The Cayman Islands is undoubtedly a leading financial centre and has a sophisticated, well developed legal system. Despite the international and cross-border nature of the jurisdiction, it is worth considering just how the islands have become the hot zone for mostly United States-based hedge funds litigating primarily against Chinese operating entities that are seeking to merge by availing themselves of the Cayman merger regime.
The Cayman Islands statutory merger regime provides a mechanism to enable former publicly listed companies to ‘go-private’. The rights afforded to so-called dissenting shareholders, being those shareholders who have dissented from a take-private merger or consolidation and therefore rejected the price offered to them for their shares, has in recent years been subject to considerable judicial scrutiny by the Cayman courts.
Petitions filed under section 238 of the Cayman Islands Companies Act are ultimately concerned with one thing: the fair value of dissenting shareholders’ shares. The company subject to the merger contends for a lower valuation; the dissenting shareholder contends for a higher valuation; expert valuation evidence, usually running to hundreds and hundreds of pages, is adduced; the court, with the assistance of the experts, arrives at a fair value figure. If the fair value figure exceeds the price that was offered to the dissenting shareholder (a price commonly referred to as the merger price), the company is required to pay that higher figure (less any payments made to the dissenting shareholder in the interim), together with a fair rate of interest.
The overwhelming majority of cases in this area have involved companies that are incorporated in the Cayman Islands, have their operations based in China, and have recently de-listed from US-based exchanges. Bona Films, Shanda Games and Qunar Cayman Islands Limited are well-known examples.
This article considers the geo-political, regulatory and financial landscape that could result in further de-listings and further litigation in this space. The development of Cayman law in this relatively nascent area of law is likely to be of great interest to investors (typically, but not always, professional funds actively investing in appraisal opportunities) seeking to argue, in any given case, that the merger price undervalues their shares.
Why is the litigation in Cayman?
According to a study prepared by Duff & Phelps, as at November 2019 there were nearly 200 Chinese based companies listed on the NYSE, Nasdaq and AMEX stock exchanges. Of those companies, approximately 70 per cent are incorporated in the Cayman Islands. Over the last 10 years there has been a privatisation trend – at its peak in 2016, but picking up again over the last two years – of Chinese based companies de-listing from the US. Further examples of such companies include Qihoo 360 Technology Co Ltd, Mindray Medical International and E-House (China) Holdings.
For now, there is no suggestion that this privatisation trend is slowing. In fact, there has been a recent increase in company announcements concerning the receipt of preliminary non-binding proposals for the purchase of company shares. Further deals are therefore likely. Moreover, there are other reasons to anticipate an even further uptick in deal activity. Front and centre amongst those reasons is the ongoing economic uncertainty caused by the Covid-19 pandemic and legal and regulatory developments in the US in connection with ongoing US-China trade war, which appears to show few signs of slowing under the new US administration.
Take-private transactions are often instigated by the companies’ controlling shareholders and management. They are usually structured under the Cayman Islands statutory merger regime, whereby, provided the merger is approved by two thirds of shareholders voting in a general meeting, the company ends up merging with a corporate vehicle that is 100 per cent owned by the buyer group’s holding company. As part of the merger regime, once the merger is approved at a general meeting, shareholders have the right to dissent from the merger. Given that the merger is already approved, their rights do not entitle them to scupper the deal, but it does entitle them to payment of the fair value of their shares. What constitutes fair value – a term that has no statutory definition under Cayman Islands law – can be a highly contentious issue given the sums at stake. It has spawned a growing body of jurisprudence in the Cayman Islands, where dissenting shareholders seek to persuade the Court that "fair value" exceeds the deal price.
To date, there have been over 26 such petitions filed in the Cayman Islands, seven have proceeded to trial, two settled during the course of or following trial and five trial judgments have been handed down.
US developments leading to further de-listings and further Cayman litigation
The Public Company Accounting Oversight Board (PCAOB) was created under the US Sarbanes Oxley Act of 2002 in order to oversee the accounting profession by establishing auditing standards for public accounting firms, inspecting registered firms for compliance, and taking investigative and enforcement actions in relation to any non-compliance. One of those requirements is that any accounting firm, whether in the US or overseas, that prepares an audit opinion in relation to any issuer of securities in the US, is required to produce the underlying work papers in relation to that audit at the request of the PCAOB.
In June last year, former President Trump released a memorandum entitled "Protecting United States Investors from Significant Risks from Chinese Companies" and tasking the President’s Working Group on Financial Markets to examine risks to investors in US financial markets posed by the Chinese government’s failure to allow audit firms registered with the PCAOB to comply with US securities law and investor requirements. The Working Group subsequently released its recommendations under cover of a letter stating that it believed that they “would help ensure that companies listed on US exchanges from Non-Cooperation Jurisdictions (NCJs) such as China meet U.S. investor protection objectives expected of all U.S. listed companies”.
Following these developments, on 18 December 2020, the Holding Foreign Companies Accountable Act, was signed into law. Amongst other things the Act, which was unanimously passed by the House of Representatives, amends the Sarbanes Oxley Act to prohibit the securities of foreign companies being traded on US exchanges if they retain a foreign accounting firm that cannot be inspected by the PCAOB for three consecutive years, beginning in 2021. In other words: de-listing from US exchanges for non-compliance.
The Holding Foreign Companies Accountable Act has unsurprisingly not been well received in China, where the spokesman for the Foreign Ministry, Wang Wenbin, has called it “an unjustified political crackdown on Chinese enterprises listed in the United States” and that “it will seriously hinder the normal listing of Chinese companies”.
The upshot of these recent developments is likely to make a continued listing on US exchanges more difficult, not least given the tension between the requirements of the Holding Foreign Companies Accountable Act and Chinese state secrecy laws. This, in turn, increases the probability of further take-private deal flow. Given the number of Chinese based companies that are Cayman incorporated and listed on US based exchanges, it is likely that we the Cayman merger regime will continue to be used as the preferred route for these companies to privatise and possibly, thereafter, relist in "friendlier" jurisdictions (for example, Hong Kong or Shanghai).
The last few years have seen a spate of decisions in the Cayman Islands courts in relation to section 238, covering all manner of procedural and substantive issues in relation to valuation principles, discovery, costs, management meetings, interim payments, interest and more. Many of those decisions are of wider application beyond the scope of section 238.
The concomitant of an increasing number of take-privates is an increasing number of dissenter disputes concerning fair value. Should that trend continue, there will be more opportunity for speculation in appraisal litigation.
This article was originally published by Commercial Dispute Resolution on 13 April 2021.