Research On Legal Issues Of Gambling In Private Equity Investment

With the prosperity of private equity investment activities in our country, the application of valuation adjustment mechanism(VAM) becomes increasingly extensive. VAM is a share option, is an adjustment mechanism of equity price. There are four reasons for its generation: First, China’s preferred stock system is in long-term imperfect; second, asymmetric information from both sides of investors and financing party; third, desirability of dynamic regulation of the valuation; fourth, business incentive.The legal subject of VAM includes investors of private equity, shareholder or actual controller and the target enterprise. The object of VAM should not only be "material", but also be "payment behavior." The author summarizes as four types: cash compensation / reward, voluntary assignment of stock rights, redemption of stock rights and re-employment of management. The content of VAM is divided into basic terms, target terms, exercise provisions and other ancillary terms. Among them, the basic terms mainly include the subject of VAM, duration and method of business valuation; objective terms can be divided into two categories-- financial performance and non-financial performance. Financial performance targets generally refer to the profits or growth business achieves. Non-financial performance targets are varied and can be roughly divided into " goals wished to be achieved" "goals not wished to be achieved" and "neutral goals"; though exercise provisions have many kinds, after concluded they are evolutions from four objectives of VAM; other supporting terms are made to coordinate with investing activities and guarantee the normal performance of VAM, further reduce risks of investors. They cannot be regarded as VAM in the strict sense to get evaluation and adjustment because they do not have the two basic features of “appraisement adjustment” and “aleatory contract” in private equity investment.With regard to the legal nature of VAM, there are opinions of conditional contracts, guarantee contracts, stock options as well as aleatory contracts. After analysis, as VAM usually comes into effect at the establishment, it does not comply with the characteristics that contracts would only take effect or terminate when conditions attached occur; guarantee contracts guarantee the achievement of creditor’s right, but VAM guarantees the normal investment activities, so VAM is not guarantee contracts; stock options are the motivational tool between enterprises and employees, although both have incentives, the subject of stock options are different from that of VAM, so VAM is not stock option, either; the author believes that VAM is a kind of aleatory contracts, because it meets two features of aleatory contracts: aleatory and the relativity of principles of compensation of equal value. In addition, the two parties involved in VAM do not play zero-sum game, the investors sign this agreement to pursue double-win with the financers. Accordingly, VAM among aleatory contracts has many similarities with the strategy of "protective put option".The legal validity of VAM has always been an issue of concern to everyone. Starting from the legal effect of aleatory contracts, VAM is the anti-risk incentive aleatory contract, which should get legal protection. On legal issues arising from different subjects, the key the target company could become a subject of VAM is that whether private equity investors are shareholders in the company in the traditional sense, namely, whether the corporate law is applicable or not. The answer is yes. The target company in the case of an independent legal personality could not be regarded as subject to VAM. When the shareholders or the actual controllers of the target company are the subject of VAM, actually the two commercial subjects should be lawfully protected in signing commercial transaction agreements. On the legal validity of VAM performance compensation, equity redemption and other contents, it should not stick to conservative thinking like "capital flight", "borrowing in the name of joint venture", instead it should be based on the sentence of Supreme Court on "Haifu case" to affirm its effectiveness. In addition, the payment for performance compensation and stock redemption in VAM is actually a valuation adjustment, rather than having the nature of liquidated damages, nor borrowing. Therefore, cash payment in VAM should not follow relevant regulations about compensating liquidated damages in law or rate restrictions of inter-enterprise lending.Finally, according to various legal issues in VAM, it is suggested that when signing VAM, target enterprise alone should not be regarded as the subject of VAM if there’s no indication that juridical personality of the target company has lost the independence; inspired by the case of "Memec business" in Supreme Court, several terms can be converted to conditional terms, or adding conditional terms to avoid disputes of legal validity of VAM and to directly fulfill the agreed arrangements and protect the interests of both the investors and financers; when investing on enterprises which laws and regulations allow to issue preferred stock, they can give preference to buy preferred stock for investment and entirely avoid legal problems caused by VAM.