Legality of VAM still in some doubt

In foreign equity investments as well as mergers and acquisitions, private equity investors are exposed to two major risks – valuation risk and management risk. On one hand, the financing sides often overvalue performance intentionally as they expect to achieve high valuation financing; on the other hand, private equity investors are not able to control the business of a company effectively as they are usually not the controlling shareholders.

To avoid these risks and motivate the management of a company, valuation adjustment mechanism (VAM) has become a tool frequently used by foreign investors in making arrangements for complex agreements on financing transactions, to enable them to adjust the valuation of their investment targets and protect their own interests. However, the legality of a VAM has not yet been recognised under Chinese law. This has led to an unresolved issue: can the legal effect of a VAM be judicially sustained if a dispute between an investor and a financing party is referred to a court in China?

The Shiheng case

In 2011, the Higher People’s Court of Gansu province made a ruling of second instance on a dispute over capital increase (the Shiheng case), confirming that the valuation adjustment terms involved in this case were invalid. The ruling immediately provoked a spate of controversies in the financial and legal sectors. Since the Shiheng case is the first case in which a higher people’s court in China made a definitive legal conclusion on the legality of a VAM, it is considered to be indicative to a certain extent, and therefore various parties are trying to interpret the case.

Vincent Mu and Blake Yang are both lawyers at Martin Hu & Partners (MHP Law Firm)