chain-type investment mode. Based on the Capital Increase Agreement and the Supplementary Agreement, Qiang Jingyan has reasons to believe that Hanlin  passed a shareholders’ meeting resolution on a series of matters including capital increase and providing a guarantee, and it is also reasonable for him to believe that Cao Wubo has obtained the authorization of the company to sign the guarantee clauses on their behalf. In addition, Hanlin did not submit any contrary evidence to prove that the guarantee was not passed by shareholders’ meeting resolution during the trial. Therefore, it should be recognized that Qiang Jingyan has performed the obligation of due diligence and formal review on the resolution of the shareholders’ meeting regarding such guarantee, and the guarantee clause stipulated in the Supplementary Agreementshall be effective and enforceable to Hanlin.


Secondly, Qiang Jingyan’s investment had all been used in the operation and the development of Hanlin, whose shareholders received benefits therefrom, and therefore, Hanlin shall bear joint and several liabilities.


The legislative purpose of Article 16 of Company Law is to prevent the major shareholders from abusing the controlling status and making the company provide guarantee for their personal debts on their personal needs, therefore endangering the corporate and minor shareholders’ interests. In this case, although a concerned guarantee clause was signed by Qiang Jingyan and Cao Wubo, who is on behalf of Hanlin, the 30 million RMB was neither spent for Cao Wubo’s personal investment or consumption, nor for his private needs, but was all transferred to the corporate account for the operation and development of the company, which is in favor of the company’s improving and continuous profitability. This was not only in line with the personal interests of the company's new shareholder Qiang Jingyan, but also in line with the interests of all shareholders of the company. Hanlin itself is the ultimate beneficiary. Even if it is true that a resolution of the shareholders’ meeting on the guarantee had not been made as Hanlin indicated, such guarantee itself is favorable for corporate development, and does not prejudice interests of the company or any other minor shareholders or contradict with the purpose of Article 16 of Company Law. Accordingly, Hanlin’s assumption of guarantee liabilities is in accordance with the general fairness principle.


III. Case Analysis


Considering the view of the SPC on “Qiang Jingyan Case”, the SPC believed that both procedures and substantive issues should be reviewed when deciding whether the invested company should be jointly and severally liable for the VAM agreement between original shareholders and investors.


1. Procedural review on whether the resolution of the shareholders’ meeting or the general meeting has been passed for the guarantee provided by the invested company


It should be noted that, even though according to Paragraph 2 Article 16 of theCompany Law, a company provides guarantee for a shareholder or the actual controller of the company shall be subject to a resolution of the shareholders’ meeting or the general meeting, whether the guarantee provided by the invested company to the original shareholders has been approved by the shareholders' meeting or the general meeting of shareholders is not a necessary factor for the court to determine whether the guarantee is effective. In judicial practice, when it comes to the company providing guarantees to shareholders, the mainstream view is that the resolution of the shareholders' meeting or the general meeting of shareholders should not affect the effectiveness of the company's guarantee. The main reasons for this are as follows:


1) The company providing guarantees in the form of contracts should be regulated by Company Law, as well as Contract Law and Guaranty Law. Pursuant to Article 52 of Contract Law and relevant judicial interpretation, the contract is invalid only when it violates the mandatory provisions of effectiveness. Additionally, the purpose of Article 16 of Company Law is to prevent the actual controller of the company from infringing the interests of the company, minor shareholders and other creditors. Therefore, Article 16 shall be a procedural regulation within the company and a management provision, and shall not affect the validity of the guarantee agreement. 


2) The creditor, who is not the shareholder of the company, usually has no access to know whether and when the shareholders’ meeting is held, let alone the legitimacy and compliance of such meetings. If an agreement is deemed as invalid on the grounds of violating shareholders resolution procedure, it might leave a system gap for the company’s dishonest behavior of claiming that the contract is invalid on the grounds of a violation of the shareholders’ resolution, which will reduce transaction efficiency and negatively affect the transaction security. Besides, Article 16 of Company Law does not impose the substantive examination obligation to the third party. Therefore, as the SPC’s opinions in this case, some courts will examine if the creditor is a bona fide third party in practice, namely, whether the third party has fulfilled the obligation of due diligence and formal examination. 


(Please refer to the following cases for details: (2012) Min Ti No.156; (2015) No.7 Lu Min Zaizhong; (2016) Xiang Minzhong No.167; (2016) Su Minshen No.3834)


2. Substantive review on whether the contributed money from investors is actually used for the operation of the invested company


In “Qiang Jingyan Case”, the SPC held that the legislative purpose of Article 16 ofCompany Law is to prevent the major shareholders from abusing the controlling status and making the company provide guarantee for their personal debts on their personal needs, therefore endangering the corporate and minor shareholders’ interests. If the guarantee is beneficial to the development of the invested company, such guarantee does not damage the interests of the company itself and its minor shareholders, and then does not violate the legislative purpose of Article 16 of Company Law


The above-mentioned view of the SPC is brand-new. However, the SPC seems only to have considered whether the increased capital of investors is favorable for the invested company, minor shareholders and creditors when the capital increase occurs, but the SPC has not considered whether the assets of invested company could substantially decrease if the guarantee liability was fulfilled, which violates the principle of capital maintenance, a mandatory provision in Company Law, and subsequently put the interests of the new creditors after the capital increase at risk. Meanwhile, the SPC seems to consider that the capital maintenance principle should not be applied in this case. We consider the reasons behind this may be as follows:


The principle of capital maintenance was set for preventing shareholders from maliciously withdrawing contributed capital from the company, which intentionally infringes the interests of the company, other shareholders and creditors. However, under the chain-type investment mode including capital increase, equity repurchase and invested company’s guarantee, the ultimate purposes of the investors are to make the invested company profitable or listed, and then achieve capital appreciation. The invested company and the original shareholders also hope such “VAM + Guarantee” models can attract more investment; hence the acts of all three parties are for further improving the profitability of the invested company and in goodwill. Accordingly, in the context of encouraging investment, the effectiveness of this investment model should no longer be denied on the grounds of violating the principle of capital maintenance. 


IV. The Author’s Suggestion


“Qiang Yanjing Case” sets a favorable precedent for identifying the validity of joint and several liabilities assumed by the invested company in VAM. However, it should be noted that the referred case has not been included in the guiding cases, and whether other courts will refer to this case when dealing with similar cases still remains to be seen.



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