Increasing demands for shell companies for backdoor listings have led to an increase in the value of the listing status. Listings of new applicants whose sizes and prospects do not appear to justify the cost or purpose associated with an IPO may be a way to create shell companies. Another way to create shell companies is for listed issuers to take corporate actions to substantially scale down their existing businesses, leaving behind very small operations. Trading and creation of shell companies invite speculative trading and can lead to opportunities for market manipulation, which may jeopardize the reputation of the Hong Kong capital market and the quality of listed companies.
The Hong Kong Stock Exchange has published various guidance letters and listing decisions on the regulation of backdoor listings and shell creation activities. The Hong Kong Stock Exchange published the above consultation paper on 29 June 2018 and proposes to codify some of the guidance letters on backdoor listings and to address specific concerns about circumvention the requirements for new applicants under the Listing Rules. A summary of the consultation paper is set out below.
A. Backdoor Listing
1. Principle based test
Rule 14.06(6) sets out the principle based test which allows the Hong Kong Stock Exchange to treat an acquisition or a series of acquisitions of assets constituting an attempt to achieve a listing of the target assets and a means to circumvent the requirements for new applicants under the Listing Rules (that is, a reverse takeover).
This listing rule, which sets out the principle based test, will, subject to the outcome of the consultation, include the following amendments, and will become Rule 14.06B:
- An acquisition or a series of acquisitions of assets covers proposed and completed acquisitions. Note that there is no prescribed fixed time period when assessing arrangements or transactions that would constitute a series (see LD109-2017).
- The six assessment criteria (sets out in GL78-14) in deciding whether the transaction would be considered a reverse takeover.
- the size of the acquisition targets relative to that of the listed issuer;
- the nature and scale of the listed issuer’s business before the acquisition(s) (eg whether it is a listed shell);
- any fundamental change in the listed issuer’s principal business(es) (eg the existing business would be discontinued or become very immaterial to the enlarged group’s operations after the acquisition(s));
- any change in control (as defined in the Takeovers Code) or de facto control of the listed issuer (other than at the level of its subsidiaries). Indicative factors for a change in de facto control includes (a) any substantial change in the listed issuer’s board of directors and key management; (b) any change in its single largest substantial shareholder; and (c) any issue of restricted convertible securities (that is, convertible securities with a conversion restriction mechanism to avoid triggering a change in control under the Takeovers Code) to a vendor as the consideration for an acquisition;
- the quality of the acquisition targets (eg whether it can meet the trading record requirements for listings, or whether it is unsuitable for listing (eg, an early state exploration company));
- other transactions or arrangements (historical, proposed or intended) which, together with the acquisition(s), form a series of arrangements to list the acquisition targets (eg, changes in control/de facto control, acquisitions, disposals or termination of original business; greenfield operations; equity fundraisings related to or for the development of newly acquired businesses). The Hong Kong Stock Exchange may regard acquisitions and other transactions or arrangements as a series if they take place in a reasonable proximity to each other or are otherwise related. The Hong Kong Stock Exchange does not intend to unduly restrict business expansion or diversification by listed issuers that take place over a reasonable period (usually three years or more) and will not normally consider that a transaction or arrangement outside the three-year period as part of the series, unless there are specific concerns about circumvention of the reverse takeover rules (eg proposing a transaction shortly after the three-year period and which accordingly is likely to have been in contemplation within the three-year period). In addition, since the series of transactions or arrangements (completed or proposed) would be treated as if it were one transaction, it is not required for the proposed transaction or the last completed transaction to be an acquisition to trigger the reverse takeover rules. See paragraphs 44 to 51 of the consultation paper for details. Note that, under the reverse takeover rules, an acquisition below the size of a very substantial acquisition may be considered a reverse takeover.
2. Bright line tests
The bright line tests refer to the two specific forms of a reverse takeover, namely (1) an acquisition or a series of acquisitions of assets constituting a very substantial acquisition where there is or which will result in a change in control (as defined in the Takeovers Code); or (2) very substantial acquisition(s) of assets (individually or in aggregate) from the new controlling shareholder and its associates within 24 months following a change in control (as defined in the Takeovers Code).
Under the consultation paper, it is proposed that the 24-month period is changed to 36-month period.
3. Restriction on material disposal
A listed issuer may not carry out a material disposal (or distribution in specie) of its existing business (1) when there is a proposed or intended change in control (as defined in the Takeovers Code) of the listed issuer (other than at the level of its subsidiaries); or (2) for a period of 36 months from a change in control (as defined in the Takeovers Code), unless the remaining group, or the assets acquired from the new controlling shareholder (and his associates) and any other person(s), would meet the requirements under Rule 8.05 (or Rule 8.05A or 8.05B).
The Hong Kong Stock Exchange may apply this restriction rule to a material disposal (or distribution in specie) by a listed issuer of its existing business (1) when there is a proposed change in the single largest substantial shareholder of the listed issuer; or (2) for a period of 36 months from such change.
4. Extreme transactions
Extreme very substantial acquisitions will be renamed extreme transactions.
An extreme transaction is an acquisition or a series of acquisitions of assets (the acquisition targets) by a listed issuer (proposed and/or completed), which individually or together with other transactions or arrangements, may, by reference to the factors set out in Note 1 to Rule 14.06B, have the effect of achieving a listing of the acquisition targets, but the listed issuer can demonstrate to the satisfaction of the Hong Kong Stock Exchange that it is not an attempt to circumvent the requirements for new applicants set out in Chapter 8 of the Listing Rules and that:
- a. the listed issuer has been operating a principal business of a substantial size, which will continue after the transaction; or
b. the listed issuer has been under the control of a large business enterprise for a long period (normally not less than 3 years), and the transaction forms part of a business restructuring of the listed issuer and would not result in a change in control (as defined in the Takeovers Code) of the listed issuer (other than at the level of its subsidiaries); and
- the satisfaction of the requirements referred to in paragraph 5 below are satisfied.
As general guidance, “a principal business with substantial size” may include a principal business with annual revenue or total asset value of HK$1 billion or more, excluding any revenue or assets not attributable to the listed issuer’s original principal business e.g. any significant investments or surplus cash of the listed issuer, and any revenue or assets attributed to a newly acquired or developed business. The Hong Kong Stock Exchange would also take into account the listed issuer’s financial position (e.g. whether the listed issuer has a very small net asset value or in a net liabilities position), the nature and operating model of the listed issuer’s business and its future business plans in assessing whether its principal business is of substantial size.
The disclosure requirements applicable to a new applicant have to be complied with.
A financial adviser (a person licensed or registered under the Securities and Futures Ordinance for Type 6 regulated activity and permitted under its licence or certificate of registration to undertake the work of a sponsor) has to be appointed to perform due diligence on the assets subject to the acquisitions (and any assets and businesses subject to a series of transactions and/or arrangements, if any).
The transaction will be presented to the Listing Committee for its determination on whether the transaction should be an extreme transaction or a reverse takeover. The classification is subject to the completion of the financial adviser’s due diligence work on the target business and its submission of a declaration to support the view that the target business is able to meet the new listing requirements. Failure to provide sufficient information for the Hong Kong Stock Exchange to make a determination may result in a ruling that the transaction is a reverse takeover.
5. Additional requirements for a reverse takeover and an extreme transaction
|Reverse takeover||Extreme transaction|
|Acquisition targets (1), (2)||Enlarged group||Acquisition targets (1)||Enlarged group|
|Rule 8.04 (suitability for listing)||✔||✔||✔||✔|
|Rule 8.05 (or Rule 8.05A or 8.05B) (track record requirements)||✔||-||✔||-|
|New listing requirements in Chapter 8 (other than Rule 8.05)||-||✔||-||✔|
- The assets acquired and/or to be acquired.
- Where a listed issuer has failed to comply with Rule 13.24 (that is, to carry on a sufficient level of operations or to have sufficient assets to maintain its listing) and proposes a reverse takeover, each of the acquisition targets and the enlarged group must meet all the new listing requirements set out in Chapter 8. Note that the carve-out for Rule 8.05 is not included in such circumstances.
6. Financial information
If an extreme transaction or a reverse takeover involves a series of acquisitions, which may have taken place over a few years, the current Listing Rules do not provide guidance on how the track record of the acquisitions would be determined and the financial information to be presented.
The circular or listing document must contain pro forma income statements for all the acquisition targets in the series of acquisitions (where applicable, would include any new businesses developed by the listed issuer that form part of the series) for the track record period (that is, the three financial years before the issue of the circular or listing document).
Paragraphs 76 to 78 set out an example where a listed issuer completed an acquisition of Target A in FY2015 and proposed an acquisition of Target B in FY2017 forming a series of acquisitions. The track record period with reference to the acquisition of Target B in FY2017 is FY2014 to FY2016.
Pro forma income statements of Target A and Target B are required.
In addition, the new Rule 4.30 requires that the unadjusted information must be derived from the accountants’ reports of the acquisition targets. In the above example, the listed issuer must produce the accountants’ reports for Target A and Target B for the track record period (that is, FY2014 to FY2016).
7. Large scale issue of securities
Where a listed issuer proposes a large scale issue of new shares (including any warrants, options or convertible securities) for cash to acquire and/or develop a new business, which, in the opinion of the Hong Kong Stock Exchange, is a means to circumvent the new listing requirements and to achieve a listing of the new business, the Hong Kong Stock Exchange may refuse to grant listing approval for the new shares. The Hong Kong Stock Exchange will not normally apply this anti-avoidance provision to an issue of securities if, taking into account the proceeds from the issue, less than half (50%) of the listed issuer’s assets would consist of cash as a result of the fundraising, unless there are specific concerns about circumvention of the rule.
B. Continuing listing criteria
1. Sufficiency of operations and assets
A listed issuer must carry out a business with a sufficient level of operations and have assets of sufficient value to support its operations to warrant its continued listing. If a listed issuer has significant assets but does not carry on a business of sufficient size, it will not meet the continuing listing criteria. This rule is a qualitative test. The onus is on the listed issuer to demonstrate to the satisfaction of the Hong Kong Stock Exchange that the listed issuer’s business has substance and/or is viable and sustainable.
Trading and/or investment in securities are excluded when considering sufficiency of operations and assets.
2. Cash companies
If a listed issuer’s assets consist wholly or substantially of cash and/or short-term investments, it will not be regarded as suitable for listing.
In assessing whether a listed issuer’s assets consist wholly or substantially of cash and short-term investments, the Hong Kong Stock Exchange will normally take into account the value of the listed issuer’s cash and short-term investments relative to its total assets, the nature of the listed issuer’s business, business model and its level of operations and financial position. Whist there is no prescribed threshold on the level of cash for the purpose of this cash company rule, normally this is expected to be much higher than half (50 per cent) of the listed issuer’s total assets.
It is proposed that the term “short-term investments” is to replace the existing term “short-dated securities” in the current Listing Rules. The Hong Kong Stock Exchange will apply a principle based approach to the meaning of this term and will consider the intention of the listed issuer in holding the assets and the marketability or liquidity of the assets. Examples of short-term investments include: bonds, bills or notes which have less than one year to maturity, or those which have maturity of over one year and are intended to be held for less than one year; securities listed on the Hong Kong Stock Exchange or other stock exchanges that are available for sale; investments that are readily realizable or convertible to cash; and advances to third parties which are repayable within one year (excluding trade receivables arising from the listed issuer’s ordinary and usual course of business).
For a listed issuer which carries on securities brokerage business, assets held on behalf of its clients relating to such business will not be taken into account in assessing whether the listed issuer is a cash company. This exemption does not apply to non-client assets.
3. Transitional period
A transitional period of 12 months from the effect date of the rule amendments applies for listed issuers not meeting the continuing listing criteria.
C. Other proposed amendments to the listing rules
1. Securities transactions
Securities trading/investment by listed issuers does not fall under the revenue exemption under the Listing Rules unless securities transactions are conducted by a member of the listed issuer group that is a banking company, an insurance company or a securities house as one of the principal activities and in the ordinary and usual course of business of the listed issuer. In other words, securities transactions conducted by other listed issuers are subject to the notifiable transaction requirements. No netting-off of sale and purchase should be permitted in determining the results of the size tests for notifiable transactions. It is not clear whether or not each securities investment should be subject to its own size tests or the pool of securities investments in total should be subject to one set of size tests.
Listed issuers should disclose in their annual reports details of each securities investment that represents 5 per cent or more of their total assets, including:
- the name and principal business of the underlying company, the number or percentage of shares held and the investment costs;
- the fair value of each investment as at the year end date and its size relative to the listed issuer’s total assets;
- the performance of each investment during the year, including any realized and unrealized gain or loss and any dividend received; and
- a discussion of the listed issuer’s strategy for the significant investments.
2. Distribution in specie of unlisted assets
A significant distribution in specie of unlisted assets is tantamount to a delisting of the business by the listed issuer. The distribution should be subject to similar levels of protection offered to shareholders as in the case of a delisting of the listed issuer’s securities. The Hong Kong Stock Exchange proposes that the distribution of unlisted assets by a listed issuer (which amounts to a very substantial disposal based on the results of the size tests) requires the approval by the independent shareholders of the listed issuer with at least 75 per cent of the votes for and not more than 10 per cent of the votes against the resolution. Controlling shareholders (or directors (other than independent non-executive directors) and the chief executive, where there is no controlling shareholder) and their respective associates must abstain from voting for the resolution.
In addition, the shareholders of the listed issuer (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.
D. Notifiable and connected transactions
1. Financial performance guarantees
For any notifiable or connected transaction, if a listed issuer acquires a company or business and receives a financial performance guarantee from the seller regarding the financial performance of the target company or business, the listed issuer must:
- announce any change to the terms of the financial performance guarantee; or failure in meeting the guarantee (or the amended guarantee); and
- disclose the outcome of the financial performance guarantee in the listed issuer’s next annual report (irrespective of whether the guarantee is met).
2. Identifies of the parties to a transaction
In order to enhance the transparency of material transactions, the Hong Kong Stock Exchange proposes that the identities and principal activities of the parties to a transaction and of their ultimate beneficial owner(s) are required to be disclosed in the announcements and circulars of notifiable and connected transactions. For notifiable transactions, the directors of the listed issuers have to confirm in the announcements of notifiable transactions that the transaction counterparty/counterparties and its/their ultimate beneficial owner(s) are independent third parties. Reasonable due diligence enquiries are expected to be conducted to ascertain correctness of such a confirmation. In addition, the transaction documents (such sale and purchase agreements) should provide an explicit warranty from the transaction counterparty/counterparties regarding their independence and the description of their principal activities.
3. Anomalous results of size tests
Listed issuers are required to classify the size of a notifiable or connected transaction using the five percentage ratios set out in the Listing Rules. The percentage ratios measure the materiality of a transaction to the issuer for the purpose of determining the applicable compliance requirements (that is, disclosure and/ or shareholders’ approval, as the case may be). The Hong Kong Stock Exchange may exercise its discretion to disregard the prescribed percentage ratios if any of them produces an anomalous result or is inappropriate to the sphere of activities of the listed issuer. Listed issuers must provide alternative size tests for the Hong Kong Stock Exchange’s consideration in this regard.
The proposed amendment makes it clear that not only the listed issuers but also the Hong Kong Stock Exchange may apply an alternative size test that it considers appropriate to assess the materiality of a transaction under the Listing Rules.
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