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Value adjustment mechanism (VAM) agreements are extensively used in private equity and venture capital (PE/VC) transactions, as well as in mergers and acquisitions (M&A) of listed companies. Although there is a relatively consistent standard for assessing the validity of VAM agreements in dispute resolution, the legal nature and exercise period of share repurchase rights under these agreements continue to be contentious issues.
Some scholars argue that share repurchase rights result from the autonomy of the parties involved and should be considered as creditors’ rights, thus subject to the statute of limitations. Others believe that they can be exercised unilaterally by one party and should be classified as rights of formation, subject to a cut-off period. The author leans towards the latter view.
The share repurchase rights in a VAM agreement is legally classified as a right of formation. This is because a right of formation allows the holder to unilaterally alter an existing civil legal relationship. In a VAM agreement, share repurchase clauses typically allow investors to demand that the financing party repurchase all or part of the equity held by the investor, or provide compensation, if the financing party fails to meet agreed targets. Essentially, these clauses grant investors the right to unilaterally establish an equity transfer relationship under specific conditions.
When the underlying conditions are met and the right is still valid, a timely and lawful repurchase notice from the rights holder creates an equity transfer contract at the pre-agreed price, leaving the repurchase obligor without the option to refuse. Therefore, the above-mentioned repurchase right is a right of formation agreed on by the parties involved.
Rights of formation are subject to cut-off periods, not statutes of limitation. A right of formation allows the holder to unilaterally create, alter or extinguish a civil legal relationship. In contrast, a statute of limitations refers to the legal system where a rights holder loses the ability to request court protection of their civil rights if they do not exercise their rights within a prescribed period. Therefore, rights of formation are governed by cut-off periods, not statutes of limitation.
According to article 199 of the Civil Code: “Unless otherwise provided by law, the duration of rights such as the right of rescission or termination, as stipulated by law or agreed upon by the parties, shall be calculated from the date the rights holder knows or should have known the right has arisen. These rights are not subject to the provisions on the suspension, interruption or extension of the statute of limitations. Upon the expiration of the duration, rights such as the right of rescission or termination shall be extinguished.”
In the civil judgment of CTSHK RV Leisure Tourism Development v Hao Gang (2021) of the Beijing High People’s Court, it was held that “the right of share repurchase is a right of formation, and its exercise should be constrained by a cut-off period. It must be exercised within a reasonable time and in a reasonable manner, not arbitrarily or at any time.”
Similarly, in the civil judgment of Lyu Huaming v Cai Bing (2020) of the Shanghai High People’s Court, it was stated that “the repurchase right, like the right of rescission and termination, is a right of formation. Once the exercise period expires, the right is extinguished and is not subject to the statute of limitations.”
In the Selected Q&A (series 9) session released by the Supreme People’s Court on 29 August 2024, the court addressed the nature of share repurchase rights in VAM agreements and the determination of their exercise periods.
The response stated: “If the parties have agreed on a period within which the investor can request a repurchase, such as within three months from the date it is confirmed that the company will not go public, this agreement should be respected to honour the parties’ autonomy.
“If the investor requests a repurchase after this three-month period, it can be deemed as a waiver of the repurchase right or a choice to continue holding the equity, and the court will not support the repurchase request. If the investor requests a repurchase within this three-month period, the statute of limitations should be calculated from the day following the request.
“If the parties have not agreed on a period for the investor to request a repurchase, the right should be exercised within a reasonable period. To ensure business stability, a reasonable period should generally be considered as not exceeding six months during judicial proceedings.”
The response contains two key points: First, the share repurchase right is subject to a cut-off period. If an agreement specifies this period, it should be respected. If not, the period should not exceed six months.
If the rights holder does not exercise the repurchase right within the agreed period or the six-month period (if not agreed), the right is extinguished, and it is deemed that the holder has waived the repurchase right and continues to hold the company’s equity. This indicates that the Supreme People’s Court supports the view that the share repurchase right in investment agreements is a right of formation subject to a cut-off period.
Second, if the rights holder exercises the repurchase right within the cut-off period, the share repurchase right, as a right of formation, transforms into a creditor’s right on the holder’s choice to exercise it. The statute of limitations for this creditor’s right starts from the day following the repurchase request and is subject to the general provisions of the statute of limitations.
It is crucial for the rights holder to issue the repurchase notice in a timely, legal and effective manner to achieve the legal effect of exercising the right. First, the notice must be issued within the agreed period or within six months to be considered timely.
Second, the method of issuing the notice must be legal and effective. For instance, the repurchase notice should be sent directly to the repurchase obligor at the address specified in the investment agreement. If the notice is only sent to an employee of the target company, and there is no proof that the employee forwarded it to the repurchase obligor, the legal effect of exercising the right is not achieved.
Rui Gang
Partner
Kangda Law Firm
Tel: +86 186 1208 3296
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