Protecting small and medium shareholders in backdoor listings

By Qu Kai, Grandway Law Offices

This column will begin its tale by looking at Shanghai Feilo’s achievement of a back door listing through China Security & Fire Technology (China Security). On 15 July 2013, Shanghai Feilo issued a preliminary restructuring plan. The preliminary restructuring plan consisted of three parts:

  1. An asset sale. Feilo would sell all of its assets and liabilities (other than cash funds and specified liabilities) to the major shareholder, INESA Electronic Group, and its affiliate, INESA Asset Group, or a non-affiliated third party.
  2. A share offering to purchase assets. Shanghai Feilo would offer shares to Shenzhen Zhongheng Huizhi Investment (ZHHZ) and purchase 100% of the equity of China Security held by it. China Security undertook that its net profit, minus non-recurring gains and losses, for the years 2014-2016 would not be less than RMB210 million, RMB282 million and RMB376 million, respectively.
  3. Raising of ancillary funds. Feilo would offer shares to Tu Guoshen, the controlling shareholder of ZHHZ, for ancillary financing, to raise not more than RMB1.125 billion.
曲凯 Qu Kai 国枫律师事务所合伙人 Partner Grandway Law Offices
Qu Kai
Grandway Law Offices

The entire story unfolded along the lines of the following script: “(1) push up the share price by virtue of an acquisition/restructuring; (2) pledge the shares to obtain more funds; (3) use the financing proceeds to continue capital operations; and (4) a pledge unwinding risk arose.” In January 2015, China Security stepped onto the capital market stage. Beginning in January 2015, ZHHZ repeatedly pledged the stock it held in China Security for financing purposes.

However, China Security failed to fulfil its profit forecast undertaking in all three years from 2014 to 2016. China Security was investigated by the CSRC in December 2016. In June 2017, the restricted shares held by ZHHZ, accounting for 4.09% of the company’s total share capital, were judicially frozen, among these being shares held in a dedicated account opened by it for compensation relating to the profit forecast. Subsequently, the shares held by ZHHZ began to be frozen or queued for freezing by various local courts.

Given that the percentage of the shares held by ZHHZ that were pledged was relatively high and that it came up to the unwinding warning line, the company shares that it held were subsequently still at risk of being frozen or disposed of in connection with other legal actions or pre-trial preservation. Additionally, as the shares held by ZHHZ in the dedicated account opened by it for compensation relating to the profit forecast were queued for freezing, there was uncertainty surrounding the time when ZHHZ and its actual controller, Mr. Tu Guoshen, could lift the freeze on the above mentioned compensation shares and, accordingly, uncertainty as to whether the giving of the above mentioned compensation shares could be promptly carried out. There was also a risk that the latter could not be carried out.

Protection of small and medium shareholders. There is little doubt that it is the small and medium shareholders who would suffer the most if compensation shares were given due to failure to achieve the performance undertakings. The question then is how does one go about protecting their lawful rights and interests?

The author’s recommendation is: approaching the issue from the perspective of protecting the lawful rights and interests of the listed company and investors and safeguarding market order and the public interest, the pledging acts of shareholders bearing performance undertaking obligations should be strictly constrained. In addition to article 13 of the Guidelines for Managing the Risks Associated with the Participation by Securities Companies in Pledge-style Stock Repo Transactions, the Supreme People’s Court should promptly issue judicial interpretations granting the priority right of repayment enjoyed by small and medium shareholders priority over other claims when enforcement is effected against such shares. (Article 13 specifies that, “Where there is a performance undertaking and share compensation agreement for pledged stock, the securities company shall identify and assess its special risks, paying particular attention to such risk factors relating to the performance undertaking compensation as the method of compensation, the undertaking period and the performance that has been undertaken, and duly guard against the risk that could arise if share compensation in connection with the pledged stock occurs. It may not participate in pledge-style stock repo transactions with a pooled asset management plan under its management or a targeted asset management client as the finance providing party.”)

The reasons for the author’s recommendation are:

  1. A shareholder that bears a performance undertaking obligation bears certain obligations from the moment he obtains equity. Taking China Security as an example, without the huge performance undertaking, the assets brought in with the restructuring would not have been assessed as increasing in value by 747.05%, and ZHHZ could not make an exchange for so many shares. Also, the huge performance undertaking obligation was linked to the compensation shares tied to the profit forecast.In other words, until the expiration of the performance undertaking period, the number of shares held by ZHHZ remained clouded in uncertainty, and they were already encumbered by the prior rights of the small and medium shareholders. On this basis, that the small and medium shareholders should have a priority right of repayment when the court effects enforcement against such equity is logical.
  2. It is in keeping with the spirit at the time of equity division reform. Originally, companies listed in China had two types of shares, non-tradable and tradable, but, other than the large difference in shareholding costs and the difference in the right to trade the same, the other rights attaching to each share were in fact the same.Based on the same logical basis, for a shareholder bearing a performance undertaking obligation, the performance that he has undertaken is one of the major factors determining his shareholding costs. Failure to grant small and medium shareholders a priority right of repayment when enforcement is effected against such shares would be a failure to recognize the difference in the shareholding costs of the two types of shareholders, not to mention protecting the lawful rights and interests of small and medium shareholders, this group that finds itself in a weak position.
  3. Elimination of the leverage generating basis. As the pledge of such shares is subject to restrictions, this eliminates the possibility of a future blow up occurring as well as the risks that such creditors as financial institutions face, as well as the risk of major volatility that unwinding would impart to the stock market.

Qu Kai is a partner at Grandway Law Offices

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