CORPORATE AND SECURITIES LAW IN
CHINA AND U.S.
I.
BASIC THEORIES ......................................................................................................... 8
A.
MECHANISMS TO ORGANISE PRODUCTION ............................................................................................... 8
B.
COSTS OF MARKET ...................................................................................................................................... 8
1.
TRANSACTION COSTS .............................................................................................................................. 8
a)
SEARCHING/DISCOVERING ............................................................................................................... 8
b)
NEGOTIATION ................................................................................................................................... 8
c)
ENFORCEMENT ................................................................................................................................. 8
2.
INCOMPLETE CONTRACTS ...................................................................................................................... 8
3.
ASSET SPECIFICITY ................................................................................................................................... 8
4.
RESIDUAL CONTROL ................................................................................................................................ 9
C.
COST OF FIRM ............................................................................................................................................. 9
1.
DIMINISHING RETURNS .......................................................................................................................... 9
2.
MULTIPLE SHAREHOLDERS ................................................................................................................... 10
a)
HETEROGENEITY IN DECISION-MAKING ......................................................................................... 10
b)
SHAREHOLDER APATHY .................................................................................................................. 10
3.
D.
AGENCY PROBLEM ................................................................................................................................ 10
AGENTS IN FIRMS ..................................................................................................................................... 10
1.
WHY USE AGENTS? ............................................................................................................................... 10
2.
AGENCY COSTS...................................................................................................................................... 11
a)
EQUITY ............................................................................................................................................ 11
b)
DEBT ................................................................................................................................................ 11
3.
BASIC MODEL OF CORPORATE GOVERNANCE ...................................................................................... 11
a)
CHINA .............................................................................................................................................. 11
b)
U.S. .................................................................................................................................................. 11
E.
PRINCIPAL IN FIRMS .................................................................................................................................. 11
F.
CONTRACTARIAN THEORY OF CORPORATION .......................................................................................... 12
G.
CORPORATE LAW AS DEFAULT RULES ...................................................................................................... 12
II.
CORPORATE FORMATION AND CAPITAL ISSUANCE ................................................ 12
A.
CORPORATE FORMATION IN U.S. ............................................................................................................. 12
1.
INTERNAL AFFAIRS DOCTRINE .............................................................................................................. 12
2.
PROMOTER’S CONTRACTUAL LIABILITY ................................................................................................ 13
3.
PROMOTER’S FIDUCIARY DUTIES .......................................................................................................... 13
a)
B.
THE OLD DOMINION CONFUSION .................................................................................................. 14
CORPORATE FORMATION IN CHINA ......................................................................................................... 15
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1.
C.
PROMOTER’S LIABILITIES IN CHINA ...................................................................................................... 15
CAPITAL MATTERS IN U.S. ......................................................................................................................... 15
1.
STOCK ISSUANCE IN U.S. ....................................................................................................................... 15
a)
AUTHORISED CAPITAL DOCTRINE ................................................................................................... 15
b)
ISSUING PRICE AND STOCK DILUTION ............................................................................................ 15
c)
D.
(1)
ANTI-DILUTION PROVISIONS ...................................................................................................... 16
(2)
JUDICIAL PROTECTION ................................................................................................................ 16
DIVIDENDS AND BUYBACKS IN U.S. ................................................................................................ 17
CAPITAL MATTERS IN CHINA..................................................................................................................... 17
1.
STOCK ISSUANCE IN CHINA ................................................................................................................... 17
a)
LEGAL CAPITAL DOCTRINE .............................................................................................................. 17
b)
INITIAL CAPITAL CONTRIBUTION .................................................................................................... 17
c)
SECONDARY EQUITY OFFERING ...................................................................................................... 18
2.
DIVIDEND PAYMENT IN CHINA ............................................................................................................. 18
3.
STOCK BUYBACKS IN CHINA .................................................................................................................. 18
III.
LIMITED LIABILITY AND BASIC GOVERNANCE STRUCTURE ...................................... 19
A.
PROS AND CONS OF LIMITED LIABILITY .................................................................................................... 19
B.
PIERCING THE CORPORATE VEIL ............................................................................................................... 19
1.
U.S. ........................................................................................................................................................ 20
a)
ELEMENTS ....................................................................................................................................... 20
b)
DOCTRINE OF INSUFFICIENT CAPITAL REJECTED ............................................................................ 20
2.
CHINA .................................................................................................................................................... 20
3.
COMPARISON ....................................................................................................................................... 21
4.
EVALUATIONS/QUESTIONS TO ASK ...................................................................................................... 21
C.
CORPORATE GOVERNANCE FOR WHOM? ................................................................................................ 22
1.
BASIC GOVERNANCE STRUCTURE IN U.S. ............................................................................................. 22
a)
DIRECTORS ...................................................................................................................................... 22
b)
SHAREHOLDERS .............................................................................................................................. 22
2.
BASIC GOVERNANCE STRUCTURE IN CHINA ......................................................................................... 22
a)
DIRECTORS ...................................................................................................................................... 22
b)
SHAREHOLDERS .............................................................................................................................. 22
3.
IV.
A.
COMPARISON ....................................................................................................................................... 23
a)
WHY DIRECTOR SUPREMACY? ........................................................................................................ 23
b)
WHAT ARE THE PROBLEMS WITH SHAREHOLDER SUPREMACY IN CHINA? ................................... 23
FIDUCIARY DUTIES ................................................................................................ 23
DIRECTOR FIDUCIARY DUTIES IN U.S. ....................................................................................................... 23
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1.
GENERAL PRINCIPLES ............................................................................................................................ 23
a)
STANDARD OF CONDUCT – INSPIRATIONAL, BEST-PRACTICE, ABSTRACT ...................................... 24
b)
STANDARD OF REVIEW – OPERATIONAL, STRIPPED OF IDEALISM ................................................. 24
2.
DUTY OF CARE ...................................................................................................................................... 24
3.
DUTY OF LOYALTY AND CONFLICT OF INTEREST .................................................................................. 25
B.
a)
CLEANSING OF CONFLICT................................................................................................................ 25
b)
EFFECT OF CLEANSING .................................................................................................................... 25
c)
DUTY TO MONITOR ......................................................................................................................... 26
DIRECTOR FIDUCIARY DUTIES IN CHINA ................................................................................................... 26
1.
DUTY OF CARE ...................................................................................................................................... 26
2.
DUTY OF LOYALTY ................................................................................................................................. 27
C.
a)
ACTIONS FORBIDDEN FOR DIRECTORS (ART 148) ........................................................................... 27
b)
CLEANING DIRECTOR’S CONFLICT OF INTEREST ............................................................................. 27
SHAREHOLDER FIDUCIARY DUTIES IN U.S................................................................................................. 27
1.
DEFINITION OF A CONTROLLING SHAREHOLDER ................................................................................. 28
2.
DUTY OF LOYALTY ................................................................................................................................. 28
a)
CLEANSING OF CONFLICT AND EFFECT ........................................................................................... 28
b)
ENTIRE FAIRNESS ............................................................................................................................ 29
3.
D.
SALE OF CONTROL ................................................................................................................................ 29
a)
SELLING CONTROL TO LOOTERS ..................................................................................................... 29
b)
NARROWLY DEFINED CONCEPT OF DUTY OF CARE ........................................................................ 29
SHAREHOLDER FIDUCIARY DUTIES IN CHINA ........................................................................................... 30
1.
CONTROLLING SHAREHOLDERS ............................................................................................................ 30
2.
SALE OF CONTROL ................................................................................................................................ 30
E.
COMPARISON OF FIDUCIARY DUTIES IN U.S. CF CHINA ........................................................................... 30
V.
SHAREHOLDER RIGHTS .......................................................................................... 30
A.
OVERVIEW ................................................................................................................................................ 30
B.
SHAREHOLDER VOTING RIGHTS IN U.S. .................................................................................................... 30
1.
ELECTION OF DIRECTORS ...................................................................................................................... 30
a)
BOARD TENURE .............................................................................................................................. 31
b)
ELECTION RULE ............................................................................................................................... 31
c)
REMOVAL OF DIRECTORS ............................................................................................................... 31
d)
NOMINATION .................................................................................................................................. 31
e)
PROTECTION OF SHAREHOLDER FRANCHISE .................................................................................. 31
(1)
PRIMARY PURPOSE & COMPELLING JUSTIFICIATION ................................................................. 31
(2)
ADVANCE NOTICE BYLAW .......................................................................................................... 32
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C.
SHAREHOLDER VOTING RIGHTS IN CHINA ................................................................................................ 32
1.
D.
DIRECTOR NOMINATION AND ELECTION ............................................................................................. 32
a)
RIGHT TO NOMINATE (NON-EMPLOYEE) DIRECTORS ..................................................................... 32
b)
RIGHT TO NOMINATE IS ABSOLUTE ................................................................................................ 32
SHAREHOLDER PROPOSALS IN U.S. .......................................................................................................... 32
1.
OVERVIEW ............................................................................................................................................ 32
a)
PROPOSAL TO AMEND ARTICLES/BYLAWS ..................................................................................... 32
b)
PROXY VOTING AND SHAREHOLDER PROPOSAL ............................................................................ 32
2.
E.
FEDERAL PROXY RULE ........................................................................................................................... 33
a)
GENERAL REQUIREMENTS FOR MAKING PROPOSALS .................................................................... 33
b)
SOURCES OF DISPUTE OVER EXCLUSION ........................................................................................ 33
(1)
RELEVANCE EXCLUSION .............................................................................................................. 33
(2)
ORDINARY BUSINESS EXCLUSION ............................................................................................... 33
SHAREHOLDER LITIGATIONS IN U.S. ......................................................................................................... 34
1.
DIRECT VS DERIVATIVE ......................................................................................................................... 34
a)
HOW TO DIFFERENTIATE?............................................................................................................... 34
b)
DERIVATIVE SUITS ........................................................................................................................... 34
c)
DIRECT SUITS................................................................................................................................... 34
2.
DEMAND AND EXCUSE.......................................................................................................................... 35
a)
EXCUSE OF DEMAND FOR FUTILITY ................................................................................................ 35
b)
UNIVERSAL DEMAND RULE ............................................................................................................. 35
3.
F.
SPECIAL LITIGATION COMMITTEE ......................................................................................................... 35
SHAREHOLDER LITIGATIONS IN CHINA ..................................................................................................... 35
1.
G.
PREREQUISITES TO DERIVATIVE SUITS (ART 151) ................................................................................. 35
SHAREHOLDER INSPECTION RIGHTS IN U.S. ............................................................................................. 35
1.
WHO CAN INSPECT? ............................................................................................................................. 36
2.
WHAT CAN BE INSPECTED? .................................................................................................................. 36
H.
SHAREHOLDER INSPECTION RIGHTS IN CHINA ......................................................................................... 36
1.
shareholders of llC (ART 33) ................................................................................................................. 36
2.
SHAREHOLDERS OF JOINT-STOCK LIMITED COMPANY (ART 97) .......................................................... 36
VI.
FINANCING THE CORPORATION ............................................................................. 37
A.
SECURITIES IN U.S. .................................................................................................................................... 37
1.
INVESTMENT CONTRACTS .................................................................................................................... 37
2.
NOTES ................................................................................................................................................... 37
a)
REBUTTAL OF PRESUMPTION ......................................................................................................... 37
b)
FAMILY RESEMBLANCE TEST ........................................................................................................... 37
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3.
EQUITIES ............................................................................................................................................... 38
a)
COMMON STOCKS .......................................................................................................................... 38
b)
PREFERRED STOCKS ........................................................................................................................ 38
4.
5.
DEBTS .................................................................................................................................................... 38
a)
TYPES OF DEBT ................................................................................................................................ 38
b)
INDENTURE/NOTE AGREEMENTS ................................................................................................... 39
c)
DEFAULTS ........................................................................................................................................ 39
CONVERTIBLES ...................................................................................................................................... 39
B.
SECURITIES IN CHINA ................................................................................................................................ 40
C.
IPO IN THE U.S. ......................................................................................................................................... 40
1.
REGISTRATION WITH SEC ...................................................................................................................... 40
2.
LISTING AGREEMENTS WITH STOCK EXCHANGES ................................................................................ 41
3.
REGISTRATION PROCESS ....................................................................................................................... 41
D.
IPO IN CHINA............................................................................................................................................. 42
1.
MAIN BOARDS ...................................................................................................................................... 42
2.
SSE START MARKET ............................................................................................................................... 42
3.
REGULATORY IPO LOCKUPS .................................................................................................................. 42
E.
DUAL CLASS LISTING IN U.S. ..................................................................................................................... 43
1.
LAW....................................................................................................................................................... 43
2.
PRACTICES ............................................................................................................................................. 43
F.
DUAL CLASS LISTING IN CHINA ................................................................................................................. 43
G.
SHELF REGISTRATION (RULE 415) ............................................................................................................. 44
H.
EXEMPTED OFFERING IN U.S. ................................................................................................................... 44
1.
REG D .................................................................................................................................................... 44
2.
REG A .................................................................................................................................................... 45
3.
CROWDFUNDING (REG CF) ................................................................................................................... 46
I.
DIRECT LISTING in U.S. .............................................................................................................................. 46
J.
SPAC IN U.S. .............................................................................................................................................. 46
1.
IPO PHASE ............................................................................................................................................. 47
2.
DE-SPAC PHASE ..................................................................................................................................... 47
K.
PRIVATE PLACEMENT & RESALE IN CHINA ............................................................................................... 47
VII.
DISCLOSURE AND SECURITIES FRAUD .................................................................... 48
A.
DISCLOSURE REQUIREMENTS IN U.S. ....................................................................................................... 48
B.
1.
BLOCKHOLDER DISCLOSURE IN U.S. ..................................................................................................... 48
2.
SHORT-SWING INSIDER DISCLOSURE AND PROFIT DISGORGEMENT IN U.S. (§16 OF 1934 ACT) ......... 49
DISCLOSURE REQUIREMENTS IN CHINA ................................................................................................... 49
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C.
SECURITIES FRAUD IN U.S. ........................................................................................................................ 49
1.
MISREPRESENTATION IN REGISTRATION STATEMENT (§11 OF 1933 ACT) .......................................... 49
2.
GENERAL ANTI-FRAUD RULE (§10(B) OF 1934 ACT) ............................................................................. 51
3.
SECURITIES CLASS ACTIONS .................................................................................................................. 51
D.
SECURITIES FRAUD IN CHINA .................................................................................................................... 52
1.
SECURITIES CLASS ACTION .................................................................................................................... 52
E.
SECURITIES FRAUD: A COMPARISON ........................................................................................................ 53
VIII.
INSIDER TRADING AND MARKET MANIPULATION ............................................... 53
IX.
M&A: BACKGROUND............................................................................................. 56
A.
DRIVING FORCES OF M&A ........................................................................................................................ 56
B.
MAJOR PLAYERS........................................................................................................................................ 57
1.
PRINCIPALS ........................................................................................................................................... 57
2.
PROFESSIONALS .................................................................................................................................... 57
C.
M&A FINANCING ...................................................................................................................................... 58
1.
DEBT FINANCING .................................................................................................................................. 58
2.
EQUITY FINANCING ............................................................................................................................... 58
D.
M&A IN U.S. AND CHINA – GENERAL COMPARISON ................................................................................ 58
X.
M&A: DEAL STRUCTURE, APPRAISAL RIGHTS ......................................................... 58
A.
STATUTORY MERGER IN U.S. .................................................................................................................... 58
1.
GENERAL IDEA ...................................................................................................................................... 58
2.
CORPORATE LAW PROCESS .................................................................................................................. 59
3.
TRIANGULAR MERGER .......................................................................................................................... 59
4.
LEGAL EFFECTS ...................................................................................................................................... 59
B.
STATUTORY MERGER IN CHINA ................................................................................................................ 60
C.
ASSET DEAL IN U.S. ................................................................................................................................... 60
D.
TENDER OFFERS IN U.S. ............................................................................................................................ 61
1.
GENERAL BACKGROUND ....................................................................................................................... 61
2.
SUBSTANTIVE RULES ............................................................................................................................. 61
E.
STOCK PURCHASES IN CHINA .................................................................................................................... 62
F.
TENDER OFFERS IN CHINA ........................................................................................................................ 62
1.
MANDATORY BID RULE ......................................................................................................................... 62
2.
SUBSTANTIVE RULES ............................................................................................................................. 63
G.
SHORT FORM MERGERS IN U.S. ................................................................................................................ 63
H.
APPRAISAL RIGHTS IN U.S. ........................................................................................................................ 63
1.
CONDITIONS ......................................................................................................................................... 63
2.
VALUATION ........................................................................................................................................... 64
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I.
APPRAISAL RIGHTS IN CHINA .................................................................................................................... 65
XI.
M&A: TAKEOVER DEFENCES AND FIDUCIARY DUTIES ............................................. 65
A.
TAKEOVER DEFENSES IN U.S. .................................................................................................................... 65
1.
REFUSAL TO SELL .................................................................................................................................. 65
2.
SALE TO ALLIES ...................................................................................................................................... 67
B.
FIDUCIARY DUTIES OF TARGET BOARD (U.S.) ........................................................................................... 68
1.
POISON PILLS UNDER UNOCAL TEST ..................................................................................................... 68
2.
REVLON RULE WHEN TARGET UP FOR SALE ......................................................................................... 69
C.
REGULATING FREEZEOUT MERGERS IN U.S. ............................................................................................. 69
D.
HOSTILE BIDS IN CHINA ............................................................................................................................ 70
E.
1.
TRADING HALT IN CHINA ...................................................................................................................... 70
2.
ZUIG INVESTMENT V ZHENXING BIOCHEM .......................................................................................... 70
a)
FIRST STAGE: NEW BOTTLE, OLD WINE .......................................................................................... 70
b)
SECOND STAGE: NOTHING VENTURED, NOTHING GAINED ............................................................ 71
c)
THIRD STAGE: FIGHTING FOR THE LAST STRAW ............................................................................. 71
d)
FOURTH STAGE: WINNING A BATTLE OR A WAR? .......................................................................... 71
e)
FIFTH STAGE: “CROWN JEWEL” WITH CHINESE CHARACTERISTICS................................................ 72
HOSTILE BIDS: A COMPARISON ................................................................................................................ 72
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I.
BASIC THEORIES
A.
MECHANISMS TO ORGANISE PRODUCTION
There are two mechanisms to organize production – firms (hierarchical, centralized); and markets
(decentralized). To this end, the same function is achieved in two different ways.
B.
COSTS OF MARKET
1.
TRANSACTION COSTS
Refers to the cost of providing for some good or service through the market rather than having it provided from
within the firm. In order to carry out a market transaction it is necessary to discover who it is that one wishes to
deal with, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection
needed to make sure that the terms of the contract are being observed, and so on.
A)
SEARCHING/DISCOVERING
The main reason why it is profitable to establish a firm would seem that there is a cost of using the price
mechanism. The most obvious cost of “organising” production through the price mechanism is that of
discovering what the relevant prices are. This cost may be reduced but it will not be eliminated by the emergence
of specialists who will sell this information.
B)
NEGOTIATION
The costs of negotiating and concluding a separate contract for each exchange transaction which takes place on
a market must also be taken into account. In certain markets, e.g. produce exchanges, a technique is devised for
minimizing these contract costs – however, they are not eliminated.
It is true that contracts are not eliminated when there is a firm, but they are greatly reduced.
C)
2.
ENFORCEMENT
INCOMPLETE CONTRACTS
It may be desired to make a long-term contract for the supply of some article or service. This may be due to the
fact that if one contract is made for a longer period, instead of several shorter ones, then certain costs of making
each contract will be avoided.
However, owing to the difficulty of forecasting (cognitive limits), the longer the period of the contract, the less
possible (and less desirable) it is for the person purchasing to specify (linguistical limit – cannot
describe/measure) what the contracting party is expected to do.
Information limit – cannot verify compliance/breach
3.
ASSET SPECIFICITY
Asset specificity is usually defined as the extent to which the investments made to support a particular
transaction have a higher value to that transaction than they would have if they were redeployed for any other
purpose.
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Williamson argued that transaction-specific assets are non-redeployable physical and human investments that
are specialized and unique to a task. For example, the production of a certain component may require
investment in specialized equipment, the distribution of a certain product may necessitate unique physical
facilities, or the delivery of a certain service may be predicated on the existence of an uncommon set of
professional know-how and skills.
This may encourage opportunism, where a party could produce poor quality goods, deliver products late, or not
follow through with the provisions of a contract.
Agreement at t0: B produces 100 widgets for A, contract price $350. Each widget costs B $2 + investment in
production equipment of $100
B invests in specific equipment at t1
A requests for renegotiation at t2 and lowers the contract price to $201. B will still accept it as the investment
by B at t1 is a sunk cost – a rational person will not consider the sunk cost in making a decision.
Foreseeing this above problem, B will not enter into an agreement with A at t0, hence efficient outcome falls
through. This is the holdup problem, a situation where two parties may be able to work most efficiently by
cooperating but refrain from doing so because of concerns that they may give the other party increased
bargaining power and thus reduce their own profits. The holdup problem leads to severe economic cost and
might also lead to underinvestment.
SOLUTION: vertical integration, where A acquires B (or vice versa) so that the contract is replaced with firm
4.
RESIDUAL CONTROL
Hart and Moore posit that the sole right possessed by the owner of an asset is his ability to exclude others from
the use of that asset. They further argue that control over a physical asset in this sense can lead indirectly to
control over human assets.
For example, if a group of workers require the use of an asset to be productive, then the fact that the owner
(“party 1”) has the power to exclude some or all of these workers from the asset later on will cause the workers
to act partially in party 1’s interest. The reason is that by doing so the workers put themselves in a stronger
bargaining position later on with the person who determines whether they have access to the asset.
This should be contrasted with a situation in which party 1 contracts for a service from someone else who owns
the asset – under these conditions, the asset’s workers will tend to act in the other person’s interest since it is
that person who is the boss they bargain with in the future.
Hence, this view of the firm as a collection of physical assets leads to the intuitive conclusion that a person will
have more “control” over an asset’s workers if he employs them than if he has an arm’s length contract with
another employer of the workers.
C.
COST OF FIRM
1.
DIMINISHING RETURNS
The law of diminishing returns is a theory in economics which predicts that after some optimal level of capacity
is reached, adding an additional factor of production will actually result in smaller increases in output.
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As a firm gets larger, the costs of organising additional transactions within the firm may rise. Naturally, a point
must be reached where the costs of organising an extra transaction within the firm are equal to the costs
involved in carrying out the transaction in the open market.
Moreover, as intra-firm transactions increase, an entrepreneur may fail to place the factors of production in the
uses where their value is greatest. Again, a point must be reached where the loss through the waste of resources
is equal to the marketing costs of the exchange transaction in the open market.
Example: A factory employs workers to manufacture its products, and, at some point, the company operates
at an optimal level. With all other production factors constant, adding additional workers beyond this optimal
level will result in less efficient operations.
2.
MULTIPLE SHAREHOLDERS
A)
HETEROGENEITY IN DECISION-MAKING
Hansmann argues that multi-stakeholdership raises conflict due to the multitude of contrasting interests and
causes incoherent strategic focus as members place their own needs and interests above those of the firm,
resulting in interest conflicts and excessive monitoring that leads the firm to fail.
Moreover, increasing member heterogeneity results in high decision-making costs – different groups of actors
are considered to have fundamentally different interests and may be of nature to solve problems and pursue
strategic directions to maximize their well-being at the expense of the welfare of the larger group to which they
belong.
B)
SHAREHOLDER APATHY
It is often said that shareholders are not interested in voting rights because each individual shareholder has only
a small interest in any given company. As a result, the expense of remaining informed about the company
exceeds the expected benefit; this is especially true given that any one shareholder’s vote is unlikely to affect
the outcome of any election anyway. This leads to the problem of free-riding, where shareholders have little
incentive to monitor senior management, because of the cost they bear while others reap benefits.
However, it may be argued that it is not that shareholders do not care, but rather that they find it inefficient to
over-invest in monitoring behavior.
3.
AGENCY PROBLEM
An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in
another’s best interests.
There may be conflicts of interest between different levels of hierarchy. The problem of inducing an “agent” to
behave as if he were maximizing the “principal’s” welfare is quite general. It exists in all organisations and all
cooperative efforts.
Agency Cost = Cost of Controlling Agent + Cost of Agent’s Opportunism
D.
AGENTS IN FIRMS
1.
WHY USE AGENTS?
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1.
2.
Cost reduction in decision-making
Specialisation
a. Agents may have certain skillsets that shareholders lack (e.g. risk management)
2.
AGENCY COSTS
A)
EQUITY
Agency cost of equity refers to the conflict of interest that arises between management and shareholders.
When management makes decisions that might not be in the best interest of the firm and that shareholders
view as an action that will not increase the value of their shares, an agency cost of equity has arisen.
For example, management may believe that a merger would be the best step forward for the business, whereas
the shareholders see that the merger would not help grow the business, and the money spent on the merger
could be better used in paying dividends and investing in other areas.
Other examples include management misfeasance (fail to perform duty correctly) and malfeasance (intentional
act of doing harm), and related party transactions.
B)
DEBT
The agency cost of debt is the conflict of interest between shareholders and creditors of a firm based on the
decisions made by management. The agency costs of debt would specifically be the actions taken by
debtholders in restricting what management can do with their capital if they believe that management favours
actions that would help shareholders instead of debtholders. For instance, managers may want to engage in
risky actions they hope will benefit shareholders, who seek a high rate of return. Debtholders, who are typically
interested in safer investment, may want to place restrictions on the use of their money to reduce risk.
Debtholders usually place covenants on the use of capital, such adherence to certain financial metrics, which, if
broken, allows the debtholders to call back their capital.
3.
BASIC MODEL OF CORPORATE GOVERNANCE
A)
CHINA
China adopts a shareholder primacy model. To this end, the Chinese model stipulates that decision control is in
the hands of the shareholders + the 2 nd board, whereas decision management is undertaken by the board and
officers.
B)
U.S.
On the other hand, the U.S. adopts a board primacy model. In this regard, the board has decision control and
the decision management is undertaken by the CEO.
E.
PRINCIPAL IN FIRMS
In both China and the U.S., shareholders are regarded as the principals of the firm. This is largely due to their
vulnerability:
1.
2.
Infinite relationship makes detailed contract illusory (vs creditors often short-term or project based)
Dispersed nature makes bargaining prohibitively costly, and monitoring difficult (collective action
problem)
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3.
Lack of organized political clout (vs labour unions, consumer organisations)
Question: How to square this with CSR?
F.
CONTRACTARIAN THEORY OF CORPORATION
The contractarian theory posits that the relationship between the managers and shareholders of a public
corporation is contractual. As owners of the company, entrepreneurs and other pre-IPO shareholders want their
company’s shares to command a high price when sold to the public. The price at which the company’s shares
are sold will depend on the “promises” the pre-IPO entrepreneurs and shareholders make to the post-IPO public
shareholders regarding governance arrangements the company will adopt once it is publicly held.
Corporate contracts that include promises of effective corporate governance arrangements mean greater value
to shareholders, which in turn means that investors will pay more for the company’s shares in the IPO and in the
secondary market thereafter. Consequently, the contractarian theory implies that corporations will go public
with corporate contracts that provide for governance structures that are, in Easterbrook and Fischel’s words,
“most beneficial to investors, net of the costs of maintaining the structure.”
In the contractarian vision, managers adopt a corporate contact by first incorporating in a state that offers
default rules best suited to it, and then by customizing their own governance arrangements to the extent
necessary to maximise the firm’s value. This customization appears as “promises in the articles of incorporation.”
Shareholders accept the contract by buying shares in the company and implicitly pricing the quality of the firm’s
governance commitments.
G.
CORPORATE LAW AS DEFAULT RULES
As Easterbrook and Fischel explain, the role of corporate law follows logically from the contractual nature of the
public corporation. That role is to facilitate atomistic contracting. Firms are believed to be heterogenous in their
governance needs and are expected to adopt a diverse assortment of governance arrangements. Entrepreneurs,
therefore, must be free to customize their corporate contracts. All the law needs to do is provide “off-the-rack”
contract terms that can be adopted, or not, to the extent they enhance a firm’s value. The contractarian theory
posits that there are no externalities in the contract between pre-IPO entrepreneurs and shareholders on the
one hand, and post-IPO shareholders on the other, so there is no need for mandatory rules; market mediated
individual choice will lead to socially optimal corporate contracts.
II.
CORPORATE FORMATION AND CAPITAL ISSUANCE
A.
CORPORATE FORMATION IN U.S.
The promoter leads the process of incorporation in a particular state. There is no federal charter. The four
essentials during incorporation are: (1) corporate name (Co or Inc); (2) registered address; (3) number of
authorized stocks; and (4) the incorporator’s name and address. The incorporation takes effect upon filing, and
directors may be appointed after incorporation.
1.
INTERNAL AFFAIRS DOCTRINE
The internal affairs doctrine is a choice of law rule in corporations law – simply stated, it provides that the
“internal affairs” of a corporation will be governed by corporate statues and case law of the state in which
the corporation is incorporated, sometimes referred to as the lex incorporationis.

Delaware is the pre-eminent state of incorporation – the courts there have been key to the state’s
dominance as they are highly efficient, and incrementally evolve through “situationally-specific”
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
discretion. Corporate franchise fees total to $500m a year and accounts for 20% of Delaware’s state
income
This can be contrasted to California, which has a long-arm statute (i.e. a statute that allows for a court
to obtain personal jurisdiction over an out-of-state defendant on the basis of certain acts committed
by an out-of-state defendant, provided that the defendant has a sufficient connection with the state).
o CGCL §2115: shareholder of 50% + voting rights have CA addresses AND 50% + business in CA
measured by corporate assets, sale or payroll; inapplicable to nationally traded corporations
o SB 826 and AB 979 of 2020: Board diversity rules, applicable to all corps with executive
headquarters in CA
The internal affairs doctrine applies to those matters that pertain to the relationships among or between the
corporation and its officers, directors, and shareholders. The conflicts practice of both state and federal courts
has consistently been to apply the law of the state of incorporation to the entire gamut of internal corporate
affairs. The internal affairs doctrine does not apply where the rights of third parties external to the corporation
are at issue, for example, contracts and torts (Vantagepoint).

The internal affairs doctrine ensures that issues such as voting rights of shareholders, distribution of
dividends and corporate property, and the fiduciary obligations of management are all determined in
accordance with the law of the state in which the company is incorporated. On the other hand, the
“external affairs” of a corporation, such as labor and employment issues and tax liability, are typically
governed by the law of the state in which the corporation is doing business.
2.
PROMOTER’S CONTRACTUAL LIABILITY
A promoter acts on behalf of a corporation before it is formed. The corporation will not be personally liable for
any contracts entered into by the promoter on its behalf prior to incorporation unless it adopts the contract,
either by direct action of the board of directors, or through implied action, by accepting the benefit of the
contract.
The promoter remains personally liable for pre-incorporation contracts he enters into, even after corporate
adoption, unless and until there has been a novation (i.e. the assumption will not be effective retroactively, so
the promoter is still liable for obligations due before assumption + even after assumption the promoter is the
pre-incorporation contract binds the promoter – essentially, the promoter is guaranteeing performance by the
corporation).
A promoter is personally liable on a pre-incorporation contract except when the counterparty knew that the
corporation was not in existence at the time of the contract but nevertheless agreed to look solely to the
corporation for performance.


The counterparty’s knowledge of the nonexistence of the corporation alone will not exempt the
promoter from personal liability. On the contrary, this knowledge indicates intention to bind the
promoter since he/she cannot be the agent of a non-existing corporation.
From a business perspective, if the pre-incorporation contract cannot bind the promoter, it won’t bind
the counterparty either. Then, the business purpose of preparing for the operation of a new
corporation will fall through.
3.
PROMOTER’S FIDUCIARY DUTIES
The promoter owes a fiduciary duty to (1) the corporation to be formed, (2) its shareholders and (3) other
promoters. In effect, this means that the promoter should avoid conflict of interests with the corporation. In
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cases of conflict, full disclosure and consent from disinterested directors, shareholders/subscribers are required,
unless the promoter can prove entire fairness to the corporation.


To prove entire fairness, need to demonstrate both fair dealing (i.e. process) and fair price (i.e.
substance). Fair dealing encompasses questions of process, including how the transaction is timed,
initiated, structured, negotiated, and disclosed and how the approvals of the directors and the
stockholders are obtained. Fair price relates to the economic and financial terms of the transaction,
including any relevant factors that affect the intrinsic or inherent value of a company’s stock, such as
the market value and assets of the company, pro forma analysis and other valuation metrics, and a
fairness opinion.
The fair price and fair dealing components are not viewed in isolation but rather in conjunction.
The most frequently seen pattern is that the promoter acquired assets and resold to the corporation after it is
incorporated at a higher price.
A)
THE OLD DOMINION CONFUSION
The Old Dominion Copper company cases demonstrate forcibly the lack of harmony in the courts as to the nature
of and remedy for promoters’ frauds in the organisation of corporations.
Summary of Facts
Bigelow (“B”) and Lewisohn (“L”) acquired a copper mine, then organized a corporation under the laws of New
Jersey (“NJ”), with an authorized capital stock of $3.75m but with only $1000 paid in (as permitted by the NJ
statute). With the latter amount paid in, the organisation was completed, whereupon the directors (the tools of
B and L), voted to increase the capital stock to its maximum, to transfer to B and L, in exchange for their mining
and other property worth not to exceed $1m, shares of stock in the new company of the par value of $3.25m,
and also to offer the balance of $500k to public subscription. The net result was as follows: B and L obtained
13/15 of the entire capital stock and the public 2/15, when, according to the amount of capital respectively
contributed, the former should have obtained 10/15 and the latter 5/15 ($1m:$500k = 2:1).
Supreme Court of U.S.
The Supreme Court of the United States held that inasmuch as B and L were at the time the contract was made
the sole shareholders in the company, the latter was bound, and the mere acquisition of new shareholders, even
by public subscription, could not change the nature of the transaction, if it was binding at the time it was made.
Holmes J laid very great stress in his opinion upon the unchanging identity of the corporate person.

The decision here seems sound. It would have been better had Holmes J not expressed himself in a way
as to make possible the inference that under no circumstances can a corporation complain of a wrong
if all the existing shareholders participated in it. B and L did in fact commit fraud against the original
subscribers at par, but Holmes J could not be persuaded that this would entitle a court of equity to treat
this as a corporate wrong to be remedied by mulcting them, principally for the benefit of their coconspirators. That a situation sometimes does arise in which to remedy a corporate wrong would
benefit some of the wrongdoers, is inevitable, but the B and L cases did not present it.
Supreme Court of Massachusetts
On the other hand, the Supreme Court of Massachusetts held that by reason of the fact that public subscriptions
were contemplated at the very time when the contract was authorized, it did not bind the corporation and
because the public paid par for its stock, the court found the value of all the stock to be par, and ordered a
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judgment against B for an amount equal to the difference between $3.25m and $1m. What is more surprising
than the court’s method of finding the amount of the fraudulent profit and mulcting B for the whole of it is the
fact that if these tortfeasors had only taken all of the stock, and donated $500k to the corporation as treasury
stock, to be sold to the public, the transaction would have passed muster.
However, something that is not discussed in both decisions is whether the issuance price is fraudulent, or
whether it is fair, which is actually (or in fact should be) the main debate here.
B.
CORPORATE FORMATION IN CHINA
Corporate formation in China is also registration based: the requisite details include name, residence, charter,
registered capital, legal representative, directors. The filing is done with the Industrial and Commercial Authority
(ICA), which conducts a procedural review before issuing a business license.


For a limited liability company, the incorporation is by the shareholders (no more than 50 natural or
legal person)
For a joint stock limited company, the incorporation is by promoters (2-200, half having residence in
China); promoters are shareholders as well
o In practice, many joint stock limited companies are converted from limited liability companies
once the number of shareholders exceeds 50 or planning for IPO
It is pertinent to note that in China, the corporate purpose still needs to be enumerated, and directors (of both
boards) need to be appointed in advance.
1.
PROMOTER’S LIABILITIES IN CHINA
Promoters are liable for contracts concluded in their names for the benefit of the corporation in formation, but
the corporation will also be liable after being formed. If the promoters enter into the contract in the name of
the corporation being formed, the corporation will be liable for these contracts after being formed, unless the
corporation can prove these contracts are purely for promoter’s benefit and the counterparty knows the fact.
(NOTE THE REVERSAL OF THE BOP CF U.S.)

Additionally, unlike the U.S., the promoter’s role as guarantor is not clear, and promoters have no
fiduciary duties
Where incorporation fails the promoters are liable for the contracts concluded during incorporation, jointly and
severally (SPC Interpretation III, art 2-4).
C.
CAPITAL MATTERS IN U.S.
1.
STOCK ISSUANCE IN U.S.
A)
AUTHORISED CAPITAL DOCTRINE
Pursuant to the authorized capital principle, the total number of stocks that can be issued must be approved by
shareholders and recorded in the charter (“authorized shares”). The Board of Directors decides when to issue,
how many to issue (“outstanding shares”), and at what price to issue, as long as the number of outstanding
shares after issuance will not exceed the total number of authorized shares.
B)
ISSUING PRICE AND STOCK DILUTION
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Stocks can be issued with or without a par value, and the par value can be any amount that is provided in the
charter.


When the stocks have par value, the price of issuance cannot be below the par value
On the other hand, when the stocks have no par value, the price of issuance is the fair value determined
by the Board
Stock dilution takes place when a company issues additional shares to new individuals joining the company in
exchange for capital, services or even professional advice. This, in turn, reduces the ownership of current
shareholders. Some common situations of stock dilution include:
1.
2.
3.
Conversion by optional security holders – stock options granted to individuals, including board
members or employees, may be converted into common shares that eventually increases the total
share count.
Offering new shares in exchange for services or acquisitions – a company may offer new shares to the
shareholders of a firm that it is acquiring. Small business can also provide new shares to people in
exchange for the services they offer. This is usually offered to consultants, advisors, key employees and
others who offer services to the company.
Secondary offerings to raise additional capital – when a company is acquiring capital for growth
opportunities, it offsets the investors equity in exchange for funding.
(1)
ANTI-DILUTION PROVISIONS
Anti-dilution provision are clauses built into convertible preferred stocks and some options to help shield
investors from their investment potentially losing value. Anti-dilution provisions are also referred to as
preemptive rights. These provisions act as a buffer to protect investors against their equity ownership positions
becoming diluted or less valuable. This can happen when the percentage of an owner’s stake in a company
decreases because of an increase in the total number of shares outstanding.
The two common types of anti-dilution clauses are known as “full ratchet” and “weighted average”.


With a full ratchet provision, the conversion price of the existing preferred shares is adjusted
downward to the price at which new shares are issued in later rounds
e.g. if the original conversion price was $5, and in a later round the conversion price is $2.50,
the investor’s original conversion price would adjust to $2.50
The weighted average provision uses the following formula to determine new conversion prices:
C2 = C1 X (A + B) / (A + C)
C2 = new conversion price
C1 = old conversion price
A = number of outstanding shares before a new issue
B = total consideration received by the company for the new issue
C = number of new shares issued
(2)
JUDICIAL PROTECTION
The issuing price cannot be below the “fair value” or used to oppress minority shareholders. To this end,
directors, being fiduciaries of the corporation, must in issuing new stock, treat existing shareholders fairly.
The power to determine the issuing price must be exercised for the benefit of the corporation and in the
interest of all the stockholders (Sidler).
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The court also recognised that a shareholder’s preemptive rights may be seriously undermined if the stock
offered was worth substantially more than the offering price, since any such purchase would dilute that
shareholder’s interest and impair his original holding.

On the facts of Sidley, the difference in selling price and book value of the stock was calculated to force
the appellant into investing additional sums. The respondents did not offer a valid business justification
for the disparity in price and were the sole beneficiaries from it. The price was a tactic to make the
failure of the appellant to exercise his preemptive rights costly. However, since the stipulation entitled
the appellant to the same compensation as the respondents, the disparity in equity interest case by
their purchase did not affect the stockholder income from Sulburn – by permitting the respondents to
recover their additional investment before the remaining assets of Sulburn are distributed, all the
stockholders will be treated equally.
C)
DIVIDENDS AND BUYBACKS IN U.S.
Dividend payments and buybacks are decided by the Board of Directors – no shareholder interference is
allowed. The minimum requirements for dividends or share buy backs are as follows:
1.
2.
3.
First, the balance sheet must show a surplus i.e. the net asset value must be > 0 (“statutory surplus”)
Second, the company cannot fall be insolvent under statute (balance-sheet) or common law (liquidity)
EXCEPTION: However, there is an exception which allows nimble dividends to be paid out – i.e. payment
of dividends from retained earnings by a firm which made no profits – provided it is paid out of net
earnings in recent two years.
“Funds legally available” is not synonymous with “surplus” - the court in SV Investments determined that “funds
legally available” contemplates funds (in the sense of cash) that are available (in the sense of on hand or readily
accessible through sales or borrowing – i.e. liquidity) and can be deployed legally for redemption without
violating the statutory surplus requirements. The court concluded that even if Thoughtworks had sufficient
surplus to effect the redemption, it did not have funds legally available to effect the redemption and, therefore,
it was not obligated to redeem the preferred stock.
D.
CAPITAL MATTERS IN CHINA
1.
STOCK ISSUANCE IN CHINA
A)
LEGAL CAPITAL DOCTRINE
The “registered capital” must be declared in the charter and registered with the ICA (art 25, 81). The registered
capital must be maintained – there is a strict procedure to change (especially reduce) registered capital. There
are further strict restrictions on dividend payments and stock buybacks.
B)
INITIAL CAPITAL CONTRIBUTION
The initial capital contribution cannot be lower than the registered capital. The initial shareholders need to
subscribe to the stocks at the price provided in the charter. Payments can be made in installments, but
shareholders are liable up to their subscription (art 28, 83).
In-kind contributions need to be appraised and cannot be less than the declared subscription amount. In case
of shortage, all initial shareholders (promoters) are liable jointly and severally to creditors of the corporation
(art 30, 93).
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C)
SECONDARY EQUITY OFFERING
Shareholders of limited liability companies have pro rata preemptive rights (art 34).
2.
DIVIDEND PAYMENT IN CHINA
There is mandatory capital reserve requirement – capital reserve funds are set aside on the basis of 10% of the
after-tax profits. When it accumulates to the level equal to 50% of the registered capital, the company can stop
setting aside the capital reserve funds.

Note optional reserve according to shareholder resolutions
Additionally, the loss of previous years needs to be made up (if the mandatory reserve is insufficient to cover
the loss).
***Dividends can only be paid after losses are made up and reserves are allocated.
3.
STOCK BUYBACKS IN CHINA
In general, stock buybacks are not allowed as there is a prohibition on capital withdrawal (art 35, 91). However,
there are six exceptions (art 142):
1.
2.
3.
4.
5.
6.
Based on shareholder resolution to reduce registered capital
a. Proposed by the board (art 46, 108) with 2/3 shareholder approval (art 43, 103)
b. Creditors must be notified within 10 days after capital reduction resolution, and newspaper
advertisements must be run within 30 days, who have the right to require debt payments or
provision of security within 30 days after receiving the notice or within 45 days after
newspaper ads (art 177)
c. The charter and registration must be changed with the ICA (art 179)
d. In Huagong v Yangduan, the court held that PRC Company Law does not prohibit limited
liability companies from repurchasing their own shares. Repurchases made in accordance with
the statutory requirements will not harm the interests of the company’s shareholders and
creditors, nor will it constitute a violation of the company’s obligation to maintain its capital.
On the facts of the case, the repurchase agreement did not ostensibly deviate from market
practice, including bearing the normal operation costs and achieve normal operational
performances.
To merge with another company that is a shareholder
Based on 2/3 director approval to grant employee stock incentives (no more than 5% of outstanding
shares)
To provide shares needed for conversion of convertible bonds
To protect corporate value or shareholder interests (10% treasury stocks allowed for up to 3 years) –
can be used for defence against hostile takeover
Due to the request of a dissident shareholder in M&A or spin off (“appraisal right” – right of
shareholder to have a judicial proceeding or independent valuator determine a fair stock price and
oblige the acquiring corporation to purchase shares at that price)
U.S. vs CHINA
Does the legal capital doctrine actually provide more protection to creditors than the authorized capital
doctrine?
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The legal capital doctrine is primarily associated with creditor protection and seeks to protect creditors by saying
that only that portion of the net assets that exceeds the capital and undistributed reserves can be paid out to
shareholders.

What will creditors consider when making decisions to lend?
Creditors consider the credit risk based on a number of factors (“5Cs):
1.
2.
3.
4.
5.
III.
Capacity
a. Lenders must be sure that the borrower has the ability to repay the loan based on the propose
amount and terms
b. E.g. For business loan applications, the financial institution reviews the company’s past cash
flow statements to determine how much income is expected from operations
Capital
a. Capital for a business-loan application consists of personal investment into the firm, retained
earnings, and other assets controlled by the business owner
b. Banks prefer a borrower with a lot of capital because that means the borrower has some skin
in the game
Conditions
a. Refers to the terms of the loan itself, as well as any economic conditions that might affect the
borrower
b. Business lenders review conditions such as strength or weakness of the overall economy and
the purpose of the loan
Character
a. Refers to a borrower’s reputation or record vis-à-vis financial matters
Collateral
a. Business borrowers may use equipment or AR to secure a loan
b. Applications for a secured loan are looked upon more favourably than those for an unsecured
loan because the lender can collect the asset should the borrower stop making loan payments
LIMITED LIABILITY AND BASIC GOVERNANCE STRUCTURE
A.
PROS AND CONS OF LIMITED LIABILITY
Limited liability reduces investment risk and encourages equity investment. It also facilitates portfolio
diversification, thus enabling shareholder passivity. On a related note, it supports separation of ownership from
control and promotes specialization (especially in management and risk-taking).
However, the flipside to limited liability is that it allows shareholders to externalize business costs to creditors.

This is especially problematic where the creditors are non-consensual, hence prices cannot be adjusted
ex ante.
B.
PIERCING THE CORPORATE VEIL
‘Piercing the corporate veil’ is an equitable exception to limited liability. However, the application of this
mechanism may differ under the following two dimensions:
1.
2.
Whether the corporation is public or private (separation vs concentration of ownership and control)
Whether the creditor is consensual or non-consensual (contract vs tort)
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Creditor Type
Contract
Low externalization;
Corporation Type
Public
High monitoring cost
Tort
Medium
externalization;
High monitoring cost
Medium externalization;
High externalization;
Low monitoring cost
Low monitoring cost
Private
1.
U.S.
Where a corporation is run purely for personal ends and not for the benefit of the corporation, then there is a
basis for piercing the corporate veil and holding the shareholder personally liable.
A)
ELEMENTS
To succeed in an action for piercing the corporate veil, the claimant must prove two things (Sea-Land Services,
applying Van Dorn):
1.
2.
First, that there is a unity of interest between the individual and the corporation; and
Second, that the allowance of a limited liability would sanction a fraud or promote an injustice
On the facts of Sea-Land, while the plaintiff was able to prove the first stage, he was unable to adduce enough
evidence with respect to the second stage. Hence, the corporate veil was not pierced as the claimant had yet to
offer evidence to completely demonstrate that the corporate veil should be pierced.
B)
DOCTRINE OF INSUFFICIENT CAPITAL REJECTED
A corporation with a minimum amount of assets is a valid one and cannot be ignored (Walkovszky v Carlton).


It is pertinent to note Judge Keating’s dissent in Walkovsky where he held that Carlton should be liable
as the corporation was intentionally undercapitalized in order to avoid liability, which is a clear abuse
of the corporate entity.
However, this “insufficient capital” rationale has not been widely persuasive with courts, perhaps due
to a fear that it would chill entrepreneurial activity.
2.
CHINA
Pursuant to art 20, s 3 of the Company Law, shareholders who abuse the independent corporate status and
limited liability to evade debts and cause serious harm to creditors will be jointly and severally liable for
corporate debts.
According to the SPC Proceedings of the National Conference on Civil and Commercial Adjudications 2019,
“abuse” has the following characteristics (art 10-12):
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1.
2.
3.
Commingling of legal status (“alter ego”) – asset commingling is the focus, whereby the shareholder
uses corporate assets without accounting records, or mixes corporate profits and shareholder dividends
Undue control (“corporate dummy”) – there are excessive related-party transactions to transfer
benefits or shift liabilities
Obvious undercapitalization – where there is a mismatch of capital and expected risk of business.
However, caution is needed in application due to the ambiguity of capital sufficiency
a. Prima facie, the claimant in Walkovsky may succeed here. But it depends on the specific factual
matrix, especially what is considered sufficient capital in the context of taxi companies
Commingling of Assets
The commingling of personnel, business, finance, and other aspects of affiliate companies that leads to the
impossibility of separating out properties and the loss of independent personalities constitutes the
commingling of properties. If the affiliate companies that comingle personalities seriously harm the interests of
their creditors, the affiliate companies bear joint and several liability among themselves for the external debt
(XCMG Construction).

On the facts of XCMG Construction, the characterization factors of personality (personnel, business,
and finance) showed a high degree of commingling, resulting in an inability to distinguish individual
property. A company’s independent property is the material guarantee of its independent bearing of
responsibilities – when affiliate companies are unable to separate their properties and lose their
independent personalities, they lose the basis for bearing responsibilities independently.
3.
COMPARISON
Insofar as piercing the corporate veil is concerned, China and U.S. have very similar legal doctrines and patterns
in practice. For example, the doctrine is only applicable for private companies, and tort creditors are no more
likely to be protected than contract creditors.
However, a salient difference between the two countries is that China is more willing to pierce the veil.
4.
1.
EVALUATIONS/QUESTIONS TO ASK
Should contract creditors to be protected the same as, or more than, tort creditors?
Many courts have acknowledged a distinction between the justifications for piercing the veil by a tort creditor
and those for a contract creditor. Nearly all such courts that have acknowledged such distinction have concluded
that tort creditors should have an easier path to piercing the corporation’s veil of limited liability.
This is because tort victims should not be required to bear the costs of risky corporate behaviour when they
neither chose to deal with the corporation nor had the opportunity to protect themselves from the risk of
corporate insolvency.
2.
Should public corporations never be pierced?
There is no record of a successful piercing of the corporate veil of a publicly traded company because of the
large number of shareholders and the extensive mandatory filling entailing in qualifying for listing on an
exchange.
3.
4.
Why are the Chinese courts more willing to pierce?
Is judicial practice in this regard messy?
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C.
CORPORATE GOVERNANCE FOR WHOM?
In the U.S., business corporation is organized and carried on primarily for the profit of the stockholders. The
powers of the directors are to be employed for that end (Dodge v Ford Motor Company), which includes
promoting the value of the company for the benefit of stockholders (eBay Domestic Holdings). In this regard,
promoting, protecting or pursuing non-stockholder considerations must lead at some point to value for
stockholders (eBay Domestic Holdings).
On the other hand, art 5 of the PRC Company Law espouses that companies engaged in business activities must,
inter alia, abide by social morals and business ethics, be honest and trustworthy, accept the supervision of the
government and the public, and assume social responsibility.
1.
BASIC GOVERNANCE STRUCTURE IN U.S.
Pursuant to §141(a) of the DGCL, the business affairs of every corporation are to be managed by or under the
direction of a board of directors (with possible exceptions, which includes provisions that provide otherwise in
the company’s certificate of incorporation).
A)
DIRECTORS
The shareholders elect the directors, who in turn elect the corporate officers. The officers are delegated with
the power to manage corporations, and the directors monitor the officers and decide strategic issues.
B)
SHAREHOLDERS
Shareholders can only vote on a limited number of issues besides the election of directors. Some of these include
bylaw amendments and M&A.
Moreover, they usually do not have the power to call special meetings (if not authorized in articles/bylaws – at
least in Delaware).
Shareholder proposal rights are limited, and they cannot conflict with the management power of the board.
Furthermore, shareholder proposals are not binding even if adopted except for bylaw amendments.
2.
BASIC GOVERNANCE STRUCTURE IN CHINA
On the other hand, China has adopted a shareholder supremacy principle – the shareholder meeting is the organ
of corporate power (arts 36, 98), and the board of directors is accountable to the shareholder meeting (art 46).
A)
DIRECTORS
China has adopted the German dual-board structure, where there is a board of directors and a supervisory
board.


The board of directors is to make proposals for shareholder resolutions, and to decide the operation
and investment plans. The board of directors also selects officers.
The supervisory board is to monitor the board of directors and officers. 1/3 of the supervisory board
must be employees (art 51, 117)
B)
SHAREHOLDERS
Shareholders holding at least 10% shares for more than 90 days can call special shareholder meetings if neither
board elects to do so (arts 40, 101).
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Shareholders in listed companies with at least 3% shares can make proposals of unlimited numbers and about
anything legitimate (art 101). These proposals are binding upon adoption.
3.
COMPARISON
A)




WHY DIRECTOR SUPREMACY?
Shareholder apathy, information asymmetry, conflicts of interests among shareholders
Separation of ownership and control: specialization
Foundation of governance: authority coupled with accountability
Rein in agency problem: judicial oversight, shareholder election right, market force
B)
WHAT ARE THE
SUPREMACY IN CHINA?


PROBLEMS
WITH
SHAREHOLDER
Board is fractional, and directors are deeply dependent on majority shareholders
o Directors generally do not consider themselves as fiduciaries of all shareholders
o Independent directors are few, weak and many are unprofessional
Small shareholders are neither mobilized nor represented
Do you think shareholders in listed companies should be empowered to oversee corporate business and
affairs directly?
Many of today’s shareholders have higher expectations relating to engagement with the board and management
than shareholders years past. Bebchuk argues that providing shareholders with the power to intervene can
significantly address importance governance problems that have long occupied the attention of corporate law
scholars and financial economists. In particular, shareholder power to make “rules-of-the-game” decisions – to
amend the corporate character or change the state of incorporation – would ensure that corporate governance
arrangements change over time in ways that serve shareholder interests. Shareholder power to make “gameending” decisions – to merge, sell all assets, or dissolve – would address managers’ excessive tendency to retain
their independence. Finally, shareholder power to make “scaling-down” decisions – to contract the company’s
size by ordering a cash or in-kind distribution – would address problems of empire building and free cash flow.
What’s your opinion about the dual board structure?
While a two-tiered structure offers some advantages over a unitary structure in its roles, representation, and
balance, it does have a few drawbacks. Supervisory boards emphasise the appointment of independent directors
to supervisory boards. While these directors may be appointed with the best interest of the company in mind,
independent directors often stand to benefit – both financially and in their industry reputations – from the
success of the company’s stock.
While prioritizing stock market performance may be in the company’s best interest, it’s not always in the best
interests of its employees. Warping a board member’s “independence” in this way also leads to more risk averse
positioning, often liming the company’s growth.
IV.
FIDUCIARY DUTIES
A.
DIRECTOR FIDUCIARY DUTIES IN U.S.
1.
GENERAL PRINCIPLES
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There are two basic duties – duty of care and duty of loyalty (which encompasses the duty of good faith).
A)
STANDARD OF
PRACTICE, ABSTRACT
CONDUCT
–
INSPIRATIONAL,
BEST-
With regard to the duty of care, the directors must be well-informed and adequately diligent. For duty of loyalty,
the directors must act in the best interest of shareholders.
B)
STANDARD OF REVIEW – OPERATIONAL, STRIPPED OF
IDEALISM
With regard to the duty of care, the business judgment rule is the applicable standard.
For duty of loyalty, the entire fairness, the intermediate standards in mergers & acquisitions (compelling
justification for interfering with shareholder franchise).
2.
DUTY OF CARE
The level of precaution required when making business decisions is that without gross negligence.
Business Judgment Rule
To pass the BJR, the following requirements must be met:
1.
2.
3.
4.
First, directors have no conflict of interest (i.e. majority of the board is independent),
Second, they made a business decision (i.e. they did something rather than taking no action)
Third, they made a decision in good faith (i.e. in the best interest of the company, sufficient as long as
any rational mind would agree the decision makes some business sense)
Directors are well-informed when making the decision. In this regard, meetings are necessary, expert
advice often essential. Voting should only be done after adequate discussion
a. On voting, it is pertinent to note that directors are not allowed to vote by proxy (unless
otherwise provided by the articles or bylaws); no alternate director
Without conflict of interest, good faith and well-informed decision are all presumed by law unless the plaintiff
can rebut these presumptions. If the plaintiff fails to do so, the court will not second guess a business decision
of the board.
In Smith v van Gorkom, the majority held that the directors were grossly negligent because they quickly
approved the merger without substantial inquiry or any expert advice. As such, the board of directors breached
the duty of care that it owed to the corporation’s shareholders and, accordingly, the protection of the BJR was
unavailable. Furthermore, the court rejected the defendant’s argument that the substantial premium paid over
market price indicated that it was a good deal. In so doing, the court noted the irony that the board stated that
the decision to accept the offer was based on their expertise, while at the same time asserting that it was proper
because the price offered was a large premium above market value.
EV1: However, it is submitted that the case was decided wrongly. As aptly put by the dissenting judge, the
application of the BJR on the facts was wrong – an overview of the entire record, rather than the limited view of
bits and pieces which the majority exploded like a popcorn, was convincing enough that the directors made an
informed business judgment which was buttressed by their test of the market. Furthermore, imposing such
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liability on directors provides a strong disincentive for the best potential directors to serve on the board, which
may consequently result in worse corporate governance.
The aftermath of this decision is reflective of the poor outcome reached here, as D&O insurance premiums
soared by 10 times, in addition to insurers pulling out of the D&O market.
EV2: As such, the Delaware legislature took swift action to change the Delaware General Corporation Law,
adding §102b(7) which exempts directors from monetary damages for breaches of duty of care.
3.
DUTY OF LOYALTY AND CONFLICT OF INTEREST
Conflict of interest arises where the director is not (1) disinterested; or (2) independent. On (1), affairs involve
the director’s own (or his affiliates’) economic stakes. On (2), the directors are beholden to someone whose
economic stakes are involved (shareholder, officer, or even a third-party).
The failure to act in good faith is a condition to finding a breach of the fiduciary duty of loyalty and imposing
fiduciary liability. However, a failure to act in good faith is not conduct that results, ipso facto, in the direct
imposition of fiduciary liability. Failing to act in good faith may result in liability because the requirement to act
in good faith is a condition of the duty of loyalty (Stone v Ritter).
A)
CLEANSING OF CONFLICT
To cleanse this conflict, there are two alternative routes that may be adopted:
1.
2.
First, through good faith and informed approval by (majority of) the other directors without conflict
(“director approval”); or
a. Approval is valid even if such directors cannot meet the quorum
b. A “special committee” composed fully of independent and disinterested directors often grants
the approval
Second, through the informed and uncoerced approval by shareholders subject to regular shareholder
approval process (quorum + majority of attending shareholders) (“shareholder approval”)
Alternatively, directors may be exempted from liabilities of appropriating corporate opportunities through
articles or board resolution (DGCL §122(17)).
B)
EFFECT OF CLEANSING
As a result of the cleansing of conflict, transactions with conflict will not be void or voidable solely because of
the conflict. However, cleansed transactions are nonetheless subject to judicial review.
Director Approval
Under this limb, the BJR is applied.
Shareholder Approval
Under this limb, there are two specific scenarios to consider:


Corwin Rule - Where interested directors and shareholders did not vote, the BJR applies even if the
majority of the board are interested or lack independence (Corwin v KKR).
Where interested directors and shareholders did vote, the entire fairness standard is applicable (Fliegler
v Lawrence).
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In Fliegler v Lawrence, the facts were such that the directors composed a majority of the shareholders. In such
a situation, shareholder ratification is not legitimate. Hence, the burden of proof that the transaction was fair
rests of the defendant-directors. On the facts, this was satisfied.
No Approval
The transaction must be entirely fair to be effective.
C)
DUTY TO MONITOR
The board breaches this duty when the board takes no action rather than makes some decision.

It is pertinent to note, however, that this is the most difficult cause of action for plaintiffs (shareholders)
to win a fiduciary case against.
In Caremark, the issue of compliance was raised – specifically, the board’s responsibility with respect to the
organisation and monitoring of the enterprise to ensure that the corporation functions within the law achieve
their purpose. To this end, the court held that most company decisions do not need director supervision – only
a sustained or systematic failure of the board to exercise oversight will establish the lack of good faith that is a
necessary condition to liability.
The point of oversight and liability was expanded upon in the latter case of Stone v Ritter. There, the court stated
that the necessary conditions that predicate for director oversight liability are:
a) The directors utterly failed to implement any reporting or information system or controls; or
b) Having implemented such a system or controls, consciously failed to monitor or oversee its operations
thus disabling themselves from being informed of risks or problems requiring their attention.
In either case, imposition of liability requires a showing that the directors knew that they were not discharging
their fiduciary obligations. Where directors fail to act in the face of a known duty to act, they breach their duty
of loyalty by failing to discharge that obligation in good faith (Stone v Ritter).
B.
DIRECTOR FIDUCIARY DUTIES IN CHINA
Pursuant to art 147, a director has two basic fiduciary duties: (a) duty of care; and (b) duty of loyalty. However,
there is a lack o a clear standard of review. To this end, judges sometimes look to American cases and legal
doctrines for guidance.
The cases on fiduciary duties are relatively few – when the rule is applied, the case is often about less complex
administrative decisions rather than complex business decisions.
1.
DUTY OF CARE
The duty of care requires that directs must make decisions in the best interest of the company, without
negligence, and with reasonable care – the determination of whether a director has fulfilled his or her duty of
care should be made based on three elements: (1) the action was taken in good faith; (2) with the care that an
ordinary person in a similar position in similar circumstances would exercise in handling his or her own affairs;
and (3) in a manner that is reasonably believed to be in the best interests of the company (Shanghai Chuanliu).
It is very risky to be directors of Chinese companies, especially listed companies:

There is no business judgment rule explicitly provided by law or stated by the court
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


Moreover, breaches of directors’ duty of care are handled like a regular tort negligence case: no gross
negligence is required
There are no exemptions provided from monetary damages for directors in breach of the duty of care
D&O insurance is very limited as well
2.
DUTY OF LOYALTY
There is no general definition in law, and the courts look to U.S. for a clue. The focus is on conflict of interest,
whereby the directors must protect the corporate interest when their own interest is in conflict with corporate
interest and must not take advantage of the director’s position in pursuit of their own or third party’s interest
at the expense of the corporate interest.
A)
ACTIONS FORBIDDEN FOR DIRECTORS (ART 148)
a)
b)
c)
d)
Taking bribes
Misappropriate or embezzle corporate assets
Deposit corporate funds into individual bank accounts
Lending corporate funds to others or provide security interest for others using corporate assets without
proper authorization by shareholders or the board
e) Self-dealing with the company without shareholder approval
f) Taking corporate opportunities
g) Competition with the company
h) Misappropriate commissions paid to the company
i) Breach of confidentiality
B)
CLEANING DIRECTOR’S CONFLICT OF INTEREST
a)
For self-dealing, shareholder approval is required (art 148) – question, however, whether interested
shareholders should recuse themselves
b) For RPTs (in listed companies), approval by a majority of disinterested directors is required. However,
if the number of interested directors outnumber those who are disinterested, then shareholder
approval is required (art 124)
However, monetary damages cannot be exempted based on disclosure and approval by shareholders if the
transaction causes loss to shareholders (Interpretation V, art 1).
C.
SHAREHOLDER FIDUCIARY DUTIES IN U.S.
Shareholders do not owe fiduciary duties to the corporation or other shareholders unless they are controlling
shareholders.
Shareholder fiduciary duty only becomes an issue when certain board decisions are involved. Examples include
having a controlling shareholder on both sides of the transaction, or a controlling shareholder competing for
(distinct) benefit against other shareholders.
In Sinclair Oil, the court held that under the BJR, a court will not interfere with the judgment of a board of
directors unless there is a showing of gross and palpable overreaching. A board of directors enjoys a
presumption of sound business judgment, and its decisions will not be disturbed if they can be attributed to any
rational business purpose.
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
On the facts of Sinclair, no self-dealing was found as Sinclair received nothing from Sinven to the
exclusion of its minority stockholders. Hence, the applicable standard was not the intrinsic fairness test,
rather the business judgment standard should be applied.
1.
DEFINITION OF A CONTROLLING SHAREHOLDER
A controlling shareholder is one who:
1.
2.
Has voting rights > 50%; or
Is a minority controller (i.e. one who has sufficient voting power and management authority) – theory
of inherent coercion
On the second limb, control of the board is key, either through general control or control of board decisions on
particular transaction with conflict of interest – in Tesla Motors, the court held that a minority stockholder may
as a matter of law be a controlling stockholder if the controller conceivably has the “de facto power of a
significant stockholder, which, then coupled with other factors, [such as managerial supremacy], gives that
stockholder the ability to dominate the corporate decision-making process.”
2.
DUTY OF LOYALTY
Controlling shareholders only have a duty of loyalty (i.e. avoiding conflict of interest) but not duty of care or
monitoring

Exception probably in relation to sale of control
A)
CLEANSING OF CONFLICT AND EFFECT
There are two ways through which controlling shareholders’ conflict of interest can be cleansed:
1.
2.
First, through a special (independent) committee approval
a. Fully authorized including negotiation with the controlling shareholder, rejection of
controller’s proposal and searching for alternatives
b. Freedom to choose its advisors at the corporation’s expense
c. Sufficient access to information including inquiries of the management
d. Proper functioning, adequate deliberation
e. Effect: entire fairness standard still applies while shifting burden of proof to the plaintiff
Second, via a majority of minority shareholder approval
a. Must be a condition of the transaction from the very beginning (start of material negotiation)
b. Informed and noncoerced
c. Effect: entire fairness standard still applies while shifting the burden of proof to the plaintiff
If both conditions are met, the effect is for the BJR to apply instead. As expounded in Kahn v M&F Worldwide
Corp, the BJR will only apply if:
i.
ii.
iii.
iv.
v.
vi.
the controller conditions the procession of the transaction on the approval of both a special committee
and a majority of the minority stockholders
the special committee is independent
the special committee is empowered to freely select its own advisors and to say no definitively
the special committee meets its duty of care in negotiating a fair price
the vote of the minority is informed
there is no coercion of the minority
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B)
ENTIRE FAIRNESS
The concept of entire fairness encompasses fair dealing and fair price. Fair dealing embraces questions of when
a merger transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how
the approvals of the directors and the stockholders were obtained. Fair price relates to the economic and
financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings,
future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock
(Weinberger v UOP Inc).
The test for fairness is not a bifurcated one – all aspects of the issue must be examined as a whole because the
question is one of entire fairness. On the facts of Weinberger, the court was of the view that fair dealing was
transgressed as the matter of disclosure to the defendant’s directors was wholly flawed by conflicts of interest
raised in the feasibility study, and the minority shareholders were denied critical information. Thus, the vote of
the minority shareholders was not an informed one.
3.
SALE OF CONTROL
Generally, there are no restrictions on the sale of control by controlling shareholders. Market forces apply, and
there is no mandatory bid requirement.
A)
SELLING CONTROL TO LOOTERS
However, liability may arise when controlling shareholders are selling control to “looters”. Under the looting
doctrine, a controlling shareholder violates his fiduciary duties when he negligently sells his controlling stake to
an apparent looter who indeed then proceeds to plunder the corporation.
As held in Harris v Carter, while a person who transfers corporate control to another is surely not a surety for
his buyer, when the circumstances would alter a reasonably prudent person to a risk that his buyer is dishonest
or in some material respect not truthful, a duty devolves upon the seller to make such an inquiry as a reasonably
prudent person would make, and generally to exercise care so that others who will be affected by his actions
should not be injured by wrongful conduct.
EV: It is pertinent to note that the duty of care that the court is advocating for in this case is not the one that is
understood generally, rather it is specific to the U.S. corporate law. Otherwise, there will be a conceptual
dissonance between the requirement of gross negligence for breaches of fiduciary duties, vis-à-vis mere
negligence being made out for breaches of duty of care.
B)
NARROWLY DEFINED CONCEPT OF DUTY OF CARE
A narrowly defined duty of care can be justified on efficiency grounds – this is because in looting cases, the
controlling shareholder’s incentives may in fact be insufficient to protect the minority shareholders. Typically,
the controller does not participate in the downside of selling to a looter, because after the sale, when the looter
starts plundering the corporation, the seller is no longer invested in the firm. Accordingly, in the absence of a
duty of care, the seller typically has little incentive to screen potential buyers. Even worse, the controller may
profit from selling to a looter, because the price that the looter offers for the controlling stake may reflect the
acquirer’s expected profits from plundering the corporation at the expense of the minority shareholders. Courts
have been very much aware of this problem and have been willing to apply the looting doctrine in scenarios
where the controlling shareholder parted with his stake at an obviously excessive price, and thus “sold out” the
minority shareholders. There is then, in looting cases, a strong case to be made for a duty of care for controlling
shareholders.
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D.
SHAREHOLDER FIDUCIARY DUTIES IN CHINA
1.
CONTROLLING SHAREHOLDERS
There is no provision of fiduciary duties for controlling shareholders in law. However, PRC company law generally
prohibits “abuse of rights to harm the company or other shareholders interest” by any shareholder (art 20).
Moreover, controlling shareholders or actual controllers of listed companies have a “duty of good faith” to the
company and other shareholders (CSRC Corporate Governance Guidelines for Listed Companies, art 63).
However, these are extremely vague standards of conduct without a standard of review – hence, shareholder
fiduciary duty cases are even rarer in practice.
2.
SALE OF CONTROL
For listed companies, the mandatory bid rule applies, hence control premium must be shared.
For private limited liability companies, other shareholders have a right of first refusal (ROFR), unless opted out
of in the articles of association (art 71).
E.
COMPARISON OF FIDUCIARY DUTIES IN U.S. CF CHINA
China seemingly follows the U.S. in both legislative and adjudicative sense, at least in terms of format. However,
there are two major differences:
1.
2.
In China, there is a lack of protection of directors
In China, there is a lack of a clear definition of controlling shareholders’ fiduciary duties
Generally speaking, fiduciary duties lawsuits arise infrequently in China.
V.
SHAREHOLDER RIGHTS
A.
OVERVIEW
There are three major shareholder rights:
1.
2.
3.
Right to vote
Right to transfer/exit
Right to suit
Additionally, there are two corollary rights:
1.
2.
Right of proposal: prerequisite to vote
Right to inspect: essential to voting and litigation
In the U.S., the board has primacy hence there is a clear boundary between board power and shareholder rights.
Conversely, in China, shareholder primacy is adopted hence shareholders enjoy much broader powers (at least
on paper).
B.
SHAREHOLDER VOTING RIGHTS IN U.S.
1.
ELECTION OF DIRECTORS
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A)
BOARD TENURE
A regular board is subject to election every year. In contrast, where staggered boards are concerned only 1/3
are subject to election every year.
B)
ELECTION RULE
For a valid quorum, at least 50% of the voting rights must be present in person or by proxy at the shareholder
meeting, subject to change by articles or bylaws – however, it cannot be below 1/3 (DGCL §216(a)).
In principle, plurality voting is applicable. However, majority voting can be adopted by the articles or bylaws in
non-contested elections. As a side, cumulative voting is barely used.



Plurality voting: whoever has the highest number of votes, even if below 50%, is elected (necessary for
contested elections without a run-off/second round)
Majority voting: elected only if received 50%+ votes cast at the election (strengthens shareholder voice
in non-contested elections; adopted by 90%+ S&P 500 corporations)
Cumulative voting: shareholders can cast all votes for one candidate; at least S/(D + 1) + 1 votes needed
to elect 1 director in an election of D directors with total S total votes cast (not very helpful in protecting
dispersed minority shareholders)
C)
REMOVAL OF DIRECTORS
Directors can be removed with or without cause in regular boards, but only for cause in staggered boards.
D)
NOMINATION
Generally, the board nominates directors. However, shareholders can nominate via “proxy access” – shorthand
for the ability of a long-term shareowner (or a group of long-term shareowners) to place a limited number of
alternative board candidates on the company’s proxy card (ballot) for the company’s annual shareholder
meeting. In order to be eligible, these shareholders must have collectively held at least 3% shareholding (by at
most 20 shareholders) for at least 3 years to nominate 20% directors (SEC rule §14a-8 and DGCL §122).
The bylaws an also require reimbursement of expenses spent by dissenting shareholders for “proxy contests” if
the dissidents at least partially won.
E)
PROTECTION OF SHAREHOLDER FRANCHISE
(1)
PRIMARY PURPOSE & COMPELLING JUSTIFICIATION
In Blasius Industries v Atlas Corp, Blasius argued that the directors of Atlas did not have authority to act for the
primary purpose of thwarting the exercise of a shareholder vote – specifically, Blasius argued that Atlas’ actions
were selfishly motivated in order to protect the incumbent board from a perceived threat to its control.
Contrarily, Atlas argued that the business judgment rule prevented the courts from looking into the reasons for
why the management voted to increase the size of the board of directors.
The court held that even when an action is taken in good faith, it could constitute an unintended violation of the
duty of loyalty that the directors owe to the shareholders. The directors are in effect agents of the shareholders.
If the purpose of an action is to obstruct the shareholders’ reasonable control over their business, that is
inequitable – if there is a disagreement between the shareholders and the directors, the directors have to defer
to the judgment of the shareholders.
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However, the court also held that there may be some compelling justification for the directors’ actions, so the
actions are not forbidden per se:
1.
2.
3.
When stockholders are about to reject a third-party merger proposal that the independent directors
believe is in their best interests;
When information useful to the stockholders’ decision-making process has not yet been considered
adequately or not yet been publicly disclosed; and
When if the stockholders vote no the opportunity to receive the bid will be irretrievably lost.
(2)
ADVANCE NOTICE BYLAW
This bylaw requires shareholders to submit to board notice and supplementary information before nominating
directors or introducing other business at shareholder meeting. The relevant information include the following:
a) Nominees’ hedging positions, background and qualifications
b) An agreement by the nominee to comply with fiduciary duties and all governance policies and
guidelines of the company
c) Advance notice is usually 60-120 days, some stretching to 180 days
Advance notice bylaws are frequently upheld as valid by Delaware courts, but often construed narrowly (Hill
International Inc v Opportunity Partners LP).
C.
SHAREHOLDER VOTING RIGHTS IN CHINA
1.
DIRECTOR NOMINATION AND ELECTION
Shareholders who hold 10% shares, individually or in concert, for 90 days, can call for special shareholder
meetings when neither board calls a meeting (art 101).
A)
RIGHT TO NOMINATE (NON-EMPLOYEE) DIRECTORS
The right to nominate non-employee directors is considered to belong solely to the shareholders (Jiang Pengnian
v Shanghai Shenhua Industries).
B)
RIGHT TO NOMINATE IS ABSOLUTE
Shareholders with 3% stocks individually or in concert can make proposals to shareholder meetings including
director nominations with 10 days’ advance notice (art 102; CISC v Haili Biotech).
D.
SHAREHOLDER PROPOSALS IN U.S.
1.
OVERVIEW
A)
PROPOSAL TO AMEND ARTICLES/BYLAWS
Article amendments are reserved for the Board, and shareholders can only dis/approve. With respect to bylaws,
only procedural amendments are allowed – substantive amendments are not allowed (CA Inc v AFSCME
Employees; DGCL §113). Once adopted, shareholder bylaw amendments are binding.
B)
PROXY VOTING AND SHAREHOLDER PROPOSAL
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Most shareholders of listed companies vote by proxy. To solicit proxies from other shareholders, disclosure must
be made about the agendas to be voted and the rationales for supporting these agenda. Federal proxy rules
provide the information to be disclosed (proxy statements) and safeguards its accuracy (SEC Rule 14a).
Proxy soliciting can be very costly. The board can always use corporate funds to do so while shareholders need
to spend their own money (reimbursement is possible only if the bylaw allows and usually when shareholders
are successful). Hence, shareholders want to have their proposals included in board proxies.
2.
FEDERAL PROXY RULE
Corporate boards can exclude shareholder proposals for various reasons and seek SEC no-action letter to
endorse the exclusion. Shareholders can challenge the decision in federal courts.
A)



GENERAL REQUIREMENTS FOR MAKING PROPOSALS
To make a proposal, the shareholder must continuously hold $2,000 in stocks for 3 years, $15,000 for
2 years or $25,000 for 1 year (SEC Rule 14a-8(a))
The proposal, including any accompanying support statement, may not exceed 500 words (SEC Rule
14a-8(d))
The proposal must be received not less than 120 calendar days before the date of the company’s proxy
statement released to shareholders in connection with the previous year’s annual meeting (SEC Rule
14a-8(e))
B)
SOURCES OF DISPUTE OVER EXCLUSION
Notwithstanding that a shareholder had complied with procedural requirements, the company may rely on
other bases to reject their proposal. These include the following:
(1)
RELEVANCE EXCLUSION
Pursuant to SEC Rule 14a-8(b)(i)(5), if the proposal relates to operations which account for less than 5 percent
of the company’s total assets at the end of its most recent fiscal year, and for less than 5 percent of its net
earnings and gross sales for its most recent fiscal year, and is not otherwise significantly related to the company’s
business.
However, proxy proposals are includable notwithstanding their failure to reach the specified economic
thresholds if a significant relationship to the issuer’s business is demonstrated on the face of the resolution or
supporting statement (Lovenheim v Iroquois Brands).
(2)
ORDINARY BUSINESS EXCLUSION
Pursuant to SEC Rule 14a-8b(i)(7), shareholders are not allowed to interfere with the board’s authority of
managing business and affairs. There are two main considerations:
1.
The first relates to the subject matter of the proposal. Certain tasks are so fundamental to the
management’s ability to run a company on a day-to-day basis that they could not, as a practical matter,
be subject to direct shareholder oversight.
a. Examples of this include the management of the workforce, such as the hiring, promotion and
termination of employees, decisions on production quality and quantity, and the retention of
suppliers
b. HOWEVER, proposals relating to such matters but focusing on significant social policy issues
generally would not be considered to be excusable because such issues typically fall outside
the scope of the management’s prerogative
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2.
The second consideration relates to the degree to which the proposal seeks to micromanage the
company by probing too deeply into matters of a complex nature that shareholders, as a group, would
not be qualified to make an informed judgment on, due to their lack of business expertise and lack of
intimate knowledge of the company’s business
a. It comes into play where the proposal seeks intricate detail, or seeks to impose specific timeframes or methods for implementing complex policies
On the facts of Trinity Wall Street v Wal-Mart Stores, the court held that under the ordinary business exclusion,
Wal-Mart can exclude in its proxy statement Trinity’s proposal which sought to require the development of
standards for determining whether to sell firearms and other products that might pose risks to the public and
to the company’s reputation and brand value. According to the court, although Trinity’s proposal addressed a
significant social policy issue, it did not transcend Wal-Mart’s ordinary business operations because weighing
safety concerns regarding large number of products was a routine business matter for retailers. Moreover, the
court opined that consideration of the risk that certain products posed to Wal-Mart’s economic success and
reputation for good corporate citizenship was enmeshed with how the company ran its business and the retailerconsumer interaction.
E.
SHAREHOLDER LITIGATIONS IN U.S.
1.
DIRECT VS DERIVATIVE
A)
HOW TO DIFFERENTIATE?
In determining whether a stockholder’s claim is derivative or direct, the issue must turn solely on the following
questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2)
who would receive the benefit of any recovery or other remedy (the corporation or the suing stockholders,
individually) (Tooley v Donaldson).
A direct shareholder claim included a duty, breach of that duty, and direct injury to the shareholder
(independent of injury to the corporation) (Tooley v Donaldson).
Examples
Direct – securities frauds (in relation to buy or sale of securities, in proxy solicitation, etc); protection of voting
rights or inspection rights; to compel payment of declared dividends; suit based on minority oppression; contract
breach or torts against individual shareholders
Derivative – waste of corporate assets or usurpation of corporate opportunities; contract breach against the
corporation; malpractice of corporate advisors
Both – breach of fiduciary duties in M&A, especially where selling a corporation
B)
DERIVATIVE SUITS
Derivative suits are considered as combining two suits: one to enforce the corporation’s obligation (to
shareholders) to enforce its claims and one to enforce corporation rights of action against the wrongdoer.
C)
DIRECT SUITS
Direct suits can be brought individually or in class.
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2.
DEMAND AND EXCUSE
Shareholders must demand the board to prosecute the cause of action before initiating derivative actions unless
the board can be excused. Once a demand is made, the board’s decision whether to bring the suit as demanded
is protected by the business judgment rule.
A)
EXCUSE OF DEMAND FOR FUTILITY
Demand is excused for futility. To raise a reasonable doubt that the directors’ actions would be protected under
the business judgment rule, the plaintiff must allege specific facts that causes reasonable doubt that (Aronson v
Lewis):
1.
2.
The directors are disinterested and independent; and
The challenged transaction was otherwise the product of a valid exercise of business judgment
B)
UNIVERSAL DEMAND RULE
Under this doctrine, there is no excuse to demand. Once rejected by the board to sue, the plaintiff must show
that the majority of the board is not independent or the board did not reject in good faith after reasonable
inquiry (MBCA §7.44(d)).
3.
SPECIAL LITIGATION COMMITTEE
Once the demand is excused and a derivative suit is filed, the board can mobilise independent directors who are
not the defendants of the suit to form a special litigation committee. This committee will review the case and
decide whether continuation is in the corporation’s interest. If it decides not, a motion to dismiss will be filed on
behalf of the corporation.
To succeed, the committee must prove its disinterestedness, independence and must act in good faith and with
care (Zapata Corp v Maldonado). Moreover, the trial court should conduct its own independent judgment to
decide whether continuing the suit is in the corporation’s interest (ibid).

Under the MBCA §7.44, instead of a trial court conducting its own independent judgment, a committee
of at least 2 members is appointed by a majority independent directors to do the same.
F.
SHAREHOLDER LITIGATIONS IN CHINA
In China, both direct and derivative litigations are allowed (art 151; art 152). Chinese law explicitly allows
shareholders to bring derivative suits against third parties that are not corporate insiders – as a side, derivative
suits against third parties are rare in the US given the demand rule.
1.
PREREQUISITES TO DERIVATIVE SUITS (ART 151)
For a shareholder to be entitled to bring a derivative suit, he must continuously hold 1% stocks individually or in
concert for 180 days. Furthermore, he must serve a demand on the board in writing (supervisory board) to sue
supervisory board members, or third parties.
When the demand is refused or no suit is brought within 30 days after demand, the shareholder can bring
derivative suits to the court.
G.
SHAREHOLDER INSPECTION RIGHTS IN U.S.
35 | P a g e
1.
WHO CAN INSPECT?
In general, there is no requirement of shareholding % (California gives 5% absolute right to inspect). However,
proper purpose is needed: e.g. to solicit support on voting issues; to uncover management wrongdoings (crucial
to derivative suits).
In Security First, the court held that the trial court could rely on all of the evidence presented at trial – the failure
of the plaintiffs to articulate certain “magic words” is not fatal to the action. Moreover, the court held that the
plaintiff had the burden of proof to demonstrate a proper purpose, but was not required to prove a
preponderance of the evidence that waste and mismanagement were actually occurring.
2.


WHAT CAN BE INSPECTED?
Shareholder list vs other books and records (DGCL §220(c))
Three categories (MBCA §§16.01(e), 16.02(a)(b))
o No proper purpose is required: articles and bylaws; shareholder meeting minutes; names and
addresses of directors and officers; latest annual reports; etc
o Proof of proper purpose: board meeting minutes; shareholder lists; accounting records
o No access: all others
H.
SHAREHOLDER INSPECTION RIGHTS IN CHINA
1.
SHAREHOLDERS OF LLC (ART 33)
Shareholders of LLCs have a right to inspect and reproduce charters, shareholders and board meeting minutes,
and accounting reports. Moreover, the shareholder has a right to inspect the accounting books with proper
purpose – a company can reject in writing within 15 days for improper purpose, and the shareholder can sue
against the rejection. Pursuant to Interpretation IV art 8, improper purpose includes (1) where shareholder and
the company is in “substantial business competition”; (2) to disclose the information to third parties who may
impair corporate interest; (3) shareholder did (2) in the past 3 years. In this regard, the burden of proof is on the
company (hence improper purpose is barely found).
2.
SHAREHOLDERS OF JOINT-STOCK LIMITED COMPANY (ART 97)
Shareholders of JSLCs have a right to inspect charters, shareholder lists, shareholder and board meeting minutes,
and accounting reports, bond issuance records. They have no right to inspect accounting books, regardless of
the purpose.
After inspection, shareholders and their advisors (accountants, lawyers) bear the duty of confidentiality.
Shareholder rights: Comparison
1.
2.
Differences
a. Scope of shareholder rights
b. Protection of shareholder rights
Which country protects shareholders (especially of listed companies) better?
a. To what extent does American “board primacy” compromised shareholder rights?
b. How much fulfillment of “shareholder primacy” in China?
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VI.
FINANCING THE CORPORATION
A.
SECURITIES IN U.S.
Under the 1934 (Securities Exchange) Act § 3(10), securities have been defined broadly to include “note, stock
… bond, debenture … investment contract … or, in general, any interest or instrument commonly known as a
‘security’.” In short, a security is one that is perceived and expected by investors as an instrument of investment.
1.
INVESTMENT CONTRACTS
To determine whether a transaction qualifies as an “investment contract”, and therefore would bioe considered
a security and subject to disclosure and registration requirements under the Act, the Howey test is applied.
Pursuant to this test, an investment contract exists if there is an (1) investment of money (2) in a common
enterprise (3) with a reasonable expectation of profits (4) to be derived from the efforts of others.




“Investment of money”
o Money is not required – property or services can suffice as investment
“Common enterprise”
o Horizontal – pooling of like interests among investors
o Vertical – success of investment linking to promoter’s efforts (broad) or fortune (narrow) – not
accepted by all courts
“Expectation of profit”
o Substantial profit motive is needed; can be fixed for variable returns
“Efforts of others”
o De minimis efforts from others does not suffice
*** Note: How an instrument is offered is more important than what is offered. Fraudulent description of an
investment opportunity with the above features can be subject to securities regulations even if no securities
ever exist at all.
2.
NOTES
Notes are presumed to be securities, with the exception of short-term notes with a maturity not exceeding 9
months (exempted). However, this presumption may be rebutted by evaluating (Reves v Ernst & Young).
A)
REBUTTAL OF PRESUMPTION
First, the court examines the transaction to assess the motivations that would prompt a reasonable seller and
buyer to enter into it (question whether investment or commercial/consumer transaction). Second, the court
examines the “plan of distribution” of the instrument to determine whether it is an instrument in which there is
common trading for speculation or investment (whether it is broadly sold to a broad segment of public). Third,
the court examines the reasonable expectations of the investing public (whether it is generally perceived as
investment opportunity). Finally, the court examines whether some factor such as the existence of another
regulatory scheme significantly reduces the risk of the instrument, thereby rendering the application of the Act
unnecessary.
B)
FAMILY RESEMBLANCE TEST
If the notes are close enough to the following,
a.
b.
Notes for consumer financing
Notes secured by home mortgage
37 | P a g e
c.
d.
Short-term notes to small businesses secured by business’ assets
Bank loans
the notes in question might be deemed not to be securities.
3.
EQUITIES
A)



Cashflow rights + voting rights: at least one class needs to have both
Residual claimants: common stocks as a call option with an exercise price equal to the amount of debt
Derivative interest of common stocks: stock rights, stock options, warrants, tracing stock
B)






DEBTS
A)


PREFERRED STOCKS
Issued at par values with designated dividend rates: “5% Series A preferred stock, par value $25 per
share”
Dividend right: cumulative (by default and most often) or non-cumulative; participation or nonparticipation
o Cumulative vs noncumulative: cumulative indicates a class of preferred stock that entitles an
investor to dividends that were missed cf noncumulative
o Participating vs nonparticipating: participating preferred stock, after receipt of its preferential
return, also shares with the common stock (on an as-converted to common stock basis) in any
remaining available deal proceeds cf non-participating
Preference right: preference in liquidation up to par value (and cumulated dividends); liquidation
events (i.e. an acquisition, merger, IPO, or other action that allows founders and early investors in a
company to cash out some or all of their ownership shares)
Voting right: class voting for director elections, M&A
Redemption right (company’s right to redeem): optional (with call protection) and mandatory (change
of control)
Conversion right (right to convert shares of preferred stock into shares of common stock): conversion
price initially set 20-30% above common stock price, adjustment protection in case of stock split/stock
dividend as well as M&A that eliminates common stocks; exercisable at any time, but subject to
company’s optional redemption (forced conversion)
o Forced conversion occurs when the issuer of a convertible security exercises their right to call
the issue. In doing so, the issuer forces the holders of the convertible security to convert their
securities into a predetermined number of shares
4.

COMMON STOCKS
TYPES OF DEBT
Bond: long-term (maturity in 30+ years), often with collaterals, issued at $1,000 face value (principle)
with fixed coupon (interest) rate
Debenture: 20-30 years, without collateral
o Backed only by the creditworthiness and reputation of the issuer. Both corporations and
governments frequently issue debentures to raise capital or funds
Note: short-term (1-10 years), with or without collaterals
38 | P a g e
o

Unsecured notes are corporate debt instruments without any attached collateral. It is merely
backed by a promise to pay, making it more speculative and riskier than other types of bond
investments (e.g. secured notes, debentures) which are backed by insurance policies
Commercial paper: < 9 months, without collaterals
o Short-term debt instrument issued by corporations, typically used for the financing of payroll,
accounts payable and inventories, and meeting other short-term liabilities
B)



Affirmative covenants: pay tax, buy insurance, disclose information, etc
Negative covenants: restrictions on (1) incurrence of new debts; (2) creating security interests; (3)
shareholder payments; (4) M&A or sale of assets; (5) related party transactions; (6) issuance of stock of
subsidiaries
Financial covenants: requirements on working capital, EBITDA, debt service coverage rate, net worth,
etc.
C)




DEFAULTS
Payment defaults: fail to pay interests (within 30-day grace period) or principle (no grace period) –
bondholder can sue
Non-payment defaults: breach of covenants, bankruptcy (involuntary with 60-day grace period,
voluntary no grace period) – only indenture trustee can sue
Cross-default: borrower in default if he defaults on another obligation
5.

INDENTURE/NOTE AGREEMENTS
CONVERTIBLES
Convertible preferred stocks
o Option for the holder to convert the shares into a fixed number of common shares after a
predetermined date
Convertible bonds
o Investment value (bond value) + conversion value (option value)
 Bond valuation is a technique for determining the theoretical fair value of a particular
bond
 Conversion value refers to the financial worth of the securities obtained by
exchanging a convertible security for its underlying assets
o Lower coupon rates than comparable bonds; (20-30%) higher conversion price than stock price
 Coupon rate refers to the nominal yield (depicted as a percentage, calculated by
dividing all the annual interest payments by the par value of the bond) annual coupon
payment (i.e. annual interest rate paid on a bond, expressed as a percentage of the
face value) paid by the issuer relative to the bond’s par value)
o Hybrid security - features of a bond, such as interest payments, while also having the option
to own the underlying stock
Why issue convertible bonds?
Companies issue convertible bonds for two main reasons: (1) to lower the coupon rate on a debt – investors will
generally accept a lower coupon rate on a convertible bond, compared with the coupon rate on an otherwise
identical regular bond, because of its conversion feature thus enabling the issuer to save on interest expenses;
(2) to delay dilution – raising capital through issuing convertible bonds rather than equity allows the issuer to
delay dilution to its equity holders. A company may be in a situation wherein it prefers to issue a debt security
39 | P a g e
in the medium term – partly since interest expense is tax-deductible – but is comfortable with dilution over the
longer term because it expects its net income and share price to grow substantially over this time frame.
Related to the second point, a company may issue a convertible bond if it is unable to issue debt/equity at a
desirable price (for instance if the credit ratings are too low and the stock is underpriced).
Delta hedging using convertible bonds
Delta is the ratio that compares the change in the price of an asset to the corresponding change in the price of
its derivative. For example, if a stock option has a delta value of 0.65, this means that if the underlying stock
increases in price by $1 per share, the option on it will rise by $0.65 per share, ceteris paribus.
Delta hedging is an options trading strategy that aims to reduce, or hedge, the directional risk associated with
price movements in the underlying asset. The approach uses options to offset the risk to either a single or other
option holding or an entire portfolio of holdings. The investor tries to reach a delta neutral state and not have a
directional bias in the hedge.
Delta hedging can be achieved using convertible bonds via convertible bond arbitrage (arbitrage is the
simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in
the asset’s listed price), a strategy that aims to capitalize on the mispricing between a convertible bond and its
underlying stock. The arbitrageur seeks to generate consistent returns through a combination of long and short
positions in the convertible bond and the underlying stock.
B.
SECURITIES IN CHINA
Unlike the US, there is no unified definition. However, the State Council has identified stocks, bonds and other
instruments.
The major types of securities circulated in China include:






Listed company stocks
Unlisted public company shares (listed on National Equities Exchange and Quotations, commonly
known as “New Third Board”): market making system, low liquidity, “selected tier” can switch listing to
SSE Star Market or SZSE ChiNext
Government bonds
Corporate bonds
Convertible bonds and exchangeable bonds of listed companies
Mutual fund units
C.
IPO IN THE U.S.
1.



REGISTRATION WITH SEC
Registration is disclosure based – there are no substantive standards
Registration under 1933 Act: Form S-1 (prospectus)
o Transaction registration: IPO registration is separate from resale registration
Registration under 1934 Act: Form 8-A
o Corporation registration: subject to current and periodic reporting
o Having securities listed on national securities exchanges
o 2,000+ shareholders of any class/500+ non-accredited investors, and $10m+ assets
40 | P a g e
2.

LISTING AGREEMENTS WITH STOCK EXCHANGES
Substantive listing standard in listing rules
o Financial standards (earnings, revenue, market capitalization)
o Distribution standards (number of shareholders, public float (i.e. shares of a company that can
be publicly traded and are not restricted), minimum price)
o Corporate governance standards (voting rights, independence of board)
3.
REGISTRATION PROCESS

Managed disclosure (1933 Act § 5)
o Prefiling period (from understanding with underwriter for IPO, “in registration”, to filing of
registration statement)
 No offer, sale or delivery
 Communications are permitted 30+ days before filing if proposed offering not
mentioned (Rule 163A)
 Regularly released information can continue (Rule 169)
 Announce the intention to IPO, securities and amount to be offered, timing, manner
and purpose of offering, but underwriter cannot be mentioned (Rule 135)
o Waiting period (from filing to registration becoming effective)
 No sale or delivery
 Oral offers permitted
 Identifying information about issuer: security, price, use of proceeds, underwriter
names etc with legend advising where to obtain preliminary prospectus (without
price or full underwriter information, “red herring”), actual preliminary prospectus
can replace legend (Rule 134)
 Free writing prospectus (FWP) allowed beyond info in prospectus as long as legend
included and FWP filed with SEC before first use and preliminary prospectus filed no
later than FWP (Rule 164)
 A FWP is any written communication that is both an offer to sell or a
solicitation of an offer to buy SEC-registered securities that is used after the
registration statement for an offering is filed
 Road shows: oral communication or FWP, preliminary prospectus need not be filed if
available online and presented by issuer management (Rule 405, 433)
o Post-effective period (from registration becoming effective)
 No delivery of securities unless accompanied by final prospectus (no other prospectus
allowed)
 However, delivery of prospectus can be fulfilled by delivery of a notice (within 2 days
after sale) informing the buyer that the sale was made pursuant to a registration
statement and buyer has the right to request physical delivery of a final prospectus
(Rule 173)
 Physical delivery of prospectus is satisfied if the issuer has filed or is planning to file a
final prospectus with SEC (Rule 172(b): “access equals delivery”)

SEC Review Process (1933 Act §8)
o Registration statements become effective automatically 20 days after filing, but the clock
restarts with every amendment. SEC can accelerate the registration effectiveness
o SEC officially has the power to refuse a registration or stop it from taking effect, but this power
is rarely used
41 | P a g e
o
o
o
D.
In practice, SEC gives informal written/oral comments to issuers which issuers will follow,
although they are not legally obligated to
 IPO price is always determined at the last minute and 20-day waiting period is
indefeasible, hence SEC’s grant of acceleration indispensable to make registration
effective
SEC does not review the issuer’s merits, but only requires disclosure
Registration statements should be written with ordinary investors in mind (“plain English
rule”), but some courts may not agree
IPO IN CHINA
1.

Main boards: to general public, or to more than 200 (unrelated) parties (penetrating rule)
o Approval based: substantive review
 JSLCs
 Operated for 3+ years
 Complying with all laws and regulations
 Net profits greater than 30m RMB in previous 3 years, net cash flow greater than 50m
RMB or total revenue greater than 300m RMB in previous 3 years
 Registered capital greater than 30m RMB
 Intangible assets account for no more than 20% of net assets
 No uncompensated loss in the previous accounting period
 25% public float
 1 RMB par value, premium issuance, pricing cannot be higher than 125% of industry
P/E ratio
o CSRC controls the flow of new IPOs
o “Gun jumping”: from submission of IPO application to publicizing of prospectus
2.

SSE START MARKET
Registration-based: supposedly, no merit review and faster, review by stock exchanges instead of CSRC
o Expected market cap > 1b RMB and (a) positive net profits in recent two years and sum up to
> 50m RMB or (b) positive net profits in recent one year and revenue > 100m RMB
o Expected market cap > 1.5b RMB, revenue in recent one year > 200m RMB, and R&D
investment in recent 3 years > 15% total revenue
o Expected market cap > 2b RMB, revenue in recent one year > 300m RMB and total net cash
flow in recent 3 years > 100m RMB
o Expected market cap > 3b RMB, revenue in recent one year > 300m RMB; or
o Expected market cap > 4b RMB and in approved science and tech industries
3.




MAIN BOARDS
REGULATORY IPO LOCKUPS
Controlling shareholders and family members: 36 months from IPO
Directors and officers: 12 months from IPO
Without controlling shareholders: 36 months from IPO for largest 51% pre-IPO shareholders
Other pre-IPO shareholders not acquired stocked within 12 months before IPO application: 12 months
from IPO
42 | P a g e

Pre-IPO shareholders acquired stocks within 12 months before IPO application: 36 months from
acquisition date
E.
DUAL CLASS LISTING IN U.S.
1.
LAW
From 1994 (NYSE Listed Company Manual 313.00; Nasdaq Listing Rule 5640)



Dual class listing allowed in all major national stock exchanges at the time of IPO
Creation of new classes of common stocks with lower voting rights than existing classes at IPO is
allowed, but not new classes with higher voting rights
State corporate laws never have restrictions on dual class structures
Restriction on dual class structure in corporate articles: sunset clauses



Transfer-based: because of transfer or dilution
Event-based: because of death or incapacity
Time-based: X years after IPO
2.
PRACTICES
Dual-class structures give specific shareholders voting control unequal to the amount of equity they hold in the
company. This is to satisfy owners who do not want to give up control of their company, but do want to tap the
public equity markets for financing.


Proponents of dual-class shares say they allow founders to pursue a long-term vision, rather than face
pressure to focus on short-term results.
o Since stock that provides extra voting rights often cannot be traded, it ensures the company
will have a set of loyal investors during rough patches
Detractors say dual-class shares creates an entrenched class of shareholder who is free to make bas
decision with few consequences
o Dual-class creates an inferior class of shareholders and hand over power to a select few, who
are then allowed to pass the financial risk onto others
F.







DUAL CLASS LISTING IN CHINA
On SSE Star Market or SZSE ChiNex
Only allowed at IPO
Super-voting shareholder are individuals with material contributions and serving as directors, or
entities controlled by these individuals
Super-voting class at least 10% cash flow rights; lower voting class at least 10% voting rights,
super:lower < 10:1
Super-voting class not traded at public market
Mandatory sunset: death/incapacity, transfer, change of control, below 10% cash flow rights
One-share-one-vote on
o Charter amendments
o Changes to super-voting rights
o Hiring or firing of independent directors
o Hiring or firing of auditors
43 | P a g e

o M&A, spin-off, dissolution, or change corporate form
Supervisory board monitors compliance of dual-class listing conditions
G.
SHELF REGISTRATION (RULE 415)
A shelf offering is a provision that allows an equity issuer to register a new issue of securities without having to
sell the entire issue at once. The issuer can instead sell portions of the issue over a three-year period without
re-registering the security or incurring penalties.




Used for continuous offering (offered within 2 days after effectiveness and lasting > 30 days) or delayed
offering (without present intention to offer)
Usually for seasoned issuers eligible to use Form S-3 (short version of S-1)
o Having a class of securities registered under 1934 Act and subject to reporting for 12+ months
o No default on dividend or debt payments since the last audited financial statement
o Public float > $75m
Filing a base prospectus with the material available at the time
o SEC will review and declare effective of the base prospects except for the Well-Known
Seasoned Issuer (WKSI, a seasonal issuer with $700m public float within 60 days or issued in
the past 3 years $1B non-convertible, non-common stock securities) whose base prospectus is
automatically effective
Take off the shelf: actual offering
o File prospectus supplements to update or new prospectus if there are fundamental changes
or > 9 months after the effective date
H.
EXEMPTED OFFERING IN U.S.
1.
REG D
Reg D governs private placement exemptions. Reg D offerings are advantageous to private companies or
entrepreneurs that meet the requirements because funding can be obtained faster and at a lower cost that with
a public offering. The regulation allows capital to be raised through the sale of equity or debt securities without
the need to register those securities with the SEC.



Accredited Investors (13 categories, Rule 501)
o Issuer’s directors, executive officers or general partners
o Natural person with a net worth of more than $1m
o Natural person with annual income of $200k (or joint income with spouse of $300k)
o Entity owned solely by accredited investors
o Anyone in good standing with professional certifications approved by SEC (e.g. investment
advisors)
o Institutional investors (banks, insurance companies, mutual funds), trusts or private funds
owning $5m in investments, family office
Small issues (Rule 504)
o Exemption from registration the offer and sale of up to $10m of securities in a 12-month period
Private placements safe harbour (Rule 506)
o Offer or sale to no more than 35 purchasers, but accreditor investors are not counted toward
the 35.
o Unaccredited investor purchasers must be knowledgeable in financial and business matters to
evaluate the merits and risk of the investment; or
44 | P a g e
o

Through an appropriate purchaser representative who is not an insider of the issuer and has
such knowledge and experience in financial and business matters to evaluate the merits and
risks for the investment
Conditions for Reg D offerings (Rule 502)
o No integration for offers/sales 30+ days before beginning of Reg D offering or 30+ days after
completion of Reg D offering
o Specified information (similar to registration or periodic reporting) needs to be provided to
unaccredited investors
o No general solicitation (contacting investors without previous relationship) except to
accredited investors
o No resale without registration or without an exemption (to accredited investors or under Rule
144)
 Rule 144 mandates that 5 conditions must be satisfied, including a minimum holding
period, quantity restrictions, and disclosure of the transaction
2.
REG A
Reg A contains rules providing exemptions from the registration requirements, allowing some companies to use
equity crowdfunding to offer and sell their securities without having to register the securities with the SEC. Reg
A offerings are intended to make access to capital possible for SMEs that could not otherwise bear the costs for
a normal SEC registration and to allow nonaccredited investors to participate in the offering. Securities in a Reg
A offering can be offered publicly, using general solicitation and advertising. An issuer can choose to use an
intermediary broker or offer the securities without one.
Companies that use the Reg A exemption can sell their securities utilizing two different tiers, each with its own
requirements. However, with both tiers, the issuer must file an offering statement with the SEC, including an
offering circular, which serves as the disclosure document for investors.
Tier 1
Under Tier 1, a company is permitted to offer a maximum of $20m in a 12-month period. The issuing company
must also file offering statements with the SEC, which need to be qualified by state regulators in the states in
which the company plans on selling the securities.
However, companies issuing offerings under Tier 1 do not have ongoing reporting requirements but are required
to issue a report on the final status of the offering.
Tier 2
Under Tier 2, companies can offer up to $75m in a 12-month period. Companies offering securities under Tier 2
are required to produce audited financial statements and file continual reports, including its final status.
Moreover, Tier 2 offerings have additional requirements such as limitations on the amount of money a nonaccredited investor may invest in a Tier 2 security.

10% of the greater of annual income or net worth (for natural persons); or 10% of the greater of annual
revenue, or net assets at fiscal year-end (for non-natural persons)
However, Tier 2 issuers are not required to register or qualify their offerings with state securities regulators but
still must file their offering with the SEC.
Testing the waters
45 | P a g e
New rules allow a company that has not yet decided on a particular offering strategy to do a generic solicitation
of interest – either publicly or privately – from potential investors to help it decide. The company must keep
copies of the testing-the-waters materials; and if it ends up doing a Reg A offering it must file those materials
with the SEC. No money can be solicited or accepted while testing the waters. Moreover, specific disclosures
must be included in the testing-the-waters materials (e.g. a statement that indications of interest are nonbinding).
3.




CROWDFUNDING (REG CF)
A ceiling of $5m annually
Limits on the amount of money a company may raise from any investor
o Investors having annual income or net worth below $107,00: $2,000 or 5% of investor’s annual
income or net worth within 12-month period
o Investors having annual income or net worth over $107,000: 10% of investor’s annual income
or net worth within 12-month period, but may not exceed $100k over the 12-month period
Through registered crowdfunding portal or broker-dealer
Disclosures about offering purpose, targeted amount, deadline for reaching the target, and information
of the company (business, capital structure, financial conditions, directors and officers, major
shareholders, etc.) need to be filed (audited financial statements required for offerings over $500k)
I.
DIRECT LISTING IN U.S.
Companies that want to do a public listing may not have the resources to pay underwriters, may not want to
dilute existing shares by creating new ones, or may want to avoid lockup agreements (contractual provisions
preventing insiders of a company from selling their shares for a specified period of time). Companies with these
concerns often choose to proceed by using the direct listing process, rather than an IPO.


Selling shareholder direct floor listing
o Essentially, a secondary offering by existing shareholders, not the issuer = resale to public
investors
o Same registration requirement, Form S-1 (resale registration), except no underwriter or
proceeds related information
o No underwriter-imposed lock up (usually 6 months)
Primary direct floor listing
o Offering by issuer without underwriting but through direct auction at stock exchange
o Extra listing conditions: > $100m market value at opening auction, or > $250m market value
at opening auction plus existing value of public float
o Investment bank serve as pricing advisor to help set the price range recorded in registration
statement
Major differences between IPO and DPL



No book-building by underwriters
No “gatekeeping” by underwriters
No price stabilizing by underwriters: no “green-shoe”
o Greenshoe is a clause contained in an underwriting agreement of an IPO that allows
underwriters to buy up to an additional 15% of company shares at the offering price
J.
SPAC IN U.S.
46 | P a g e
1.







A blank cheque company often sponsored by private equity organisers or celebrities is listed publicly
Form S-1 registration requirements, but less disclosure due to lack of business operation, so IPO phase
can be faster. No contact with potential acquisition target
Almost always offered at $10/unit, which includes one common stock and fractional warrants with
strike price of $11.50 per whole warrant
o Stock warrants represent the right to purchase a company’s stock at a specific price and at a
specific date
o A strike price is the set price t which a derivative contract can be bought or sold when it is
exercised. For call options, the strike price is where the security can be bought by the option
holder; for put options, the strike price is the price at which the security can be sold
Sponsors take 20% equity, with same proportion of warrants, in SPAC at a nominal amount ($25k), but
usually bear management costs and subsidize underwriting fees
Underwriters charge 2% of IPO proceeds at this phase and another 3.5% at closing of de-SPAC
IPO proceeds are kept in a trust account and can only be invested in short-term treasury bonds
Sponsors and other institutional investors sign forward purchase agreements to commit more funds for
acquisition at de-SPAC phase
2.








DE-SPAC PHASE
Either consummate a business combination or liquidate within a fixed period of time (3 years under
listing rules, but almost always 2 years provided by SPAC articles)
This combination must spend 80%+ of the proceeds in the trust account
IPO shareholder approval required before closing the acquisition
IPO shareholders have opportunities to redeem their investments at $10/unit with return from treasury
bonds, usually regardless of their votes at approval of the combination
Redemptions are often overwhelming, and the law only requires a minimum of $5m in trust account
after redemption to continue with the combination. But target will require a high amount available to
pay for the acquisition
To make up the gap left by redemptions, sponsors usually have to introduce new institutional investors,
private investment in public equity (“PIPE”)
o PIPE refers to the practice of private investors buying a publicly-traded stock at a price below
the current price available to the public. PIPE deals are often offered by companies looking to
raise a large amount of capital quickly
Normal M&A deal structure will be used to consummate the combination. A “super 8-K” must be filed
within 4 business days to detail the business operation and all other information required by Form S-1
in a regular IPO
Sponsor lockup usually 1 year after de-SPAC
K.

IPO PHASE
PRIVATE PLACEMENT & RESALE IN CHINA
Private placement
 Approval based (by CSRC)
 No more than 20% of outstanding
 No more than 35 purchasers
 No less than 80% of the average price of previous 20 trading days
47 | P a g e
 Lockups

•
Auction-based pricing: 6 mons
•
Fixed pricing: 36 mons
•
Strategic investors: 18 mons; however, most cases 36 mons on “voluntary” basis
Resale restrictions (post IPO lockup period)
 Controllers: 1% thereafter (or 2% through block trade) of outstanding very 90 days
 Directors and officers: less than 25% of holding when in office; 6-month lockup since leaving;
1% (or 2% through block trade) of outstanding very 90 days when allowed
 Pre-announcements required before selling
VII.
DISCLOSURE AND SECURITIES FRAUD
A.



DISCLOSURE REQUIREMENTS IN U.S.
IPO: registration statements
Periodic reports
o Annual report (Form 10-K)
 Within 90 days of the close of each fiscal year
 Itemized disclosures are detailed in SEC instructions: business, risk factors, legal
proceedings, management’s discussions, and analysis of financial conditions and the
results of operations (MD&A), financial statements (audited), directors and executive
officers, corporate governance, executive compensation, related party transactions
o Quarterly report (Form 10-Q)
 Within 45 days of the close of each of the first three quarters
 Mainly financial statements (unaudited), MD&A, and updated risk factors
o Must be certified by CEO and CFO for accuracy of material disclosed information; knowing or
willful falsehood of a criminal offense
Current Report
o Within 4 business days after occurrence of material developments
o Material agreements especially M&A (full agreements needed to be disclosed); delisting, sale
and trading of securities; change of auditors (PCAOB registered); change in control; change of
D&O; amendments to articles or bylaws
1.
BLOCKHOLDER DISCLOSURE IN U.S.
A blockholder is the owner of a large block of a company’s shares and/or bonds. In terms of shareholding, these
owners are often able to influence the company with the voting rights awarded with their holdings. Shareholders
must file a Form 13D with the SEC when their ownership block reaches 5% of a company’s outstanding shares.

5% threshold with intent to influence and control (Schedule 13D)
o 5% of beneficial ownership (either voting power or investment power) of any class of equity,
but non-voting stock excluded
o Disclose by filing Schedule 13D within 10 days after reaching the threshold
 Security, issuer and identity of purchasers
 Source and amount of funds used in making purchase
48 | P a g e

 Purpose of transaction
 Contracts or agreements between multiple purchases (groups) or with the issuer
5% institutional investors or passive investors
o Disclose by filing Schedule 13G within 45 days after the end of calendar year or 10 days after
acquisition, respectively
 Security, issuer and purchasers
 Certifying acquisition in ordinary course of business or without intent to influence
control
2.
SHORT-SWING
INSIDER
DISCLOSURE
DISGORGEMENT IN U.S. (§16 OF 1934 ACT)






PROFIT
Insiders
o Directors or officers at either the time of sale or purchase
o 10% shareholders (beneficial owner of equity) immediately before both transactions
Disclosure
o Initial report (Form 3) within 10 days after becoming an insider (only purchase matters for 10%
shareholders)
o Report of any change (Form 4) within 2 business days of the change
o Annual position report (Form 5)
Profit disgorgement
o Profits from any matched transactions (buy and sale, or vice versa) within 6 months disgorged
to the issuer
B.


AND
DISCLOSURE REQUIREMENTS IN CHINA
IPO disclosure
Continuous disclosure (art 70)
o Annual report: within 4 months after fiscal year, financial statements, management
shareholding, outstanding shares, controlling shareholder
o Semi-annual report: within 2 months after semi-fiscal year, similar to annual report
o Quarterly report: within 30 days after 3rd and 9th months of fiscal year, simplified financial
statements report
Current report (art 80)
o Material information likely to affect price such as M&A or transaction involving 30% of total
asset value, major litigations, change of controlling shareholder
Blockholder disclosure (art 63)
o 5% of outstanding, immediate standstill, disclosure within 3 days, disclose each 1% change and
repeat standstill for each 5% change thereafter
Short-swing profit forfeiture (art 44)
o Directors, officers, 5%+ shareholders
o Matching purchase and sale within 6 months
C.
SECURITIES FRAUD IN U.S.
1.
MISREPRESENTATION IN REGISTRATION STATEMENT (§11 OF
1933 ACT)
49 | P a g e




Plaintiffs: all purchasers of registered securities whose purchases can be traced back to the registration
in question
Material misinformation or omission
o Materiality: a substantial likelihood that a reasonable investor would consider it as altering the
total mix of information in deciding whether to buy or sell (TSC Industries v Northway Inc)
o Omission is actionable only if the omitted part makes the disclosed part misleading
Defendants
o Issuer
o Signers of registration statements: issuers’ executive officers
o Directors at the time of filing
o Underwriters
o Experts: auditors, credit-rating agencies
Strict liability with defenses available to defendants other than the issuer
Defenses
Expertised portion
Nonexpertised portion
Expert
Actually and reasonably believes after
reasonable investigation that information
is true (ignorance not OK) – due diligence
No liability
Nonexpert
No reason to believe that information is
false (ignorance OK) – reasonable reliance
Actually and reasonably believes after
reasonable investigation that information is
true (ignorance not OK)
In Escott v BarChris, it was held that this
reliance will not be recognised if the
officer, director or underwriter was aware
that the accounting report was inaccurate.
Outside
Directors
In BarChris, the court held that although outside directors (i.e. directors who are not
employed by the issuer and who normally have other full time occupations) can delegate a
duty of investigation, he or she is liable if the person to whom this duty was delegated does
not perform it properly.
BarChris also held two outside directors with relevant areas of expertise to a higher standard
than that of a run-of-the-mill outside director. On the facts, the court judged the two
directors (lawyer and investment banker) by the standards applicable to their professions,
rather than those that might apply to a director who had no expertise in the registration
process and did not undertake to oversee compliance with the requirements.


Reliance: unnecessary unless
o The plaintiff knew of the falsity of the information; or
o The securities were bought after 1 year since effectiveness of the registration statement and
an earnings statement had been released
Damages
o Difference between purchase price and actual value (if not sold) or sale price (if sold) and
capped at offering price
50 | P a g e
o

Joint and several liability except for non-managing underwriters (limited to the amount of their
participation in the offering) and outside directors (proportionate to the damages he/she
caused)
Rescission of purchase
o §12(a)(2) creates liability for any person who offers or sells a security through a prospectus or
an oral communication containing a material misstatement or omission, is liable to the
purchaser for rescission of the purchase or damages, provided that the purchaser did not know
about the misstatement or omission at the time of the purchase
2.







Plaintiffs: purchasers and sellers, but not offerors
Defendants: anyone making false statements and inducing others to trade
Materiality
Scienter
o Awareness of the true state of affairs and appreciation of the propensity of his or her
misstatement or omission to mislead
o Simple negligence not sufficient, but recklessness is sufficient when circumstantial evidence
strongly suggests actual knowledge
o Misstatements won’t be excused because they advance certain corporate purpose under the
securities law (although they may be excused under corporate law)
Reliance (transaction causation)
o Fraud-on-the-market theory (Basic Inc v Levinson)
o Assumption of reliance can be rebutted by evidence showing plaintiffs would have traded even
with knowledge of the truth
Causation (loss causation)
o Between fraud and loss, plaintiff bears the burden
 Losses caused by systemic risk or issuer’s normal risk not included
o Loss does not have to be a drop in price – can be sustainability of price or price rebound (i.e.
price has risen from a lower level)
o In practice, “event studies” are often uses to identify causation
 Event study refers to an empirical analysis that examines the impact of a significant
catalyst occurrence or contingent event on the value of a security
Damages
o Capped at the difference between transacted price and the average of daily prices during the
90-day period after corrective disclosure
3.




GENERAL ANTI-FRAUD RULE (§10(B) OF 1934 ACT)
SECURITIES CLASS ACTIONS
Class actions: to overcome “free-rider” problem
o Numerous plaintiffs
o Questions of law or facts common to the class
o One lead plaintiff whose claims are typical to the class and who can fairly and adequately
protect the interest of the class, usually with the largest financial interest in recovery
Opt-out system: at class certification/notice, or at settlement
Litigation costs are advanced by plaintiff lawyers who are paid on contingent-fee basis
Most class actions usually settled
o Plaintiff: no cost to settle, may be some small payment
o Plaintiff’s lawyer: get money and save effort
51 | P a g e
o
o
o
D.










Defendant: winding up a case with a big release; D&O insurance usually covers the payments
which are not available if defendant loses at trial
Courts: settlements rarely disapproved; difficult to reject when both parties want to settle
Result: frivolous actions abound
SECURITIES FRAUD IN CHINA
No difference between misrepresentation in offering documents and post-offering market
Plaintiffs, investors (implicitly purchasers or sellers)
Defendants
o Issuer
o Directors, officers, controller (direct or indirect), underwriter (sponsor) (art 85)
o Other intermediaries of securities issuance or trading: accountants, lawyers, credit-rating
agencies (art 163)
Material misrepresentation or omission (not clear what kind of omission included, issuer likely to be
responsible to clarify in case of market rumours)
Culpability (art 85, 163)
o Issuer: strict liability
o All others: rebuttable presumption of fault (res ipsa loquitur)
Both materiality and culpability in civil litigations heavily rely on prior enforcement actions taken by
China Securities Regulatory Commission (CSRC)
Reliance: fraud-on-the-market
Loss causation: increasingly leaning toward financial models
Civil damages
o No cap
o All defendants and jointly and severally liable
 But is apportionment of liability needed? (Courts start to say yes, at least when
intermediaries are involved)
Administrative penalties (art 181, 182, 183)
o Issuer and its controller: 10% to 100% of issuance proceeds or RMB 2m to 20m
o Directors and its officers: RMB 1m to 10m
o Intermediaries: 100% to 1000% of service revenue or RMB 1m to 10m
o Intermediary responsible individuals: RMB 0.5m to 5m
1.


SECURITIES CLASS ACTION
Regular representative action (opt-in)
o Multiple plaintiffs start the lawsuit and the court notifies the public to join
o Regular civil jurisdiction applies
When 50+ plaintiffs request to be represented by CSICS, a special representative action, i.e. opt-out
class action, can start (art 95)
o Case will be moved to Shanghai Financial Court or Shenzhen Intermediate Court (but this does
not happen in reality)
o CSISC selected cases to be pursue (an expert committee exists)
o In reality, it is CSISC that solicits, with much difficulty, the 50 plaintiffs
o Plaintiffs can opt out after notice of special representative action is made and at settlement
stage (but can they opt out on appeal?)
52 | P a g e
E.



VIII.
Why (or why not) differentiate misrepresentations in offering and post-offering? Which approach
makes more sense, China or U.S., especially when it comes to culpability?
o Do you think strict liability or scienter is more appropriate for securities fraud?
 Scienter is more appropriate – fraud requires knowledge, or wilful blindness, on the
part of the defendant. This goes towards the mens rea, hence scienter should be part
of the inquiry
Compare the judicial reasoning when determining culpability
o Compare Escott v BarChris and Wang Feng v Wu Yang
o Both are trial decisions, supposed to focus on fact finding including culpability
Compare the securities class actions in two countries
o Why does China limit the lead plaintiff, essentially to CSISC?
o What will be the incentives of various parties to sue and settle in China?
INSIDER TRADING AND MARKET MANIPULATION
A.





WHY FORBID INSIDER TRADING?
If we want the stock price to reflect information of the issuer, and insiders have such information, then
their trading will bring the price close to the actual information (or value) of the issuer – for instance,
in the case of misrepresentation that fraudulently raises the stock price, letting insider sell will quickly
bring the price close to the truth (Macey)
o Nonpublic information reflected in security’s price, hence making the markets more efficient
Fairness
o But parity of information is not required
Property rights
o But what is the loss to the owner of the confidential information, i.e. issuer?
Market integrity
o Market liquidity providers (market-makers) will lose systematically to insiders and have to
increase the bid-ask spread (trading becomes costly)
 Bid-ask spread is the amount by which the ask price exceeds the bid price for an asset
in the market
o Investors will discount issuers’ security prices when insider trading is allowed (cost of capital
rises)
 Discount refers to a situation when a security is trading for lower than its fundamental
or intrinsic value
B.

SECURITIES FRAUD: A COMPARISON
INSIDER TRADING IN U.S.
Who are insiders?
o Those who are in fiduciary or confidential relation to issuers or holders of the securities –
directors, officers, employees entrusted with confidential information
o “Parity of information” rejected in the U.S. (Chiarella)
Outsiders deemed as insiders
o Those outsiders entrusted with confidential information yet deceives the source of
information and trade on the confidential information, which essentially violates the duty of
confidentiality – “misappropriation theory” (O’Hagan)
o Duty of confidentiality (SEC Rule 10b5-2(b))
 Recipient agreed to maintain confidentiality
53 | P a g e





Having a history, pattern, or practice of sharing confidential information so that the
recipient had reason to know the communicator expected recipient to keep
information confidential
 Communication within family
 Congress members and legislative employees (STOCK Act of 2012)
Outsiders receiving tips from insiders: tipper-tippee liability (Dirks v SEC)
o Tipper breached fiduciary duty by obtaining personal benefit
o Tippee knew or should have known the breach
Misappropriation of tender offer information
o Prohibition of anyone other than the bidder to trade on insider information he/she knows
from the bidder of the target (SEC Rule 14e-3)
o No breach of fiduciary duty or duty of confidentiality needed – parity of information
Inside information – material, nonpublic
State of mind – trade with “conscious knowledge” of inside information (SEC Rule 10b5-1(b))
C.


Forbidding selective disclosure of inside information to some market professionals, in particular sellside analysis, and security holders who are “reasonably foreseeable” to trade on the information
o Intentional disclosure: simultaneous to general public and selected analysis or investors
o Unintentional disclosure: disclose promptly (within 24 hours) after disclosure to selective
disclosure
But can it eliminate selective disclosure adequately?
D.


REGULATION FAIR DISCLOSURE
MARKET MANIPULATION IN U.S.
Why regulate manipulation?
o Market is not symmetric – price can rise more quickly when you buy than it drops when you
sell
o Market-makers will lose systematically to manipulators, and have to increase the bid-ask
spread, which raises the cost of trading and reduces liquidity
 Essentially, manipulators are insider-traders to market-makers, hence manipulation
similar to insider trading
What is manipulation? (§9 of 1934 Act and SEC Rule 10b-5)
o Any intentional interference with market supply and demand
 Intent – wilful action (stricter requirement than scienter)
 Causation: loss (difference between trading price and actual value) is a direct
consequence of manipulation
o Examples: wash sale, matched order, parking, spoofing, entering limit orders to change
published prices (“lit”)
 Wash sale – a transaction in which an investor seeks to maximise tax benefits by
selling a losing security at the end of a calendar year so they can claim a capital loss
on taxes that year. Investor’s intent is likely to repurchase the security again after the
start of the new year, if possible even lower than when they sold
 Stock parking – illegal practice of selling share to another party with the
understanding that the original owner will buy them back after a short time. The goal
of stock parking is to conceal a stock’s real ownership while maintaining the
appearance of regulatory compliance
54 | P a g e

o
E.




INSIDER TRADING IN CHINA
Insiders
o Directors, officers, supervisory committee members, controller (and its D&O), 5%+
shareholders of issuer, others who acquire inside information because of business relationship
with the issuer
o Tender offeror or material asset acquirer and its D&O and controller
o Underwriter, sponsor, and other intermediaries
o Regulators and other public servants in charge of securities transactions (art 51)
o Those who illegally obtain inside information (art 50, misappropriators and tippees)
Information
o Material, nonpublic information about the issuer that will impact price
Disgorgement of profits + fine up to 10 times of profit or up to RMB 5m (art 191)
F.

Spoofing – type of scam in which a criminal disguises an email address, display name,
phone number, etc to convince a target that they are interacting with a known,
trusted source
 Limit orders – a type of order to purchase or sell a security at a specified price or
better. For buy limit orders, the order will be executed only at the limit price or a
lower one, while for sell limit orders, the order will be executed only at the limit price
or a higher one. This stipulation allows traders to better control the prices they trade
Manipulation vs hedging (Sharette v Credit Suisse International)
 A manipulative act is one that is intended to mislead investors by artificially affecting
market activity and requires a determination whether the transaction or series of
transactions sends a false pricing signal to the market or otherwise distorts estimates
of the underlying economic value of the securities traded
 Hedging is, by itself, generally not manipulative
 However, hedging activities can constitute market manipulation under the Act of
1934 if the hedging activity is specifically intended or designed to manipulate the
price of a security
MARKET MANIPULATION IN CHINA
Types (art 55)
o Continuous trading to affect prices
o Collusion to conduct matched transactions
o Wash sale
o Spoofing
o Using fraudulent or uncertain information to induce transactions
o Public evaluation, forecast, or investment advice about issuer coupled with opposite
transactions
o Manipulation through actions in other related markets
Is intent required?
o Not clear – “affect or intend to affect securities transaction prices or volumes” (art 55)
o But why continuous trading is manipulation if without intent?
o Why fraudulent information is regulated as manipulation rather than securities fraud? Why
uncertain information is prohibited?
G.
INSIDE TRADING AND MANIPULATION: A COMPARISON
55 | P a g e



IX.
Overall
o U.S. rules are more principle-based, while China lacks a consistent principle or theory but relies
on lists of prohibited situations
o In China, the line between legitimate and illegitimate transactions can be blurred, so the rules
appear uncertain and overinclusive (selective enforcement a bigger concern)
Insider trading
o U.S. law differentiates between insiders and outsiders relatively clearly (except perhaps in
tipper-tippee cases)
o Chinese law essentially adopts parity of information
Market manipulation
o A difficult issue for both countries: But U.S. law focuses on intent, which alleviates concern
about deterring trading, while Chinese law does not seem to underscore intent, which will
cause chilling effects on trading
o Chinese law does not seem to clearly differentiate between anti-manipulation and anti-fraud
while in U.S. the former is likely to be absorbed into the latter when spread of fraudulent
information is involved
M&A: BACKGROUND
A.



DRIVING FORCES OF M&A
Economic rationales
o Reduce transaction costs (Coase, Williamson)
 Vertical integration to avoid holdup
o Strategic acquisitions for synergies
Sources of synergy
o Operating synergy
 Revenue enhancement
 Greater pricing power: increase price, but may face anti-trust challenges
 Combination of functional strengths: one form good at marketing and the
other at R&D – but why must acquire instead of outsourcing? Possibly
because of above reason (i.e. greater pricing power)
 Expansion into fast-growing markets: post-merger integration can be
challenging
 Cost reduction
 Due to economies of scale: reaching minimum average cost; spreading
overhead costs
 Due to greater pricing power: lower prices paid to suppliers, not necessarily
monopolistic
o Financial synergy
 Debt coinsurance (Lewellen 1971): Diversification of risk profiles so as to reduce
volatility of cash flow, hence the likelihood of financial distress; cost of debt financing
decreases and higher usage of debt brings more tax deductions
 Tax benefit: taking advantage of Net Operating Loss (NOL) tax deduction
o Governance synergy
 Spillover effects on targets of good governance practices when targets are in
jurisdictions of relatively weaker shareholder protection
Managerial hubris: empire building by strategic acquirers
56 | P a g e
o


Acquirers on average lose value after acquisition which means the benefits of synergy, if any,
would go to target shareholders
o Bad bidders could become good targets (Mitchell & Lehn 1990)
 Firms that subsequently become takeover targets make acquisitions that significantly
reduce their equity value, and firms that do not become takeover targets make
acquisitions that raise their equity value
o CEOs of bad acquirers are more likely to be replaced (Lehn & Zhao 2006)
Tax inversion: acquiring a foreign corporation and reincorporate in that country (e.g. US to Ireland)
Demand for M&A as PE/VC exit strategy: M&A is more important that IPO as an exit strategy
B.
MAJOR PLAYERS
1.


Financial investors
o Private equity funds looking for underperforming targets or partnering with management in
management buyouts (MBO)
o Operating synergy is less salient, and targets are often worth the same value to different
financial investors. Hence, they are vulnerable to the “Winner’s Curse” (i.e. the tendency for
the winning bid in an auction to exceed the intrinsic value of an item)
Strategic investors
o Operating companies seeking synergies
o They often outbid financial investors, either because of synergies or management hubris
2.


PRINCIPALS
PROFESSIONALS
Investment Bankers
o Sell-side: informational intermediary (connecting bidders and targets); developing valuation
and advising target board in business negotiation; providing fairness opinion to target board
on the fairness of the final deal price
o Buy-side: mainly to provide financing for the purchase
o Conflict of interest
 Sell-side is usually a one-off client whereas buy-side is often a repeated client. Hence,
sell-side bankers unwilling to negotiate vigorously against buyers who may well
become their next clients
 Playing on both sides
 Advising the target while providing financing to the buyer
 Advising target while holding equity in the buyer
Transaction Attorneys
o Provide clients with visions and spot significant issues in the transaction
o Design transaction structures to achieve business intentions and lower legal/regulatory
hurdles
o Negotiate deal terms relying on solid knowledge of “what is market” and lubricate the deal
process
o Draft documents to comply with regulatory requirements and reduce the risk of ex post
disputes
o “Quarterbacking” to coordinate with various lawyers in specialized areas (tax, employment,
IP, financing, anti-trust, etc.), client’s in-house counsels and other advisors (bankers in
particular)
57 | P a g e
C.

M&A FINANCING
Acquisition decision and financing decision can be decoupled so that different types of investors can be
attracted to the deal
1.






Regular bank loans: term loans or revolving lines of credit, often secured
Leveraged bank loans: junior secured (secondary mortgage) or mezzanine (senior unsecured) debts
Junk bonds: high risk, high yield (noninvestment grade), usually 4 percentage points higher yield than
US Treasury debt or similar maturity
Convertible bonds: issued at lower interest rate than regular bonds and convertible at a substantial
discount to common stock
Bridge loans: short-term (usually 6-9 months) unsecured debt provided by 1-banks or hedge funds
Seller financing: essentially deferred payment by the buyer, sometimes to mitigate the risk of
acquisition (earn-outs)
o Earnout is a contractual provision stating that the seller of a business is to obtain additional
compensation in the future if the business achieves certain financial goals, which are usually
stated as a percentage of gross sales or earnings
2.



X.
EQUITY FINANCING
Cash raised as equity: PE investment
Stocks
o Common stocks: often used by listed companies when their stocks are overvalued, can be
issued after deal closing to pay off related debts
o Preferred stocks: similar to debts as a type of fixed income security
D.

DEBT FINANCING
M&A IN U.S. AND CHINA – GENERAL COMPARISON
Biggest difference: Sale of company (US) vs sale of control (China)
o US acquirers rarely leave minority (especially public) shareholders in the post-acquisition
companies except for key management teams (roll-over)
 Rollover equity is when a seller reinvests a portion of the proceeds from a sale into
equity of the acquisition company that is formed to buy the business
o Chinese acquirers almost never buy out public investors 100% although public companies (or
PE) do buyout private targets
Chinese regulators are more paternalist whereas courts are largely out of the picture
o More cautious about high leverage ratio, hence leverage buyouts
 As a result, Chinese acquirers have few financing channels at their disposal
o Seriously concerned about acquisition of private targets by public companies at inflated prices
M&A: DEAL STRUCTURE, APPRAISAL RIGHTS
A.
STATUTORY MERGER IN U.S.
1.

GENERAL IDEA
A majority driven system
58 | P a g e


DGCL §251(a)
o Merger: seller/target merged into buyer/acquirer, without involvement of a third entity; both
are “constituent corporations”, and the acquirer becomes the “surviving corporation”
o Consolidation: two constituent corporations combine to form a new entity, the “resulting
corporation”
Minority protection
o Fiduciary duties in the M&A process
o Appraisal right to ensure exit without harm
2.



CORPORATE LAW PROCESS
Resolutions by both boards to approve the merger agreement and recommend it to shareholders (DGCL
§251(b))
Shareholder approval from both constituent corporations, in principle, by majority of outstanding
shares entitled to vote (DGCL §251(c)), or if bylaw permits, by written consent (DGCL §228)
o However, approval by shareholders of the surviving corporation is not needed if:
 The surviving corporation’s articles is not amended
 There is no change in the characteristics of the outstanding stock of the surviving
corporation; and
 The surviving corporation does not issue more than 20% of its outstanding shares in
connection with the merger (DGCL §251(f))
o In addition, NYSE and NASDAQ listing rules both require acquirer shareholder approval if
acquirer is to issue 20%+ outstanding shares in connection with the merger. But only a majority
of the voting shares at a meeting with a valid quorum is required – approval of share issuance
instead of merger itself (NYSE Listed Companies Manual Rule 312, NASDAQ Listing Rule
4350(i))
o Filing of proxy statements (Schedule 14A) is required for listed corporations when shareholder
approval rights are sought
Filing of certificate of merger with the state – making merger officially effective (DGCL §251(c))
3.
TRIANGULAR MERGER
In a triangular merger, the acquirer creates a wholly-owned subsidiary, which in turn merges with the selling
entity. The selling entity then liquidates. The acquirer is the sole remaining shareholder of the subsidiary.


Forward triangular merger: merger sub acquires target, so merger sub survives
Reverse triangular merger: merger sub merged into target, so target survives; target shares are
cancelled, and merger sub’s shares are converted into newly issued shares of the surviving corporation
Why?




Target debts separated from the acquirer
Acquirer is merger sub’s sole shareholder, hence buyer shareholder voting avoided (unless issuing 20%+
buyer shares)
Target maintains its operational independence, easier for post-merger integration
Reverse triangular merger keeps target business name, and may not be viewed as assignment of target
contractual rights, so avoiding disruption of target relationship with suppliers, lenders, employees
(unless there is a change of control clause)
4.
LEGAL EFFECTS
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


Constituent corporations merged into one
By operation of law, all rights, privileges, powers, assets, duties, restrictions, disabilities of the
disappearing corporation inherited by the surviving corporation
Disappearing corporation’s status in legal proceedings is also inherited by surviving corporation except
shareholder plaintiffs’ standing to file derivative suits
B.


Types
o
o
Merger: one corporation acquires another (absorbing merger)
Consolidation: constituent corporations combined to incorporate a new corporation (newestablishing merger)
 Barely used – when incorporation is not easy and, in particular, when new
corporation needs to reacquire all the licenses/approvals for its operation, who will
want to establish a new entity?
Legal procedure
o Proposal by boards and supermajority (2/3) approval by shareholders from both sides
o Regulatory approval
o Execution of merger agreements
o Compiling balance sheets and asset lists
o Creditors on both sides should be notified within 10 days after shareholder resolution; ads
should be published within 30 days in major newspapers
 Creditors can then request (within 30 days of notice or 45 days if without notice) for
advance repayment or provision of security (art 173)
o Filing registration with ICA and tax authorities
C.




STATUTORY MERGER IN CHINA
ASSET DEAL IN U.S.
A sale of all or substantially all of the assets of a corporation is functionally equivalent to sale of a
corporation, and the buyer of assets is essentially the buyer of the target.
o First, target sells all or substantially all assets per DGCL §271 (board resolution + majority
outstanding shareholder approval)
o Second, target voluntarily dissolves its corporate entity per DGCL §275 (board resolution +
majority outstanding shareholder approval + filing)
“Substantially all” (Hollinger Inc v Hollinger Int)
o Quantitatively vital: necessary to the continuation of the corporation’s life (“half is not
substantially all”); and
o Qualitatively vital: out of the ordinary for the corporation
Effects
o Title of each identified assets must be individually transferred
o Liabilities left behind
 The sale proceeds are used to pay off liabilities before distributed to target
shareholders as special dividends
 If target’s creditors are not properly paid, many states, including Delaware, allow
creditors to seek repayment from acquirer
De facto merger doctrine
o Substance over form: merger and asset deals are substantively the same - so should be treated
equivalently under the law
o Delaware rejects de facto merger doctrine so target shareholders will not have appraisal rights
in asset deals; but creditors can still rely on de facto merger doctrine if debts are not repaid
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D.
TENDER OFFERS IN U.S.
1.
GENERAL BACKGROUND
A tender offer is a bid to purchase some or all of the shareholders’ stock in a corporation. Tender offers are
typically made public and invite shareholders to sell their shares for a specified price and within a particular
window of time. The tender offer typically is set at a higher price per share than the company’s current stock
price, providing shareholders a greater incentive to sell their shares. In the case of a takeover attempt, the tender
may be conditional on the prospective buyer being able to obtain a certain amount of shares to constitute a
controlling interest in the company.




Wellman v Dickinson
o Active and widespread solicitation of a substantial percentage of the issuer’s securities with a
premium in price, on fixed terms, conditional upon the tender of a fixed number of securities,
and open for a limited period of time
o Pressuring security holders to respond
o Involving public announcement of a purchasing program preceding or coinciding with a rapid
accumulation of shares
Regulated by Securities Exchange Act §14(d) and §14(e) (Williams Act)
Why tender offer?
o Faster (minimum 20 days vs three months for mergers due to shareholder voting)
 When concerned about third party interloper, tender offer gives acquirer quicker
control of target
 But speed is not guaranteed if regulatory approvals are required, financing is pending,
or securities registrations are needed
o Hostile bids
Downside
o Target shareholders can withdraw until tender offer closes whereas once a merger is approved
by shareholder, no vote can be rescinded
o Unless 100% target shares are tendered, a second step is needed to buy out remaining
shareholders to complete acquisition after a tender offer closes (2-step merger)
2.





SUBSTANTIVE RULES
Start: filing Schedule TO and publishing summary ads in a national newspaper; offer documents mailed
to securities holders
Offer period: at least 20 business days (announcement day counted as day 1)
Amendments
o Changing considerations: offer must remain open for an extra 10 business days from the date
of first notification of the change
o Other changes: offer must remain open for an extra 10 business days
o However, if there are 10 (or 5) business days remaining within the original offer period after
the change, then no extension of offer period is required
All-holders/best price rule: offer open to all holders of the same class of securities being offered and
the price paid to every security holder must be the highest price paid to any security holder
o Target’s self-tender cannot exclude hostile bidders
Withdrawal: tendered shares can be withdrawn anytime before offer closes; but in practice withdrawal
rarely happens because tender happens at the last minute
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


Pro rata acquisition from all security holders who tendered if total tendered shares > shares offered to
purchase
Prohibition of purchases outside the offer during offer period by offeror
Target board response: filing Schedule 14D-9 within 10 days after offer starts to publish board’s
recommendation
o Usually, a “stop, look, and listen” letter comes first from the target board asking shareholders
to wait for Schedule 14D-9
E.
STOCK PURCHASES IN CHINA
This is the most frequently used route for M&A transactions in China



Essentially, to buy shares, not corporations, from shareholders through private agreements or public
tender offers
o Impractical to buy all shares, and unnecessary since the purpose in China is to buy control, not
corporations
o As a result, minority shareholders will be left in the target
If the target is a listed company, then the mandatory bid rule may be triggered
o Mandatory bid rule provides that a bidder is required to offer a bid to all remaining
shareholders if he acquires a specified percentage of voting shares or interests in voting shares
o This rule offers minority shareholders an opportunity to avoid future exploitation by the new
controller of the company, when control is transferred
When listed companies acquire private targets, Value Adjustment Mechanism (VAM) is often used
o VAM refers to an agreement that is designed by investor and financing party when reaching
an equity financing agreement to resolve the uncertainty, information asymmetry and agency
costs between the two parties to a transaction in relation to the future development of the
target company, and such agreement contains the equity repurchase, monetary compensation
and other valuation adjustment of the future target company
o Setting up performance indicators usually within the next 3 years. If missed, sellers should
return merger price (partially) to the listed company
 Investor’s valuation of the target is usually based on the future performance
expectations of the target company. If it fails to meet the expectation, the valuation
of the target company needs to be adjusted, that is, to protect the investor’s
investment interests by means of performance compensation and/or equity
repurchase.
o Cf earnouts in the U.S.
F.
TENDER OFFERS IN CHINA
1.






MANDATORY BID RULE
Below 30% to above 30% through negotiated purchase or indirect purchase  general offer
Below 30% to exact 30% through negotiated purchase or indirect purchase  general offer or partial
offer (5%+)
Below 30% to 30% through secondary market  standstill, disclose then general offer or partial offer
(5%+)
At 30% or above, purchasing no more than 2% annually  requires no offer
At 30% or above, purchasing 5% or more  partial or general offer
Below 30% to below 30%  partial or no offer
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2.










SUBSTANTIVE RULES
Starting after submission of official offer documents to CSRC
o Preliminary tender offer report first, waiting for regulatory clearances, then definitive tender
offer report
No shorter than 30 days, no longer than 60 days
Price no lower than the highest price paid in 6 months before initial disclosure
Offeror cannot withdraw during the offer period, but offeree can withdraw tendered stocks till 3 days
before offer expiration
Revisions need approval from SCRC and cannot revise within 15 days after offer expiration except due
to competing bids
Offeror needs to provide assurance (20% cash, 100% stock or commitment letter from banks)
Offeror cannot purchase stocks outside offer
Target directors cannot resign during offer period
Target cannot take actions that can materially affects its assets after initial offer disclosure without
approval by shareholder assembly
Target boards should investigate offeror, review offer conditions and make recommendations to
shareholders within 20 days after the tender offer starts
G.
SHORT FORM MERGERS IN U.S.
A short form merger combines a parent company and a subsidiary that is substantially owned by the parent.
Either entity can be designated as the survivor of the merger. The statutes typically mandate that the parent
company must own at least 90% of the subsidiary before it can use a short form merger.



Cashing out minority without shareholder voting: indeed, the voting result will be pre-ordained since
majority voting rights held by the acquirer (parent)
DGCL §253
o 90+% shares held by parent
o Tender offers usually won’t receive so many shares, so target boards will top-up for the
acquirer to reach the threshold, but often still difficult
DGCL §251(h)
o Allowing short form mergers with (usually) 50%+ shares held by the Parent
o Conditions
 The target must be a public corporation (listed or with 2000+ shareholders)
 Friendly tender offers for all target shares and reaching an agreement with target
board explicitly permitting short form merger under this section
 Merger to be consummated as soon as practical after the first step tender offer on
the same conditions
o Amended in 2014 to allow “interested” acquirer (with 15%+ shares) to use this section
 But if the acquirer is a controlling shareholder, DGCL §251(h) mergers will be subject
to entire fairness review
H.
APPRAISAL RIGHTS IN U.S.
An appraisal right is the statutory right of a corporation’s shareholders to have a judicial proceeding or
independent valuator determine a fair stock price and oblige the acquiring corporation to purchase shares at
that price.
1.
CONDITIONS
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


A judicial procedure to determine the fair value for dissenting shareholders’ shares in merger
Available in which transactions? (DGCL §262)
o Statutory mergers, but not asset deals or tender offers
o But not available for any publicly-traded shares or shares of a surviving corporation where
shareholders were not required to vote
 Unless shareholders of constituent corporations are required to accept a merger
consideration other than stock of the surviving corporation or publicly traded stock
of another corporation (“market out”), which basically means cash
 “market out”, generally, is a condition precedent in an acquisition
agreement or tender offer that allows a buyer to avoid the closing if there is
a significant disruption in the financial, banking, or stock markets. Marketout clauses protect a buyer by reducing its additional exposure to marketrelated events that are beyond the control of the parties involved in a
particular transaction
 Not applicable to §253 short form mergers, but applicable to §251(h) short
form mergers
Who can demand for appraisal?
o Record or beneficial owners
o Collectively owning 1%+ or $1m worth of stocks
o Who made a written demand for appraisal before shareholder meeting
o Did not vote “yes” for merger at the meeting (if you made a mistake, you lose the right (In re
Appraisal of Dell Inc); and
o Remain shareholders from the date of demand, through the pendency of the appraisal action
2.

VALUATION
Fair value: court discretion
o In re Appraisal of Dell Inc, the court held in an appraisal proceeding that the fair value of Dell
Inc was 28% higher than the price paid for it. The court concluded that the deal price
undervalued Dell because there was a significant “valuation gap” between the long-term value
of Dell and the market’s short-term focus, and the agreed-upon price was the product of a
competition among like-minded financial bidders who were price-constrained by targeted
internal rates of returns in LBO pricing models. Even though the deal price represented a nearly
30% premium to market and was within range of DCF values provided by the Dell special
committee’s financial advisors, the court held that a DCF valuation, using the court’s inputs,
produced a better approximation of the “fair value” of Dell than the results of the sales process
 The court here failed to give weight to the result of a full and fair sale process or the
market’s expectations for Dell’s future performance and value. While the facts
include some unusual circumstances, its reasoning could be applied to any
transaction where the public markets and markets for corporate control do not give
full credit for a company’s business plans and projections
 The reasoning of this case calls into question the ability of financial sponsors, and to
some extent, all buyers, to reliably estimate their exposure to appraisal claims,
undermining the certainty that buyers and sellers need to optimize sales of corporate
control. This uncertainty will cause significant issues for parties planning mergers.
Stockholders will see appraisal as a potentially valuable option and, by voting against
mergers they might otherwise think should be approved, seek to preserve the right
to obtain appraisal. Buyers will hold back some amount to deal with potential
appraisal claims (or insist on complex corporate structuring to avoid appraisal). The
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
economic frictions created may be considerable and will affect even the many
transactions where the appraised value likely would not exceed the merger price
o Reversed in Dell Inc v Magnetar, where the court held that the court below erred in giving no
weight to Dell’s pre-deal stock price or the deal price when determining the fair value in this
appraisal proceeding. In the court’s view, the “market-based indicators of value – both Dell’s
stock price and the deal price – have substantive probative value” and “deserved heavy, if not
dispositive, weight.”
 Court reaffirmed its decision in DFC Global Corporation not to establish a
presumption that the dela price constitutes “fair value” yet joined DFC in strongly
suggesting that deal price – assuming a reasonable sale process – merits substantial,
and perhaps dispositive weight
Several principles
o Only target standalone value will be awarded, no synergy can be included
o No minority discount although dissenting shareholders are in minority
o No liquidity discount although dissenting shareholders will lose liquidity after merger
I.


XI.
APPRAISAL RIGHTS IN CHINA
Possible under the company law
o Dissenting shareholders in mergers, spin-offs or sale of substantially all assts can demand the
company to buy out their shares at a fair price (art 74, 142(4))
However, almost never heard of in practice
o Not surprising given that Chinese are acquiring control rather than companies
M&A: TAKEOVER DEFENCES AND FIDUCIARY DUTIES
A.
TAKEOVER DEFENSES IN U.S.
1.

REFUSAL TO SELL
Shareholder rights plan (“poison pill”) – poison pills allow existing shareholders the right to purchase
additional shares at a discount, effectively diluting the ownership interest of a new, hostile party
o Mechanism
 The target board to issue rights through a board resolution without shareholder
approval
 The rights give shareholders the ability to buy stocks of the issuer
 Initially, the rights are deliberately designed as “out of the money options” (exercise
price higher than market price of stocks)
 Options – for a premium, stock options give the purchaser the right, but not
the obligation, to buy or sell the underlying stock at an agreed-upon price
before an agreed-upon date. This agreed-upon price is referred to as the
strike price and the agreed upon date is known as the expiration date
 An option to buy an underlying asset is a call option, while an option to sell
an underlying asset is called a put option
 OTM refers to option that has no intrinsic value, only extrinsic value
 The rights are triggered when someone acquires a specified percentage of target
stocks (“acquirer”), usually 10%-20%
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


o

Once triggered, the rights are re-priced so that, usually, upon exercise, each holder
of a right can receive the number of stocks having a market value of twice the original
exercise price of a right
 E.g. original exercise price = $500, current market price of issuer stocks =
$50, then once triggered each right can be used to purchase (500 * 2)/50 =
20 shares
However, the acquirer cannot exercise the rights, and instead their rights are voided
once triggered
 The outcome is that, once triggered, acquirer’s shareholding in the issuer
will be significantly diluted
However, before being triggered, rights can be redeemed at a nominal price by the
target board, and target board can also decide who can be excluded from the
definition of “acquirer”
 Hence, poison pill creates an incentive for potential acquirers to engage
directly with the target board
Twists

Whose stocks to purchase?
 Initially, the rights would allow purchase of stocks of the combined
corporation (“flip-over pill”)
 Then the rights evolved to allow purchase of target stocks (“flip-in pill”)
 Later, the prevailing design included both flip-over and flip-in features
 Use blank check preferred stocks instead of common stocks – this is a method
companies use to simply the process of creating new classes of preferred stock and
to raise additional funds from investors without obtaining separate shareholder
approval. This kind of stock can also be created by a public company as a takeover
defense in the event of a hostile bid for the company
 Rights are used to purchase preferred stocks which are entitled to vote in
the same class as common stocks on mergers (e.g. preferred shares could be
given special voting rights or be convertible to common stock)
 Since preferred stocks are authorized as blank checks, they are even easier
than common stocks to be used by the board without shareholder approval
o Legal documents
 Certificate of Designation to the target articles to set forth basic terms of the rights
 Indenture agreement between the target and a trustee to set forth the terms once
the rights are triggered
 Since no shareholder approval is required and the documents can be prepared in one
or two days, essentially every listed company in the U.S. has a poison pill (“shadow
pill”) regardless of declaration of a rights plan
 Shadow pill = the right to adopt a pill at any time
o Effect
 Poison pills are so formidable that they have been triggered only twice since invented
 Poison pills are considered most effective when combined with a staggered board
 Empirical evidence disagrees on the impact of poison pills on firm values, some found
positive effects, some (small) negative effects. And pills seem to give target board a
stronger bargaining position which has led to higher takeover premium
Leveraged recapitalization – company changes its capitalization structure by replacing the majority of
its equity with a package of debt securities
o Borrow money to pay dividends or buy back stocks or even to acquire other companies
including the acquirer (“pac man”)
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o


The main purpose is to exhaust the amount of money that can be borrowed against target
assets so that the acquirer cannot borrow additional money against the same assets to finance
its acquisition
Structural defenses (“shark repellents”)
o Dual class structure – two or more classes of share with different voting rights. Typically,
insiders are given access to a class of shares that provide greater control and voting rights,
while the general public is offered a class of shares with little or no voting rights
o Staggered board – a board that consists of directors grouped into classes who serve terms of
different lengths
o Supermajority vote requirements
 80% of outstanding shares and a majority of shares not owned by the acquirer
o Golden parachute – lucrative severance packages inked into the contracts of top executives
that compensate them when they are terminated. In addition to large bonuses and stock
compensation, golden parachutes may include ongoing insurance and pension benefits
o Advance notice bylaw – require a stockholder to provide prior notice to a corporation of a
stockholder’s director nominees or business to be brought before a stockholder meeting
Embedded defense
o Embedded in the terms of contracts reached between the target and a third party
 Poison put: accelerated debt repayment upon change of control
 A poison put is a takeover defense strategy in which the target company issues a bond
that investors can redeem before its maturity date i.e. bondholders can redeem their
bond before the maturity date and receive full payment in the event there is a
takeover of the company. Thus, the poison put is an added expense the acquiring
company must pay if it wishes to acquire the target company
2.

SALE TO ALLIES
“White knight”
o A “white knight” is usually a friend of the target board/management so they can keep their
positions after the sale
o Deal protections (lock ups) in favour of “white knights” – deal protection mechanisms are
essentially contractual agreements between the preferred bidder and the target that are
designed to discourage competing bids and to protect the preferred bidder if a competing bid
emerges
 Break-up fee (termination fee) – used in takeover agreements as leverage on the
seller against backing out of the deal to sell to the purchaser. A breakup fee is
required to compensate the prospective purchaser for the time and resources used
to facilitate the deal
 Empirical evidence found it can also be used to attract bids and bring higher
acquisition premiums for target shareholders
 Cf reverse break-up fee (paid by the offering entity)
 Stock lockup – a device to prevent large shareholders from selling their shares too
quickly and causing a sudden change in stock prices after a company goes public
 Crown jewel (asset lockup option) – stock option offered by a target company to a
white knight for additional equity or the purchase of a portion of a company (e.g.
some of target’s best assets i.e. crown jewel)
o Risks
 Deal protection terms are subject to judicial review and may be voided
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

Putting target up for sale will subject board to a duty to sell to the highest bidder
(Revlon rule) who may be unfriendly
“White squire” – target board selling a block of shares to a friendly shareholder
o Purchase a partial stake cf white knight that purchases the entire company
B.

FIDUCIARY DUTIES OF TARGET BOARD (U.S.)
Unocal intermediate standard of judicial review of takeover defenses
o Under Unocal standard, business judgment rule is applied in the context of a hostile battle for
control where board action is taken to the exclusion of, or in limitation upon, a valid
stockholder vote. However, the board must carry its own initial two-part burden: first, a
reasonableness test which is satisfied by demonstration that the board of directors had
reasonable grounds for believing that a danger to corporate policy or effectiveness existed;
second, a proportionality test, which is satisfied by a demonstration that the board of
directors’ defensive response was reasonable in relation to the threat posed.
o First prong: target board must show reasonable grounds for believing that a danger to
corporate policy or effectiveness existed
 Threats: opportunity loss, structural coercion, substantive coercion (shareholders
mistakenly accepted underpriced hostile bid due to insufficient information)
 Good faith response to perceived threat, not for the purpose of entrenching
themselves
 Reasonable investigation: target directors well informed in making responses
o Second prong: target board needs to further prove that the defense was reasonable in relation
to the threat posed by the hostile bid (proportionality)
o Unocal test recharacterized in Unitrin. Respond with 2 qns:
 Is it draconian (coercive or preclusive)?
 Reasonable within a “range of reasonableness”?
o Business judgment rule is reinstated if both prongs are satisfied
1.


POISON PILLS UNDER UNOCAL TEST
Generally okay - in Moran v Household International, court found that the adoption of poison pill was
a legitimate exercise of business judgment. To this end, the defensive tactics adopted by the board
need not have been in anticipation of any specific threat and the adoption of a preemptive plan
developed before the pressure of a crisis increased the likelihood that the board was acting out of a
business judgment
Exceptions
o “Dead-hand poison pill” – issue new shares to everyone but the hostile bidder seeking to buy
the company. It serves to dilute the value of the shares the acquirer already purchased,
reducing its percentage of ownership and making it more costly to seize control. Dead hand
provisions may only be rescinded by the directors who adopted them (intention is to close the
proxy contest/redemption loophole in standard poison pills by precluding newly elected
directors from redeeming the pill)
 Outlawed in Delaware and many other states
 Both preclusive and coercive
 preclusive, as the added deterrent effect of the provision made a takeover
prohibitively expensive and effectively impossible
 coercive, as the pill effectively forced shareholders to re-elect the incumbent
directors if they wished to be represented by a board entitled to exercise its
full statutory powers
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o
o
“Slow-hand/No-hand poison pill” – pill nonredeemable for a fixed period of time
 In Quickturn Design Systems, court held that no hand pill limited a newly elected
board’s authority by precluding redemption of the pill – and thereby precluding an
acquisition of the corporation – for six months
 Consequently, the no-hand pill tended to “limit in a substantial way the freedom of
[newly elected] directors’ decision on matters of management policy.” Accordingly, it
violated “the duty of each [newly elected] director to exercise his own best judgment
on matters coming before the board’
Anti-activist pills during Covid-19 – use of poison pills against activists in corporate governance
contests (as distinguished from corporate control contests)
 excessively low triggering point: 5% including options and warrants; overbroad
definition of “act in concert” including a “daisy chain” (A & C are imputed as acting in
concert if A & B and B & C are acting in concert respectively); narrowing the definition
of passive investors excluded from “acquirer”
 the particular features of a pill, most importantly the threshold and what ownership
interests count toward it, are highly significant for activists.
2.






REVLON RULE WHEN TARGET UP FOR SALE
The Revlon rule is the legal principle stating that a company’s board of directors shall make a reasonable
effort to obtain the highest value for a company, when a hostile takeover is imminent
When target board put the company up for sale, its duty “changed from preservation of” target “as a
corporate entity to the maximization of the company’s value at a sale for the stockholders’ benefit”
The directors’ role changed from defenders of the corporate bastion to auctioneers charged with
getting the best price for the stockholders at a sale of the company”
No single roadmap board must follow in Revlon-land, but practices often involve either bidding before
reaching an agreement (no-shop approach) or solicitation after reaching an agreement (go-shop
approach)
Best deal: mainly about price and certainty, other considerations including form of consideration, tax
consequences, timing of the deal, antitrust issues
Applicability
o Paramount Communications v Time Inc
 Target initiates active bidding to sell itself or effect a reorganization
 Target absconds its long-term strategy and seeks a break-up in response to a bid
o Paramount Communications v QVC Network Inc
 Sale of control: cash out or sale to an acquirer with a controller
C.
REGULATING FREEZEOUT MERGERS IN U.S.
A cash out merger (i.e. freezeout merger) results from a merger of two entities in which the shareholders of the
target company do not want to be involved with the new company. In the case of a freeze out merger, the
shareholders of the target company are often forced to sell their shares as part of the acquisition or merger deal.


Freezeout mergers can be structured either in 1 step (statutory mergers) or 2 steps (tender offer + short
form merger)
Either way, for public corporations, Schedule 13E-3 needs to be filed with SEC, in addition to regular
disclosures required for the particular deal structure, detailing the process of and rationales for
conducting the freezeout merger (or going private)
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
When initiated by controlling shareholders, entire fairness test is applicable unless structured with
double protection: special committee approval + majority of minority shareholder approval (In re MFW
Shareholders Litigation), and then business judgment rule applies
o 2-step freezeouts may be subject to a similar rule (In re CNX Gas Corp Shareholders Litigation)
o Previously, however, In re Siliconix Inc Shareholders Litigation, the first step tender offer was
not subject to entire fairness review if without “actual coercion or disclosure violations”, and
in Glassman v Unocal Exploration Corp, the second step short form merger was not subject to
entire fairness review either
D.


HOSTILE BIDS IN CHINA
Quite active since 2018, somehow slower in recent years
o A good number of Chinese listed companies have dispersed ownership structure – controlling
shareholders have about 20%-30% shares
o Baoneng’s bid for Vanke was a highly visible case, which accumulated target shared from the
secondary market and allegedly involved some regulatory violations
o As blockholder disclosure rules tightened, fewer toeholds used in hostile bids, and the new
generation of bids rely more on public tender offers and even creeping acquisition
China’s law does not have clear guidance about takeover defenses
o The overall regulatory environment evolves in the pro-bid direction
o E.g. CSISC in recent years has been active in fighting against “shark repellents”
o Trading halt was a powerful defense frequently used
1.


TRADING HALT IN CHINA
A unique Chinese practice
o Issuer can apply voluntarily
o Due to a variety of (often unverifiable) reasons, e.g. asset restructuring (or recapitalization),
acquisition, private placement
o For as long as 6 months or maybe even longer
Both stock exchanges revised trading halt rules in 2016 and 2018, after Vanke’s long-term halt as a
defense against Baoneng (halted for 6+ months), mainly to restrict the length of the halt
o Material asset restructuring, usually 10 trading days, extendable up to 25 trading days for
special regulatory reasons (SSE)
o Other important matters: tender offer or change of control, up to 10 trading days
2.
ZUIG INVESTMENT V ZHENXING BIOCHEM
A)




FIRST STAGE: NEW BOTTLE, OLD WINE
Zuig informed Zhenxing of its intention to bid for control and requested Zhenxing to disclose its
intention on June 21, 2017, but Zhenzing delayed for a week and filed Zuig’s preliminary tender offer
report on June 28, 2017
A partial tender offer of 27.49% of Zhenxing’s outstanding common stocks at a price of ¥36 per share
(about 16% premium relative to last available trading price and 28% premium relative to previous 30day VWAP)
Zuig’s “new bottle” – tender offer: before the tender offer, Zuig only held 2.51% of Zhenxing’s stocks,
and never bought Zhenxing’s stocks within 6 months before the preliminary report
Zhenxing’s “old wine” – trading halt: Zhenxing’s stock trading halted from Jun 21, claiming plan for
recapitalization
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B)



Barbarian’s around the corner
o Zuig’s tender offer pan matured after 60 days’ waiting so it could launch an official tender
anytime from Aug 28, 2017
o Zhenxing’s trading halt was approaching a mandatory end on Sept 21, 2017 based on the new
regulation on trading halt
Imaginative lawsuit – Zhenxing’s largest shareholder at the time filed lawsuit in Shanxi High Court
against both Zuig and Zhenxing on Sept 13, 2017
o Against Zuig: Nondisclosure of purchase by alleged parties acting in concert (even true, only
accumulated 4.74% stocks): insider trading by Zuig’s employees (who are really outsiders);
price manipulation before announcing preliminary tender offer plan – price fell from ¥33.48
to ¥25.58 (evidence? causality?)
o Against Zhenxing: Failure to discover and stop Zuig’s alleged misbehaviours (issuer should play
regulator’s role?)
Regulator weighed in: SZSE issued inquiry letter to Zhenxing on Oct 11, requesting for specific facts
indicating Zuig’s alleged misbehaviour
C)







THIRD STAGE: FIGHTING FOR THE LAST STRAW
Zuig started the formal tender offer on Nov 3, 2017 at ¥36 per share, and the offer would close on Dec
5, 2017
The offer went smoothly until Nov 29 when Zhenxing’s largest shareholder at that time announced
reaching an agreement to sell its stocks to Kaisa Group, an HK listed real estate developer, at ¥43 per
share (closing price on Nov 28 at ¥33.54)
o What’s behind the sale? Stirring up shareholders’ suspicion about the sufficiency of Zuig’s offer
price
o Why on Nov 29? Offer terms cannot be changed within the last 15 days of the offer
Regulator weighed in again – SZSE issued another inquiry letter asking about the validity of the transfer
(e.g. of pledged stocks) at mid-night on Nov 29
On Nov 30, Zuig held a press conference explaining the meaning and risks of Kaisa’s deal to public
investors
On Dec 1, SZSE issued still another inquiry letter questioning the capital structure of Kaisa and the
source of its purchase money
D)

SECOND STAGE: NOTHING VENTURED, NOTHING GAINED
FOURTH STAGE: WINNING A BATTLE OR A WAR?
Zuig successfully completed its tender offer on Dec 5, 2017 with more than 140m Zhenxing stocks
tendered (about 55% of outstanding stocks, and 75.5% of circulating stocks), doubling the amount in
the offer
Being the first hostile bidder that successfully acquired the control block of a public company through
tender offers, Zuig made history in Chinese capital markets. It “opened a new chapter in corporate
governance of Chinese listed companies”
However, the former controlling, now the 2nd largest, shareholder did not give up
o On Jan 8, 2018, Shi Family reported to former CBRC (now CBIRC) that Minsheng Bank, Zuig’s
debt financier, violated regulatory rules forbidding lending to parties in pending litigations
o On Jan 17, 2018, one of Shi brothers resigned from CEO and CFO positions, and representatives
from Kaisa took over these offices
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E)
FIFTH STAGE:
CHARACTERISTICS






JEWEL”
WITH
CHINESE
On Jan 3, 2018, shortly after Zuig completed the tender offer, but before it could join the board,
Zhenxing’s original largest shareholder reshuffled the board of Shuanglin Bio-Pharmacy Co, Zhenxing’s
wholly-owned subsidiary. In fact, Shuang Lin contributes to Zhenxing’s 99% revenue – “crown jewel”
To entrench Shuanglin’s incumbent board, on Jan 5, 2018, Shuanglin’s articles of incorporation was
amended to require 2/3 of its shareholders’ approval for board election or future amendment of
articles
On Dec 14, 2018, Shuanglin’s board held an emergency meeting to fire its CEO, potentially a Zuig ally –
then Zuig controlled Zhengxing’s board, but not Shuanglin’s board
On Jan 5, 2019, Zhengxing’s board held an emergency meeting to revoke Shuanglin’s articles amended
on Jan 5, 2018, reshuffle Shuanglin’s board, and reinstate its expelled CEO
Zhengxin’s original largest shareholder sued again on Jan 15, 2019 to invalidate Zhenxing’s board
resolution adopted on Jan 5, 2019 which was eventually withdrawn
E.

“CROWN
HOSTILE BIDS: A COMPARISON
China started with a very unfriendly environment for hostile bidders
o Liu Shiyu, CSRC Chairman: acquisition funds making hostile bids are “barbarians”, “robbers of
the industry”, “challenging the bottom line of financial laws and regulations of the state”
However, China has pivoted toward a more bidder-friendly environment in a short period of time,
especially due to the changes in trading halt rules by the stock exchanges and the anti-takeover stance
taken by CSISC
o Except “poison pills” which is not available due to the legal capital doctrine, the takeover
defenses in China are heavily borrowed from the American playbooks
o Similarly, the anti-defense campaign in China also follows American theories and practices
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