U.S.-Listed China Stocks Vulnerable to Management Buy-Outs

Some US-listed China stocks are priced at bankruptcy levels, which will lead the way to more "Going Private" transactions.

Yesterday China Security & Surveillance (CSR) announced that they received a non binding "Going Private" proposal from its Chairman and CEO, Mr. Guoshen Tu. Mr. Tu wants to acquire all the outstanding shares of the company's common stock for $6.50 per share in cash.

In general terms, a "going private transaction" is the exchange of cash for the shares of a company's existing public shareholders so that, at the end of the transaction, the company's shareholder base has been sufficiently reduced to permit the company to elect to terminate its public company status.

The forms of going private actions vary, including (i) mergers of the company with a newly formed company owned by the control group; (ii) tender offers by such a new company; or (iii) a self-tender by the company for its own shares with a follow-up reverse split. The form chosen for a going private transaction in a particular case depends on:

• The structure of the company and its shareholder base
• Those participating in the transaction
• The source of financing for the transaction - almost all going private transactions require some degree of outside financing

In addition, each form has different implications, including costs, timing, disclosures, and legal standards of judicial review that should be considered with counsel in each case. For instance , the SEC requires detailed filings in connection with a going private transaction, and the nature of these filings depends in part upon the structure of the transaction.

A going private transaction typically is initiated by a controlling shareholder (Mr. Tu, 20.9%) or by a group of shareholders that either constitutes a majority or at least a control position in a company. Senior management of the company often comprises such a buyout group, often making going private transactions appear to be management buyouts.

The reason for a company to go private include the following;

• Eliminating the significant costs of being a public company
• Realizing the full value of a company in a situation where the public market fails to adequately value the company (i.e., due to short seller attacks, or inadequate coverage of the company by analysts and other investors)
• Reducing or eliminating the obligation to disclose competitive business and other sensitive information
• Allowing for additional corporate governance flexibility
• Allowing management to focus more on long-term goals and objectives than short-term management of market expectations
• Allowing for a greater knowledge of and control over the company's shareholder base
• Reducing the potential liability for acts of directors and officers, especially in light of SOX reforms
• Providing liquidity to minority shareholders without brokerage fees and at capital gains tax rates

As previously mentioned, a going private transaction involves the payment of cash to existing public shareholders and the preparation of lengthy SEC filings. Nevertheless, most companies choose for this option for two reasons. First, a going private transaction provides a better environment to defend against any lawsuit that might be brought by minority shareholders alleging a breach of the directors' fiduciary duty, since these shareholders receive cash for their shares in a going private transaction.

Second, a going private transaction reduces the risk of a scenario in which the company is required to "turn the lights back on". This scenario occurs subsequent to going private if the number of record holders of the company's stock once again exceed the applicable 300/500 threshold used to deregister as a public company.

Going private results in a suspension, and not a termination, of a company's filing obligation under the 1934 Act. This suspension remains in effect so long as the company has fewer than the appropriate threshold number of shareholders.

China Security & Surveilance's Board of Directors has formed a special committee consisting solely of independent directors to consider, among other things, the proposal made by Mr. Tu. This committee has retained Nomura International Ltd. as its financial advisor and Shearman & Sterling LLP as its legal advisor to assist them in their work.

To understand the consideration and actions necessary to accomplish a going private transaction, it is important to understand the concept of judicial review. As a general rule, actions taken by a company's board of directors are protected by the "business judgment rule" - the presumption that in making business decisions not involving direct self-interest or self-dealing, corporate directors act on a informed basis, in good faith, and in the honest belief that their actions are in the company's best interest. This rule shields corporate directors from liability for unprofitable or harmful corporate transactions if the decisions approving such transactions were made in good faith, with due care, and within the directors' authority. In cases where plaintiffs challenge a decision of the board of directors, assuming there is no allegation of self-interest or self-dealing, the plaintiff has the burden of proof to overcome the protection of the business judgment rule.

What is going to happen now with the proposal?

The special committee is empowered to negotiate and evaluate the "going private" proposal by Mr. Tu. The independent directors will determine whether or not it is fair. In fact, according to judicial precedents, a properly constituted and functional special committee can shift the burden of proof back to the minority shareholders challenging the going private transaction to show evidence of any unfairness.

In addition, to obtain a form of validation of the fairness of the proposal, many companies seek "majority of the minority" approval of going private transactions. This means obtaining the approval of the transaction by the majority of the unaffiliated, minority shareholders, which may be done in various forms.

To be honest I never traded China Security & Surveillance Technology. But now I find this company at $5.20 a real nice trading opportunity, because I think $6.50 is the first offer. I am convinced the special committee will obtain an independent valuation, fairness opinion, or both to establish a fair minority share price. This fair price could be a little bit higher than the current price offer.

Disclosure: I am long CSR.