Although most plants subsist on water, sunlight and carbon dioxide, there are a few whose diet includes insects. The pitcher plant, for instance, lures its prey into its mouth with a sweet nectar before trapping them and digesting them. Drawn by sweet scents and bright colors, unsuspecting insects ignore the dangers within.
Much like the pitcher plant’s methods, Chinese companies have been engaging in a similar strategy with US exchanges over the past decade. After launching much-lauded initial public offerings (IPOs), many Chinese companies subsequently devalued their shares, were taken private, and eventually re-emerged a few years later in Chinese exchanges at substantially higher valuations. The problem is that these new valuations are so large as to raise questions about those unsuspecting investors left in the lurch when firms cancel their shares and grossly under-compensate them. Although the current political tensions between the US and China are stealing the spotlight, this behavior may be a more immediate problem for US investors.
Qihoo 360, a Chinese Internet-security company known for its antivirus software, stands out as a recent example. After the company announced plans to privatize through an effort spearheaded by chairman and chief executive officer Zhou Hongyi in 2016, investors were given the option to claim repayment for their shares. However, the low-ball valuation that minority investors were forced to accept turned out to be relative pennies when the company re-listed in Shanghai for a massive valuation that was more than 550% higher.
Delisting is proposed as an ordinary strategy decision, but when viewed in a broader context, exposes a troubling pattern of companies extracting capital from US equity markets by exploiting legal loopholes. This practice, while not illegal, poses distressing situations for both Chinese companies dragged into prolonged litigation and minority investors.
The Chinese loophole
Qihoo 360 was first listed on the New York Stock Exchange in 2011, exploiting the eagerness of US investors to tap the Chinese growth miracle before delisting shares in a privatization transaction worth US$9.3 billion in 2016. Chinese companies seeking US listings, akin to Qihoo 360, are commonly incorporated in the Cayman Islands because of its flexible laws that allow controlling shareholders and founders to vote on and pass delisting proposals – a controversial policy at best. After delisting in 2016, Qihoo 360 returned to public markets two years later, listing in Shanghai at a valuation of $62 billion. However, considering the absence of real value added in the time between events, the drastic revaluation is suspect at best.
The scheme, which was perpetrated by the majority of Qihoo 360 co-investors, delivered a windfall to the conspirators, but raised the ire of former investors who claimed they were misled by the company’s advisers in advance of the privatization. Financing for the privatization was raised on the basis that it would return investor funds by 2019 compared with the dimmer prospects shared with the company’s shareholders ahead of the “take-private” transaction. US investors lost the vote and had to approve the transaction, albeit at a steep discount to the company’s “true value” as alleged by the numerous lawsuits currently entangling Qihoo 360 in Cayman courts.
Although on its own the move could be viewed as somewhat harmless, especially when considering the legality of the transaction, the Qihoo 360 story reflects many similar situations that have followed the same playbook. For Chinese companies, the strategy often delivers a payout bonanza, known commonly as the “Chinese loophole.” Minority investors are the ones who ultimately pay the price. However, investors are fighting back, attempting to claim funds they believe they are entitled to because of the possibly fraudulent circumstances underpinning these re-listing outcomes.
While litigation has become a more prominent tool for fighting back against these severely underpriced valuations, these showdown attempts with massive corporations face immense challenges to recover funds for investors and on the other hand, expose companies to investor mistrust, exposure of intellectual property (IP) and embarrassment. Although the benefits of a judgment are palpable, reaching that preferred outcome has proved difficult. The prospect of a messy situation could mean many cases face a better prospect of resolution outside the courtroom.
Mediation may be best course
Even for the largest corporations, litigation always presents risks outside of the monetary sphere. Investors face an uphill battle due to jurisdictional issues, but corporations face the threat of revelation and significant reputation damage. For the most part, Chinese companies become largely insulated once they leave US markets, as China fiercely protects its own. Investors may face difficulty procuring witnesses, gaining access to information for discovery, and more. Nevertheless, a prolonged litigation is incredibly damaging in its own way.
Shanda Games stands out as an example of how it can go bad for corporations after it was taken to court by hedge fund Maso Capital Investments. Sure that it would fare well in litigation, the company refused to mediate or settle, and was left with a judgment against it that hurt. The original judgement issued against the company forced it to pay out more than 80% of its original sale price to investors. Moreover, the company suffered reputation damage after it was dragged through a very public court case.
In cases where companies are forced into court battles, the price may have more than a dollar tag on it. Should companies be dragged into discovery procedures, they may experience IP leaks, uncomfortable questions asked, and transparency issues that could cause long-term harm to share prices and overall company valuations.
Perhaps that’s why Focus Media Holdings, for instance, was more proactive when faced with a class-action lawsuit upon its US-listed exit. Despite facing a class-action suit brought by investors, which is normally easier to fight than other types of suits, the company opted to take the settlement route with investors and paid out $55.6 million without being forced to admit any wrongdoing. As a result, Focus Media faced far less public scrutiny than some contemporaries. In the end, with a $3.7 billion privatization that was followed by a $7.0 billion re-listing, the quick settlement of the class-action suit delivered enormous savings for Focus Media.
The Qihoo case now stands out as the next test case for Chinese companies. The lawsuit opened in the Cayman Islands is also being brought by Maso Capital Investments, and Qihoo 360 has shown little inclination for a protracted fight. Qihoo has already suffered some complications and reputation damage after its own delisting process in the shape of document discovery orders, external probing and evaluations, and court reprimands.
The loophole remains open
Even when considering the successful battles waged by frustrated shareholders, there is still nothing to prevent the “Chinese loophole” strategy from proliferating. High-profile court cases and low-profile settlements have not dissuaded the process from playing out in recent years. Yet the stakes for companies engaging in these strategies are high. The possibility of protracted public cases should serve as a sign of caution for Chinese companies contemplating similar privatizations and subsequent re-listings. Suffering through a long, possibly nasty court fight can result in demoralized investors, lower share prices, and long-term reputation damage that could have financial implications.
By mediating, companies can move forward with lucrative plans without having to keep one foot in the door and risk more damage. As awareness of the strategy grows and investors seek to hold companies accountable thanks to precedent-setting cases, will we see more legal battles or a tendency for more sophisticated and elegant solutions?