The valuation adjustment mechanism (VAM), also known as the gambling agreement in China, is a commonly used tool in investment circle. VAM is a set of contracts between investors and investees regulating their rights and obligations based on the uncertainty of the investees’ future performance. It is an option embodied in binding contracts, which can protect the investor’s interests. However, a recent judgement held that the contract carrying the option was void. This was the first time a Chinese court issued its opinion on the effectiveness of VAM and poses uncertainties to private equity investors.

Gansu Shiheng Nonferrous Resources Recycle is a wholly foreign-owned enterprise, fully owned by Hong Kong Diya. In 2007, Suzhou Industrial Park Haifu invested Rmb20 million ($3,142,377) into Shiheng and became the other shareholder of Shiheng, holding 3.85% of its equity interest. The VAM agreed upon by the parties is that if Shiheng’s net profit in 2008 does not reach Rmb30 million ($4,712,351), Shiheng shall indemnify Haifu an amount equalling to Rmb20 million x (1- 2008 net profit/Rmb30 million) and Diya shall undertake supplementary liability of indemnity if Shiheng fails to fully indemnify Haifu.

Shiheng realised a profit of Rmb26,800 ($4,220) in 2008 and was then sued together with Diya by Haifu, requesting an indemnity of Rmb19,980,000 ($3,138,453), as agreed in the investment contract. Both the First Instance Court and the Court of Appeal adjudicated that the VAM provided for in the investment contract was invalid, but on different grounds.

The First Instance Court held the VAM void on the grounds that the investment contract was in violation of Article 8 of the China Sino-foreign Equity Joint Venture Law. The Court held that by allowing the indemnity, the parties failed to distribute the net profit of Shiheng to its shareholders in proportion to their respective contributions to the registered capital. The Court also thought that the existence of the VAM jeopardised the interests of Shiheng and its creditors, violating Article 20 of the China Company Law. The contract was therefore deemed invalid due to its violation of laws and the VAM payable not allowed.

The Court of Appeal ruled the VAM invalid on different grounds. The Court did not even define the Rmb20 million invested into Shiheng as investment. Rather, pursuant to Article 4(2) of the Answers to Questions Regarding Trial of Cases about Economic Association Contract Cases  from the Supreme People’s Court, the Court of Appeal declared that most of the fund was a loan owed to Haifu because Haifu neither participated in Shiheng’s operation nor assumed any risks. According to the VAM, where the agreed profit target is not reached, Haifu may recall its principal and interest. For this consideration, the Court ruled that the contract violated relevant financial regulations, was invalid and Shiheng should be liable to pay back to Haifu Rmb18,850,000 ($2,968,096) with interest.

Despite both the First Instance Court and the Court of Appeal basing their ruling on different grounds, they both declare void the investment contract and make the VAM unenforceable. The First Instance Court’s reasoning on profit distribution is doubtful since the VAM is not set for profit distribution and Haifu has never claimed distribution of profit. The Court also failed to clarify how the agreed indemnity can be considered profit distribution. Their other finding regarding the Company Law is not appropriate in this case, as the Law only applies where the shareholders abuse their rights to harm the company, or jeopardise the creditors’ interests by abusing the company’s status as an independent legal person and the shareholder’s limited liabilities. Even if Shiheng suffers losses by indemnifying Haifu in accordance with the VAM, it is for the performance of the investment contract rather than the consequence of Haifu’s abuse of its shareholder’s right.

The ruling from the Appeal Court is also questionable. The legal basis for the ruling is the Supreme Court’s Answers. This is a judicial interpretation issued in 1990 regulating a specific type of business activity. The Answers are outdated and apparently not designed to regulate VAM. Even if the Answers are applicable to VAM, it is still problematic because of the contradictions.

Article 4(2) of the Answers stipulates that if an enterprise investing into an economic association neither participates in its operation nor assumes risks by way of recalling the principal and interest regardless of profit or loss, or gaining fixed profit as scheduled, the relation shall be deemed as a loan which violates relevant financial regulations and shall be held invalid. If the rulings were justified, the voided VAM should have always enabled Haifu to recall its principal and interest regardless of whether Shiheng made a profit, or gained fixed profit as scheduled.

However, this is not the case. It is true that Haifu is entitled to the indemnity when Shiheng’s profit in 2008 is less than Rmb30 million. According to the investment contract, which seems to enable Haifu to recall its principal and interests when Shiheng fails to achieve expected profits, but when Shiheng’s profit in 2008 exceeds Rmb30 million, Haifu is not entitled to the indemnity and cannot recall its principal and interest. Naturally Haifu cannot always recall its principal and interests, nor can it gain fixed profit as scheduled.

Although China is not a case law country, this decision will send a message to other courts and affect judge’s understanding of the VAM. Undoubtedly, this case will affect the outcome of future cases.