Jurisdiction - Hong Kong
Reports and Analysis
Hong Kong – Legal And Regulatory Issues In PIPE Transactions.

13 August, 2012

 
 
Introduction
 
Private investment in public equity (or PIPE) transactions are an increasingly common source of funding for companies listed on The Stock Exchange of Hong Kong Limited (the HKEx). For listed issuers, PIPEs are filling a gap created by the unavailability of traditional funding sources in the current economic climate and a disinclination to issue new common shares at prices below their perceived value. For investors, PIPEs offer the opportunity to invest in a structured manner in companies that are already public with an established trading market for their equity, a combination that may compare favorably to pre-IPO investments in companies whose prospective IPOs may not occur in a timely manner or at all. This memorandum highlights some of the key features and issues in structuring and executing PIPE transactions for companies listed on the HKEx.
 
Structural and Relevant Considerations
 
Structuring Alternatives. The range of securities that may be issued in Hong Kong PIPEs is quite broad, and includes:
 
  • ordinary shares;
  • convertible preference shares;
  • convertible bonds;
  • convertible notes;
  • warrants; or
  • a combination of any of the foregoing.
 
Moreover, PIPE transactions can be structured to provide investors with rights and protections typically not enjoyed by individual holders of a listed company’s shares, such as veto powers over corporate actions, board representation or observer rights, antidilution protection (both weighted average and full ratchet) and performance ratchets. This flexibility available to investors stands in stark contrast to pre-IPO investments, where HKEx policies and practice generally mandate that any special investor rights terminate upon completion of an IPO.
 
The specific terms of any PIPE investment, including the purchase price and any lockup period or dealing restrictions, are a matter for negotiation between the company and the investors and, as one might expect, are driven by the relative bargaining power of the parties. See “Recent Trends” below for a discussion of some of the trends in recent PIPE transactions and the attached summary table highlighting the principal terms of PIPE transactions since the beginning of 2012.
 
Timing.
 
The timing required to complete a PIPE depends primarily on whether the deal falls within an existing “general mandate” from a company’s shareholders to issue new securities or requires a special mandate to be obtained from the shareholders. Generally, if a PIPE can be structured to fit within an existing general mandate a transaction can be completed from within several days to a few weeks, depending on the extent of negotiation. If a meeting of shareholders is required to approve a special mandate, the process will take longer, as the company will be required to give 10 clear business days’ notice as mandated by the Corporate Governance Code set out in The Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (the Listing Rules) or any longer notice period as may be provided in its constitutive document or by the laws of the country in which it is incorporated. To address potential insider dealing concerns (further discussed below), a company also may need to make a public announcement of operational or financial information prior to entering into a PIPE if that information is material in nature and has been provided to investors but has not been disclosed previously to the public.
 
Shareholder Approval.
 
PIPEs involve the issue of new equity or securities convertible into equity, and the company will need to ensure that it is authorized by its shareholders to issue that equity 
— either through a general mandate or a specific mandate. Most HKEx-listed companies will, as a matter of course, obtain a general mandate from shareholders each year at their annual general meeting to issue additional equity during the course of the following year. The standard regulatory requirements for a general mandate include that:
 
  • the company only may issue securities representing up to a maximum of (a) 20 percent of its existing issued share capital on a fully diluted basis, plus (b) the number of securities repurchased by it since the granting of the general mandate (the amount repurchased is restricted to a maximum of 10 percent of its existing issued share capital);
  • the securities may be issued at a discount of no more than 20 percent to the higher of (a) the closing price of the company’s securities on the date the agreement to issue the securities is signed and (b) the average closing price for the five trading days immediately prior to the date of the announcement of the issue of securities, the date of the agreement or the date on which the issue of securities or subscription price is fixed, whichever is the earlier; (A deeper discount is possible in the limited circumstances where the company can convince the HKEx that it is in significant financial distress and the issue of securities is the only means of remedying its financial position)and
  • no securities be issued to any “connected person” of the issuer except as part of a pro rata issuance of securities to all shareholders or pursuant to a previously endorsed share option scheme (see “Connected Transactions” below for further discussion).
 
If a PIPE is conducted under a general mandate, any conversion price adjustments will be subject to the 20 percent discount restriction, calculated in aggregate with any discounts initially given at the time of issue or conversion. In other words, even if the company subsequently conducts a dilutive equity issuance that lowers the conversion price of the PIPE security, the benchmark price from which the maximum discount is calculated will remain the same.
 
PIPEs that are not structured to fall within a general mandate must be conducted pursuant to a special mandate granted by the company’s shareholders. A circular containing all relevant material information relating to the PIPE transaction, including a description of the principal terms of the transaction, will need to be dispatched to the shareholders at the same time as, or prior to, the notice of meeting being given.
 
Due Diligence / Insider Dealing.
 
Few potential PIPE investors will be willing to proceed with an investment based solely on a review of publicly available information and will want to conduct due diligence on the company. This may include meeting with company management and a review of key documents with a view to (a) learning about recent developments in the company’s business and financial position and (b) uncovering any matters that may impact the decision to proceed with a deal. The insider dealing provisions of the Securities and Futures Ordinance (the SFO), as well as the securities laws of other jurisdictions, may restrict the ability of an investor to purchase or sell securities of a company in circumstances where it is in possession of material non-public information (or MNPI) about that company. In Hong Kong, if the diligence process elicits MNPI from the company or its management, entry into a transaction on the basis of that information, in and of itself, is likely to breach the insider dealing provisions of the SFO and could subject both the company and the investorto civil and criminal sanctions. To mitigate these risks, the company typically will require potential investors to enter into a confidentiality agreement that restricts disclosure of MNPI to third parties other than advisers and trading in the company’s securities while the investors are in possession of MNPI. To the extent that MNPI is disclosed during the diligence process, the company must make a public announcement of that information prior to entering into any agreement with a PIPE investor. In light of this, and as listed companies often are reluctant to provide updates to the market outside of their usual reporting timetables, PIPE transactions often are effected during the period shortly after a company’s scheduled release of annual or interim results.
 

Similarly, a PIPE investor may have board appointment, board observer or ongoing information provision rights that result in it coming into possession of MNPI from time to time (such as in the period leading up to the publication of annual or interim results). Possession of such information by an investor or its associated persons may restrict the investor and its associated persons from trading in any securities or derivatives of the company or its related companies. PIPE investors therefore need to give careful consideration to balancing the protection afforded by these rights against the flexibility to convert, trade in or exit an investment at any time.

 

Takeovers Code Mandatory General Offer Considerations.

 
Under Hong Kong’s Takeovers Code, the acquisition by any person or group of persons acting in concert of 30 percent or more of the voting rights of a Hong Kong public company, whether through a one-off transaction or a series of transactions, will trigger an obligation on the part of such person or persons to make an offer to all shareholders of the company to acquire their shares. Furthermore, any person or persons acting in concert holding between 30 percent and 50 percent of the voting rights that acquire an additional 2 percent also will trigger a mandatory general offer obligation (It should be highlighted that these percentages relate to actual voting equity held. Consequently, any convertible securities or warrants will not count towards these percentages until such time as they are converted into securities carrying voting rights).
 
Waivers may be granted by the Executive of the Securities and Futures Commission (SFC) in certain prescribed circumstances, including, for example, where independent shareholders have approved a cash subscription by an investor (commonly referred to as a “whitewash waiver”) or where the listed issuer is in serious financial distress that renders it impractical for independent shareholders to vote to approve the issue, but these waivers need to be obtained prior to any acquisition of shares. 
 
Consequently, an investor that potentially will hold 30 percent or more of the issued share capital of a company and does not want to make a general offer should either (a) make the transaction conditional upon the company obtaining a whitewash waiver or (b) where convertibles or warrants have been acquired, exercise or convert them in multiple tranches so that they do not hold 30 percent of the voting rights at any given point in time.
 
Board Considerations.
 
As noted earlier, it is common to see certain minority or special rights provided to investors in PIPE transactions. Directors of HKEx-listed companies have fiduciary duties to act honestly and in good faith in the interests of the company as a whole. In negotiating, considering and approving any minority and special rights, such as board seat rights, senior management nomination rights, veto rights, anti-dilution and pre-emptive rights, it is important that the directors weigh these rights against those of existing shareholders and satisfy themselves that the relevant terms of the PIPE transaction are in the best interests of the company as a whole.
 
Public Float Requirement.
 
To ensure that there is an open market for listed securities, the HKEx normally requires that at least 25 percent of a company’s total issued share capital be held by the public, unless the HKEx has exercised its discretion to accept a lower percentage at the time of the company’s public listing (The discretion is exercised only for companies with market capitalizations in excess of HK$10 billion at the time of listing). Any shareholdings of a “connected person” — a definition that includes any shareholder entitled to exercise 10 percent or more of the votes at a general meeting, the CEO and directors of a company, and any entities that such persons or their family members control 30 percent or more of the voting rights of, or any person who is accustomed to taking instructions from, or whose acquisition has been directly or indirectly financed by, a connected person — will not count towards a company’s public float. The acquisition by PIPE investor of 10 percent or more of the voting rights of a company with a low public float prior to the investment could therefore result in the company ceasing to meet the public float requirement. Where the public float requirement has been breached, the HKEx has the right (which it routinely exercises) to suspend trading of the securities pending remedial action by the company, resulting in an adverse or undesirable impact on the relevant securities and the ability of shareholders to trade in their shares.
 
Third Party Approvals and Consents.
 
In addition to corporate approvals, investors and companies also will need to ensure that any other required government approvals or waivers and third party consents are obtained. For example, listed companies incorporated in the People’s Republic of China may need to obtain the prior approvals of the China Securities Regulatory Commission and other government authorities prior to any issue of shares or consummation of a PIPE transaction. Obtaining any required approvals may be time consuming. Moreover, the consent of other third parties, such as creditors or other stakeholders, may be required.
 
Connected Transactions.
 
A PIPE transaction entered into between a listed company and a connected person generally is subject to the rules applicable to “connected transactions” under the Listing Rules. These rules mandate reporting, announcement and independent shareholders’ approval of such transactions, depending on the size and nature of the transaction. Subject to certain limited exceptions that will not apply to PIPE transactions, an issue of securities to a connected person will require approval from disinterested shareholders in general meeting. On the other hand, if a connected person (such as a controlling shareholder) merely is providing a guarantee or form of security over its shares in the listed company or its own assets (and not over the assets of the listed company) as part of a PIPE transaction, an exemption from the connected transactions rules typically will apply.
 
Where a PIPE investor becomes a connected person upon the completion of the PIPE transaction (by reason of it holding 10 percent or more of the voting rights), any subsequent business dealings between the PIPE investor and the company will be subject to the reporting, announcement and independent shareholders’ approval requirements applicable to connected party transactions.
 
Disclosure of Interests.
 
Any PIPE investor holding 5 percent or more interest in the share capital of a listed company will be required to disclose its interest in a form submitted to the HKEx and SFC. The information on these forms will become available publicly for inspection via the HKEx’s website. The calculation of the percentage interest held must include any underlying shares that may be issued pursuant to any “equity derivatives,” a category into which convertible securities or notes typically will fall. Any subsequent changes in the nature of the investor’s holding or changes in the level of interest crossing a whole percentage (or falling below 5 percent), unless exempted under the SFO, will be subject to further disclosure requirements.
 
Listing of Securities.
 
A listing application must be filed by a listed company with the HKEx for
the listing of, and permission to deal in, the relevant securities at least four business days before the proposed date of issuing the securities. In order to enable PIPE investors to freely convert, exercise or trade in their investment, it typically is a condition to closing a PIPE transaction that the company obtains the listing approval for any securities that may be issued pursuant to a PIPE transaction.
 
Recent Trends
 
PIPE transactions come in various forms and the considerations taken into account for one deal may be starkly different to another (for example, when investing in a high-growth technology company as opposed to a more mature utility company). With that in mind, we have reviewed the PIPE transactions entered into so far this year and note some of the following trends, many of which perhaps evidence a lack of conviction about the economic climate and prospects for growth:
 
  • more PIPE transactions took the form of convertible securities (generally with terms from one to five years) than share subscriptions, with five transactions involving a combination of both convertible securities and shares;
  • the types of investors investing in the PIPE transactions represented a balanced mix of investors, with nine transactions involving corporate investors (three of which are themselves listed companies), five involving individual  investors (most of whom invested through an investment vehicle and were connected persons of the listed issuer) and seven involving private equity investment firms (one of those a sovereign wealth fund);
  • there were a number of relatively small scale PIPE investments representing an initial investment of less than HK$50 million, which evidences that PIPE transactions have attracted both large and small scale investors alike;
  • certain governance and special investor rights such as veto rights, pre-emptive rights, anti-dilution rights and director, committee member and senior management nomination rights, are less prevalent than in previous years, even for investments involving the acquisition of a substantial stake in the company. However, information access rights, negative pledges and covenants not to issue securities, price adjustment mechanisms and redemption rights remain relatively common;
  • lock-up periods within which investors are restricted from dealing in the relevant securities are rare, with only one PIPE transaction involving a lock-up period (of six months); 
  • conversion prices for the majority of convertible securities have stayed within a single digit or relatively low double-digit premium to the latest market price, with only a few involving premiums greater than 50 percent;
  • some tailored conversion price determination and reset mechanisms linked to financial performance metrics and target volume weighted average share prices have been adopted in some cases; and 
  • one transaction was structured as an investment in both a listed company and a subsidiary that was proposed to be spun-off at a future date. A summary table of some of the major terms of PIPE transactions in 2012 appears on the following pages.
 
For a summary table for PIPE Transactions in Hong Kong Since January 2012, please click here.

 

 

For further information, please contact:

 

Christopher W. Betts, Partner, Skadden
 
Ivy Wong, Partner, Skadden
 
Alec P. Tracy, Partner, Skadden
 

Edward Lam, Partner, Skadden

 

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