PE/VC investors and start-up company founders received an important message on how the redemption rights in their investment agreements should be exercised, or be defended against, by a set of formal replies published in the Supreme People’s Court’s newspaper on August 29, 2024. [1]In one of the replies (the “SPC Reply”), namely “how to measure the time limit for an equity investor to exercise its redemption right”, a query from a judge in the Shanghai Higher People’s Court was addressed by a judge of China’s Supreme People’s Court.
This query involves a long time controversial and confusing judicial question regarding (i) the legal nature of an equity redemption right in a Chinese law-governed PE/VC deal, and (ii) the legitimate procedure for exercising such right, in accordance with the very often used (and arguably “abused”) clauses in China-related PE/VC transactions, i.e., so called “valuation adjustment mechanism (VAM)” clause/agreement.
In the published SPC Reply, the Supreme People’s Court generally sets up the following doctrines:
(A) Any express agreement regarding the time limit or procedures in such a VAM agreement should be respected by the court; and the court will interpret such agreement by considering the contractual provisions’ text, the nature and purpose of such agreement, the market norms, and the statutory principle of good faith.
(B) While respecting the parties’ mutual agreement and the explicit contractual provisions, the court should also protect the investee company’s reasonable business expectations in its operation. In other words, an uncertain/unlimited time length to allow such company’s investor-shareholder to request and sue for redemption will not be supported by the court.
(C) Further, the Supreme People’s Court holds the view that when the investment agreements set up a timing triggering a redemption, e.g., the failure of the investee company’s qualified IPO or its failure to meet certain net profits achievements, the parties may agree in advance to a time period (3 months, as exampled by the SPC Reply) for the investor-shareholder to request for redemption.
(D) In the case that the parties did not specify such time limit for requesting a redemption, the Supreme People’s Court further indicated clearly in the SPC Reply that the reasonable time limit for an investor-shareholder to request for redemption should be no longer than 6 months; and then the statute of limitation[2] for a lawsuit on such redemption request should be calculated from the next day of such request.
Even though such judicial comments on such a specific issue in PE/VC transactions and related disputes could be understood to be for court trials only, these doctrines summarized above could also offer arbitrators certain significant reasoning basis while arbitrating similar cases.
As a more specific introduction:
(I) Nature of Redemption Right
There has been a very long time debate on the nature of a redemption right in a China PE/VC deal in both legal professions and academic communities.
Theory of Claim for Creditor's Rights: There is a view that the investor-shareholder's contractual right for requesting equity redemption is a claim in the nature of a regular creditor's right, and so the statute of limitation should apply. The arguments for this view are mainly that the equity redemption right is a right arising from contractual agreements (often seen in a shareholders’ agreement in China-based PE/VC investments). When an investor-shareholder requires certain other shareholders or actually controlling persons of the investee company to repurchase or redeem shares, in essence, it is requiring the redeeming party to fulfill the payment obligation stipulated in the contract.
Theory of Right of Formation: However, controversies exist. The other view is that such investor-shareholder's request for redemption or repurchase is a “right of formation”, a legal concept that originated and exists in the civil law system jurisdictions (especially Germany and German-speaking jurisdictions); therefore there should be a reasonable time period for exercising such right, while in statutes, such a reasonable period will often be specified to be much shorter than the regular statute of limitations in law for creditor’s rights as mentioned above.
Despite of such theoretical debates, the SPC Reply does not provide a crystal clear cut on such redemption right’s nature. Instead, the SPC Reply insists that “(such) investor has the discretion to elect to either request for redemption, or not to request for redemption but just keep holding the invested shares/equity. However, the SPC Reply does emphasize that if the investor-shareholder elects to request for redemption, such request must be brought up in a “reasonable time period.” The SPC Reply then specifies that such doctrines’ rationale is to protect the parties’ reasonable business expectations.
(II) Potential Impact on the China PE/VC Investment Market
In recent years, more and more investors elect to pursue for compensation by bringing up lawsuits or arbitrations on the basis of such redemption clauses or VAM agreements. While the SPC Reply clarifies Chinese judicial authorities’ understanding and preference when determining the justifiability of a redemption lawsuit, the parties in the China PE/VC market could be facing various challenges:
(i) Time is of essence: When the relevant redemption triggering event occurs, it will be challenging to an investor-shareholder as it may have to determine whether to request for redemption in a very short period of time, especially when there is no such agreed time limited under the original investment agreements.
(ii) Risks of the Right’s “Expiration”: If an investor-shareholder fails to request for redemption in such a reasonable period, from the perspective of Chinese laws, such failure could be viewed as a waiver of this contractual right and therefore resulting in the investor-shareholder losing the opportunities to sue for redemption in Chinese courts. This negative result may force more and more institutional investors to elect to request for redemptions considering their own fiduciary duty and obligations towards their upper-level investors (e.g., the limited partners in an investment fund, when the fund manager / general partner manages the holding and exit of such fund’s investee companies for the benefits of such limited partners).
(iii) Domino Effect on the Investee Companies: In practice, a redemption request from one investor-shareholder could lead to a series of chain reactions from the investee-company’s other investor-shareholders. Many investment agreements or shareholders’ agreements in China-based PE/VC transactions specify that one investor’s redemption request could simultaneously trigger and entitle the other investors’ rights for requesting redemptions. Such impact could be vital to start-up companies and their founders.
In summary, for such contractual redemption right in a "VAM" agreement in China-related PE/VC transactions, it is now challenging for both the start-up companies and founders (who are often the joint obligors of redemption obligation), as well as the investor-shareholders (who face the time pressures to consider how to maximize the protection of its invested funds).
Our informal English translation of this SPC Reply can be found below for ease of reference:
问题2：“对赌协议”中股权回购权性质及其行权期限如何认定？
Question 2: How to determine the nature of the equity redemption right and its exercise period in a VAM agreement?
答疑意见：“对赌协议”中经常约定股权回购条款，如约定目标公司在X年X月X日前未上市或年净利润未达到XX万元时，投资方有权要求股东或实际控制人按照X价格回购投资方持有的股权。审判实践中，对上述股权回购权性质和行权期限，存在较大争议。有观点认为投资方请求回购股权系债权请求权，适用诉讼时效制度。也有观点认为投资方请求回购股权系形成权，受合理期间限制。
Answer: VAM agreements often stipulate equity redemption clauses, e.g., stipulating that when the target company fails to be listed publicly or its annual net profit does not reach certain amount by a specific date, the investor has the right to require the company’s shareholder(s) or actual controller(s) to redeem/repurchase the equity held by such investor at a pre-agreed price. In trial practice, there are considerable controversies over the nature and exercise period of the above-mentioned equity redemption rights. There is a view that the investor's request to redeem the equity is a claim for creditor's rights, and the statute of limitations system should applie. There is also a view that the investor's request to repurchase the equity is a right of formation and its exercise should be subject to a reasonable period of time.
我们认为，该问题的实质是如何认识投资方请求大股东或实际控制人回购股权的权利性质。就股权估值调整协议中投资方有权请求大股东或实际控制人回购股权的约定，根据民法典第一百四十二条第一款确立的合同解释规则，对该约定除按照协议所使用的词句理解外，还要结合相关条款、行为的性质和目的、习惯以及诚信原则来理解。从双方约定的目的看，实际上是在符合（未上市或利润未达标）条件时投资方既可以请求对方回购进而自己“脱手”股权，也可以不请求对方回购而继续持有股权。因投资方行使此种权利有自主选择的空间，以合理期限加以限定，较为符合当事人的商业预期。
In our view, the essence of this issue is how to understand the nature of the investor's right to request the major shareholder or actual controller to repurchase/redeem the equity or shares. With regard to such provisions that the investor has the right to request the major shareholder or actual controller to repurchase/redeem the equity in an equity valuation adjustment agreement, according to the rules of contract interpretation established in the first paragraph of Article 142 of the Civil Code, the agreement should be interpreted in conjunction with the relevant contractual provisions, the nature and purpose of the act, the market norms, and the principle of good faith, in addition to the words and phrases used in the agreement. Judging from the purpose agreed by the two parties, in fact, when the conditions are met(i.e. the failure of IPO or unsatisfactory profits), the investor can either request the other party/ies to repurchase or redeem and then "get rid of" the equity previously invested by itself, or it can continue to hold the equity without requesting the other party/ies to repurchase/redeem it. Since the investor has the discretion for independent choice in exercising this right, it is more in line with the business expectations of the parties to limit it by adopting the limit of a reasonable period.
具体而言：1.如果当事人双方约定了投资方请求对方回购的期间，比如约定投资方可以在确定未上市之日起3个月内决定是否回购，从尊重当事人自由意志的角度考虑，应当对该约定予以认可。投资人超过该3个月期间请求对方回购的，可视为放弃回购的权利或选择了继续持有股权，人民法院对其回购请求不予支持。投资方在该3个月内请求对方回购的，应当从请求之次日计算诉讼时效。2.如果当事人双方没有约定投资方请求对方回购的期间，那么应在合理期间内行使权利，为稳定公司经营的商业预期，审判工作中对合理期间的认定以不超过6个月为宜。诉讼时效从6个月之内、提出请求之次日起算。
Specifically: 1. If the parties agree on the period during which the investor should request the other party redemption, for example, it is agreed that the investor can decide whether to go for redemption within 3 months from the date of determination that it is not publicly listed, the agreement should be respected from the perspective of respecting the free will of the parties. If the investor requests the other party to repurchase/redeem after such three-month period, it can be viewed as having waived the right of redemption or has chosen to continue to hold the equity, and the people's court should not support the redemption request. If the investor requests the other party to repurchase/redeem within such three months, the statute of limitations shall be calculated from the day after such redemption request is made. 2. If the parties have not agreed on the period during which the investor should request the other party to repurchase/redeem, then the right must be exercised within a reasonable period, and in order to stabilize the business expectations of the company's operation, it is appropriate to determine such a reasonable period to be no more than 6 months in court trials. The statute of limitations then begins from the day after the redemption request is made within such 6-month period.
咨询人：上海市高级人民法院商事审判庭（破产审判庭） 孟高飞
Querier: Meng Gaofei, Commercial Division (Bankruptcy Division) of Shanghai Higher People's Court
答疑专家：最高人民法院民一庭 杜军
Q&A expert: Du Jun, First Civil Division of the Supreme People's Court
[1] https://finance.sina.com.cn/jjxw/2024-08-29/doc-incmhmet9785356.shtml
[2] In principle, three years under Chinese law (Clause 188, the Civil Code of the People’s Republic of China)
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