SPECIFIC ISSUES IN IPOS

Transcription

1 Chapter 4 39 SPECIFIC ISSUES IN IPOS This chapter discusses a number of specific issues that may be encountered by a listing applicant in an IPO in Hong Kong. In particular, we will focus our attention on suitability for listing, a general requirement imposed by the Hong Kong Stock Exchange on all listing applicants. While there are no clear-cut rules delineating whether an applicant is suitable for listing, this issue goes to the very heart of a listing application. Any applicant seeking a listing in Hong Kong is strongly advised to do an in-depth study on this issue to determine whether it satisfies this fundamental requirement. 1. Suitability for Listing (1) Avoiding Creation of Listed Shells 1.1 Introduction Pursuant to Rule 8.04 of the Rules Governing the Listing on The Stock Exchange of Hong Kong Limited (the Listing Rules ), the listing applicant and its business must, in the opinion of The Stock Exchange of Hong Kong Limited (the Hong Kong Stock Exchange ), be suitable for listing. Suitability for listing depends on many factors, and listing applicants should appreciate that mere compliance with the Listing Rules may not itself ensure their suitability for listing. In recent years, the Hong Kong Stock Exchange has noted that some applicants appeared to be listing their companies (especially GEM listings where profitability is not a requirement) so that they could sell the listed entities as listed shells for another business. In the famous Magnum case, a Hong Kong nightclub owner which was listed in Hong Kong in 2014 was subsequently sold to a PRC-based purchaser four months after the one-year lockup period had expired. The listed

2 40 company was renamed and, apart from operating as a nightclub, has been exploring investments in other sectors, such as property management. The Hong Kong Stock Exchange s concerns led to its review of all new listings on the Main Board and Growth Enterprise Market Board between 2012 and 2014 together with selected companies in The review sought to identify characteristics of listed shells created in view of the perceived premium attached to listing status rather than the development of the underlying business or assets. This subsequently led to the issue of Guidance Letter GL68-13A by the Hong Kong Stock Exchange in June 2016, which seeks to address this particular issue on suitability for listing. The Hong Kong Stock Exchange is of the view that such companies will invite speculative trading activities when identified by potential buyers, which can lead to opportunities for market manipulation, insider trading and unnecessary volatility in the market post-listing, none of which is in the interest of the investing public. It also considers that the creation of listed shells will damage the quality and reputation of the capital markets in Hong Kong. At the same time, a balance should be struck between allowing genuine commercial transactions and regulating the market appropriately. 1.2 Seven characteristics of listed shells The Hong Kong Stock Exchange observed in Guidance Letter GL68-13A that listed shells usually had one or more of the following seven characteristics: (i) small market capitalization; (ii) only marginally meet the listing eligibility requirements; (iii) involve fund raising disproportionate to listing expenses (i.e. a high proportion of the listing proceeds were used to pay listing expenses); (iv) involve a pure trading business with a high concentration of customers; (v) are asset-light businesses where a majority of the assets are liquid and/or current assets; (vi) involve a superficial delineation of business from the parent whereby the applicant s business is artificially delineated from the parent by geographical area, product mix or different stages of development; and/or (vii) have little or no external funding at the pre-listing stage.

3 41 The existence of some of the above characteristics will bring into question the suitability for listing and whether the listing applicant in question should be subject to a more focused review by the Hong Kong Stock Exchange. It is also important to note that this list of characteristics is not intended to be exhaustive and the Hong Kong Stock Exchange may raise other issues that could render a listing applicant unsuitable for listing. 1.3 Areas of analysis to substantiate suitability for listing For a listing applicant which exhibits some of the above characteristics, such listing applicant and its sponsor(s) should provide a robust analysis to substantiate that such listing applicant is suitable for listing, including, among other things, in the following areas: (i) Use of proceeds The listing applicant should disclose specific uses for proceeds commensurate with its past and future business strategy and observed industry trends and explain the commercial rationale for listing. (ii) Future objectives and strategies A comprehensive analysis should be provided to demonstrate that the listing applicant has a detailed strategic plan for its business operations and growth. (iii) Profit and revenue growth where a listing applicant (a) has experienced decreasing or low profit and revenue growth; and/or (b) is expected to record decreasing or low profit and revenue growth after listing, a comprehensive

4 42 analysis is required to substantiate that the applicant s business is sustainable (see also Section 2 Sustainability of Business Model below); and (iv) Potential sunset industries if a listing applicant is in a potential sunset industry or in an industry that has declining market prospects, it must be able to demonstrate that its business is feasible and it has both the ability and resources to modify its business to respond to the changing demands of the market. The listing applicant should also demonstrate that the returns from the business justify the cost of listing. The sponsors are also expected to ensure that they are aware of all material issues which, in their reasonable opinion, are necessary for consideration of whether the listing applicant is suitable for listing. 1.4 Extended lock-up period Following the issue of Guidance Letter GL68-13A in June 2016, we note that the controlling shareholders of quite a number of newly GEM-listed companies have undertaken with the Hong Kong Stock Exchange to lock up their shares for a longer period than required by the GEM Listing Rules. Such extended lock-up periods on top of the required one-year lock-up period could range from 12 months to 30 months. This suggests that the Hong Kong Stock Exchange has tightened its scrutiny over GEM listing applicants and will impose extended lock-up periods to make it more difficult and time-consuming for controlling shareholders to sell their listed shells.

5 43 2. Suitability for Listing (2) Sustainability of Business Model The Hong Kong Stock Exchange s Guidance Letter GL68-13 provides guidance on the factors that it would take into consideration when assessing whether a company s business is suitable for listing. One of these factors is sustainability of a company s business model. Where a company s business model is believed to be unsustainable, the Hong Kong Stock Exchange will consider it unsuitable for listing. A business model may be considered unsustainable due to a combination of factors, such as: significant and recent changes in the revenue model such that its trade record is not representative of its past performance; changing regulatory environment and industry outlook; deteriorating financial performance during the track record period and no sign of improvement in the forecast period and beyond; one-off windfall profits unlikely to be recurring. While none of the factors alone may necessarily be detrimental, the Hong Kong Stock Exchange will consider the combined impact of such factors on the applicant s business. This is particularly important for GEM listing applicants as the GEM Listing Rules only require positive cash flow for the two preceding financial years and do not require profitability during the track record period. We set out below some examples of GEM listing applicants whose businesses were considered by the Hong Kong Stock Exchange as unsustainable and whose listing applications were rejected: Company A was engaged in a regulated business and applied for GEM listing. The Hong Kong Stock Exchange had grave concerns on the sustainability of Company A s business in light of its existing financial outlook as follows: (i) heavy indebtedness with minimal cash at bank and unutilized banking facilities; (ii) uncertainty as to whether Company A could obtain independent financing after using up the unutilized banking facilities and ceasing its reliance on its controlling shareholders to guarantee its borrowings after listing;

6 44 (iii) significant trade receivables, and deteriorating and long receivable turnover days; (iv) minimal cash and cash equivalents due to cash flow mismatch between settlement of expenses and the long period taken before Company A would be able to bill its major customers; and (v) high concentration of customers which raised doubts as to Company A s bargaining power with its customers. Company B was a hotel developer and owner and applied for GEM listing. The Hong Kong Stock Exchange considered Company B s business model to be unsustainable because: (i) Company B relied on government discretionary interest subsidies to maintain sufficient cash to meet its debt payments; (ii) it had a loss-making history which would likely continue in the foreseeable future and would be further aggravated by its proposed business expansion plans; and (iii) there was no clear path to profitability for its properties and Company B estimated a long break-even and payback period of over 15 years. Company C was a manufacturer and seller of consumer products and applied for GEM listing. The Hong Kong Stock Exchange had concerns over the sustainability of Company C s business in light of: (i) the unpredictable non-recurring nature of sales, as there had been fewer than ten transactions during the track record period; (ii) the deteriorating financial performance decreasing net profit and net profit margin during the track record period, the reasons for which Company C failed to explain; and (iii) insufficient disclosure of Company C s future plans and prospects in light of the austerity measures by the local government which directly affect Company C s targeted customers. Company D engaged in a processing business with ancillary trading in raw materials and applied for GEM listing. The Hong Kong Stock Exchange had concerns over Company D s business sustainability mainly in light of:

7 45 (i) a deteriorating financial performance during the track record period with no sign of improvement in the forecast period; (ii) a lack of effective measures to manage its exposure to raw materials price fluctuation during the track record period and going forward; (iii) the gross profit margin of its manufacturing activities being lower than that of its trading activities, which cast doubt on whether Company D could sustain itself at such a gross profit margin; (iv) one-off windfall profits from foreign exchange gains unlikely to be recurring; and (v) uncertainty over the future prospect of Company D s sales for returning to profitability. The examples above show that mere compliance with the GEM Listing Rules may not itself ensure a listing applicant s suitability for listing, and one important factor that the Hong Kong Stock Exchange will consider is sustainability of an applicant s business model. For this reason, companies that intend to apply for listing in Hong Kong (especially GEM) must carefully evaluate their business sustainability before deciding whether to seek listing in Hong Kong.

8 46 3. Suitability for Listing (3) Non-compliance Incidents When it comes to non-compliance incidents of a listing applicant, the Hong Kong Stock Exchange will generally first consider whether such non-compliance incidents, in particular systematic or intentional ones, or those involving repeated breaches of laws and regulations, would affect the listing applicant s suitability for listing. When it is determined that the non-compliance incidents can be resolved by way of disclosure, the Hong Kong Stock Exchange will expect the listing applicant to disclose such non-compliance in its listing documents according to the guidance issued by the Hong Kong Stock Exchange. 3.1 Suitability of directors and suitability for listing For the Hong Kong Stock Exchange, material non-compliance incidents may be viewed as an issue of suitability of directors or suitability for listing of the listing applicant. The Hong Kong Stock Exchange will take into account the following factors in determining the impact of non-compliance on a listing: the nature, the extent and the seriousness of the breaches, for example, whether the breaches involve dishonesty, or whether the breaches involved newly established laws and regulations which may be subject to different interpretations by legal professionals; the reasons for the breaches: whether the breaches were intentional or due to negligence or recklessness; the impact of the breaches on the listing applicant s operations; the rectification measures adopted; and the precautionary measures put in place to avoid future breaches.

9 47 Moreover, the Hong Kong Stock Exchange will normally require the listing applicant and the sponsor to provide the following information for consideration: Listing applicant a detailed account of the involvement of its directors and senior management in the breaches; and an explanation of whether its directors involved possess the expected qualities to the standard to act as directors required under Listing Rules. Sponsor the basis of its view that the applicant has sufficient internal controls given the regulatory non-compliance matters; and on a case by case basis, the Hong Kong Stock Exchange may request the sponsor s view to be disclosed in the prospectus. If the non-compliance incidents are of a serious nature (e.g., involving fraud or deceit by directors or senior management, systematic failure of a listing applicant s internal controls and/or matters with significant financial impact on a listing applicant), the Hong Kong Stock Exchange may directly reject a listing application. In other cases, the Hong Kong Stock Exchange will request a demonstration period of compliance from the cessation of the noncompliance incidents to demonstrate that the rectification measures and enhanced internal control measures adopted are effective, and there is no financial impact on the applicant. The demonstration period would generally be required to be an audited period.

10 Disclosure and rectification of non-compliance incidents If the Hong Kong Stock Exchange determines that the non-compliance incidents do not give rise to a suitability issue, the expected level of disclosure in the prospectus on the non-compliance incidents and the need for their rectification is based on the category to which such incidents belong: Category Definition Disclosure Rectification Material Impact Noncompliances Non-compliance incidents which have had or may have in the future, a material financial or operational impact on the listing applicant. The Hong Kong Stock Exchange expects the listing applicant to disclose in its prospectus the reasons, nature and extent of the breaches, directors and senior management s involvement, consequences (such as penalties), remedies (such as enhanced internal control measures), how and when the rectification actions were taken/will be taken, and views of the directors and sponsor(s) on adequacy and effectiveness of the enhanced internal control measures. The Hong Kong Stock Exchange normally expects the rectification to be completed before a listing. While the Hong Kong Stock Exchange accepts the rectification to be completed within a short period after listing, the prospectus should disclose a legal adviser s view.

11 49 Systemic Noncompliances Non-compliance incidents which are not material impact noncompliances, but reflect negatively on the listing applicant s or its directors /senior management s ability or tendency to operate in a compliant manner. The Hong Kong Stock Exchange expects the listing applicant to disclose in its prospectus the reasons, nature and extent of the breaches, directors and senior management s involvement, consequences (such as penalties), remedies (such as enhanced internal control measures) (to the extent necessary to enable investors to make an informed assessment of the listing applicant), and the views the directors and the sponsor(s) on the adequacy and effectiveness of the internal control measures. The Hong Kong Stock Exchange does not require the rectification of any systemic non-compliance. The decision to rectify systemic non-compliances rests with the listing applicant s directors and its sponsor(s).

12 50 Immaterial Noncompliances Non-compliance incidents which are neither material impact non-compliances nor systemic noncompliances. The Hong Kong Stock Exchange does not require the disclosure of immaterial noncompliances. The Hong Kong Stock Exchange does not require the rectification of immaterial noncompliances. 4. Ownership Continuity Requirement Latest Development 4.1 Ownership continuity and control requirement and definition of controlling shareholder Rule 8.05(1)(c) of the Listing Rules provides that in order to meet the profit test, a listing applicant must have an adequate trading record under substantially the same management and ownership. This means that a listing applicant or its group must, amongst other criteria, have ownership continuity and control for at least the most recent audited financial year. Ownership continuity and control means the continuous ownership and control of the voting rights attaching to the shares by a controlling shareholder, or where there is no controlling shareholder, a single largest shareholder. The Hong Kong Stock Exchange considers the ownership continuity requirement to be important due to the high probability that dominating shareholder or shareholder groups can exert substantial influence on the management of a group seeking listing during the track record period. Furthermore, such requirement would help prevent listing applicants from packaging their business to meet the profit record requirement. In the context of new listings, controlling shareholder(s) means any person who is or group of persons who are together (i) entitled to exercise or control the exercise of 30% or more of the voting power at general meetings of the listing applicant; or (ii) in a position to control the composition of a majority of the board of directors of the listing applicant.

13 Hong Kong Stock Exchange s recent clarifications While the process of identifying the controlling shareholder(s) of a listing applicant is a casespecific exercise and depends on the facts and circumstances of each case, the Guidance Letter GL89-16 recently issued by the Hong Kong Stock Exchange in November 2016 provides listing applicants with some guidance on how the Hong Kong Stock Exchange interprets the definition of controlling shareholders(s) under different ownership structures. As regards the ownership continuity requirement, the Hong Kong Stock Exchange has clarified its practice regarding the period within which ownership continuity is required and the detailed requirements under different situations, which may be summarized as follows: (i) The period within which ownership continuity is required: The Hong Kong Stock Exchange makes it clear that a listing applicant must demonstrate ownership continuity for at least the most recent financial year up until the time immediately before the offering and/or placing becomes unconditional (the Relevant Period ). (ii) Detailed requirements under different situations:

14 52 Situation Detailed requirements Generally for at least the Relevant Period, there has been no change to any controlling shareholder(s) identified at the beginning of the most recent financial year A listing applicant with a group of controlling shareholders holding their interests directly in the listing applicant A listing applicant with a group of controlling shareholders holding their interests indirectly in the listing applicant (such as through a SPV(Note)) The shareholders constituting such group of controlling shareholders must not change (i.e., no addition or departure of shareholders) There must be no material changes in the voting interests in the listing applicant held by each shareholder constituting such group of controlling shareholders Such group of controlling shareholders together remains a group of controlling shareholders of the listing applicant and there are no new controlling shareholders The shareholders constituting such group of controlling shareholders must not change (i.e., no addition or departure of shareholders) There must be no material changes in the voting interests in the SPV held by each shareholder of the SPV The SPV remains a controlling shareholder of the listing applicant and there are no new controlling shareholders Note: The Hong Kong Stock Exchange presumes ALL shareholders of the SPV (being a common investment holding company)(including those holding less than 50% of the shareholding in the SPV) to be a group of controlling shareholders of the listing applicant, unless there is an acceptable rebuttal of such presumption.

15 53 The detailed requirements imposed by the Hong Kong Stock Exchange make it more difficult for listing applicants to satisfy the ownership continuity requirement, because any addition or departure of shareholders to or from the group of controlling shareholders would break the ownership continuity. It also remains to be seen what change will constitute a material change in the voting rights held by a member of such group of controlling shareholders, as the Hong Kong Stock Exchange was silent on this point in the new guidance letter. 5. Avoiding Use of Marketing Language in Prospectuses One of the general principles of the Listing Rules is that potential investors are given sufficient information to enable them to make a properly informed assessment of a listing applicant. To support this general principle, the Listing Rules require that information contained in a listing document (such as a prospectus) should be clearly presented in plain language. The Hong Kong Stock Exchange issued the Guide on Producing Simplified Listing Documents relating to Equity Securities for New Applications (the Guide ) in February 2016 to reinforce the importance of a clear, concise and plain-language listing document. Under the Guide, the Hong Kong Stock Exchange lists specific DOs and DON Ts when drafting a prospectus, and one of the DON Ts is avoiding marketing language. Avoid marketing language means to avoid statements that are included in the prospectus solely for marketing purpose. The prospectus is the most important document of a listing applicant. The prospectus presents material information,

16 54 including but not limited to the business and financial information of the listing applicant to the investors. In order to attract potential investors and benefit the stock selling, the listing applicant and its underwriter may at times draft the prospectus in fancy and attractive language instead of in a matter-of-fact and routine tone. However, the Hong Kong Stock Exchange is of the view that listing documents are legal documents and not merely marketing documents. The Hong Kong Stock Exchange will require removal of statements which do not give a fair, unbiased, balanced and factually supported view of an applicant s business. The Hong Kong Stock Exchange has provided the following two examples of marketing language which should be avoided in the listing document: largest domestic fashion sportswear brand by revenue The Listing Committee had previously requested a listing applicant to remove a reference that it was the largest domestic fashion sportswear brand by revenue on the basis the fashion sportswear market was itself a relatively small segment of the retail clothing market and a hybrid of the sportswear market. The statement may give a misleading impression on the size of the applicant. the second largest retailer by number of stores in Northwestern China Source: Listing Document Simplification Guide issued by the Hong Kong Stock Exchange in March 2016 A company claimed itself to be the second largest retailer by number of stores in Northwestern China, as defined by the industry consultant, in its listing document. The defined Northwestern China areas were quite different from the commonly accepted understanding of northwestern China. The

17 55 company failed to give any context as to how such ranking was calculated and it in fact had no presence in three out of the five provinces comprising Northwestern China. Also, 70% of the company s stores were located in, and sales were derived from, one city in one of the provinces typically comprising Northwestern China. The Listing Committee was of the view that this statement gave misleading information on the size of the company. Listing applicants are reminded that their directors are individually and collectively responsible for the contents of the prospectus and are required to confirm that the information contained in the prospectus is accurate and complete in all material respects and not misleading or deceptive. As such, a balance should be struck carefully between the desire for attractive language and the need for fair and unbiased statements in a prospectus. Troutman Sanders 34/F Two Exchange Square, 8 Connaught Place, Central, Hong Kong Tel: Fax: Website: Allen Shyu allen.shyu@troutmansanders.com Tel: or Jason Kuo jason.kuo@troutmansanders.com Tel: Rossana Chu rossana.chu@troutmansanders.com Tel: Dennis Yeung dennis.yeung@troutmansanders.com Tel:

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