1. What is the "preferential liquidation right" clause?

"Right of first refusal" clauses are commonly found in various types of investment agreements, including private equity investment agreements. Capital entering the portfolio company at a high premium usually does not exit at the normal price. Therefore, it is common to include a preferential liquidation clause in the investment agreement. The so-called "preferential liquidation right" clause generally refers to the clause that when the company is liquidated (deemed to be liquidated), the investor has the right to distribute the remaining assets of the company in priority over other shareholders in accordance with the investment agreement and other agreements.

2. Types of "preferential liquidation rights" clauses

In practice, the "preferential liquidation right" clause mainly includes the following types:

1. Preferential liquidation clause that does not participate in distribution. The clause of such preferential liquidation right stipulates that the shareholder of the investor shall have the right to distribute the remaining property in the first place, and after the shareholder of the investor distributes the remaining property in accordance with the investment agreement, if there is a surplus, the investor will no longer participate in the distribution of the remaining property.

2. Preferential liquidation clause for full participation in distribution. The clause of such preferential liquidation right stipulates that after the shareholders of the investor distribute the remaining property according to the first rank they enjoy, if there is a surplus, the investor will still participate in the distribution of the remaining property, and the investor will distribute the remaining property together with other shareholders according to their respective shareholding ratios.

3. Priority liquidation clause with upper limit to participate in distribution. The clause of such preferential liquidation right stipulates that after the investor shareholder distributes part of the remaining property according to the first rank he enjoys, he will continue to distribute the remaining property together with other shareholders according to their respective shareholding ratios, and will no longer participate in the distribution of the remaining property after reaching a certain upper limit through the distribution of the first two ranks.

3. The legal basis of the "preferential liquidation right" clause

According to Paragraph 2 of Article 186 of the Company Law, the remaining property of the company after paying the liquidation expenses, employees' wages, social insurance fees and statutory compensation, paying the taxes owed, and paying off the company's debts shall be distributed according to the proportion of capital contributed by the shareholders by the limited liability company and distributed by the joint stock limited company according to the proportion of shares held by the shareholders.

This clause contains the following meanings:

First of all, it explains the meaning of "residual property" mentioned above, that is, "the remaining property of the company after paying liquidation costs, employees' salaries, social insurance expenses and statutory compensation, paying the taxes owed, and paying the company's debts" can be used for shareholder distribution, which is also the "final principle of shareholders".

Secondly, it stipulates the principle of distribution of surplus property under normal circumstances, that is, "a limited liability company is distributed according to the proportion of capital contributed by shareholders, and a joint stock limited company is distributed according to the proportion of shares held by shareholders".

Finally, according to the usual interpretation of the Company Law, since the above-mentioned clause does not provide for exceptions such as "unless otherwise agreed in the articles of association", is the above-mentioned principle of distribution of surplus property a mandatory principle of validity, and is the provision of "preferential liquidation right" in the investment agreement legal? How is it determined in practice?

IV. Judicial Practice

The author searches for relevant cases with "priority of liquidation right" as the keyword, Beijing Third Intermediate People's Court (2019) Jing 03 Min Zhong 6335 TThe Civil Judgment of Second Instance of the Equity Transfer Dispute between Lin Yu and Beijing Beike Innovation Investment Center (Limited Partnership) makes the following analysis of "whether the capital increase agreement claimed by Lin Yu is invalid because it contains the same sale of shares, anti-dilution, priority liquidation right, etc.": Article 186 of the Company Law of the People's Republic of China stipulates: "After cleaning up the company's assets and compiling the balance sheet and property list, the liquidation team shall formulate a liquidation plan and report it to the shareholders' meeting, the shareholders' general meeting or the people's court for confirmation." The remaining property of the company after paying the liquidation expenses, employees' wages, social insurance expenses and statutory compensation, paying the taxes owed, and paying off the company's debts shall be distributed by the limited liability company according to the proportion of capital contributed by the shareholders, and the joint stock limited company shall be distributed according to the proportion of shares held by the shareholders. ""According to the above provisions, when a company is liquidated, liquidation expenses, employees' wages, social insurance expenses and statutory compensation, taxes owed, and company debts have priority over shareholder distribution. In this case, the case involved the "preferential liquidation right" clause in Article 15 of the Capital Increase Agreement, whereby after the target company paid the liquidation expenses, employees' salaries, social insurance fees and statutory compensation, paid the taxes owed, and settled the company's debts, Beike Center distributed in the shareholders' distribution in priority over other shareholders, and the agreement stipulated that after paying the legally superior amount distributed between the shareholders, the shareholders' internal agreement on the distribution order did not violate the provisions of Article 186 of the Company Law of the People's Republic of China. TTherefore, the provisions on the priority liquidation right in the Capital Increase Agreement do not violate laws and regulations. Article 4 of the Interpretation (I) of the Supreme People's Court on Several Issues Concerning the Application of the <> of the Contract Law of the People's Republic of China (I) stipulates: "After the implementation of the Contract Law, the people's court shall confirm the invalidity of a contract on the basis of the laws formulated by the National People's Congress and its Standing Committee and the administrative regulations formulated by the State Council, and must not be based on local regulations or administrative rules." Article 14 of the Interpretation (II) of the Supreme People's Court on Several Issues Concerning the Application of the <> of the Contract Law of the People's Republic of China stipulates: "The 'mandatory provisions' provided in Article 52(5) of the Contract Law refer to mandatory provisions of validity. "According to the above provisions, only violations of the mandatory provisions on the validity of laws and administrative regulations will lead to the inevitable invalidity of the contract. From the above, none of the contents stipulated in the Capital Increase Agreement in the case violated the mandatory provisions of laws and regulations. Therefore, the capital increase agreement claimed by Lin Yu is invalid because it contains provisions such as equity sale right, anti-dilution, and priority liquidation right, and lacks legal basis, and this court does not support it.

The court judgment in this case has made a positive determination of the validity of the "preferential liquidation right" clause, which may have a certain guiding effect on the judgments of other courts in similar cases, but since China is not a case law country, it cannot be assumed that other courts will not make subsequent contrary judgments based on this case alone.

5. The "preferential liquidation right" clause has not been remedied by the court

As mentioned above, although the equity transfer dispute between Lin Yu and Beijing Beike Innovation Investment Center (Limited Partnership) affirmed the legality of the "preferential liquidation right" clause, in order to avoid different courts from having different understandings of this clause, it is recommended to clearly stipulate in the design investment agreement that "if the investor is subject to relevant Chinese laws and regulations, the investor cannot distribute according to the preferential liquidation right clause." The founder shareholders agree to compensate the investors for the difference between the property that the investor should receive distributed under the terms of the preferential liquidation right and the distributed property that the investor actually received in liquidation. The compensation shall be that the founding shareholders agree to pay the remaining assets acquired at the time of liquidation to the investor shareholders immediately and in full until the investor shareholders recover the property that should be distributed under the terms of the preferential liquidation right, or the founding shareholders may compensate the investor shareholders in a manner approved by other investors (including but not limited to free gifts to the investor shareholders) until the investor shareholders recover all the property entitled to distribution under this agreement."

(This article is translated by software translator for reference only.)