Tightened Listing Rules on “backdoor” listings

Introduction

The Stock Exchange of Hong Kong Limited (HKEX) has published its consultation conclusions on backdoor listing, continuing listing criteria and other rule amendments (Consultation Conclusions).

HKEX has decided to amend the Listing Rules to tighten restrictions on “backdoor” listings and other related matters.

The Listing Rule amendments, together with the three new guidance letters (GL104-19 to GL106-19) on the application of the revised Rules, will take effect on October 1, 2019.

Background

The Consultation Conclusions mark the HKEX’s latest effort in addressing concerns over “backdoor” listings and related “shell” activities in Hong Kong.

Backdoor listings have been the subject of regulatory scrutiny as they are often associated with attempts to list assets with quality or suitability issues in circumvention of the new listing requirements. Demands for listed “shell” companies as vehicles for backdoor listings can also lead to “shell” activities which are not in the interests of the investing public or the market as a whole.

To combat these issues, HKEX has already tightened its suitability review of issuers with “shell” characteristics, introduced an enhanced regime for delisting issuers engaging in “shell” activities and has also been taking a robust approach in regulating transactions with “backdoor” listing concerns.

From October 1, 2019, the regulatory regime for listed “shells” and backdoor listings will be strengthened further.

In addition to codifying HKEX’s guidance letters and practices in recent years, the revised Rules will widen the regulatory net for HKEX to crack down on “shell” activities, tighten the qualification requirements for “backdoor” listings, enhance the continuing listing criteria to tackle listed “shell” issues and will also broaden the scope of transactions that can be caught under the new regime.

Key features of the revised framework governing backdoor listings through reverse takeovers (RTOs) and related matters and the enhanced continuing listing requirements are set out below.

Part I: Amendments relating to “backdoor” listing issues

Overview

The diagram below illustrates some key issues to consider under the revised “backdoor” listing governing regime.

Key features

1. Deemed new listing – “RTO” definition modified

(a) Principle-based test

(b) Bright-line tests

2. Codifying restrictions on backdoor listing through large scale securities issue

3. Retaining the restriction on disposals with modifications

4. Codifying the “Extreme VSA” category with new requirements

5. Additional requirements for “RTO” and “Extreme transactions”

Part II: Amendments relating to continuing listing criteria

Listing Rules governing the continuing listing criteria and “cash company” will be tightened to better tackle listed “shell” issues – key features of the amendments are set out below.

1. Enhanced continued listing criteria

2. “Cash company” Rules modified

Part III: Other amendments

In addition to the above, amendments will also be made to Chapter 14 (notifiable transactions), Chapter 14A (connected transactions) and the annual report disclosure requirements of the Listing Rules to enhance investor protection and better address “shell” activities issues.

Key features of the changes are set out below.

(a) Securities transactions

• Confining the “revenue exemption” for securities transactions:

• Transactions that are of a revenue nature in the issuer’s ordinary and usual course of business are fully exempt from the disclosure and shareholders’ approval requirements for notifiable transactions under Chapter 14 of the Listing Rules (revenue exemption).
• To deter securities transactions from being used in “shell” maintenance activities, the “revenue exemption” for the purchase or sale of securities will be confined so that the exemption will only be available where the securities purchase or disposal is carried out by a banking company, an insurance company or a securities house (which is mainly engaged in regulated activities under the SFO) within the issuer’s group in its ordinary and usual course of business.

• Disclosure of significant investments in annual reports:

• To enhance transparency, details of each securities investment that represents 5% or more of an issuer’s total assets (calculated based on the value of the issuer’s investments in the investee company as at the year-end date) will need to be disclosed in the issuer’s annual reports.

(b) Significant distribution in specie

• For significant distributions of unlisted assets, the requirements in Listing Decision LD75-4 will be codified into the Listing Rules. Accordingly, where an issuer intends to conduct a distribution in specie (other than HKEX listed securities) and the size of the assets to be distributed amounts to a “very substantial disposal” under the Rules:

• the issuer must obtain prior approval for the distribution by independent shareholders in a general meeting;
• the controlling shareholders (or if there is no controlling shareholder, the directors (excluding independent non-executive directors) and chief executive) and their respective associates must abstain from voting in favour of the resolution;
• the approval must be given by at least 75 per cent of the votes attaching to any class of listed securities held by holders voting (in person or by proxy) at the meeting, and the number of votes cast against the resolution must not be more than 10 per cent of the votes attaching to any class of listed securities held by holders permitted to vote at the meeting; and
• the issuer’s shareholders (other than the directors (excluding independent non-executive directors), chief executive and controlling shareholders) should be offered a reasonable cash alternative or other reasonable alternative for the distributed assets.

(c) Other matters relating to notifiable/connected transactions

• Disclosure requirements in the notifiable/connected transaction Rules will be extended:

• to require (i) disclosure on the outcome of any financial performance guarantee of an acquisition target (irrespective of whether the guaranteed financial performance is met) in the next annual report; and (ii) disclosure by announcement (including directors’ views) if there is any subsequent change to the terms of the guarantee or if the acquired target’s actual financial performance fails to meet the guarantee; and
• to require (i) disclosure of the identities of the parties to a transaction in the announcements and circulars of notifiable transactions; and (ii) disclosure of the identities and activities of the parties to transactions and of their ultimate beneficial owners in the announcements of connected transactions (in addition to the existing disclosure requirements in connected transaction circulars).

• Alternative size tests:

• Amendments will also be made in Chapter 14 (notifiable transactions) and Chapter 14A (connected transactions) to make it clear that, where any calculation of the percentage ratios produces an anomalous result or is inappropriate to the sphere of activity of the issuer, HKEX (or the issuer, with HKEX's prior consent) may apply an alternative size test that it considers appropriate to assess the materiality of the transaction.

SFC’s approach to backdoor listing and shell activities

In tandem with the Consultation Conclusions, the Securities and Futures Commission (SFC) has also issued a statement on its approach to backdoor listings and shell activities, emphasizing that it will not hesitate to utilise its statutory powers (e.g. powers to investigate or to object to a listing application or direct a trading suspension) where appropriate and that the following factors are likely to be relevant in considering whether there are “red flags” in cases involving backdoor listings/shell activities:

• whether there are any red flags indicating concealed arrangements or understandings (such as one involving a change in control or de facto control) between the parties involved, including the directors, shareholders, intermediaries and advisers
• whether the listed issuer or the listing applicant has disclosed the true nature or extent of its business, affairs and plans
• whether there are any fundamental issues relating to the new assets or businesses being injected or to be injected that would lead to concerns as to whether these assets or businesses should be allowed to be listed and have access to public investors' capital
• whether there are any concerns that the directors might not have fulfilled their fiduciary duties and acted in the interests of the shareholders as a whole
• whether sufficient due diligence has been conducted on the assets or businesses acquired, and whether the scope of due diligence is appropriate

Way forward - Actions required?

The revised Listing Rules, together with the SFC/HKEX’s robust enforcement approach, should serve as a strong deterrent to those looking to skirt the new listing requirements by a “backdoor” listing and help stem tide of “shell” activities. At the same time, the increased regulatory risks and hurdles involved in backdoor listing-related transactions may also make “front door” listing (IPO) a more appealing option for companies seeking to list their assets on the Hong Kong bourse.

On the other hand, in view of the broad scope of the revised Rules, issuers should be careful not to inadvertently trigger the tightened rules or the extended restrictions under the new regime. Early advice should be sought, particularly in transactions where substantial changes to the issuer’s shareholdings or existing businesses are contemplated.

Issuers should also be mindful of the continuing requirements in the revised Rule 13.24 (sufficient operations and assets to warrant a continued listing) and Rule 14.82 (“cash company” rule) as mentioned above. A 12-month transitional period from the effective date (i.e. October 1 2019) will apply to issuers that do not comply with the new Rule 13.24 or 14.82 strictly as a result of the Rule amendments. The transitional arrangement, however, would not apply to issuers that do not comply with the current requirements under the existing Rule 13.24 or 14.82, or become non-compliant with the new Rule 13.24 or 14.82 after the effective date. Issuers should therefore conduct an internal compliance check as soon as possible and take necessary action to ensure that the enhanced requirements are met before the expiry of the transitional period.