Abstract
Betting agreements are arrangements between investors and investees whereby, based on the target company's performance or successful listing within a specified timeframe, the target company compensates investors for excess investment or requires additional capital from under-investing parties. These agreements or clauses aim to address information asymmetry and valuation uncertainties in the PE/VC investment sector, as well as to incentivise company operations and safeguard profit margins [1]. Under the "Nine-Ministry Memorandum" ("Jiumin Jiyao"), betting agreements are reviewed within the framework of the Company Law. With the comprehensive revision of the "Company Law of the People's Republic of China" (hereinafter referred to as the "New Company Law"), changes to the regulatory framework of betting agreements are inevitable. This article examines the impact of the New Company Law on betting agreements and offers practical recommendations.
I. Current Rules for "Betting Transactions" under the Nine-Ministry Memorandum
(A) Legal Logic of "Betting Transactions" under the Nine-Ministry Memorandum
In 2019, the Supreme People's Court issued the "National Civil and Commercial Judicial Work Conference Memorandum" (hereinafter the "Nine-Ministry Memorandum"), establishing fundamental rules for betting transactions in the investment and financing sector and unifying the adjudication standards for disputes arising from betting agreements. According to Article 5 of the Nine-Ministry Memorandum, the Supreme Court evaluates betting transactions from the perspectives of "contract validity" and "contract performance." In the absence of statutory grounds for contract invalidity, the focus shifts to the "practicability of performance" of the betting agreement. The memorandum sets distinct "practicability of performance" criteria for two types of betting agreements: for equity repurchase agreements, the standard is whether the company has completed the capital reduction procedures; for monetary compensation agreements, the standard is whether the company has sufficient profits to pay the compensation [2].
Pursuant to Article 5, Paragraph 2 of the Nine-Ministry Memorandum, for equity repurchase agreements, courts should examine compliance with Article 35 (prohibition of capital withdrawal by shareholders) or Article 142 (mandatory provisions on share repurchase) of the Company Law. If the target company has not completed the capital reduction process, the court should dismiss the lawsuit. The Supreme Court deemed it necessary to require the completion of capital reduction procedures to prevent betting agreements from becoming mechanisms for capital withdrawal.
Under Article 5, Paragraph 3 of the Nine-Ministry Memorandum, for monetary compensation agreements, courts must review compliance with Article 35 (prohibition of capital withdrawal by shareholders) and Article 166 (mandatory profit distribution rules) of the Company Law. If the target company lacks profits or has insufficient profits to compensate investors, courts should dismiss or partially grant the claims. The Supreme Court noted that monetary compensation betting does not involve changes to the PE/VC investors' shares and thus cannot be treated as capital reduction. Instead, it should be compared to profit distribution, effectively constituting a directed profit distribution to PE/VC investors [3]. Although the Supreme Court’s direct characterization of monetary compensation as profit distribution may overlook the genuine commercial intentions of the parties, it remains the most commercially aligned technical approach within the current Company Law framework.
(B) Value Position of "Betting Transactions" under the Nine-Ministry Memorandum
The scrutiny standards for betting agreements established by the Nine-Ministry Memorandum essentially uphold the "Capital Maintenance Principle," which protects creditors' interests, and the "Equitable Share Principle," which ensures equal rights among shareholders. These principles naturally inform the institutional arrangements chosen.
1. Capital Maintenance Principle
The "Capital Maintenance Principle" or "Capital Adequacy Principle" requires a company to maintain real assets commensurate with its capital during operations, preventing arbitrary outflow of company assets to shareholders. Although not explicitly stated, various provisions in the current Company Law collectively establish the capital maintenance regime:
o Article 166 mandates adherence to profit distribution rules when distributing profits to shareholders.
o Article 177 stipulates that shareholders wishing to retract their investments must follow mandatory capital reduction procedures, including majority shareholder approval, creditor notification, and prepayment or provision of guarantees.
o Articles 35 and 200 strictly prohibit shareholders from withdrawing capital.
Thus, the Company Law restricts the outflow of net assets to shareholders through stringent procedures and profit distribution rules, while also preventing capital embezzlement by shareholders. The Nine-Ministry Memorandum classifies "betting transactions" as capital transactions, embeds betting agreements within the Company Law framework, and subjects disputes to Company Law standards. By linking the completion of capital reduction procedures with equity repurchase agreements and the fulfilment of profit distribution rules with monetary compensation agreements, the memorandum reinforces the "Capital Maintenance Principle" and prioritises creditor protection.
2. Equitable Share Principle
The "Equitable Share Principle" or "Equal Rights Principle" ensures that shareholders receive equal treatment based on their capital contributions and shareholdings, preventing disproportionate benefits for certain shareholders. The Nine-Ministry Memorandum mandates that betting agreements between investors and target companies adhere to Company Law procedures, aiming to prevent investors from arbitrarily reducing the company's net assets or individual shareholders from circumventing Company Law procedures to effect "targeted capital reductions" or "targeted distributions." If major shareholders enter into betting agreements without disclosing them to minority shareholders, the execution of such agreements could result in biased distributions, harming the interests of other shareholders.
II. Impact of the New Company Law on "Betting Transactions"
(A) New Company Law's "General Prohibition on Targeted Capital Reduction" Increases the Difficulty of Fulfilling Equity Repurchase Betting Agreements
Article 224, Paragraph 3 of the New Company Law stipulates: "When reducing registered capital, a company shall proportionally reduce the capital contributions or shareholdings of shareholders, except as otherwise provided by law, agreed upon by all shareholders of a limited liability company, or stipulated in the articles of association of a joint-stock company." This provision generally prohibits targeted capital reductions unless specific legal exceptions are met. Prior to the revision, whether a targeted capital reduction required a majority or unanimous shareholder vote was a contentious issue. One view held that targeted capital reductions should follow the majority vote requirements for capital reduction procedures, while another argued that targeted reductions could disrupt the initial share distribution framework, thus requiring unanimity to alter the share structure formed by the shareholders' consensus [4]. The New Company Law adopts the latter view to protect minority shareholders, mandating unanimous consent for targeted capital reductions in limited liability companies or explicit provisions in the articles of association for joint-stock companies.
The introduction of rules governing targeted capital reductions in the New Company Law effectively heightens the challenges in executing equity repurchase betting agreements. Under the existing Nine-Ministry Memorandum rules, equity repurchase betting agreements required the target company to undertake a targeted capital reduction before investors could compel the company to repurchase shares. The New Company Law now requires unanimous shareholder consent or clear provisions in the articles of association, thereby increasing the need for coordination between betting investors and other shareholders and raising the threshold for achieving betting outcomes.
If betting investors fail to comply with the New Company Law’s requirements for targeted capital reductions, what legal consequences ensue? Practical judicial cases indicate that if a target company violates the capital reduction procedures, other shareholders may file a lawsuit challenging the validity of the capital reduction resolution on grounds of procedural non-compliance or abuse of shareholder rights, potentially rendering the capital reduction resolution invalid and resulting in the betting agreement being legally unenforceable.
Additionally, Article 226 of the New Company Law introduces new legal consequences for unlawful capital reductions: "If a company reduces its registered capital in violation of this Law, shareholders shall return any received funds, and any reductions in paid-in capital shall be restored; if the company suffers losses, the shareholders and responsible directors, supervisors, and senior management personnel shall be liable for compensation." Therefore, if betting investors violate the procedural requirements for targeted capital reductions, external creditors may also have the right to sue for restitution and damages.
(B) New Company Law Imposes Liability for Unlawful Profit Distributions, Increasing Litigation Risks for Monetary Compensation Betting
Under Article 5 of the Nine-Ministry Memorandum, monetary compensation betting agreements are treated as directed profit distributions from the target company to investors. Courts must review these agreements in accordance with Article 35 (prohibition of capital withdrawal by shareholders) and Article 166 (mandatory profit distribution rules) of the Company Law. Practically, this means that monetary compensation betting is considered akin to directed profit distributions, subject to the same regulatory scrutiny as profit distributions under Company Law.
The New Company Law, Article 210, Paragraph 5, stipulates: "After offsetting losses and allocating reserves, a limited liability company shall distribute profits to shareholders in proportion to their paid-up capital contributions, unless all shareholders agree otherwise; a joint-stock company shall distribute profits in proportion to shareholders' shareholdings, unless otherwise stipulated in the articles of association." Similar to the provisions on targeted capital reductions, monetary compensation betting involves directed profit distributions and thus requires unanimous shareholder consent or explicit provisions in the articles of association.
Some argue that Article 5 of the Nine-Ministry Memorandum requires that monetary compensation claimed by investors under betting agreements should derive from distributable profits, meaning that compensation should not impair the company’s ability to cover losses or allocate mandatory reserves [6]. They contend that the memorandum does not equate monetary compensation with profit distribution, asserting that whether the target company’s payment of compensation violates internal resolution procedures is an internal matter and not the focus of the memorandum’s review.
However, this perspective is untenable under the New Company Law. If monetary compensation betting is not treated as directed profit distribution, or if the requirements for unanimous shareholder consent or explicit provisions in the articles of association are not strictly enforced, significant litigation risks arise. Article 211 of the New Company Law states: "If a company violates this Law in distributing profits to shareholders, shareholders shall return the unlawfully distributed profits to the company; if the company suffers losses, shareholders and responsible directors, supervisors, and senior management personnel shall be liable for compensation." This addition imposes liability on shareholders and responsible officers for unlawful profit distributions, enabling minority shareholders to challenge the validity of profit distribution resolutions or file derivative lawsuits to demand the return of compensation and seek damages for tortious acts by betting investors and responsible officers, thereby increasing litigation risks for betting transactions.
(C) New Company Law’s "Prohibition of Financial Assistance" May Hinder Other Forms of "Indirect Betting"
In judicial practice, when investors consider that "direct betting with the target company" is subject to Company Law procedural constraints, they may resort to "indirect betting" by converting the target company's obligation to pay betting sums into guarantee liabilities. This involves requiring the target company to assume joint and several guarantee responsibilities for the repurchase obligations of founding shareholders, allowing investors to directly pursue guarantees through litigation without undergoing capital reduction procedures. Such "indirect guarantees" enable the target company to avoid engaging in "capital transactions" directly with betting investors, thereby circumventing the procedural requirements set by the Nine-Ministry Memorandum for capital reduction or profit distribution. Reference cases (2016) Supreme Court Civil Appeal No. 128 and (2017) Supreme Court Civil Appeal No. 258 suggest that such "indirect guarantees" may be recognised by courts.
However, the New Company Law's new "prohibition of financial assistance" provision may obstruct such indirect betting arrangements. Article 163 of the New Company Law states: "A joint-stock company shall not provide gifts, loans, guarantees, or other financial assistance to others to acquire shares of the company or its parent company, except for employee shareholding plans." Originating from the UK’s anti-unfair acquisition laws, the prohibition on financial assistance aims to regulate investors' use of leveraged acquisitions of equity. The constitutive elements include:
1. Investors purchase shares of the target company;
2. The target company provides financial assistance to investors;
3. The financial assistance aims to facilitate the investors’ acquisition of shares, establishing a causal link between the assistance and the acquisition.
Although the prohibition on financial assistance in the New Company Law does not explicitly address guarantees for indirect betting, providing guarantees for investors to acquire the target company’s shares effectively meets the criteria for "financial assistance," thereby posing a risk of violating Article 163.
III. Strategies for Addressing "Betting Transactions" under the New Company Law
(A) When Betting with a Limited Liability Company, Betting Investors Should Pre-Agree with All Shareholders
The New Company Law maintains the Nine-Ministry Memorandum’s emphasis on protecting creditor interests and shareholder equality, explicitly requiring unanimous consent for targeted capital reductions or directed profit distributions, thereby prohibiting the abuse of majority shareholder control. To ensure that the target company can smoothly execute capital reductions or profit distributions to fulfil betting agreements, betting investors should secure prior unanimous consent from all shareholders through the following methods:
Betting investors may require all shareholders of the target company to sign the betting agreement, stipulating unconditional resolutions for targeted capital reductions or profit distributions upon the occurrence of betting events. For example, an agreement might state: "Upon the occurrence of a repurchase event, all shareholders are obliged to unanimously approve a resolution to reduce capital for the repurchase of shares, failing which they shall be liable for breach of contract."
It is important to note that limited liability companies often undergo multiple investment rounds, with new investors entering through capital increases or share transfers. Since these new shareholders may not have signed the unanimous consent betting agreement, they might not be bound by its terms. To address this, agreements should include clauses such as: "If new shareholders enter the company through share transfers, the transferring shareholders must ensure that the new shareholders agree to the relevant betting arrangements, failing which they shall be liable for breach of contract." Additionally, investors should monitor changes in the rights of investors across investment rounds during post-investment management.
(B) When Betting with a Joint-Stock Company, Betting Investors Should Explicitly Include Rights for Targeted Capital Reduction and Profit Distribution in the Articles of Association
According to Articles 210 and 224 of the New Company Law, joint-stock companies require explicit provisions in their articles of association to implement targeted capital reductions or directed profit distributions. Therefore, when betting with a joint-stock company, investors can predefine specific rights, such as the right to demand share repurchases, within the company’s articles of association.
For instance, the articles of association might include a clause stating: "In the event of a repurchase event, the company shall convene an extraordinary general meeting within ten days and pass a capital reduction resolution. All shareholders irrevocably agree to the capital reduction resolution; if the company fails to pass the resolution within the stipulated time, other shareholders irrevocably waive their voting rights on the capital reduction matter, and the company is authorised to execute the necessary capital reduction procedures on behalf of the repurchase rights holder."
(C) In Monetary Compensation Betting Agreements, Investors Can Leverage the New Company Law’s "Class Shares" Provisions to Establish Priority Dividend Rights
Article 144 of the New Company Law states: "A joint-stock company may, in accordance with its articles of association, issue classes of shares with rights different from ordinary shares, including shares with priority or subordinate rights in profit or residual asset distribution..."
The introduction of class shares in joint-stock companies under the New Company Law offers a new avenue for implementing monetary compensation betting. While the Nine-Ministry Memorandum views monetary compensation betting as directed profit distribution from the company to investors, this article suggests that from the investors' shareholder perspective, such betting can be regarded as investors holding class shares with priority profit distribution rights. Consequently, betting investors can transform "monetary compensation" clauses in betting agreements into "priority dividend rights" clauses within the company’s articles of association, stipulating that upon the triggering of betting conditions, investors are entitled to receive dividends before other shareholders, thereby indirectly achieving the betting objectives.
For example, investment agreements and articles of association might include: "The parties agree that upon completion of this capital increase, the target company shall duly distribute dividends as stipulated in the articles of association. In the event of a betting event as defined in the agreement, investors shall have the right to receive the company’s allocated profits for the year preferentially. Until the target company has fully paid dividends to investors, it shall not distribute any dividends to other shareholders in cash, shares, or other forms."
(D) In Equity Repurchase Betting Agreements, Investors Can Utilize the New Company Law’s "Anti-Oppression" Provisions to Assert Minority Shareholders’ Repurchase Rights and Indirectly Exit the Target Company
Article 89 of the New Company Law introduces a new provision under the "Anti-Oppression" clauses: "If the controlling shareholder abuses shareholder rights and seriously harms the company or other shareholders’ interests, other shareholders have the right to request the company to purchase their shares at a reasonable price."
In betting transactions, the founding shareholders or actual controllers of the target company typically hold controlling shares. If betting investors can provide evidence that the conditions of an equity repurchase betting agreement have been triggered and the repurchase obligations have been met, but the controlling shareholders, abusing their dominant position, neglect to convene shareholder meetings to initiate capital reduction procedures or maliciously cast opposing votes to obstruct capital reduction resolutions, investors can invoke the "Anti-Oppression" clauses under Article 89 of the New Company Law. This allows them to request the company to repurchase their shares at a reasonable price, thereby indirectly achieving their commercial objective of exiting the target company.
References
1. Wang Weibin, Huang Zhongwei, Comprehensive Practical Guide to Private Fund Legal Disputes, Legal Publishing House, 2021, p. 149.
2. See Dai Lingyun, Wang Liang, "Commentary on the Nine-Ministry Memorandum – Perspectives from Betting and Repurchase Agreements," published on the WeChat official account of "Tongshang Law Firm," 29 November 2019.
3. Liu Yan, "Judicial Pathways and Policy Choices for 'Betting Agreements' – An Analysis Based on PE/VC and Corporate Betting Scenarios," Legal Studies Research, Issue 2, 2020, p. 145.
4. (2022) Su 02 Min Zhong 4501 Case.
5. See Liu Siyuan, Wang Wei, "Opportunities or Challenges? – The Direction of Betting Rules in the Era of the New Company Law," published on the WeChat official account of "Beijing Jing Tian Gong Cheng Law Firm," 26 January 2024.
6. See Chen Jianmin, Tao Bingli, Yang Yang, "Legal Perspectives: Analysis of Monetary Compensation Obligations in Private Fund Performance Betting Disputes," published on the WeChat official account of "Financial Legal Services," 15 February 2023.
7. See Pi Zhengde, "Construction of the Company Law on the Prohibition of Financial Assistance," Legal Studies Research, Issue 1, 2023.
8. See Lei Jiping, Li Wei, Du Mingzhao, "Frontier Issues in Company Listing Betting (II) – How Equity Repurchase Betting Can Navigate Procedural Requirements for Capital Reduction," published on the WeChat official account "Yichuan Law," 11 October 2022.
9. See Lei Jiping, Li Wei, Du Mingzhao, "Frontier Issues in Company Listing Betting (II) – How Equity Repurchase Betting Can Navigate Procedural Requirements for Capital Reduction," published on the WeChat official account "Yichuan Law," 11 October 2022.
