Supreme Court’s ruling in PE case comes down to shareholder rights

On 7 November 2012, the Supreme People’s Court (SPC) rendered a final judgment in the first dispute case in China involving a valuation adjustment mechanism in a private equity (PE) investment. Although China is not a case law country, the SPC’s judgment will, in practice, have a guiding and demonstrative effect on the trial of similar cases.

The judgment

In 2007, Haifu injected RMB20 million (US$3.2 million) in cash to increase the capital of Shiheng, and executed a capital increase agreement with Diya (Shiheng’s sole investor) and Lu Bo (the actual controller of Diya), which provided for a valuation adjustment mechanism as follows: if Shiheng’s 2008 actual net profit did not reach a target of at least RMB30 million, Haifu would have the right to demand that Shiheng pay it compensation; and if Shiheng failed to perform its compensation obligation, Haifu would have the right to demand that Diya perform the compensation obligation. On 30 December 2009, as Shiheng’s actual net profit for 2008 failed to reach the target, Haifu instituted a legal action pursuant to the valuation adjustment clause, requesting that Shiheng, Diya and Lu Bo be ordered to pay it compensation.

Both the Lanzhou Municipal Intermediate People’s Court in its judgment at first instance, and the Gansu Higher People’s Court in its judgment at appeal, found the valuation adjustment clause invalid, but on different grounds.