On 3 April 2019 the Jiangsu High People’s Court delivered the (2019) S.M.Z.No.62 judgement to close the share purchase case brought by Jiangsu Hua Gong Business Investment Co., Ltd. (“HG”), Yangzhou Forging Machine Limited by Shares (“YF Shares”), Pan Yunhu, etc. which involved a fairly large amount (of RMB 22,000,000 excluding interest) and had lasted for a long time. During the second trial the Jiangsu High Court accepted that the repurchase agreement between the investor and the targeted company was valid despite the rule that “repurchase agreed by the targeted company is invalid” established by the Supreme People’s Court in 2016 to decide the Haifu Investment v. World in Color case. Although our country has no case law, cases decided by the Supreme Court are used for reference by courts of all levels. There are controversies over the Supreme Court’s decision since it was taken. Arbitration authorities do not accept it as well. However, courts of all levels internally accept it as a rule. The only change to this situation occurred in September 2018 when the Supreme Court decided the share transfer case between Qiang Jingyan, Cao Wubo and Shandong Hanlin Bio-technology Co., Ltd. which established the rule that guarantee on the shareholder’s repurchase obligation given by targeted companies is legal and valid. The Jiangsu High Court’s decision was against the Supreme Court’s decision and questionable in many aspects.      

During the appeal of second trial of the “YF Shares case” the Jiangsu High Court inappropriately decided based on its superficial analysis of financial statements of YF Shares that payment for the repurchase price would not affect the ability of YF Shares to pay its debts or affect creditors’ interests. Liu Yan, professor of Beijing University wrote an article VAM and Capital Control under Company Law - US Case Practices and Studies to adduce the Thought Works case decided by the Delaware State Court in 2010 and put forward arguments similar to ones stated in the appeal of second trial court’s decision for “YF Shares case”, believing that she had a good understanding of the Supreme Court’s decision for “World in Color case”. I dare to say that the arguments are of almost no reason. Chinese and US legal systems are very different. The “World in Color case” did not involve share repurchase and was different from the Thought Works case in basic legal relationship. Comparing the two cases was perhaps intended to attract larger attentions on the internet.

Another issue arising from the retrial court's decision for "YF Shares case" and the masterpiece by professor Liu Yan is what kind of protection should be given for the interests of the targeted company’s creditors in the process of signing and performing an investment agreement containing VAM clauses, or what are the targeted company's responsibilities that should be included in the VAM clauses in order to avoid affecting the creditors’ interests? Repurchase is not feasible. What if give compensation for inadequate performance?  

In the "World in Color case", the High Court of Gansu Province decided that the compensation clauses were invalid on the ground of "fake investment and real borrowings" and amounted to "payment of debts". The decision was revised by the Supreme Court for reasons other than damaging the creditors' interests. You could see that when dealing with the issue of compensation for inadequate performance, the Supreme Court won’t consider other creditors' interests, whether the company pays compensation or debts.

In the "Hanlin Biology case", the Supreme Court delivered its judgement accepting the targeted company as guarantor that was jointly responsible for paying the repurchase price. Reasons for this are easy to understand. After fulfilling the guarantee obligation as guarantor taking the joint responsibility, the company could claim damages against the person (shareholder) having the payment obligation without affecting the interests of the company's creditors in general.

In the above two cases, the company's cash flow would severely damaged and its ability to pay its debts were bound to decrease. There is no argument that the creditors' interests were not harmed. According to the Company Law, however, creditors have no right to claim about that.

At present protection of creditors of companies is based on the "capital maintenance rule", which implies that the debtor-creditor relationship between creditors and the company is based on their trust in the adequacy of the company’s registered capital. Therefore, in case of registered capital decrease, the creditors’ interests in their trust are damaged, in which case the Company Law provides that creditors are entitled to require the company to pay the debts in advance or give a valid guarantee but does not set out remedies available to creditors when the company neither pay the debts in advance nor gives the guarantee. In contrast, creditors seem to have no right to claim under the Company Law unless registered capital decreases.  

On the other hand, if the creditors’ interests in their trust are only based on registered capital, banks should not have given any company credits more than its registered capital and creditors would be solely responsible for the debts owed to them in excess of registered capital. Furthermore, registered capital related to the interests in trust is subject to change from time to time. Registered capital at the time of entering into the debtor-creditor relationship and capital increases after that time seem unrelated to the creditors. If the company decreases its registered capital later and the registered capital after the decrease is more than that at the time of entering into the debtor-creditor relationship, the creditors’ interests in their trust would not be affected, so should the creditors be entitled to require the company to pay the debts in advance or give a valid guarantee?   

Judging by the above creditors are mechanically and inadequately protected under the current company law. 

We should also be aware of the following facts. 

a.The amounts of net assets and registered capital are usually different due to profits or losses arising from the company’s business operation;

b.Premium finance would result in difference between the amounts of net assets and registered capital;

c.Registered capital, legal surplus, undistributed profits, owners’ interests, etc. are account names and cannot reflect the actual cash flow of the company. Net assets and cash flow of a company are different in amount.

Therefore, registered capital is not a reliable criterion for the ability of a company to pay its debts and is the bottom line for creditors to judge the company’s ability to pay its debts, which was helpful before March 2014 and is now useless in today’s lenient legal capital system. If the argument for the legal protection of creditors is based on no reduction of the company’s ability to pay its debts that they trust in, it is wrong, especially companies having executed VAM clauses to define the creditor’s right to claim by just replying on registered capital. There is great uncertainty about previous increases in the company’s net assets due to the VAM clauses, which is very likely to mislead creditors.       

VAM clauses mentioned in this article only include ones under which companies have the obligation to pay for repurchase price or compensate for failure to realize their commitments, which also applies to companies that are not obligated but jointly liable to make the payment or the compensation under the agreement, in which case net assets of the company are not reduced (credit: monetary funds; debit: other receivables) but the cash flow needed for business operation is heavily affected and claims may not be acceptable. 

Risks are there when VAM clauses are made, so why creditors are not considered until they are put into action? A VAM agreement or clause relating to a company’s obligation should be at least partially announced after its establishment so that creditors can make a comprehensive evaluation of the company’s financial conditions and bad debt risk.

In fact, few companies submit true and complete copies of capital increase agreements to the administration for market regulation. Some of the reasons for this are not disclosed by companies and investors. Others include negligence of general clerks who are reluctant to review complicated documents and recommend simplified documents or even insist that documents submitted be completely the same as templates they have provided.  

As far as I can remember, there is a similar case decided in which a signed agreement was not in accord with documents filed with the administration for industry and commerce but conformed to their true intentions and could be used as a criterion by the court to decide the case. In my opinion, such agreement is to some extent reasonable and makes it possible for VEM not to be fully announced.    

Change registration and recordation under the existing Company Law can only be valid to parties involved, excluding third parties. It is all about shareholders and potential shareholders of companies and meets the purposes of the Company Law. Announcement of VAM clauses is closely related to creditors’ interests and should be a mandatory rule requiring that if not announced, a VAM clause is invalid. Without such a rule, the system would be open to abuse and protection for creditors inadequate.