By Mengting Chen

The buyback clause serves as a crucial exit mechanism in equity investments, enabling investors to require the target company to repurchase their shares under specific conditions, thereby safeguarding investors' interests. When the target company fails to fulfill its repurchase obligations in a timely manner, investors typically seek to protect their rights by holding the company liable for breach of contract. In judicial practice, courts may limit or deny the target company’s liability for breach of contract based on considerations such as creditor protection and market order maintenance. This article provides an overview of the legal validity of buyback clauses, outlines three judicial approaches to investors' claims for breach of contract by target companies, and offers risk mitigation strategies for investors.

1.Legal Validity of Buyback Clauses

The legal validity of buyback clauses has evolved from being contentious to becoming increasingly clarified. Initially, certain opinions regarded buyback clauses as violating mandatory provisions of corporate law, such as prohibitions against capital withdrawal or actions detrimental to creditors’ interests, thus deemed them invalid. However, recent judicial practice has predominantly recognized the validity of buyback clauses, provided they adhere to the principles of fairness and do not infringe upon the legitimate rights of the company or external creditors.

Article 5 of the National Court's Civil and Commercial Trial Work Conference Memorandum (hereinafter referred to as the "Nineth Civil Memorandum") stipulates that investors’ requests for target companies to repurchase shares must comply with the corporate law requirements regarding prohibitions on capital withdrawal and mandatory provisions on share repurchase. If the target company fails to complete the statutory procedures for capital reduction, the people's court shall dismiss such claims.

2. Judicial Determination of Breach of Contract by Target Companies for Failure to Fulfill Repurchase Obligations

When a court dismisses an investor’s claim for equity repurchase due to the target company’s failure to complete the statutory procedures for capital reduction, the investor may pursue damages for breach of contract under the terms of the investment agreement. Judicial practice in these cases often involves balancing the complexities of competing interests, including the protection of contractual freedom, the assurance of reasonable returns for investors, the preservation of corporate capital adequacy, and protection of creditors’ interests. Courts have adopted three distinct approaches in handling such disputes:

Requiring the Target Company to Pay Liquidated Damages as Specified in the Agreement

In Case No. (2024) Zhe 0108 Minchu 1744, the Intermediate People’s Court of Shaoxing, Zhejiang Province, held that the agreements reflected the true intent of the parties, did not violate mandatory legal provisions, and were therefore valid. Since the target company failed to complete the statutory procedures for capital reduction as required, it was found in breach of its contractual obligations and ordered to pay overdue payment penalties at four times the Loan Prime Rate (LPR) stipulated in the contract.

Requiring the Target Company to Pay Adjusted Liquidated Damages

In Case No. (2021) Jing Min Zhong 495, the Beijing High People’s Court upheld the validity of the investment and supplementary agreements, recognizing their fairness and compliance with the Contract Law of the People’s Republic of China. While affirming the company’s liability for breach, the court adjusted the liquidated damages amount, considering the high daily penalty rate of 0.05% excessive. Instead, the court lowered the rate to 0.03%, based on the actual damage, the contract's performance, the parties’ fault, and expected benefits.

Firstly, the court of first instance affirmed the validity of the "Investment Agreement" and the "Supplementary Agreement" for the following reasons: "For investment contracts containing 'betting' clauses, the law has not issued any negative evaluation. When the 'Supplementary Agreement' does not fall under the invalidity provisions in Article 52 of the Contract Law of the People's Republic of China, the validity of the 'Supplementary Agreement' should be affirmed according to the law." Furthermore, "Although the target company’s repurchase of the investor’s shares as stipulated in the agreement may, in objective terms, harm the target company’s capital maintenance and external solvency as a legal entity, the target company’s signing of the 'Supplementary Agreement' and obtaining investment funds from the investor helps the company with financing and its operational activities, which in turn supports its capital maintenance and external solvency."

Secondly, with regard to breach of contract liability, both the courts of first and second instance supported the investor’s claims. The first-instance court held that the target company’s failure to complete the capital reduction procedure caused the investor not to receive the redemption price in a timely manner, and therefore, the investor’s demand for overdue payment penalties was supported by the contract. The second-instance court stated that when entering into the "Investment Agreement" and the "Supplementary Agreement" and during its performance, all parties should have a reasonable expectation of its ability to fulfill their corresponding obligations and perform them honestly. The target company’s failure to timely perform the capital reduction procedure violated its ancillary obligations under the contract, resulting in its failure to pay the redemption price to the investor within the agreed time frame, and thus, the target company should bear the delay in performance liability for failing to fulfill its contractual obligations in a timely manner. The court further noted that the payment of liquidated damages by the target company would not lead to a reduction in its registered capital nor would it necessarily harm the interests of creditors.

Lastly, with regard to the calculation of the penalty for expected performance delay, the investor requested the target company to pay overdue payment penalties based on the equity repurchase price, calculated at a rate of 0.05% per day, as well as a penalty of 1% of the actual investment amount (300,000 RMB) according to the breach of the "Supplementary Agreement." The first-instance court held that the investor's request for both liquidated damages and overdue payment penalties was excessive, and the 0.05% daily calculation rate was too high. Therefore, the overdue payment calculation rate was adjusted to 0.03% per day. The second-instance court, based on the losses caused by the breach, considered factors such as the contract’s performance, the degree of fault of the parties, and expected benefits, and upheld the first-instance court’s ruling.

Rejecting Investors’ Claims for Liquidated Damages

In Case No. (2020) Jing Min Zhong 549, the Beijing High People’s Court dismissed the investor’s claim, reasoning that the target company had not completed capital reduction procedures necessary for repurchasing shares. Supporting the investor's claim for damages would effectively allow the company’s shareholders to indirectly withdraw capital, violating mandatory legal provisions. As a result, rejected the investor’s claim for liquidated damages.

3. Risk Mitigation Strategies for Investors

(I) Enhancing Due Diligence

Before signing investment agreements, investors should comprehensively assess the target company’s financial status, including analyzing balance sheets, monitoring cash flows, examining governance structures, and evaluating business performance. Legal risks should also be scrutinized, with a particular focus on potential litigation, compliance issues, and historical capital reduction records to gauge future risks.

(II) Optimizing Buyback Clauses

Investors should draft buyback clauses with clear conditions, specific triggers (e.g., performance shortfalls, delays in public listing), and detailed procedures covering notifications, timelines, and payment methods. Liquidated damages should be structured to provide effective deterrence while setting reasonable limits. Additionally, collateral measures such as guarantees from controlling shareholders or asset pledges should be incorporated to enhance enforceability. Importantly, buyback clauses must comply with legal and regulatory requirements to ensure validity and enforceability.