A wave of Chinese stocks is poised to exit the US and seek capital back in Shanghai or Hong Kong, following recent fraud allegations of Nasdaq-listed Luckin Coffee and intensifying political tensions. Senior practitioners provide insights into the transactions that are fuelling their return
Privatizations of public companies incorporated in the Cayman Islands and listed on a major stock exchange are in vogue again for a variety of reasons, financial and regulatory. In the US, for example, the Holding Foreign Companies Accountable Act will prohibit trading in the shares of a company if the Public Company Accounting Oversight Board is unable to conduct an inspection of the audit papers of the company’s foreign auditor for three consecutive years. Chinese companies are a particular target.
Privatizations can be effected by: (1) a general offer and compulsory acquisition; (2) a scheme of arrangement; or (3) a long-form or short-form merger.
Long-form mergers have been the predominant method of taking a company private in US markets since the merger provisions were introduced in 2009. But a long-form merger, at least a cash squeeze-out merger, carries a high risk of dissentient shareholders applying to the Grand Court to have the fair value of their shares assessed by the court.
A short-form merger can be undertaken by the buying consortium forming a bid vehicle (Bidco), and the Bidco acquiring shares carrying at least 90% of the voting rights exercisable in general meetings of the target company. The Bidco will then become the parent of the target company and can effect a short-form merger, with the target company being the surviving company in the merger.
Under section 238(1) of the Companies Law, shareholders of the target are entitled to payment of the fair value of their shares, but only upon dissenting from a merger.
The advantage of the short-form merger is that shareholder approval is specifically not required (section 233(7) of the Companies Law), and so is not sought, and the statutory procedural requirements are very different from a long-form merger. There is no vote or decision from which shareholders can “dissent”, and none of the antecedent conditions that are required to be met to exercise appraisal rights in a long-form merger can be satisfied in the case of a short-form merger.
Appraisal rights do not stand in isolation and cannot be crafted out of thin air. Only a member – i.e., a person who is a shareholder entered in the register of members of the company pursuant to section 38 of the Companies Law – of a constituent company in a merger is entitled to an appraisal right. It does not include the holders of American Depositary Shares (ADS) or the holders of depositary instruments.
The exercise of a statutory right to effect a short-form merger, without appraisal rights, at a 90% threshold (albeit voting rights) is consistent with a compulsory acquisition following a general offer (90% acceptances) and to a scheme of arrangement (majority in number of members holding 75% in nominal value of the scheme shares), neither of which carry appraisal rights.
In a retreat from the dizzy days of an appraisal award being made at 235% of the merger consideration (in the matter of Shanda Games FSD 14 of 2016, 25 April 2017), perhaps some semblance of reality has crept into recent appraisal awards where, in one case, the fair value was found to be a mere 1.2% over the merger consideration (in the matter of Qunar, 2019) and a minority discount might be found to apply (Maso Capital Investments Ltd & ors v Shanda Games Ltd ).
However, as the author perpetually stresses, each determination of fair value is highly dependent on its own facts, and upon agreement or disagreement of the valuation models or their components by the valuation experts in each case. Valuation cases do not necessarily form transferable precedents.
From a buy-side perspective, short-form mergers are therefore highly attractive, since they may eliminate the tail-end price risk associated with buying out dissentient minority shareholders at a price which, if applied to the buy-side generally, would potentially make the pricing for the privatization unrealistic.
One example of a short-form merger is the privatization of Jumei International Holding, which was listed on the New York Stock Exchange (NYSE). There have been other public company short-form mergers, but the Jumei transaction is the first two-step merger in the Cayman Islands.
Jumei had a dual-class share structure with the buying consortium holding class B shares (10 votes per share) representing approximately 44.6% of the issued shares and carrying 88.9% of the votes exercisable in general meetings.
The buying consortium had to acquire further shares so that it held at least 90% of the total voting rights to effect the short-form merger. A general offer (the first step) was therefore made for all the issued class A shares (one vote per share) of Jumei, with an acceptance condition that required the tender of sufficient class A shares to enable the buying consortium to hold at least 90% of the total voting rights exercisable in general meetings.
The offer price represented a premium of 14.7% to the closing price of Jumei’s ADS on the NYSE on the last trading day prior to the announcement of the going-private proposal, and a premium of 29.3% to the closing price of Jumei’s ADS on the last trading day prior to the execution of the merger agreement.
After completion of the offer, the remainder of the shares not tendered to the offer were cancelled in a short-form merger (the second step) for the same price as the offer price. Appraisal rights did not apply. Two-step short-form mergers are here to stay.
David Lamb is a consultant at Conyers Dill & Pearman, and acted as the leading Cayman counsel for the buying consortium in Jumei’s privatization. He can be contacted on +852 6469 3377 or by email at email@example.com
Recently, issues related to the removal of the variable interest entity (VIE) structure, which was very popular five years ago, have received renewed attention. On the one hand, the attraction of the domestic capital market to enterprises has increased. With the good wealth effect of the Shanghai Stock Exchange Science and Technology Innovation Board (Star Market), the promotion of a Growth Enterprise Market (GEM) registration system, and resilient valuations under the COVID-19 pandemic, the domestic A-share market has become a safe harbour as a capital market of global funds.
On the other hand, the overseas COVID-19 pandemic situation has not been brought under control. The Luckin Coffee counterfeiting incident caused a crisis of trust among China-related stocks. Against a background that the decoupling of strategic relations between China and the US seems irreversible, the listing of red-chip companies in the US is worrying, and the remaining Hong Kong market is currently very crowded.
Therefore, the removal of the VIE and its return to the domestic capital market are again receiving attention. However, the legal environment in China has changed in the past five years, and it is inevitably biased if the discussion of the VIE removal plan is not based on these changes. This article focuses on the impact of value-added telecom service licences on the removal of the VIE structure.
VALUE-ADDED TELECOM SERVICE LICENCE
In recent years, an important reform in China’s capital market is the acceptance of red-chip enterprises that are incorporated offshore. However, at present, CR Micro is the only company in the domestic capital market that is directly listed on the Star Market with a red-chip structure. There is no restriction on foreign investment in the integrated circuit business operated by CR Micro, which is fundamentally different from ordinary VIE enterprises.
Therefore, its successful listing does not prove that VIE enterprises can also successfully be accepted by the A-share market. Returning to A shares after removing the VIE structure may still be the mainstream choice for many enterprises.
According to statistics, VIE enterprises generally hold value-added telecom service licences. Take the Chinese enterprises listed in 2019 in the US as an example; 62.5% of them hold value-added telecom service licences. Value-added telecom service is currently one of the few industries in China that restrict foreign investment. Therefore, the vast majority of the holders of these licences are domestic companies without foreign investment, which are controlled by overseas entities through control documents in the VIE structure.
Accordingly, for enterprises that intend to remove the VIE structure, after the structure is removed and foreign funds become shareholders in domestic entities, whether they can handle the sustainability of the value-added telecom service licences they hold is an important issue for these enterprises to consider.
RELAXED EXAMINATION AND APPROVAL
The threshold for foreign investors to take a stake in China’s value-added telecom enterprises was once very high. First of all, the power of examination and approval is concentrated in the Ministry of Industry and Information Technology, and the provincial communications departments only had the right to receive the documents. In addition, what is more difficult to grasp is the hard threshold for foreign investors’ industry performance and experience.
In accordance with relevant laws and regulations, major foreign investors of foreign-invested telecom enterprises operating value-added telecom services shall have good performance and operation experience with value-added telecom services.
However, most of the overseas funds that have invested in the Chinese market have only successfully invested in Chinese internet enterprises, and do not engage in telecom services directly. These requirements of performance and experience have really made it difficult for domestic enterprises invested by overseas funds to apply for a value-added telecom licence.
Since 2018, the state has further relaxed restrictions on the shareholding ratio of foreign investment in value-added telecom services. At the same time, the communications authorities have slightly relaxed the review standards for the performance and experience requirements on major foreign investors.
The results are reflected in the data. The number of foreign-invested value-added telecom enterprises approved has increased rapidly. Compared with 2018, the number of domestic foreign-invested telecom enterprises increased by more than 50% in 2019. Even with the COVID-19 pandemic, the number of enterprises increased by 21.47% as of the first quarter of 2020, compared with the same period in 2019. It is predicted that the increase in the number of enterprises in 2020 will be even greater.
The author believes that enterprises that intend to remove the VIE structure should first consider the follow-up treatment of all kinds of value-added telecom service licences that they have previously held or will soon apply for.
First, VIE enterprises may no longer need to hold value-added telecom service licences to continue their service due to changes in their service models. The present definition of value-added telecom services by the authorities tends to be strictly interpreted. Ordinary enterprises selling their own products or providing their own services through the internet or mobile internet are not generally regarded as B25 or B21 telecom services, and there is no need to apply for a licence. Enterprises are simply required to apply to the communications authorities for revocation of the original licence.
Second, to decide whether the company still needs a value-added telecom service licence for business operation, it should make a judgement and evaluation based on the proportion of foreign capital of the company in future, and the performance and operation experience of foreign shareholders. If it is decided as basically feasible, the VIE structure can be removed and a new value-added telecom service licence for foreign-invested telecom enterprises can be applied for. In this case, the process of applying for a foreign-invested value-added telecom service licence and the time required (usually more than six months) should be included in the schedule for removing and restructuring the VIE structure for overall consideration.
Finally, even if the shareholding ratio of foreign shareholders, or their performance and operation experience, cannot meet the actual operation requirements of the examination and approval authority, the enterprise can still choose to reduce the shareholding ratio of foreign shareholders through equity transfer, so that the enterprise may be able to maintain the value-added telecom service licence of the original domestic enterprise.
Cai Hang is the administrative partner at the Shanghai office of AnJie Law Firm. He can be contacted on +86 21 2422 4860/4866 or by email at firstname.lastname@example.org
Yao Ting is an associate at the Shanghai office of AnJie Law Firm. She can be contacted on +86 21 2422 4898 or by email at email@example.com
Hong Kong, which has ranked first in the global initial public offering market in terms of funds raised in seven of the past 11 years, is a pre-eminent listing venue for local, mainland China and international companies, given its proximity to the mainland, sound legal system, solid regulatory regime and advanced financial infrastructure.
The Stock Exchange of Hong Kong operates two markets, namely the Main Board and Growth Enterprise Market (GEM). The Main Board is designed for larger and more established companies, while the GEM is for small and mid-sized companies.
Companies must meet the basic qualifications that are prerequisites to the listing of securities on the stock exchange unless a waiver from strict compliance with the requirements is granted. The basic requirements for listing on the Main Board include a trading record of not less than three financial years, management continuity for at least the three preceding financial years, and ownership continuity and control for at least the most recent audited financial year.
Companies must also satisfy either the profit test, the market capitalization/revenue/cashflow test, or the market capitalization/revenue test, and possess an expected market capitalization at the time of listing of at least HK$500 million (US$64.5 million).
Companies applying to list on the GEM must have a trading record of not less than two financial years, be under substantially the same management throughout the two preceding financial years, and ownership continuity and control through the preceding financial year. It must also have a positive cashflow generated from operating activities of at least HK$30 million in aggregate for the two preceding financial years, and possess an expected market capitalization at the time of listing of at least HK$150 million.
In addition to the financial requirements, upon listing, a company must satisfy the minimum public float requirement, with at least 25% of the total number of issued shares held in public hands. Such shares in public hands at the time of listing must be held by at least 300 shareholders for companies listed on the Main Board, and 100 shareholders for companies listed on the GEM.
Depending on the place of incorporation, additional requirements may be applicable to companies incorporated outside Hong Kong. Companies incorporated in the Cayman Islands, Bermuda and mainland China are generally permitted to list in Hong Kong subject to compliance, with additional requirements set out in the listing rules.
Examples of additional requirements applicable to a company incorporated in mainland China include requirements for the articles of association to provide a sufficient level of shareholder protections, to be duly incorporated in mainland China as a joint stock limited company, and for its annual accounts to be presented in accordance with the relevant reporting standards.
The stock exchange is also keen to attract companies incorporated in other overseas jurisdictions to list in Hong Kong provided that, among other factors, the standards of shareholder protection are at least equivalent to those provided in Hong Kong.
Another factor that the stock exchange will consider in a listing application is suitability for listing. Suitability for listing is a concept that covers a wide range of factors, and the stock exchange has issued Guidance Letter HKEX-GL-68-13, setting out a list of non-exhaustive factors that may be relevant to assess whether a company is suitable for listing.
Examples of the factors include integrity non-compliance, material non-compliance, sustainability of the business, and the use of contractual arrangements. In addition to the guidance letter, it may also be useful to refer to the listing decisions made by the stock exchange to gain a better understanding on the interpretation of the listing rules, although each decision is case-specific.
The above-mentioned criteria are not exhaustive, as the listing regime evolves over time. The recent changes to the listing regime brought amendments to the Main Board listing rules to permit the listing of biotech issuers that do not meet any of the financial eligibility tests, and companies with weighted voting right structures, and established a new concessionary secondary listing route for Greater China and international companies that wish to make a secondary listing in Hong Kong, effective in April 2018.
Hong Kong has successfully attracted well-known mainland and international companies to list, or consider listing, in Hong Kong, such as Xiaomi Corporation, Alibaba Group Holding, Budweiser Brewing Company APAC, NetEase, Inc. and JD.com. The recent changes to the listing regime and successful listing of these world-famous companies in Hong Kong may encourage companies originally not qualified or listed on other stock exchanges to consider listing in the city, which in turn enhances the competitiveness of Hong Kong in the global market.
Samuel Wong is an associate at CFN Lawyers. He can be contacted at +852 3468 7362 or by email at firstname.lastname@example.org
Athena Tang is a trainee solicitor at CFN Lawyers. She can be contacted at +852 3468 7612 or by email at email@example.com