2014Cambridge Conference Business & EconomicsISBN : 9780974211428

Betting on China with Legal Uncertainty: An Investment Case Study
Zhaodong Jiang
Faculty of Business Administration,
The Chinese University of Hong Kong,
Shatin, NT, Hong Kong SAR
Email:
Phone: (852) 3943 7751
2/25/2014

I would like to thank my wife Yan for her untiring supportsduring my research as well as invaluable comments on my early draft.

Abstract: Certainty or predictability is essential to business and investment decisions. China’s past economic accomplishments have been largely due to the ability of businesses to secure their deals through informal channels in the absence of official intervention. As the country’s next phase of development requires sophistication such as private equity financing, however, legal uncertainty should pose significant hurdles to its achievement of the same success as in the past. By studying a recent Chinese court case on the validity of the valuation adjustment mechanism in a private equity deal, this paper discusses issues and questions raised by the judicial rulings that showed little respect for privately negotiated bargains, which point to a lack of predictability in adjudication of commercial disputes. It looks into various institutional and cultural factors and examines how they contributed to the courts’ decisions. Those factors include Chinese courts’ broad powers to invalidate contracts; non-statutory considerations behind their rulings; absence of rules and practices by which one may ascertain the validity or applicability of a norm; liberty with which judges may decide a dispute on any ground they see fit; and lack of reasoned decisions. Against this background, Chinese judges have been motivated more by career and policy considerations than by reputational concerns. Two policy considerations that animated the courts’ decisions in particular were protection of banks/creditors and local/national protectionism. The paper concludes by summarizing some of the steps the country should take in improving judicial predictability as well as difficulties it encounters to achieve the goal.

Betting On China with Legal Uncertainty: The Study of an Investment Case

ABSTRACT

Certainty or predictability is essential to business and investment decisions. China’s past economic accomplishments have been largely due to the ability of businesses to secure their deals through informal channels in the absence of official intervention. As the country’s next phase of development requires sophistication such as private equity financing, however, legal uncertainty should pose significant hurdles to its achievement of the same success as in the past.

By studying a recent Chinese court case on the validity of the valuation adjustment mechanism in a private equity deal, this paper discusses issues and questions raised by the judicial rulings that showed little respect for privately negotiated bargains, which point to a lack of predictability in adjudication of commercial disputes. It looks into various institutional and cultural factors and examines how they contributed to the courts’ decisions. Those factors include Chinese courts’ broad powers to invalidate contracts; non-statutory considerations behind their rulings; absence of rules and practices by which one may ascertain the validity or applicability of a norm; liberty with which judges may decide a dispute on any ground they see fit; and lack of reasoned decisions. Against this background, Chinese judges have been motivated more by career and policy considerations than by reputational concerns. Two policy considerations that animated the courts’ decisions in particular were protection of banks/creditors and local/national protectionism.

The paper concludes by summarizing some of the steps the country should take in improving judicial predictability as well as difficulties it encounters to achieve the goal.

  1. INTRODUCTION

“Betting on China” has been a familiar leitmotiv since Adams Smith (Koepp 2012, 42-43). Many agree that an economic bet has been winning since the Country’s launch of modernization reform in late 1970s. But what has been less noticed is how risky a bet on China’s legal system could be. Recent cases which reveal the execution of businessmen for having engaged in shadow banking operations testify to “law-enforcement departments that infringe upon law, property and life” of ordinary people with impunity (Schuman 2014). Cruel punishments for so-called economic crimes, while very frightening, are not common and may not be the biggest risk for investors, domestic or foreign. Legal uncertainty or lack of judicial predictability, however, could be.

This paper looks into this risk through the analysis of the courts’ decisions on the validity of the valuation adjustment mechanism (“VAM”) in the case of Haifu Investment limited Company of Suzhou Industrial Zone v. Shiheng Non-Ferrous Resources Recycling Limited Company of Gansu (“Haifu”). The VAM is an agreement between a private equity (“PE”) investor and the investment-recipient enterprise to address problems of information asymmetry and incentives. It has been adopted in numerous PE deals across China. While its validity has not been questioned outside China, all the three courts involved in Haifu defied the principle of freedom of contract and ruled against the validity of the VAM, wholly or partly. More disturbing are the various grounds the courts relied upon to support their ruling as well as the ways those grounds were invoked and explained by the courts. The case illustrates that adjudication of routine commercial disputes in China can be fraught of uncertainty and unpredictability. An analysis of the case further reveals several statutory, institutional, and cultural factors that contribute to such risk for domestic and foreign businesses and investors. It also illuminates the arduous task of those who try to create new policy and institutional environments aiming at spurring more sustainable economic growth in the country. Absent an improvement in law in general and legal certainty in particular, the economic bet on China would go sour as the existing growth model and its underlying institutional infrastructures may not be able to support the country for moving to the next phase of development.

The discussions are organized as follows. Section B introduces the VAM and the case of Haifu, followed by discussions on legal certainty and freedom of contract, two notions central to business deals and expectations in market economies. Section D examines the development of China’s contract law and examines Haifu in light of the statutory backgrounds. More institutional and cultural explanations for the lack of judicial predictability are presented in Section E. The paper concludes in Section F by summarizing difficulties and challenges China’s reformers are facing in modernizing the country’s law and judicial process.

  1. THE VAM IN CHINA AND THE CASE OF HAIFU

When funding an enterprise, the PEinvestor suffers disadvantages vis-a-vis the entrepreneur, who is in control of information and management of the enterprise. The PE’s business valuation of the enterprise may turn out to be incorrect if the entrepreneur has been less than truthful in supplying information or too optimistic in his projection. The investor also faces the risk of expropriation by the entrepreneur. The VAM provides a contractual protection for the PE. It sets a financial, business or performance target - such as net profit, profit growth rate, turnover volume, sales growth rate, market share, or events such as M&A and IPO - for the enterprise/ entrepreneur to meet. Should the target fail, the enterprise and/or entrepreneur would compensate the PE investor by paying a pre-determined amount of cash or transferring or selling some or all of its/his shares at a discount to the latter. Should the target be reached, the PE may reward the enterprise and/or the entrepreneur through additional investment or share transfer. As its effect depends on future events which are uncertain at the time it is made, the VAM is often dubbed in China as a “betting” agreement or 对赌协议, because of its contingent nature.

The VAM has been a common practice in China’s nascent private equity markets. Among the best known examples of VAM was the deal in 2003 between Morgan Stanley and two other international investors (“Morgan Stanley and others”) on the one hand and the management of Mengniu Diary (“Mengniu”) on the other. In 2002, Morgan Stanley and others became Mengniu’s shareholders, and invested the next year $35.23 million which could be converted into Mengniu shares at the price of about $0.1 per share. The deal included the target of an annual growth rate of 50% for Mengniu to achieve; Morgan Stanley and others would transfer their existing Mengniu shares to the Mengniu management should the target be met; otherwise the Mengniu management would give Morgan Stanley and others six to seven million shares of its own. The deal worked out for both sides. As the target was successfully met, Morgan Stanley and others exercised the option price when the share price was over $0.8 per share; meanwhile, the Mengniu management received shares from Morgan Stanly and others as rewards. Another win-win case was the deal concluded by Goldman Sachs and two other private equity firms with Yurun Food. In 2005, the three investors put together $70 million for Yurun Food and the controlling shareholder of Yurun agreed to buy back their shares at a 20% premium if the company’s 2005 profit was below RMB 259.2 million yuan. The company’s 2005 financial report showed a 72 percent increase in sales and a 110 percent rise in net profits amounting to RMB 360 million yuan. In return, the investors also agreed not to exit until after one year of the company’s IPO. Meanwhile, there were cases where the VAM targets were missed. In 2005, Morgan Stanley and CDH Investment, a domestic PE fund, made an investment in Yongle, an electronic product chain, and both the investors and the management of Yongle agreed on a multilayer valuation adjustment: either the investors or the management would transfer shares to the other party depending on the profit level of the enterprise. As Yongle’s profit was disappointing, its management lost control and the company was the subject of a takeover.

Despite its popularity, the VAM was not legally tested for its validity and effectiveness until 2011 when the case of Haifu came up. Shiheng, a zinc mining company, was wholly owned by Diya, a Hong Kong-based company. Both Shiheng and Diya were managed by Ms. Lu Bo, a Shanghai resident. In November 2007, Haifu, a Suzhou-based private equity firm, agreed to invest RMB 20 million yuan in Shiheng, of which RMB 1.15 million yuan went to the latter’s registered capital, representing 3.85% of the total. Ms. Lu then agreed to transfer certain mining assets to Shiheng, and Shiheng also agreed to prepare its Initial Public Offering (“IPO”) in a domestic stock exchange. According to the VAM of the parties, should Shiheng’s 2008 net profit come below RMB 30 million yuan Haifu would receive a compensation calculated on the basis of how much the profit target[1] was missed, either from Shiheng or from Diya. In addition, should Shiheng fail to get its IPO by October 20, 2010 Haifu would have the right to demand Diya to buy back its shares in Shiheng at an annual return rate of not less than 10% since 2008. Shiheng’s 2008 net profit was RMB 26,858.13 yuan. Haifu filed a claim with the Lanzhou Municipal Court in December 2009, requesting Shiheng, Diya, and Ms. Lu to pay RMB 19.98 million yuan in compensation according to their VAM.

The Lanzhou Municipal Court ruled that the VAM in question was invalid for two reasons. First, it violated the principle that one’s return should be commensurate with his investment as Haifu would be able to recoup its investment even when the company suffered losses. Secondly, it harmed Shiheng and Shiheng’s creditors. On an appeal by Haifu, the Gansu Provincial Court disagreed on both grounds, but still invalidated the VAM provision because, according to a Supreme Court’s 1990 directive, the underlying deal between Haifu and Shiheng was not an equity investment as it was risk-free for Haifu and therefore was indeed an illegal loan. As Haifu agreed to invest because of its reliance on the promises of Shiheng and Diya, however, it should be recoup its investment, the Provincial Court found, and therefore awarded Haifu RMB 18.85 million yuan to be paid by Shiheng and Diya. Upon the petition by Shiheng and Diya, China’s Supreme Court intervened. For the Supreme Court, the Provincial Court’s reasoning was flawed and to be rescinded, but the argument that the VAM would hurt Shiheng and its creditors had merits and should be supported under Chinese company law. But the highest court held Diya liable to pay Haifu RMB 19.98 million yuan under the VAM.

  1. LEGAL CERTAINTY AND FREEDOM OF CONTRACT

The Supreme Court’s eclectic approach, which invalidates one part of the VAM but enforces the other part of the same, should have pleased both the supporters and opponents of the VAM. In the end, the investor got exactly what it had been asking in the lawsuit. The real loser, however, is a central value of law, which is certainty and predictability. On the surface of the Supreme Court’s ruling, the validity of the VAM seems to be settled now: it is invalid if the enterprise/company is liable to pay compensation, but, it is valid if a third party is liable to do so. But many issues remain unclear. If the enterprise/company is the only party named in the VAM to pay compensation, what is the legal consequence if the agreement is invalid? Is the VAM always valid when a party other than the enterprise/company is liable to compensate the investor? Will the ruling apply to other agreements on calculating the investor’s return, which may or may not be contingent on future events, for example, an agreement setting a fixed return regardless of the company’s performance or an agreement for a variable rate of return depending on future events? To answer those questions, one has to decipher the underlying rationale of the Supreme Court’s ruling. The case has also raised a number of issues relating to the operation of the Chinese judicial process and giving rise to concerns for uncertainty and unpredictability. For examples, Chinese courts enjoy broad powers to invalidate contracts; their rulings are motivated by considerations not based on public announced rules; there is neither rule nor practical way by which one may ascertain the validity or applicability of a Supreme Court directive like the one cited by the Gansu Provincial Court; judges appear to be free to decide a dispute on any ground they see fit; and they do not have to explain their rulings.

Legal uncertainty or lack of predictability is nothing new in China. Donald Clarke found, for instance, that Chinese law provides no clear answer to whether a business organization exists (Clarke 2005). Does predictability really matter to economic development? The answer should be yes. Although law is associated with justice (Sandel 2009, 6), for many people, especially, businesses and investors, law is also valuable for providing certainty and predictability. Business and investment decisions are made with the expectation that such decisions are lawful and therefore will be given effect to if the aid of law is called for. Law functions as guidance to tell what people can do or cannot do. “‘Let us know where we stand’ is the demand of the liberal individualists, ‘so we can get on our lives’” (Atiyah 1995, 139). Once business and investment decisions are made according to law’s demands and promises, they are expected to be judicially recognized and enforced. If a dispute is brought to court, the result should match the one contemplated by the agreement of the parties. Naturally, if law yields uncertain and unpredictable results, people would lose faith on the system and business would suffer. By providing certainty and predictability, law primarily binds government officials including court judges to a well-defined course of action. This is the essence of the rule of law and what American jurist Lou Fuller called standards of law’s morality. Those standards include generality, namely, law being capable of general application; promulgation, namely, law being publicly communicated; respect for legal precedent; and congruence between announced law and judicial actions, among other (Fuller 1964, 46-51, 79-91).

Support for legal certainty is not, however, universal. Some claim that as each case is different and unique and arguments can often be made on both sides, court decisions can never be one hundred per cent predictable. Others might even go so far as to contend that certainty is not even desirable since rules of law need to evolve as society changes. Those claims have their supports and distractors, and this is not a place to debate on the underlying issues (Atiyah 1995, 141-143). It suffices to say that from the viewpoint of expectation, legal certainty is critical to any investment and business planning. While it is impossible to predict the outcome of a judicial case with absolute certainty, a well-functioning legal system needs to contain basic rules to constrain official discretion and power so the expectations of businesses and investors would be as much respected as possible. In such system, as Henry G. Manne has noted, judges “are not there to regulate individuals’ behavior in accordance with the judge’s own preferences, but rather to enforce the free choices, private contracts, and reasonable expectations of the parties.” (Manne 1997, 33)