From China to Wall Street and back

Concomitant with the corporate governance and disclosure standards of US securities laws, the laws also impose significant liabilities for failing to comply, including failing to make accurate and timely disclosures. With the recent spate of negative publicity, those China-based companies publicly traded in the United States are now finding themselves increasingly ensnared in administrative and civil actions. During the past several months, the SEC has initiated investigations into a number of these companies and has also suspended trading in at least six RTO companies. Regulatory agencies, including the SEC and the Public Company Accounting Oversight Board, have issued releases and alerts highlighting risks associated with China-based companies, particularly RTO companies. Unsurprisingly, the plaintiffs' bar in the US has responded and an increasing number of these companies are now finding themselves the subject of shareholder class actions and other related lawsuits. Even those that are not subject to any such lawsuits or administrative actions have found their share valuations declining as a result.

Because of these factors, especially the substantial management time and expense for an SEC reporting company to address ongoing compliance matters, the negative publicity, the decreased valuations and the increased risk of lawsuits and administrative actions, a number of China-based companies that are publicly traded in the US have decided or may decide that now is a good time to go private.

Methods of going private

Taking companies private involves cashing out all or a substantial portion of a company's public shareholders so that the company becomes eligible to delist and deregister its shares under the Securities Exchange Act of 1934, as amended (the Exchange Act). Depending on company-specific factors, going-private transactions are often structured as one-step mergers or as tender offers followed by a short-form merger. In certain instances involving the participation of affiliates, going-private transactions require transaction participants to file a Schedule 13E-3, which, among other things, addresses the fairness of the going-private transaction for non-affiliated shareholders.

Mergers

Short-form mergers

The quickest way for a company to go private is if at least 90% of the outstanding voting shares of each class of its stock are owned by its parent (which can be arranged by an acquiring group that holds 90% of such shares). Under most state corporate laws governing US-incorporated companies, “short-form” mergers can be effected and minority stockholder shares cancelled simply by having a 90% or more parent file a certificate of ownership and merger with the secretary of state in the subsidiary's jurisdiction of incorporation. Neither stockholder nor board approval by the target company is required. A notice of merger and appraisal rights will need to be sent to stockholders following the merger and minority stockholders can either accept the cash merger consideration or assert appraisal rights, if any. In the event appraisal rights are asserted, fair value is appraised by a court and the fair value can be appraised at a price higher or lower than the merger consideration.

Long-form mergers

While more time-consuming than short-form mergers, long-form mergers also provide US-incorporated companies that are not 90% or more owned by the acquiring group a means of going private. In contrast to short-form mergers, because shareholder and board approval of the target company will be required for a long-form merger, a publicly-traded, US-incorporated company will need to prepare and submit a preliminary proxy statement for review by the SEC, a process which may take several months to complete. The proxy statement must include, among other things, a description of the proposed transaction, the proposed merger consideration, the vote required for approving the transaction, the date for the stockholder meeting and appraisal rights, if any. Once the preliminary proxy statement has been cleared by the SEC, the date for the stockholders meeting can be set and the company can mail definitive proxy statements to stockholders. If a controlling stockholder is the acquirer or if affiliates participate in the transaction, the merger may be reviewed under the more rigorous “entire fairness” standard, which requires the board to achieve both procedural and substantive fairness. As a result, long-form merger going-private transactions will commonly involve the company's use of a special committee consisting of independent, disinterested members of its board of directors tasked with evaluating and negotiating the proposed transaction and authorised to, among other things, reject the proposal, evaluate alternative transactions, adopt defensive measures and engage separate financial and legal advisors.

Once all conditions to the merger are met, the merger closing takes place and the target merges with a subsidiary formed by the buyer and shares other than those owned by the buyer's subsidiary are cancelled and converted into the right to receive the proposed cash merger consideration (and the right to assert appraisal rights, if any, otherwise arises), thereby rendering the surviving corporation eligible to delist and deregister.

Tender offers

Tender offers are an alternative method to go private and involve the purchase of shares of a company directly from a company's stockholders. Tender offers are often conditioned upon the acquirer receiving at least 90% of the voting shares so that any remaining minority stockholders can then be eliminated through a short-form merger.

In connection with tender offers, the acquirer will be required to file with the SEC, among other things, a Schedule TO, the “offer to purchase” and a letter of transmittal. The tender offer must be open for at least 20 business days after the date on which the Schedule TO is filed with the SEC and the tender offer is publicised and commenced. In addition, the target company will need to file a response in the form of Schedule 14D-9 within 10 business days after the tender offer commences. The board of the target company must disclose in the Schedule 14D-9 its recommendation whether stockholders should accept or reject the tender offer or that it expresses no opinion. The Schedule TO and Schedule 14D-9 will typically be reviewed by the SEC.

Foreign private issuers

The manner by which foreign private issuers go private is governed under the laws of the jurisdiction in which they were incorporated, such as the Cayman Islands or the British Virgin Islands. Traditionally, companies incorporated under the Cayman Islands or British Virgin Islands laws have privatised through a scheme of arrangement, which is a court-supervised process requiring supermajority approval of the affected shareholders. Statutory mergers have become more commonly used in going-private transactions by companies incorporated in the Cayman Islands or British Virgin Islands. While the proxy rules of the US securities laws are not applicable to foreign private issuers, the US tender offer rules are. Depending on the percentage of securities held by US holders, certain exemptions, however, provide partial relief from these rules.

Schedule 13E-3 disclosure obligations

In addition to the proxy statements or tender offer materials, if any, that may need to be filed, going-private transactions conducted by the target company or its affiliates generally require the filing of a Schedule 13E-3. Schedule 13E-3 requires disclosure to stockholders of, among other things, the purposes for the transaction as well as a statement as to the fairness of the transaction to unaffiliated holders.

Discussion of the purposes of the transaction should include a description of the alternatives considered and why the alternatives were rejected, the rationale for the transaction structure and for undertaking the going-private transaction at the current time and effects of the transaction on the company, its affiliates and unaffiliated stockholders. Disclosure regarding the fairness of the transaction should include an explanation of how the transaction is both substantively fair and procedurally fair. Substantive fairness relates to the price paid to stockholders and procedural fairness relates to the entire process of negotiating, structuring, disclosing and approving the transaction. Each filing person must include a separate statement as to whether the filing person believes the transaction is substantively and procedurally fair. Furthermore, all reports, opinions and appraisals “materially related” to the transaction must be described and filed with the SEC. “Materially related” is interpreted broadly and it is important to note that documents that have not been prepared specifically for the transaction may be considered “materially related.”

Delisting and deregistering

In addition to going private, a company publicly listed in the U.S. will also have to take measures to terminate and suspend its various reporting obligations. A typical IPO issuer listed on the NYSE or Nasdaq will have obligations to register its securities and file reports with the SEC under the Exchange Act. RTO companies quoted on the Over the Counter Bulletin Board (OTCBB) will also have registered their securities and have obligations to file reports with the SEC under the Exchange Act in connection with becoming OTCBB-eligible. Companies publicly listed in the US will have obligations to register and/or file periodic reports under Sections 12(b), 12(g) and/or 15 of the Exchange Act, and will have to terminate and/or suspend these obligations in order to be able to “go dark” and complete the going-private process.

Final thoughts

Given current market sentiment and low share prices, many China-based companies that are publicly-traded in the US are considering going private. In light of the recent heightened scrutiny of these companies, thorough and careful preparation of disclosure documents and proper use of procedural safeguards will be critically important to the success of such transactions, particularly in the event of subsequent litigation.

Steven Winegar, David Grimm and Tim Sung, Paul Hastings, Hong Kong