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NQ Mobile's Bylaw Proposal Reminds Some Of Chesapeake, Green Mountain

When insiders of any company pledge their shares for a personal loan, eyebrows are raised, and now NQ Mobile Inc NQ is changing its bylaws make it easier for what some see as a questionable practice.

NQ Mobile Inc ADR (NQ - Get Report) has been the focus of public scrutiny since notorious short selling firm Muddy Waters accused it of fraudulent practices. Since then, many well-known funds have taken up or added to their positions in support of NQ and against Muddy Waters. Before the short selling firm targeted NQ Mobile, shares were on track to climb nearly 400% this year.

So what exactly is the deal with NQ Mobile Inc ADR (NQ - Get Report)? Is there a big problem with its accounting practices, or not? Because of the questions surrounding the company, any changes it makes at the corporate level are being scrutinized by investors, one of whom directed our attention to a change the company is proposing in its bylaws. The person questioned the implications of the proposal, should it pass.

NQ Mobile proposes some changes to its bylaws

The day after Thanksgiving, NQ Mobile filed a regulatory document with the Securities and Exchange Commission revealing the proposed changes and announcing its annual meeting on Dec. 23. At that meeting, shareholders will have to vote on a change to the incentive plan for the founders. Here is the proposed change word-for-word from the regulatory document:

'Upon any sale, pledge, transfer, assignment or disposition of Class B Common Shares by a holder thereof to any person or entity which is not an Affiliate of such holder or a Founder or an Affiliate of one or more Founders, each such Class B Common Share shall be automatically and immediately converted into one Class A Common Share; provided that a except as set forth in Article 6div below, a change in the beneficial ownership of Class B Common Shares from a holder of Class B Common Shares to an Affiliate of such holder or to a Founder or an Affiliate of one or more Founders shall not cause a conversion under this Article 6diii and b any sale, pledge, transfer, assignment or disposition of Class B Common Shares by a holder thereof effected as part of the creation of any security interest or other encumbrance over such Class B Common Shares including, without limitation, any transfer of legal title to such Class B Common Shares effected as part of the creation of any security interest or other encumbrance over such Class B Common Shares shall be exempt from, and shall not trigger, the automatic conversion contemplated under this Article 6diii unless and until the legal title to such Class B Common Shares is transferred to any person or entity which is not an Affiliate of such holder or a Founder or an Affiliate of one or more Founders as a result of the enforcement of such security interest or other encumbrance. In addition, if at any time more than fifty percent 50% of the ultimate beneficial ownership of any holder of Class B Common Shares other than a Founder or an Affiliate of one or more Founders changes, each such Class B Common Share shall be automatically and immediately converted into one Class A Common Share. For the avoidance of doubt, the sale, pledge, transfer, assignment or disposition of Class B Common Shares by a holder thereof to any of the following shall be exempt from, and shall not trigger, the automatic conversion contemplated under this Article 6diii: i a Founder or an Affiliate of one or more Founders or ii an Affiliate of such holder. For the purposes of these Articles, "Founders" means each of Dr. Henry Yu Lin, Dr. Vincent Wenyong Shi and Mr. Xu Zhou and "Founder" means any one thereof.'

Concerns about pledging shares for personal loans

The main issue in this proposed change is whether the founders of NQ Mobile Inc (NQ - Get Report) are doing this in order to be able to pledge their shares as collateral for personal loans without those super voting Class B shares being converted to standard Class A shares immediately. Attorney Howard E. Berkenblit of Boston law firm Sullivan and Worcester told ValueWalk that the proposed change by NQ Mobile appears to allow the founders to do this—unless they should default on their loan, thus transferring the shares to the lender, upon which they would automatically convert to Class A shares.

“On the proposed charter changes, they appear to create greater flexibility for the Founders to move around shares both among themselves and their affiliates, including pledging the shares absent a default, without triggering the conversion features,” Berkenblit said. ”Whether this was to clarify the provision because someone such as a pledgee bank thought the provision was ambiguous and needed to be clarified, or was proposed because the founders wanted more flexibility to use their shares to secure loans and felt the current articles prevented that or was for some more nefarious reason, I can't tell.”

NQ Mobile shareholders see a bit more risk

Of course a mere pledge of shares for a personal loan isn’t a problem. It’s the defaulting on the loan which would be a problem, and at this point, we have no idea of the intent, if any, of NQ Mobile Inc (NQ - Get Report)’s founders. There have been major cases of pledging like this causing serious problems for companies, such as in the cases of notorious former Chesapeake Energy Corporation (CHK - Get Report) CEO Aubrey McClendon and Green Mountain Coffee Roasters Inc (GMCR - Get Report) founder Bob Stiller.

The problem is if executives put up shares of their company as collateral for personal loans and then are unable to pay those loans back, the lender gains control of them. At that point, the lender could sell the shares to cover the loan, thus flooding the market. Investors should note that in the case of NQ Mobile, this is still a big IF statement. However, Berkenblit also says this proposed change by NQ Mobile is the opposite of what many of his clients are doing.

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