What the SPC's VAM judgement means for investors

The valuation adjustment mechanism (VAM), also known through its Chinese name as a gambling agreement, used to attract attention from private equity (PE) investors. This was caused by unexpected decisions made by the first instance court and the appeal court declaring the invalidity of the VAM arrangement in Haifu v Shiheng and Diya, dubbed as the first gambling agreement case. On November 7 2012, the Supreme People's Court (SPC) delivered its final judgment on the case by reversing the decision of the appeal court and upholding the VAM arrangement between Haifu, the investor, and Diya, the original shareholder. Understanding the Supreme Court's opinion is key for PE investors.

Haifu made VAM arrangements with the invested company, Shiheng, and the original shareholder, Diya. Haifu invested Rmb20 million ($3.2 million) into Shiheng and became the other shareholder of Shiheng, holding 3.85% of its equity interest. The VAM agreed upon by the parties was that if Shiheng's net profit in 2008 did not reach Rmb30 million, Shiheng would indemnify Haifu in an amount equaling Rmb20 million multiplied by (1- 2008 net profit divided by Rmb30 million) and Diya would undertake the liability of indemnity if Shiheng failed to fully indemnify Haifu. The Supreme Court held that the VAM arrangement between Haifu and Shiheng was invalid, while holding that the VAM arrangement between Haifu and Diya was valid (see figure 1).