Background

In recent years, companies with operations in China which are listed on global stock exchanges (a dominant number of which are Cayman Islands companies) have been actively seeking restructuring opportunities for various reasons, including the recent regulatory developments in China. Such strong demand has driven a major increase in take private activities of Cayman Islands companies.  There are various methods provided under Cayman Islands law for the taking private of Cayman Islands companies listed on global stock exchanges. In this overview, we consider the take private methods available in the Cayman Islands, including statutory merger, schemes of arrangement and takeover offer or squeeze-out; address the key steps involved with each and discuss the key considerations for board members engaged in mergers and acquisitions (M&A) involving Cayman Islands companies. We also provide an overview of the recent state of play with appraisal rights actions before the Courts of the Cayman Islands.

Introduction

In 2021, we’ve seen a significant surge in global merger and acquisition activities.   According to a recent Reuters article[1], the figures on global merger and acquisition activities released by Refinitiv data reported that the total value of pending and completed merger and acquisition deals in 2021 has reached US$3.6 trillion year-to-year, surpassing the full year tally of US$3.9 trillion in 2020.  In a report of Mergermarket published in April 2021 (Mergermarket releases 1Q21 Global M&A report | Mergermarket), M&A activities in the first quarter of 2021 reached US$1.16 trillion in transactions, which outweighed both the 2018 and 2019 averages.  Cross-border transactions have been the major driver behind this spike, hitting a record of US$516.6 billion for the first quarter of 2021.  The US is to be named as the top country for M&A activity in 2021, having reached its highest market share in 14 years, netting 54.4% of global deal value. Closer to home, according to an analysis published by EY[2] in August 2021, China recorded US$197 billion value of domestic M&A deals in the first six months of 2021, which was eight times more than foreign-invested M&A deals.   

A significant contributor to the strong M&A performance in 2021 is the increase in overall IPO activity, in particular, IPOs of special purpose acquisition companies (SPACs) in the US.  A SPAC is a "blank-check" company which is incorporated solely for the purpose of raising capital to go public through an IPO.  After the SPAC goes public, it generally has between 18-24 months within which to identify a target company for acquisition and consummate a deal.   The SPAC will subsequently merge with or acquire the target company, which is invariably an existing operating business. The acquisition process (also known as the 'de-SPAC' transaction), leads to the target private company effectively becoming a publicly listed vehicle.  The list of benefits of a SPAC IPO compared to a traditional IPO, such as a shorter timeline with lesser exposure to valuation volatility, makes the SPAC IPO an attractive alternative investment gateway for growing startups in various industry sectors (fintech, health care, cryptocurrency, etc.).   

Another popular trend in the M&A world is the privatisation and delisting of Chinese companies listed on US securities exchanges.  With the recent proposals of tightened SEC regulations in the US against "Foreign Private Issuers", which includes compliance with US audit disclosure and disclosure requirements, US-listed Chinese companies are looking for alternatives to minimise the potential negative impacts from these new regulations. Taking the company private (often by a consortium led by the founder or management group of the company) is one of the most straight-forward routes to achieve this.

Cayman Islands companies continue to be favoured by sponsors and investors when structuring a SPAC or IPO transaction, particularly where the target company (in the case of a SPAC), or underlying operating company (in the case of an IPO), is based outside of the US.  The Cayman Islands offers a range of benefits, such as a sophisticated judicial system which is substantially based on English common law, political stability, tax efficiency, flexibility of capital maintenance rules, no restrictions on exchange control, a straightforward statutory merger regime and a long history of recognition by the world's leading financial centers and securities exchanges.

M&A deals involving Cayman Islands companies are mostly structured through Cayman Islands statutory mergers (for instance, most SPACs with non-US targets are using Cayman Islands incorporated companies as the SPAC to cater for the subsequent de-SPAC transaction).  As of June 2021, there were 289 Cayman Islands companies listed on NASDAQ and 185 Cayman Islands companies listed on the New York Stock Exchange.   By end of 2020, there were 1,186 Cayman Islands companies listed on the Hong Kong Stock Exchange, which accounted for 60.36% of the aggregate number of listed companies on the Hong Kong Stock Exchange. The significant increase in de-SPAC transactions and the privatization of US-listed Chinese companies could best explain why 2021 has become one of the busiest periods in recorded history for Cayman Islands mergers.

Methods of going private for Cayman Islands Companies[3]

1. Statutory merger or consolidation

The Cayman Islands statutory merger is by far the most commonly adopted method to effect a takeover, acquisition or business combination of a Cayman Islands company since its introduction in 2009.  Amongst the available Cayman Islands merger mechanisms, the statutory merger has the lowest approval threshold (two-thirds majority of each merging company's shareholders attending the meeting who are entitled to vote, unless higher as may be specified in the articles of association) and no court procedure is involved. 

What is a statutory merger or consolidation?

Pursuant to the Cayman Islands Companies Act (Companies Act), a merger means the merging of two or more companies and the vesting of their undertaking, property and liabilities in one of such companies as the surviving company, and a consolidation refers to the combination of two or more companies with one or more other existing companies.

Cayman Islands companies limited by shares and overseas companies are entitled to implement a merger or consolidation under the statutory merger regime (in relation to overseas companies, provided such merger or consolidation is permitted or not prohibited by the laws of their home jurisdiction). 

Upon a merger becoming effective, the surviving company shall assume all of the undertakings, property, assets, rights, obligations and liabilities of the non-surviving merging entity.  The non-surviving merging entity will then cease to exist.

One of the major attractive features of the statutory merger regime is the relatively simple and efficient procedures for its implementation.  Once the necessary consents from directors and shareholders by way of a special resolution (i.e., at least two-thirds majority or such higher number as may be specified in the merging company's memorandum and articles of association) of each merging Cayman Islands company are obtained, and the set of documents as prescribed under the Companies Act are submitted to the Registrar of Companies for registration, including consent from secured creditors of the merging companies, and assuming the Registrar of Companies is satisfied with the documents submitted, it will register the plan of merger and issue a certificate of merger or consolidation.  The certificate of merger or consolidation will be the prima facie evidence of compliance with all requirements under the Companies Act in respect of the merger or consolidation. 

A Cayman Islands incorporated company which holds 90% or more of the voting rights in another Cayman Islands company may implement the statutory merger without the need to obtain shareholders' approval by way of a special resolution as outlined above but a copy of the plan of merger containing the requisite details shall be given to the shareholders of each merging company.  This is often referred to as the "parent-subsidiary" or "short form" merger.  The "parent-subsidiary" or "short-form" merger offers an efficient gateway for inter-group merger. For example, Alibaba's acquisition of Youku Tudou, a leading multi-screen entertainment and media company in China, in November 2015 was implemented by way of a "short-form" merger. Such mergers may implemented within a relatively aggressive timetable in the context of a "short-form" merger vis-à-vis a traditional merger.  However, the right of shareholders to dissent is still available under a "parent-subsidiary" or "short-form" merger, which we will discuss in the below.

Appraisal Rights

Pursuant to the Companies Act, a shareholder of a Cayman Islands company that is going through a merger, is entitled to payment of fair value for the shares held by such shareholder, if it dissents from the merger or consolidation.  In the event a shareholder decides not to accept the merger consideration being offered by the merging company, the shareholder is entitled to make an application to the Cayman Islands Grand Court (Court) to demand payment of a fair value for their shares, with the 'fair value' to be determined by the Court.  The Companies Act sets out the necessary steps and procedures which a dissenting shareholder is bound to comply with in order to exercise the appraisal rights afforded by the Companies Act.   It should be noted that even where an application has been made by a dissenting shareholder to the Court for the appraisal of fair value of shares, this will not stop or delay the process of the merger. 

Specifically in the context of a "short-form" merger, the question of whether shareholders are entitled to have the Court determine the fair value of their shares had previously been a controversial topic. However, the Court confirmed in the recent case of Changyou.com Limited FSD 120 of 2020 that the Companies Act does confer the right for a dissenting shareholder to be paid fair value for its shares, notwithstanding the fact that the shareholders technically do not have the right to vote with a "short-form" merger mechanism.    The Court elaborated that the appraisal rights of shareholders under the Companies Act are available to all dissenting shareholders, whether in the context of a traditional merger or a "short-form" merger.  

The exercise of the right for dissenting shareholders to have the Court determine the fair value of their shares has resulted in significant case law in the Cayman Islands on this issue in recent years.  In recent judicial judgments (which will be discussed below), the Court has tended to take the view that there is no "one size fits all" approach in the context of assessing the fair value of the shares, but rather a mixture of factors will be taken into account, such as the specific terms of the merger transaction, the conduct of the parties and the assessments of experts. 

These recent judgments provide valuable guidance on the measures that may be taken in the structuring of the deal in order to mitigate potential litigation risks.  For example, it may be beneficial to obtain an expert fairness opinion produced by an independent advisor for the assessment of the value of shares.  Ideally, this report should be obtained in the early stages of the deal to ensure that the directors are sufficiently informed when they make the decision on whether or not to proceed with the merger.  That way, in the event that shareholders decide to exercise their appraisal rights pursuant to the Companies Act and petition to the Court to determine the fair value of their shares, this bolsters the evidence that the directors have exercised adequate skill and care by seeking and relying on independent advice, which in turn may mitigate potential legal risks that may arise regarding the fair value of shares.  Recent trends in Cayman Islands appraisal litigation are discussed in more detail below. 

Special Committee Considerations

Although not statutorily required, it is common for the target company in a take private transaction, particularly where the buyer consortium includes members of the board of directors of the target, to establish a special committee to evaluate the take-private proposal and make a recommendation to the board on whether or not to accept the proposal.  The remit of the special committee is to act independently and fairly taking into account the interests of the target company and its shareholders, in particular if there is a chance that the management of the target company may have a conflict with the interests of the shareholders of the target company. (e.g., in the case where the management join the buyer consortium or roll over some or all of their equity interests into the new private company upon closing of the take-private transaction).   The special committee usually consists of members of the board of directors who are independent and disinterested (i.e. they are not buyer consortium members).

As directors of the target company, members of the special committee are governed by the same set of statutory and fiduciary duties applicable to other directors, and they are expected to discharge the same level and degree of skill, care and diligence when exercising their judgment in the decision making process.  One of the main requirements of special committee members is to maintain their independence and hence avoid any influence from potentially interested parties. 

Pros and Cons of the statutory merger regime

As noted above, the Cayman Islands statutory merger regime provides a straightforward and well-tested merger mechanism, with a relatively low approval threshold.  It does not require any Court approval which reduces costs and shortens the deal implementation timetable.  The major downside is that shareholders retain a statutory right to petition the Cayman Islands Courts for the payment of ‘fair value’ for their shares.  This can lead to uncertainty at the tail-end of deals and needs to be carefully managed.

2. Schemes of Arrangement

The Cayman Islands Companies Act provides for a scheme of arrangement (Scheme) regime, based on the English common law equivalent, which is an alternative to the statutory merger regime.  Although a Scheme is suitable for taking Cayman Islands companies private, they have historically been used for complicated restructurings, involving, for example, a capital reduction.  A Scheme is a court sanctioned compromise or arrangement between a company and its creditors, or between a company and its shareholders, or any class of them. The statute does not restrict the nature of the arrangement that may be agreed between the company and its members/creditors.   For the purpose of this article, we will focus on members' Schemes, which are more relevant in the context of M&A.  In addition to the power to compromise with creditors and members, the Companies Act includes broad provisions facilitating reconstruction and amalgamation of companies, including where a scheme or contract involves the transfer of shares or any class of shares to another company, and provides for the power to acquire shares of dissentient shareholders.  

A Scheme usually begins with setting out the proposals in detail in a set of shareholders' communication documents (such as, public announcements, circulars, notice of court meeting, notice of shareholders' meeting, etc.).  The Company then applies to the Court to obtain permission to proceed with the Scheme. Once the Court provides its green light to proceed, the company may convene a meeting with its shareholders according to the directions given by the Court at the first direction hearing for approving the Scheme (the Shareholders Meeting).  Pursuant to the Companies Act, a scheme of arrangement must be approved by at least a majority in number, representing at least 75% in value, of the shareholders or class of shareholders who are present and voting either in person or by proxy at the shareholders' meeting, i.e., the 'headcount test' and the 'value test'.   Once the requisite shareholders' approval thresholds for approving the Scheme have been obtained, there will be another Court hearing for the purpose of sanctioning the Scheme.  All shareholders are entitled to attend the sanction hearing and express their objections if they want to.   Once the Court is satisfied that all the prescribed conditions under the Companies Act are fulfilled (which include, shareholders being well informed of the scheme proposal, all meetings properly convened and held, and such other conditions which may be imposed by the Court), the Court will sanction the Scheme.   

At the Shareholders' Meeting, the voting thresholds apply to each class of shares. i.e., shareholders holding different classes of shares will vote as separate classes, which is also a key challenge in the context of implementing a scheme of arrangement.  Attention must be paid to the relevant listing rules and regulations which the company is subject to when interpreting the 'headcount test' and the 'value test' in the context of voting at the Shareholders' Meeting.  The 'headcount test' is one of the best examples to show how these tests are open for interpretation.  Most shares in a HKEx listed company are held by a nominee company such as the HKSCC Nominee Limited in Hong Kong.  Similarly, shares in US-listed Chinese companies that issue ADRs will be held by a central depositary. The question would be on the calculation of the number of 'heads' in respect of those shares held by the nominee company at the Shareholders' Meeting.  The company may apply to the Court for a direction to 'look' through the nominee to determine the 'genuine' headcount.

Once the Scheme is sanctioned by the Court at the second hearing, all shareholders are bound including those shareholders who did fail to vote or voted against the Scheme in the meeting. No appraisal right is available.  The latest notable transaction in the market by way of a Scheme is the filing of a petition by Luckin Coffee Inc. with the Court in September 2021 in connection with the restructuring of its US$460 million 0.75% convertible senior notes due 2025 proposed by Luckin Coffee and its joint provisional liquidators.

 Pros and cons of the Scheme of Arrangement approach

As a Cayman Islands scheme of arrangement requires two court hearings, the implementation of these types of transactions is generally longer than a typical merger transaction, and in addition significantly more expensive. However, a major advantage of the scheme of arrangement mechanism is that once the Scheme has been sanctioned at the second Court hearing, it will become binding on all shareholders, and there is no route to dissent or petition for fair value as is the case with the merger regime.

3. Takeover Offer or Squeeze-Out

The statutory squeeze-out, or a takeover, under the Companies Act refers to an acquisition where an offeror which has acquired at least 90% of the issued share capital in a target company may compel the acquisition of the shares of the remaining minority shareholders.  Once the squeeze-out offer is effective, the offeror can require the transfer of minority shareholders' shares to it, to become the sole shareholder of the target company.     

The process begins with the offeror sending the offer details to the shareholders of the target company.   In case the target is a public company, a set of takeover documents will be distributed to the shareholders of the target company including public announcements, circulars, etc., which will also be required to be filed with the relevant stock exchange.  If the offer is accepted and the offeror has acquired 90% or more in value of the shares in the target company, the offeror may proceed with exercising the squeeze-out provision without the need to obtain separate shareholders' consent.   The offer is a lengthy process.  The offeror can only exercise its squeeze-out under the Companies Act after the expiry of 4 months from the date the offer is made.  Dissenting shareholders have limited rights to object to the acquisition; they shall have one month from the date they receive notice of the offer to apply to Court if they object to the acquisition, although in practice it is unlikely that the Court will intervene unless the parties to the offer are in breach of any statutory requirements under the Companies Act.

Once the abovementioned requirements under the Companies Act have been complied with, and provided that no order to the contrary has been made by the Court, the parties will proceed with the completion logistics to register the offeror as the sole shareholder of the target company and to pay the shareholders of the target company the consideration sum. 

Since the commencement of the Cayman Islands statutory merger regime, the use of the “short-form” merger has emerged as an alternative last step to the squeeze-out process.  When the 90% acceptance threshold is met, the squeeze-out can be implemented by way of a "short-form" merger pursuant to the Companies Act, which allows the offeror holding 90% or more of the voting rights in the target company to undertake a merger with the target company; no shareholders' approval is required but appraisal rights will apply. 

Pros and cons of the Takeover Offer or Squeeze-Out approach

The squeeze-out approach to acquiring a Cayman Islands company is generally seen as a cheaper alternative to the merger or scheme of arrangement approaches discussed above, as there are no shareholder meetings nor Court hearings involved.  However, the statutory timetable, if strictly followed, can mean these transactions can take 6 months or more to fully implement.

Recent Trends in Cayman Islands Appraisal Litigation

In recent years, the Cayman Islands courts have become the battlefield for dissenters petitioning under the statutory merger regime in relation to their appraisal rights pursuant to the Companies Act.  The argument is always around the question of "fair value" of the dissenter's shares in the target company.  “Fair value” here is a legal rather than an economic construct, without a defined valuation methodology or prescriptive formula.  The Cayman Islands Court of Appeal summarised the position in Shanda Games: “s.238 requires fair value to be attributed to what the dissentient shareholder possesses. If what he possesses is a minority shareholding, it is to be valued as such. If he holds shares to which particular rights or liabilities attach, the shares are to be valued as subject to those rights or liabilities.”[4] This is in contrast to the “fair value” in Delaware, where “the shares of dissenters are regarded as proportionate shares in the value of the business itself as a going concern".[5]  Given the complex construction of the concept, it was commented by the Court that the assessment of fair value is “more of an art than a science”, that "it is more than imply the application of mathematical formulae or economic principles."[6]

A related issue is whether to apply minority discount to the shares held by the dissenters. In Shanda Games, the Privy Council held that the Delaware approach to valuing the shares of a minority (on a pro rata basis, as opposed to by reference to the minority shares themselves) does not apply to appraisals pursuant to the Companies Act.

The Privy Council's judgement was followed and interpreted in more detail by the Court in Trina Solar. In Trina Solar, Segal J emphasised that the Privy Council had explained that a minority discount could be applied in an appropriate case, but did not rule out the possibility that there might be a case where such a discount was inappropriate. Faced with these often entrenched positions, the Court has in recent cases proceeded to “blend” valuation approaches in reaching its final determination of fair value, applying different weightings to market approaches as well as to the traditional income (discounted cashflow) approach. In both Trina Solar and Nord (as well as Qunar before them), the Grand Court determined fair value by blending different valuation methodologies.

Only five cases have gone to trial to date: Re Integra Group [2016 (1) CILR 192], Re Shanda Games (judgments in the Grand Court, Court of Appeal and the Privy Council), Re Qunar Cayman Islands Ltd. [2019 (1) CILR 611], Re Nord Anglia Inc (Unreported, Grand Court, 17 March 2020) and most recently, Re Trina Solar (Unreported, Grand Court, 23 September 2020).  Trina Solar is the first judgement in which fair value was determined to be below the merger price.  The Company’s valuation expert used a blended approach to valuation, ascribing 40 per cent weighting to the merger price, 40 per cent to the unaffected trading price and 20 per cent to a discounted cash flow valuation, reaching a valuation that was below the merger price.

Another recent trend in the appraisal cases relates to the scope of dissenter discovery. Although dissenter discovery was ordered in many previous cases, a number of recent Court decisions demonstrated a trend to limit the scope of dissenters' discovery.

In Re eHi Car Services Limited, the Grand Court rejected the company's attempts to extend categories of disclosure to be provided by dissenting shareholders. The Court opined that these extensions are disproportionate, as it had done in prior cases. Subsequently, in Re FGL Holdings the Court once again rejected an attempt which sought to impose an obligation on the dissenters to the effect of giving general discovery.

Outlook

Despite the constantly changing economic landscape, and the challenges brought by the highly volatile market conditions, we are optimistic about the growth in the level of global M&A activity in 2022.  To remain competitive, companies will continue to explore strategic opportunities through mergers and acquisitions as a gateway to maximising the valuation of their business and returns.  US-listed Chinese companies delisting from US securities exchange, and the need for existing SPACs to complete de-SPAC mergers will both contribute strongly to global and regional M&A activity for the foreseeable future.