Viewpoint... The dispute over the validity of the gambling agreement and the dilemma of performance.

"Gambling agreement", also known as valuation adjustment mechanism (Valuation Adjustment Mechanism) or "valuation adjustment agreement", is a type of contract mainly used in the field of venture capital. The performance is that the investor becomes the shareholder of the target company through investment, obtains the equity, and at the same time makes an agreement on the future operating performance of the target company and the listing of the company. When the agreed goal fails to be achieved or realized, the target company or its shareholders shall make equity compensation, cash compensation or buy back the shareholders' equity according to the agreed terms according to the agreed proportion or amount.

The value of the gambling agreement is reflected in its reasonable allocation and fair arrangement of investment interests and investment risks. On the one hand, in investment activities, information asymmetry is widespread and doubled, and the use of gambling agreements can relatively adjust and balance the asymmetry of investment information between the financing parties and reduce investment risk. On the other hand, investors often do not participate in the management of the company, the interests of enterprise managers and investors are not always the same, in order to prevent the target company from harming the rights and interests of investors for their own interests, the introduction of gambling agreements can effectively motivate and restrain the management of the enterprise, to achieve a win-win situation between investors and enterprise management.

In practice, the parties often defend the nature of the gambling agreement, arguing that the legal relationship involved is not an investment relationship but a real debt, and thus arguing that the relevant repurchase clause is invalid. Although there are many similarities between the two, they are actually two different investment methods, and there is a view in academia that the gambling agreement is a third investment method between equity investment and bond investment, which has both characteristics and is different from the above two investment methods.

From the appearance of the transaction, the gambling agreement and the real debt of the name shares are in the form of equity transactions. Common bargaining chips for gambling agreements include cash compensation, equity compensation, share buybacks, drag-out rights, and preferential liquidation rights, with cash compensation and share buybacks being the most common. The real debt of the stock is often due to the maturity of the exit and fixed income commitment as the core elements. Since both transactions are in the form of equity transactions, with both margin-making and repurchase provisions, it is highly confusing.

First of all, the two investment purposes are different. The main purpose of the investors of the gambling agreement is to obtain the equity appreciation of the target company. The signing of the gambling agreement is only to protect the rights and interests of the investors and attract the funds of the investors. The investors of nominal shares and real bonds are to obtain fixed income after a certain period of time, and their income will not increase or decrease due to different operating conditions of the target company.

Second, the two trigger buybacks for different reasons. When the conditions agreed in the gambling agreement are reached, the repurchase obligation of the repurchase obligor will be triggered. This condition can be either a target such as listing, financial indicators such as profit and revenue, or non-financial indicators such as market share and user volume. The triggering of repurchase of famous shares and real debts has nothing to do with the company's operation, but only with the time agreed in the contract.

In most cases, the determination of an investment as a debt investment does not affect the validity of the contract, but there are exceptions, such as when the investor constitutes an illegal transfer or professional lending, the investment contract will be considered invalid. However, even if the contract is not invalid because it is found to be a debt investment, its specific content may be affected, for example, the court may adjust its agreed interest rate and liquidated damages.

Depending on the subject involved in the bet, the bet agreement can be divided into two broad categories: investor-shareholder bet and investor-company bet. In practice, there is no dispute about the validity of the gambling agreement signed between the investor and the shareholder. If there is no other invalid reason, it is determined to be valid and supports the actual performance; the common disputes about the validity of the gambling agreement mainly focus on the validity of the gambling between the investor and the company, The judgment rules related to this have undergone a series of changes from the "Haifu case" known as the "first case of gambling" to the introduction of the nine people's minutes.

Basic case:

In 2007, Haifu Company and Dia Company signed a joint venture contract; Suzhou Haifu Company, as an investor, signed a Capital Increase Agreement with Gansu Shiheng Company, Dia Company and natural person Lu Bo (Lu Bo is the legal representative of Shiheng Company and Dia Company). According to the above two agreements, Haifu Company invested 20 million RMB to acquire 3.85 per cent of the shares of Shiheng Company, and the other 96.15 per cent of the shares were held by Dia Company.Performance target agreement: Shiheng Company's net profit in 2008 was not less than 30 million yuan. If the actual net profit of Shiheng Company in 2008 fails to reach 30 million yuan, Haifu Company has the right to demand compensation from Shiheng Company. If Shiheng Company fails to fulfill its compensation obligation, Haifu Company has the right to demand Dia Company to fulfill its compensation obligation.Share repurchase agreement:If the listing cannot be completed due to the reasons of Shiheng Company by October 20, 2010, Haifu Company has the right to require Dia Company to buy back all the shares of Shiheng Company held by Haifu Company at that time at any time. Dia Company shall pay Haifu Company the full price in one lump sum according to the agreed repurchase amount within 180 days from the date of receiving the written notice from Haifu Company.

In December 2009, because Shiheng Company's actual net profit in 2008 was only 26858.13 yuan, which was far lower than the agreement of 30 million yuan in gambling, Haifu Company filed a lawsuit with Lanzhou Intermediate People's Court.

Summary of the trial:

In 2012, the Supreme Court made a retrial judgment, holding that the target company's commitment to performance compensation to investors is invalid in violation of the mandatory provisions of laws and administrative regulations, while the corresponding commitments made by the shareholders of the target company are legal and effective. The reasons are as follows:

(1) Shiheng Company, Haifu Company, Dia Company and Lu Bo agreed in the Capital Increase Agreement that if the actual net profit of Shiheng Company is less than 30 million yuan, Haifu Company has the right to obtain compensation from Shiheng Company and agreed on the calculation formula. This agreement allows Haifu's investment to obtain a relatively fixed income, which is divorced from Shiheng's operating performance and harms the interests of the company and the interests of the company's creditors. The Supreme Court held that it was correct for the court of first instance and the court of second instance to determine that this part of the "Capital Increase Agreement" was invalid in accordance with Article 20 of the the People's Republic of China Company Law and Article 8 of the the People's Republic of China Law on Chinese-Foreign Joint Ventures. The court of second instance held that the name of Haifu Company was investment and there was no legal basis for borrowing.

(2) In the Capital Increase Agreement, Dia's compensation commitment to Haifu does not harm the interests of the company and its creditors, does not violate the prohibitive provisions of laws and regulations, is the true intention of the parties, and is effective. In the event that Shiheng's profit in 2008 does not reach the agreed target, Dia shall compensate Haifu at the request of Haifu in accordance with the agreement.

Basic case:

On April 26, 2011, Hanlin Company (Party A), Qiang Jingyan and other legal and natural persons (Party B) and Cao Wu Bo (Party C) jointly signed the Capital Increase Agreement and Supplementary Agreement on the capital increase and gambling of Qiang Jingyan and others to Hanlin Company. Among them, it was agreed that Qiang Jingyan would increase its capital to Hanlin Company by 30 million yuan, of which 4 million yuan would be the registered capital, 26 million yuan would be listed as the company's capital accumulation fund, and Qiang Jingyan would hold 0.86 percent of the equity of Hanlin Company.Share Repurchase AgreementThe Supplementary Agreement stipulates that if the target company, namely Hanlin Company, fails to complete the qualified IPO before June 30, 2013, Qiang Jingyan has the right to require Cao Wu Bo to buy back the shares of the target company held by Qiang Jingyan in cash. The agreement also provides for Hanlin to provide joint and several guarantee liability for Cao's repurchase.

On May 31, 2012, Qiang Jingyan and Cao Fubo signed the Equity Transfer Agreement, but Cao Fubo has not fulfilled his payment obligation. After notifying Cao Wu Bo and Han Lin Company in writing on April 2, 2014 that they failed, Qiang Jing Yan filed a lawsuit with the court on May 14, 2014.

Summary of the trial:

The courts of first and second instance both recognized the legality and validity of the agreement on the terms and prices of the share repurchase in the Supplementary Agreement, but both held that the agreement on the joint and several guarantee liability of Hanlin Company for the repurchase was invalid.The court of first instance held: First, Qiang Jingyan shall submit relevant evidence that the guarantee provided by Hanlin Company for shareholder Cao Yubo has been adopted by resolution of the shareholders' meeting; secondly, the agreement harms the interests of the Company, other shareholders of the Company and creditors of the Company and shall be deemed invalid.The court of second instance held: Hanlin Company provided guarantee for the equity transfer payment of Cao Wu Bo's repurchase of Qiang Jing Yan's equity, which enabled the shareholder Qiang Jing Yan to avoid the transaction risk and transferred the possible risks of poor management and poor performance of Hanlin Company to Hanlin Company and its creditors, which seriously damaged the legitimate interests of other shareholders and creditors of Hanlin Company and should be deemed invalid.The Supreme Court retrial held: The agreement of Hanlin Company to provide joint and several guarantee liability for repurchase is valid. Qiang Jingyan has provided guarantee to Hanlin Company. After the resolution of the shareholders' meeting, the guarantee provided by Hanlin Company is conducive to its own business development needs and does not harm the rights and interests of the Company and its small and medium shareholders.

Basic case:

On July 6, 2011, Huagong Company and Yangforging Group Company, Pan Mou, Dong Mou and others jointly signed the "Capital Increase and Share Expansion Agreement" and the "Supplementary Agreement", agreeing that Huagong Company will increase the capital of Yangforging Group Company in cash of 22 million yuan, of which 2 million yuan is the registered capital and 20 million yuan is listed as the company's capital accumulation fund.Share Repurchase Agreement: If Yangforging Group Company fails to be listed on the domestic capital market before December 31, 2014 or the main business, actual controller and board members of Yangforging Group Company undergo major changes, Huagong Company has the right to request Yangforging Group Company to buy back all its shares. At the same time, it was agreed that any loss incurred by Huagong Company due to the breach of contract of Yangforging Group Company, Pan, Dong, etc., and Yangforging Group Company shall be jointly and severally liable.

Summary of the trial:

The courts of first and second instance both found the share repurchase agreement invalid on the grounds that "the share repurchase agreement violates the principle of capital maintenance of the company and independent property of the legal person", which is also in line with the ruling rule that "gambling with the target company is invalid and gambling with shareholders is valid" established since the Haifu case.

However, the Jiangsu High Court did not follow this ruling rule in the retrial, but affirmed the agreement between investors and the company to repurchase shares for the following reasons: First, my country's "Company Law" does not prohibit limited liability companies from repurchasing the company's shares., The repurchase of the company's shares by a limited liability company does not of course violate the mandatory provisions of my country's "Company Law. The repurchase of the Company's shares by a limited liability company after fulfilling the statutory procedures will not be detrimental to the interests of the Company's shareholders and creditors, nor will it constitute a violation of the Company's capital maintenance principle. Second, the agreement on the investment income of Huagong Company does not violate the prohibitive provisions of national laws and administrative regulations, and there is no invalidity of the contract as stipulated in Article 52 of the the People's Republic of China Contract Law, nor does it belong to the standard contract or standard clause stipulated in the contract law, and there is no question of obvious unfairness. Third, as long as the capital reduction procedure is fulfilled in accordance with the legal procedures, the gambling agreement involved in the case, whether it is for the capital injection part included in the registered capital or the capital injection part of the capital provident fund, has the legal possibility of performance. In addition, referring to the proportion of equity held by Huagong Company in Yangforging Company and the dividends paid by Yangforging Company over the years, the payment of share repurchase funds agreed in the gambling agreement involved in the case will not lead to impairment of Yangforging Company's assets, nor will it damage Yangforging Company's solvency to other debtors, and will not constitute an obstacle to the realization of creditor's rights to other creditors due to the performance of this obligation. That is, the gambling agreement in question is legally and de facto enforceable. Fourth, the invalidity of the gambling agreement involved in the case not only harms the legitimate rights and interests of Huagong Company as a creditor, but also infringes the interests of the shareholders of Huagong Company and the creditors of the company, which violates the principle of good faith and fairness in commercial activities.

Therefore, the agreement between Huagong Company and Yangforging Company and its shareholders to repurchase shares does not violate the prohibitive provisions of laws and administrative regulations, and there is no invalidity of the contract as stipulated in Article 52 of the Contract Law, nor does it belong to the provisions of the Contract Law. There is no obvious unfairness in the format contract or the format clause, and it should be recognized as valid.

On November 8, 2019, the Supreme Court issued the "Minutes of the National Court's Civil and Commercial Trial Work Conference" (hereinafter referred to as the "Nine People's Minutes"). The Nine People's Minutes clearly stated the validity of the gambling agreement and the performance of the judgment: "For the investor If there is no other invalid cause for the 'gambling agreement' concluded with the shareholders or actual controllers of the target company, it is deemed valid and supports the actual performance". As for the "gambling agreement" concluded with the target company, the Jiumin minutes further stipulates its validity determination and performance. Article 5 of the Jiumin minutes stipulates: "If the" gambling agreement "concluded between the investor and the target company does not have any legal invalid reasons, the target company only claims that the" gambling agreement "is invalid on the grounds of equity repurchase or monetary compensation agreement, the people's court will not support it, however, if the investor advocates actual performance, the people's court shall examine whether it complies with the mandatory provisions of the Company Law on 'shareholders may not withdraw their contributions' and share repurchase, and whether the judgment supports its claim."

The introduction of the Jiumin minutes affirmed the validity of the gambling agreement with the target company, but this did not completely solve the problems in the application of the gambling agreement, and the "inability to perform" became a new problem faced by the gambling agreement after the validity dispute.

Share repurchase is the most common form of gambling with the target company, which is manifested in the agreement between the investor and the target company that if the target company fails to meet or achieve the agreed target, it is necessary to fulfill the agreement to buy back the shares held by the investor. According to the relevant provisions of the Companies Act, the target company must go through a capital reduction process to fulfill its repurchase obligations under the gambling agreement, but this process is likely to be unsuccessful.

After triggering the repurchase condition, the investor needs to ask the target company to hold a shareholders' meeting and make a capital reduction decision. On the one hand, the target company may not cooperate with the convening of the shareholders' meeting; on the other hand, according to the provisions of Article 43 and Article 103 of the Company Law, the capital reduction resolution should be passed by shareholders with more than 2/3 of the voting rights. Once the major shareholders do not agree to the capital reduction, it is difficult for investors to realize the repurchase application. The general meeting of shareholders is not actionable, and in the event of a dispute, it is difficult for investors to obtain a capital reduction resolution, nor can they induce the target company to pass a capital reduction resolution through litigation. However, the capital reduction procedure is also a necessary procedure for the target company to repurchase its shares, and Article 142 of the Company Law stipulates that "the company shall not acquire the shares of the company", and the capital reduction procedure is one of the statutory exceptions. Repurchases without capital reduction procedures may involve the withdrawal of capital contributions by shareholders and would also violate the capital maintenance principle. After the introduction of the Jiumin minutes, some investors tried to ask the target company to buy back its shares through litigation without capital reduction procedures, but all of them were rejected by the court.

In addition, Article 177 of the Company Law stipulates: "After the company has made a resolution to reduce its capital, it shall notify the creditors and make a public announcement, and the creditors shall have the right to require the company to pay off its debts or provide security." However, there is no clear stipulation as to whether the capital reduction procedure for the completion of the share repurchase needs to be premised on the completion of the above-mentioned creditor protection procedure. Part of the view is that Article 12 of the (III) of Interpretation of the Company Law has clearly stipulated that the shareholders who withdraw their capital contributions shall bear supplementary liability to the creditors within the scope of the principal and interest of the capital contribution, that is, the creditors have a clear path of relief. And share buybacks do not necessarily harm the interests of creditors, especially when the target company is in good business condition and has a strong solvency. Opponents argue that the completion of the creditor protection procedure is the necessary procedure for the target company to complete the share repurchase, considering that the nine people's minutes take the protection of creditors' interests as the priority value consideration. The Understanding and Application of the Minutes of the National Court's Civil and Commercial Trial Work Conference also clearly mentions that "the reason why the target company is required to perform the capital reduction procedure is essentially to correctly handle the relationship between the company's shareholders and the company's creditors ...... In the case of conflict between the two, it is generally believed that the interests of the company's creditors should be protected first, not the interests of the shareholders."

Both the capital reduction procedure and the creditor protection procedure hinder the realization of the share repurchase agreement between the investor and the target company.

Cash compensation is also a common form of gambling between investors and target companies, and although cash compensation is not subject to the company's prohibition on share buybacks, its realization is also hampered. The Ninth Minute limits the scope of property subject to compensation obligations and provides that payments can only be made from distributable profits. Therefore, when the investor requires the target company to pay cash compensation, it needs to prove that the target company has decided to distribute profits or has distributable profits in accordance with the provisions of the Companies Act. However, it is not easy for investors to meet the above evidentiary requirements.

On the one hand, as a target company, just as the target company is required to hold a shareholders' meeting to pass a capital reduction resolution, the target company is very likely to not cooperate with the shareholders' meeting to make a distribution resolution; on the other hand, investors who sign a gambling agreement with the target company often do not participate in the actual operation and management of the target company, so investors are required to prove that the target company has decided to distribute profits or has distributable profits in accordance with the provisions of the Company Law, in fact, it is an excessive burden of proof for investors.

In order to achieve the purpose of the gambling agreement to safeguard the interests of investors, a series of obstacles that may be faced in the subsequent performance should be considered at the time of the signing of the gambling agreement.

First of all, investors should carefully choose the subject of the gambling agreement. Although the promulgation of the "Nine Minute" makes it clear that "the 'gambling agreement' concluded between the investor and the shareholders or actual controllers of the target company shall be deemed valid and support the actual implementation if there are no other invalid reasons", when the investor advocates share repurchase or performance compensation, it is restricted by the principle of capital maintenance of the company. If the company refuses to cooperate with the shareholders' meeting and make a capital reduction decision or a distribution resolution, the investor's share repurchase or performance compensation requirements may not be met. And because the shareholders' meeting is not justiciable, it is difficult for investors to seek legal means to protect their rights and interests.

Secondly, a reasonable agreement on the share repurchase price, the amount of performance compensation and the liquidated damages. If the amount is too high, it will be adjusted when the lawsuit goes to court. According to relevant cases, once the court adjusts it, the amount will often be much lower than the upper limit that can be agreed. Therefore, at the beginning of the signing of the gambling agreement, a reasonable agreement within the scope of the law can try to avoid the agreed amount from being adjusted by the court. However, this upper limit is not clear at present, there have been cases, some courts to 24% as the upper limit, some courts to 4 times the LPR as the upper limit, there are individual courts that 1.5 times the LPR agreement has been too high, but on the whole, to not more than 4 times the LPR for the agreement is more safe.