Debate on the validity of gambling agreement: how to protect the interests of PE investors

-A lawsuit in the Supreme Court of China has attracted a lot of attention. /Zheng Dui Gambling Agreement of Beijing Tiantong Law Firm, also known as valuation adjustment mechanism, refers to the agreement reached by both investment and financing parties on future uncertainty. Gambling agreement can not only encourage financiers to achieve profit targets, but also reduce the risk of information asymmetry of investors, so it is widely used in PE investment. Only when the investment and financing parties have the same expectations for the future earnings of the enterprise will a gambling agreement be reached. However, market risks are difficult to predict, and disputes are inevitable if the original expectations cannot be realized. Once a lawsuit is involved, the issue of the effectiveness of the gambling agreement is often the first to bear the brunt and become the focus of the lawsuit. Lawyer Peng Qing, a partner of Beijing Tiantong Law Firm, pointed out that with the intensification of world economic fluctuations and the slowdown of China's economic growth, PE investment disputes are bound to increase, most of which will involve the validity of gambling agreements. At present, many gambling agreements are directly transplanted from abroad. Under China's relatively strict financial system, the validity of these imported clauses is controversial. Recently, as a professional law firm specializing in the settlement of high-end civil and commercial disputes in China, Tiantong paid attention to a typical case being tried by the Supreme Court of China, which involved the validity of the gambling agreement. In this case, the investor signed a capital increase agreement with the financier and its original shareholders, stipulating that the investor would subscribe for the increased registered capital of the financier at a premium equivalent to 20 times of the capital increase. The agreement stipulates the profit target of the financier. If the target is not achieved, the investor has the right to demand compensation from the financier. If the financier fails to fulfill the obligation of compensation, the investor has the right to demand compensation from the original shareholders. Because the profit of the financier is far from the expected, the investor sued the court and demanded compensation from the financier and its original shareholders. In view of the effectiveness of the compensation clause, there is a heated debate between the litigants: the investor advocates compensation according to the contract, while the financier thinks that the compensation clause belongs to the guarantee clause and is invalid because it harms the interests of the company and creditors. If the court of first instance finds that the compensation clause has harmed the interests of the company and creditors, it shall be deemed invalid, and the investor has no right to claim compensation. The court of second instance found that the compensation clause violated the principle that * * * bears the investment risk, and it belongs to the loan in the name of investment, which should be deemed invalid, and the funds invested by investors at a premium should be returned. The judgments of the two courts are quite different, but both think that the compensation clause is invalid because it violates the principle of taking risks at your own risk. The financier refused to accept the judgment of the second instance and applied to the Supreme Court for retrial. As of press time, the case is still under trial in the Supreme Court. Violation risk * * *? Or is the interest gambling? In PE investment, the common gambling agreement stipulates that the financier exercises his rights when the performance reaches the standard, and the investor exercises his rights when the performance fails to meet the standard. However, the compensation clause in this case only stipulates that the investor shall exercise his rights when the performance is not up to standard, but does not stipulate that the financier shall exercise his rights when the performance is up to standard, which seems to be protecting the unilateral interests of the investor and violating fairness. Therefore, the court of second instance found that the compensation clause was invalid because it violated the principle of self-risk. Zheng of Beijing Tiantong Law Firm believes that the view of the court of first instance is debatable. The compensation clause involved in this case is still a manifestation of the gambling agreement. This clause does not stipulate the exercise right of the financier, because the investor has invested at a premium of up to 20 times, which is equivalent to the financier having exercised his rights in advance. If the performance of the financing party reaches the standard, the high premium investment of the investor will only get a very small part of the equity, and most of the premium will be transferred to the financing party. If the performance of the financier is not up to standard, the compensation is equivalent to re-approving the investment amount of the investor and does not increase the risk of the financier. The compensation clause does not protect the unilateral interests of investors, on the contrary, it has already satisfied the interests of financiers in advance, so it is difficult to find that it violates the principle of risk taking. Zheng pointed out that whether the compensation clause involved in this case is effective is not whether it violates the principle of taking risks at your own risk, but whether the gambling between shareholders and the company infringes on the interests of the company and creditors. The compensation clause is not a bet between shareholders, but an agreement on the dual responsibilities of the company and shareholders. This agreement fails to take into account the provisions of the China Company Law, and there are major defects. The compensation clause is suspected that the company returns its capital contribution to shareholders and infringes on the interests of the company and creditors, which is likely to be deemed invalid. Gambling between similar companies and shareholders is common overseas, but if it is directly applied in China, it is likely to be considered invalid. For example, Sequoia Capital invested in He Fei Dairy, and both parties agreed that if the performance was not up to standard, He Fei Dairy would buy back the equity from Sequoia Capital at a premium. It may not be barrier-free for the agreement to be applied to American law, but if similar agreements are directly transplanted to China, the effectiveness of the agreement will face a series of risks, such as the equity repurchase will harm the interests of creditors, and the investment is actually inter-enterprise lending. Whether the gambling agreement is valid or not needs legal clarity, and there is no written law in China. Some people think that the CSRC's "zero tolerance" for the proposed listed company's gambling agreement seems to indicate that the gambling agreement is not recognized in China. Lawyer Peng Qing of Beijing Tiantong Law Firm believes that the CSRC has no uniform provisions on gambling agreements. For example, the gambling agreement of Robot (SZ300024) only involves investors' incentives to the management, and has not caused the instability of equity, that is, the meeting has been successfully held. Moreover, the CSRC has not denied the effectiveness of the gambling agreement that may cause equity instability by requiring prior cleaning and detailed disclosure. On the contrary, the premise of cleaning up should be to admit that the gambling agreement is effective. Therefore, it is difficult for the attitude of the CSRC to be used as a basis for denying the effectiveness of the gambling agreement. How to determine the effectiveness of the gambling agreement can only be gradually clarified through the authoritative judicial institutions in individual cases. Tiantong will continue to pay attention to the judicial attitude of the Supreme Court in this case. 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