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.
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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
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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:
