Liquidation preference is frequently used in China’s venture capital and private equity investment sectors. In practice, the legal effect of liquidation preference is also among one of the most frequently consulted legal issues.
Liquidation preference refers to the priority of specific shareholders over other shareholders to receive the distribution of residual property and realize liquidation income when the company enters into the liquidation procedure, or when a deemed liquidation event occurs.
There are two types of circumstances triggering the liquidation preference: (1) the liquidation events listed in article 180 of the Company Law; and (2) the deemed liquidation events agreed among shareholders, including the acquisition of the company, the transfer of shares of controlling shareholders, the change of actual controllers, and the disposal of major assets of the company.
Statutory liquidation events
Paragraph 2 of article 186 of the Company Law provides that, “After paying off the liquidation expenses, wages of employees, social insurance premiums and legal indemnities, the outstanding taxes and debts of the company, the residual properties may, in the case of a limited liability company, be distributed according to the proportion of capital contribution of the shareholders, or, in the case of a joint stock limited company, be distributed according to the proportion of stocks held by the shareholders.”
Compared with the provisions of article 34 of the Company Law on dividend distribution for liquidation, the Company Law only provides that the residual property of the company shall be distributed in proportion to the capital contribution or shareholding of shareholders, without any provision of exception.
Will a violation of the above-mentioned provisions by liquidation preference arrangement affect the legal effect of liquidation preference? First of all, in accordance with article 52 of the Contract Law and article 14 of the Judicial Interpretation (II) of the Contract Law, the authors are of the opinion that the provisions on validity, which lead to the invalidation of a contract, are an important channel for public law to enter private law, and have the significance of introducing validity provisions of public law into private law. Therefore, provisions on validity often refer to mandatory provisions in public law.
However, the understanding of provisions of public law should be determined by the legal relationship regulated by specific provisions. For example, “the distribution of the residual property among shareholders after paying off the company’s debts”, stipulated in article 186 of the Company Law, shall belong to the scope of private law. When the shareholders concerned reach a separate agreement on distribution, the application of the provisions should be excluded.
Secondly, it is proposed that, in accordance with the Answers of the Supreme People’s Court on Several Issues Concerning the Trial of Disputes over Joint Operation Contracts, the return-guarantee clause violates the principle of sharing profits and losses and risks to be followed in joint venture activities, and impairs the rights and interests of other creditors of the joint operation, so it should be declared invalid. The liquidation preference clause should also be considered invalid.
But the authors believe that when a company is under liquidation, if, and only if, there is residual property can the investor enjoy the liquidation preference, and there is no guarantee that the investment income can be recovered. That is to say, there is no contradiction between liquidation preference and “investment with risks”.
Finally, although the Supreme People’s Court has not yet issued any guiding case on the legal effect of the liquidation preference, the judgment of Beijing No.3 Intermediate People’s Court on a dispute over the transfer of equity interest on 18 June 2019 holds that when a company is under liquidation, after the company pays the amount legally prioritized over the amount to be distributed to shareholders, specific shareholders are granted distribution priority of the residual property, which is an agreement among shareholders on the distribution order of the residual property, does not violate the provisions of article 186 of the Company Law, and should be deemed valid.
To sum up, the right to distribution of residual property, similar to the right to profit distribution, falls into the category of a shareholder’s self-benefit right. It adjusts the proportion and order of distribution of specific property among shareholders, does not violate the mandatory provisions of law, and does not undermine the interests of creditors of the company. Therefore, the autonomy of will among shareholders should be respected, and the “agreement on liquidation preference” should be deemed legal and effective in principle.
Deemed liquidation events
Different from that of the statutory liquidation events, after the occurrence of the deemed liquidation events, the company is not required to enter the liquidation procedure and perform the liquidation property distribution procedure. Under the premise of the existence of the company, investors’ requests of the company to distribute property to them, or of shareholders to compensate them, is similar to the case of a value adjustment mechanism (VAM). In both cases, it is agreed that the company or shareholders shall bear the VAM obligations when a certain event is triggered.
On 8 November 2019, the Supreme Court issued the Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts, and established the following principles to decide on the validity of a VAM:
(1) If there are no other invalid reasons for a VAM between investors and shareholders, it shall be deemed valid. The liquidation preference provisions regarding repurchase or compensation by specific shareholders under the deemed liquidation event shall be effective; and
(2) For a VAM between investors and the company, if any amount is due from the company to shareholders, on the premise that the company has distributable profits, if the company is required to reduce its capital and repurchase its equity, the capital adequacy of the company shall not be affected. Therefore, the liquidation preference provisions meeting the above-mentioned requirements shall be effective.
As for the validity of the liquidation preference, although different parties hold different opinions based on different positions in practice, theories, investment practices and existing judicial decisions tend to believe that the qualified “liquidation preference provisions” are effective.
However, it is advisable, for the benefit of investors, that when liquidation preference provisions are devised, the parties to such an arrangement should be reasonably determined, the provisions should be clear and detailed, and the transaction arrangements should be verified to meet the requirements of the minutes.