Redemption obligation in equity investment deals

The valuation adjustment mechanism (VAM) clause is crucial for equity investment deals. A VAM arrangement serves both roles of a security tool to the investors and a motivation tool to the founding team. From the perspective of protecting investors, this article discusses who should assume the share redemption obligation (SRO) and how this obligation may be fulfilled in the context of Chinese judicial practice.

Instead of imposing the SRO directly on the target companies, investors may require the existing shareholders of the targets to take this obligation. In practice, many investors agree with the existing shareholders and the targets that when certain conditions are met, the targets should be obliged to redeem shares from the investors, with the existing shareholders held jointly and severally liable for fulfilling this obligation.

However, in the final decision dated 2012 for Haifu Investment v Gansu Shiheng Non-ferrous Metal Resources Recycling, the Supreme People’s Court (SPC) held that the agreement imposing the SRO on Shiheng was invalid, arguing that “the agreement was detrimental to the interests of the target and its creditors because it allowed Haifu to receive relatively fixed income independent of Shiheng’s business results through the investment”. This has become a consensus opinion of judges.

Ren Shanshan is a partner at Merits & Tree

5/F, Raffles City Beijing Office Tower

No.1 Dongzhimen South Street

Dongcheng District, Beijing 100007, China

Tel: +86 10 5650 0900

Fax: +86 10 5650 0999

E-mail:

shanshan.ren@meritsandtree.com

www.meritsandtree.com