Loophole Exploitation Aggravates Chinese and Foreign Regulators
Following the 2009 financial crisis, a drought of initial public offerings in the U.S. equity markets quickly turned into a tsunami in 2010 as companies raced to cash in on the China growth narrative. Attracted in part by the prestige of listing on a reputable U.S. exchange, Chinese companies listed in droves, sometimes doubling valuations in the hours and days after the listing. However, the attractive capitalization conditions were equally fraught with rampant speculation that beckoned malign behavior and misleading offerings on the part of certain players.
To this day, related matters are still being litigated in court and forcing companies to abandon strategies that capitalized on limited shareholder protections as regulators increasingly scrutinize the structures and loopholes company’s use to access financing.
Excluded from Hong Kong
Many companies from China recognized the eagerness of foreign investors to capitalize on the BRIC thesis coined and touted by Goldman Sachs during the early 2000s. China was expected to represent one of the biggest global growth stories for decades to come, and foreign investors lined up to add exposure. One of the reasons behind Chinese companies’ willingness to chase foreign capital outside Chinese borders in large part stems from restrictions placed on foreign investors. Until recently, even the largest global investment managers and funds faced allocation restrictions barring them from accumulating more than a certain percentage of ownership in Chinese stocks and bonds.
However, even long before the limits were removed, doing business in China was not only difficult but fraught with pitfalls. For Chinese companies seeking capital, the U.S. represented one of the most attractive destinations to list shares and raise capital for a very simple reason: exclusion from Hong Kong’s markets. Although just over the border, Hong Kong places much tougher restrictions on corporations that wish to list on its exchanges. The main consideration that prevented many Chinese companies from previously accessing the Hong Kong Stock Exchange and London Stock Exchange, was the “differential voting rights” exhibited by corporations.
Differential voting rights (DVRs) refers to the issuance of multiple classes of shares, each of which entitles the holders to different voting rights. In certain circumstances, this results in investors holding majority economic ownership of a company, but not necessarily commanding the majority voting rights. These specific restrictions made it more attractive for Chinese firms to incorporate in offshore havens like the Cayman Islands to not only avoid direct taxation but also eventually list in the United States while maintaining a tiered voting structure that directly benefited owners.
The Proliferation of VIEs
One of the biggest examples of a Chinese company listing abroad for equity fundraising is homegrown Chinese darling Alibaba. Investors in the U.S. clamored to buy a slice of Alibaba’s listing on the New York Stock Exchange in 2014, but what most didn’t realize is that they instead purchased shares in a Cayman Islands-based corporation that was simply a shell company. Due to the restrictions, especially for Internet companies in China, many turned to the variable interest entity (VIE) to circumvent domestic limits on foreign ownership. Unfortunately, this complex legal structure puts shareholders at a steep disadvantage.
For one, while Chinese companies pledge to pass cash flows and earnings through the offshore vehicle, should anything go wrong, investors have little ability to enforce better governance in these companies since decisions are made on the mainland, absent investor participation. These opaque practices have created problems in the past, notably for foreign investors. Alibaba, in particular, exemplified these very risks after the company opted to remove AliPay from the main holding company, drawing the ire of major investors like Yahoo! and SoftBank.
In China, regulators were loath to allow foreign investors to own a slice of a licensed non-bank payment company, hence the spinout. However, investors did not find out until after the decision, highlighting the disparity between expectations and the reality of investing in Chinese companies while underlining the veritable minefield of risks. Although the matter was eventually settled, it did not necessarily satisfy shareholders or analysts who highlighted the murkiness of the mechanism that would be used to compensate jilted investors like Yahoo!
Hong Kong has since changed its stance towards dual-class shares which assign different voting rights (like DVRs), paving the way for a secondary offering of Alibaba shares in its exchanges. Yet, Alibaba is far from the only company that will use its newfound access to Hong Kong. Another U.S.-listed firm, SMIC, China’s biggest chip maker (and also a Cayman-incorporated entity), recently announced plans to delist from the New York Stock Exchange, potentially paving the way for its own relisting either on the mainland or in Hong Kong. The move was immediately panned by investors, dropping shares by 4.90% the day of the announcement. Because of its complex structure, dissenting shareholders will probably be forced to battle the company in Cayman courts to ascertain and realize the “fair value” of their holdings.
From Delisting to Relisting
U.S. investors are afforded many rights when dealing with U.S.-listed companies, but this is not universally true, especially when it comes to the opacity of investing in U.S.-listed entities belonging to Chinese companies. For one, attempting to fight companies in China is not only difficult but in some cases impossible. Second, depending on the incorporation jurisdiction, local laws may limit the legal actions they can take against companies. This is especially true in terms of the delisting and relisting strategy exploited by many Cayman-incorporated companies.
Chinese companies listed in the U.S. have used loopholes in Cayman Island law to delist from U.S. exchanges before engaging in “take-private” deals and eventually relisting on the mainland where conditions are more favorable for improving valuations. Because of the Cayman Islands’ flexible incorporation laws which permit the board of directors to approve delisting plans before submitting to two-thirds of voting shareholders to agree, tiered ownership structures can effectively sidestep dissenting shareholders.
Though many companies have followed this blueprint, success is not universally guaranteed, and the path is fraught with risks. Chinese video-game-maker Shanda Games, for instance, was listed in the U.S. before a delisting and take-private deal was initiated. Maso Capital, a Hong Kong-based fund that invests specifically in Chinese companies being delisted, challenged the company in Cayman Courts to improve the value assigned its shares during the take-private valuation, ultimately resulting in an 80% higher payout for shareholders above the take-private figure.
Maso Capital and other dissenting shareholders allege that Qihoo 360 intentionally hid material information from shareholders during the board-approved take-private transaction, using a legal mechanism to have the court decide the “fair value” of shares. Although the case is ongoing, often with the revelation of embarrassing details about the Qihoo 360 operation and management, it highlights the opaque nature not only of the ownership structures, but internal deliberations regarding forecasting, valuations, and more. Many legal observers have suggested that the ongoing legal battle will likely head towards mediation as it allows Qihoo 360 to save face and continue its march towards market expansion.
However, Qihoo 360 did not only face the ire of investors after it delisted but also when it relisted in Shanghai for a 550% gain over its take-private price less than two years later. Furthermore, it also raised eyebrows amongst Chinese regulators. Officials, attempting to curb speculation, are examining the issue with greater fervor, especially when considering the steep valuation mismatch between foreign and domestic listings.
Local Regulators Also Question Motives
When it attempted to relist in Shanghai via a reverse takeover (backdoor listing) of SIEC, Qihoo 360 was similarly questioned by the China Securities Regulatory Commission (CSRC). Eventually, the deal moved forward, likely because of Qihoo’s stated intentions to play a more integral role in domestic cybersecurity initiatives. The regulator had been harsher in the past towards these types of backdoor listings, especially given that it was encouraging rampant speculation in small-cap stocks amid a large backlog of companies trying to go public.
While China has since eased the restrictions on companies trying to relist on the mainland, especially high-quality companies, the murky corporate maneuvers that Chinese companies engage in should give investors pause for caution. Despite regulatory measures designed to protect investors, allowing class-action lawsuits akin to the WuXi pharmaceutical take-private transaction to proceed, lawmakers are debating other measures. Members of U.S. Congress are pushing for more transparency, including audits and increased scrutiny, but until regulators end the practice of opaque ownership structures being allowed to list, the likelihood of preventing similar circumstances is distant at best.
Although Hong Kong may arise as the preferred destination for Chinese dual-listed companies in the near-term over the U.S. due to regulatory changes, the pipeline of companies waiting to IPO in the U.S. shows no signs of shrinking. Ultimately, this risk will be borne by investors, making them a ripe target for companies that exhibit far-less transparency relative to other global peers forced to meet high disclosure requirements. It puts the onus on regulators to contain the risks or implement a higher threshold for companies that wish to access capital markets. By demanding more transparent corporate governance, regulators could handedly end the practice of luring in unsuspecting investors unaware of a potential governance nightmare that could prevent them from realizing the true value of their capital.