China’s Supreme Court Ruling in Haifu v. Shiheng Changes the Landscape for Value Adjustment Mechanisms in Onshore Private Equity Transactions

The Supreme People’s Court of China (the “Supreme Court”) rendered its final judgment on November 7, 2012, in the Haifu Investment Co., Ltd. v. Gansu Shiheng Nonferrous Resources Recycle Company Limited (“Haifu v. Shiheng”). Despite the Supreme Court’s lack of appreciation of the role of private equity in China, the decision brings much-needed guidance to the structuring of value adjustment mechanisms (“VAMs”) commonly used in onshore private equity (“PE”) transactions in China.


Since the adoption of the Provisions for Foreign Investors to Merge and Acquire Domestic Enterprises (????????????????) in August 2006, it has been increasingly difficult for foreign PE investors in China to make their investments through offshore holding companies. Accordingly, such foreign PE investors have increasingly invested directly in portfolio companies established onshore in the PRC.2 Due to the rigid corporate governance associated with PRC limited liability companies, PE investors have had to utilize creative techniques to replicate the downside protections that are customary in offshore PE transactions. One of the most fundamental of such protections are VAMs, which are designed to provide the PE investor with remedies in the event the actual valuation or financial performance of the Company diverges from the valuation and performance underlying the PE investor’s original valuation model. After years of speculation by industry as to the enforceability of VAMs in PRC companies, as well as inconsistent findings in the lower courts, the Supreme Court in Haifu v. Shiheng has delivered PE investors much-needed guidance on the types of VAM structures that may be enforceable in onshore PE investments. In doing so, the Supreme Court has also helped bring closure to the long-running court saga of Haifu v. Shiheng by overruling the decision of the court of appeals (which characterized a portion of such PE investments as loans for which the investor was entitled to the equivalent of the return of its principal and accrued time deposit interest) and partially overruling the decision of the court of first instance (which found VAMs categorically unenforceable against a portfolio company as well as its controlling shareholder).

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