Lawsuit filed by Shenyang [Certain] Venture Investment Co., Ltd. against Zhou, Hou [Certain], Cao [Certain], Li [Certain], Wu [Certain], and Zheng regarding a contract dispute.

[Keywords]   

Civil/Contract Disputes/Shareholder Betting Agreements/Equity Inheritance

【Key Points of the Ruling】

If an investment agreement with a wager clause is entered into by investors and the original shareholders of the target company based on their genuine intentions and does not violate applicable legal provisions, such agreement shall be lawful and valid.

After the original shareholder of the company dies following the signing of a wagering agreement, all contractual rights and equity interests held by that shareholder shall be inherited by their legal heirs. Unless the articles of association of the company or the wagering agreement contain special provisions regarding the succession of equity interests, as long as the legal heirs have not renounced their inheritance of the equity interests, they shall enjoy the corresponding rights and bear the corresponding obligations. In accordance with the principle of consistency between rights and obligations, they must fulfill the relevant contractual obligations and assume the corresponding liabilities.

[Basic Facts of the Case]

On December 3, 2015, Shenyang Certain Venture Investment Co., Ltd. (hereinafter referred to as “Shen Chuang Tou Company”) made an equity investment in Shenyang Weiding Robot Co., Ltd. (hereinafter referred to as “Weiding Company”). In conjunction with the original shareholders Zhou, Hou, Cao, Li Ning, and Weiding Company, they signed an “Investment Cooperation Agreement” which stipulated the following: 1. Weiding Company would raise new capital of RMB 750,000, which would be subscribed by Shen Chuang Tou Company for RMB 16.75 million, thereby increasing Weiding Company’s registered capital by RMB 750,000 at a price of RMB 22.33 per share; 2. Article 4 of the Agreement provided that Zhou, Hou, Cao, Li Ning, and Weiding Company jointly committed to achieving a post-tax net profit of RMB 7.44 million for Weiding Company in 2016. If this target was not met, the shortfall would be supplemented by Zhou, Hou, Cao, and Li Ning to Weiding Company within 180 days from the date on which they received a compensation notice from Shen Chuang Tou Company. After the “Investment Cooperation Agreement” took effect, Shen Chuang Tou Company paid the investment amount to Weiding Company and became a shareholder of Weiding Company through the capital increase.

In February 2017, Zhongzhun Certified Public Accountants (a special general partnership) conducted an audit of Weiding Company’s financial and operational performance for the year 2016. According to the audit results, Weiding Company’s actual net profit after tax for 2016 was RMB 1.2675 million, falling short of the 2016 operating target stipulated in the Investment Cooperation Agreement. Pursuant to the terms of the Investment Cooperation Agreement, Zhou, Hou, Cao, and Li Ning were required to make up the shortfall—amounting to RMB 6.1725 million—to Weiding Company. Since the original shareholder Li Ning passed away on December 4, 2015, Li Moumou, Wu Moumou, and Zheng Mou, as Li Ning’s legal heirs, were recognized as shareholders of Weiding Company in Case No. (2016) Liao 0102 Min Chu 7282. The court determined the respective equity proportions inherited by each heir: Li Moumou holds a 3.3% stake in Weiding Company, Wu Moumou holds a 3.3% stake, and Zheng Mou holds a 13.4% stake. All of the above equity confirmation matters have been duly registered with the Administration for Market Regulation.

The shareholders of Yinweiteng Company—Zhou, Hou, Cao, Li, Wu, and Zheng—all failed to fulfill their obligations to make up the shortfall as stipulated in the Investment Cooperation Agreement. Consequently, Shen Chuangtou Company has filed a lawsuit against these shareholders, demanding that each shareholder perform their obligation to make up the shortfall. Lawyers Wu Jianping and Tang Ning have been retained by Shen Chuangtou Company to serve as litigation agents and participate in the proceedings.

【Judgment Result】

First-instance judgment result:

The People's Court of Huanggu District, Shenyang City, issued Civil Judgment No. (2018) Liao 0105 Min Chu 3286, ruling as follows:

1. Defendants Zhou, Hou, Cao, Li, Wu, and Zheng shall, within fifteen days from the date on which this judgment becomes legally effective, jointly make up to the third party, Shenyang Weiding Robot Co., Ltd., the shortfall in after-tax net profit for the year 2016 in the amount of RMB 6,172,463.54 (Defendants Li, Wu, and Zheng shall bear responsibility within the scope of the inheritance they have received from the deceased Li Ning).

2. Defendants Zhou, Hou, Cao, Li, Wu, and Zheng shall, within fifteen days from the date on which this judgment becomes legally effective, jointly pay the third party, Shenyang Weiding Robot Co., Ltd., the overdue interest on the shortfall in the 2016 post-tax net profit that was not made up on time, amounting to RMB 6,172,463.54 (calculated at the contemporary loan interest rate set by the People's Bank of China from February 13, 2018, until the date of actual payment). Defendants Li, Wu, and Zheng shall bear their respective liabilities within the scope of the inheritance left by the deceased Li Ning.

If the monetary obligation specified in this judgment is not fulfilled within the prescribed period, interest on the debt for the period of delay shall be doubled in accordance with Article 253 of the Civil Procedure Law of the People’s Republic of China.

• Dismiss the other claims of both the plaintiff and the defendant.

Second-instance judgment result:

After the first-instance judgment was rendered, Li Moumou, Wu Moumou, and Zheng Moumou filed an appeal to the Shenyang Intermediate People's Court, dissatisfied with the ruling. Following a review by the second-instance court, the court issued a judgment dismissing the appeal and upholding the original judgment.

【Reasons for the Ruling】

The central issue in this case is whether the defendants, Li Moumou, Wu Moumou, and Zheng Mou, should assume the obligations promised by shareholder Li Ning in the investment agreement—that is, whether the three of them, together with the original shareholders of Weiding Company, Zhou Mou, Cao Moumou, and Hou Moumou, are jointly required to make up for the operating shortfall for the year 2016 and the corresponding interest owed to the third party, Weiding Company.

Judging from the validity of the Investment Cooperation Agreement, the agreement reflects the true intentions of the parties involved and does not violate any applicable legal provisions; therefore, the agreement is lawful and valid. As a former shareholder of Weiding Company, Li Ning was a party to the Investment Cooperation Agreement and thus bound by its terms. Upon his death, all contractual rights and equity interests he held were inherited by his legal heirs. Since there were no special agreements between the parties regarding the succession of equity interests, his legal heirs, while enjoying the rights, are also obligated to fulfill the corresponding contractual duties—in particular, the obligation to make up for any shortfall in the company’s profits, in accordance with the principle that rights and obligations should be commensurate.

Regarding the issue of Shenzhen Venture Capital Co., Ltd.'s request that Zhou, Hou, Cao, Li, Wu, and Zheng pay the shortfall compensation for the 2016 operating targets, together with interest: The Investment Cooperation Agreement stipulates that the original shareholders shall make up the shortfall to the target company within 180 days from the date of receiving the compensation notice issued by the investor. On August 14, 2017, Shenzhen Venture Capital Co., Ltd. issued a notice requiring Zhou, Hou, Cao, Li, Wu, and Zheng to compensate Weiding Company for the shortfall in the 2016 net profit target. This notice was served on all six individuals—Zhou, Hou, Cao, Li, Wu, and Zheng. Furthermore, in the agenda of the notice issued by the third party, Weiding Company, on August 25, 2017, announcing the convening of the first shareholders’ meeting of Weiding Robot Co., Ltd. for 2017, the aforementioned notice issued by Shenzhen Venture Capital Co., Ltd. was also included as an item on the meeting agenda. Therefore, it can be determined that Zhou, Hou, Cao, Li, Wu, and Zheng have all received this notice; however, none of the six individuals has made up the shortfall as agreed, and thus they should bear liability for breach of contract. According to the audit results, Weiding Company, the third party, reported a post-tax net profit of RMB 1,267,536.46 for 2016, with a shortfall of RMB 6,172,463.54 compared to the operating target. Shenzhen Venture Capital Co., Ltd. now claims that Zhou, Hou, Cao, Li, Wu, and Zheng should make up the aforementioned shortfall to Weiding Company and pay overdue interest at the contemporary loan rate set by the People's Bank of China, calculated from February 13, 2018, until the date of actual payment. This claim is consistent with applicable legal provisions.

Regarding the claim by Zhou, Hou, and Cao that they should make up the shortfall to the third party, Weiding Company, based on the upper limit of their original shareholding ratios, and pay interest thereon: According to the provisions of the Investment Cooperation Agreement, if the target company fails to achieve its 2016 operating target of a post-tax net profit of 7.44 million yuan, the investors shall have the right to require the original shareholders to compensate the target company in cash. The compensation shall take the form of the original shareholders making up the difference between the 2016 operating target and the actual net profit realized in 2016 to the target company. In this agreement, Zhou, Hou, and Cao, as original shareholders, jointly undertook the commitment to make up the profit shortfall; however, no specific arrangement was made regarding each of their respective shares of responsibility. Therefore, the argument advanced by Zhou, Hou, and Cao that they should not bear joint and several liability is not upheld.

【Relevant Statutes】

Contract Law of the People's Republic of China

Article 8: A contract established in accordance with the law shall be legally binding on the parties involved. The parties shall perform their respective obligations as agreed upon and may not unilaterally alter or terminate the contract. A contract established in accordance with the law is protected by law.

Article 60: The parties shall fully perform their respective obligations in accordance with the agreement.

Article 107: If one party fails to perform its contractual obligations or performs them in a manner that does not conform to the agreed terms, it shall bear liability for breach of contract, including continuing to perform the contract, taking remedial measures, or compensating for losses.

Article 113: If one party fails to perform its contractual obligations or performs them in a manner that does not conform to the agreed terms, causing loss to the other party, the amount of damages shall be equivalent to the loss caused by the breach, including the benefits that could have been obtained had the contract been performed; however, such damages shall not exceed the loss that the breaching party could have foreseen or ought to have foreseen at the time of entering into the contract.

The Inheritance Law of the People's Republic of China

Article 33: Inheritance of an estate shall be used to pay the taxes and debts that the deceased was legally obligated to pay. The payment of taxes and the settlement of debts shall be limited to the actual value of the deceased’s estate. Any amount exceeding the actual value of the estate, if voluntarily repaid by the heirs, shall not be subject to this limitation.

If an heir renounces the inheritance, they shall not be liable for repaying any taxes and debts that the deceased was legally obligated to pay.

[Lawyer’s Perspective]

A wagering agreement is an arrangement entered into by investors and the target company or its shareholders to mitigate investment risks. Under such an agreement, if the target company fails to meet certain performance targets or fulfill specific requirements, the original shareholders of the target company are obligated to compensate the investors or transfer a specified percentage of the company’s shares at a predetermined price. In this case, the “Investment Cooperation Agreement” signed between Shen Venture Capital Company and Weiding Company as well as its original shareholders—Mr. Zhou, Ms. Hou, Mr. Cao, and Mr. Li Ning—is a fairly typical example of a wagering agreement.

In this case, the Investment Cooperation Agreement does not violate any mandatory provisions of laws and regulations. The agreement was signed by Li Ning himself and was approved by a resolution of the shareholders’ meeting prior to its execution. Although the first-instance defendant, Zheng, is Li Ning’s spouse, according to relevant provisions of the Company Law, resolutions on increasing or decreasing a company’s registered capital must be adopted by the company’s shareholders; such resolutions do not extend to the spouse who is not registered as a shareholder in a jointly held equity interest. Therefore, the Investment Cooperation Agreement is lawful and valid.

Regarding the issue of Zheng, Li Moumou, and Wu Moumou being liable for making up the profit shortfall in this case: The shareholder status of Li Ning, the original shareholder of Weiding Company, has been inherited by Zheng, Li Moumou, and Wu Moumou. These three individuals now enjoy all rights associated with shareholder status. Moreover, thanks to the investment made by Shen Chuangtou Company, the value of their equity holdings has far exceeded Li Ning’s original capital contribution. Therefore, Zheng, Li Moumou, and Wu Moumou should bear the obligations arising from their equity holdings—and naturally, they should also be held responsible for compensating for any shortfall in operating performance. Furthermore, based on the investment agreement, Li Ning had an obligation to compensate Weiding Company whenever net profits failed to reach the targeted business objectives. This agreement was signed during Li Ning’s lifetime, and in 2016, when Weiding Company’s actual net profits fell short of the targeted level, the compensation liability stipulated under the agreement was triggered. Thus, although the compensation liability was determined after Li Ning’s passing, given that the agreement was executed while Li Ning was still alive—only the triggering event occurred in 2016, leading to its determination posthumously—it follows that the compensation liability borne by Li Ning should be regarded as part of his outstanding debts.