4 March, 2013
Legal News & Analysis – Asia Pacific – Hong Kong – Capital Markets
In addition to a number of objective listing criteria, The Stock Exchange of Hong Kong Limited (the “HKEx“) also has a broad discretion under Rule 8.04 of The Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (the “Listing Rules“) to reject applications from companies it does not believe are “suitable for listing”. As part of the listing application process, the HKEx also has a number of documentary requirements that can be difficult to comply with. Against this backdrop, set out below is a list of common issues that can impact the feasibility of conducting an IPO on the Main Board of the HKEx (in no particular order):
1. Lack of key licenses / permits
While private companies can, and often do, operate perfectly successfully for long periods of time without all necessary licenses and permits, companies hoping to go public on the HKEx are held to a higher standard. Companies should possess all applicable licenses, permits and other forms of approval that are required under applicable laws and regulations to operate their businesses. Legal counsel will be required to provide an opinion on whether a company is in possession of all of these. If not, then the HKSE may call into question the suitability of the company to list (on the basis that it has, in effect, been operating illegally). On a related note, the HKEx will also expect legal counsel to be able to confirm that shareholders in companies have complied with applicable foreign exchange laws when obtaining their shareholdings (e.g.,
2. Lack of property titles
Companies without proper title certificates for the properties they rely on in their businesses can sometimes be found unsuitable for listing by the HKEx – this depends primarily on the significance of the issue. For example, a single-project real estate developer without proper title to their sole project will almost certainly be unsuitable to list, while a company that leases several hundred properties that could be easily substituted by others if one or a small number of them were rendered unusable will likely be able to list provided that any risks are adequately disclosed.
3. Tax, housing and social insurance liabilities
The HKEx requires companies with operations in the PRC to obtain confirmations from tax authorities stating (i) the tax rates that apply to the company and (ii) whether the company has settled all outstanding tax liabilities. Legal counsel is also required to opine on whether all housing, social insurance and other benefits have been paid to the company’s employees. For companies with irregularities in their historical tax or social benefits payments, obtaining the relevant confirmations or a “clean” legal opinion can be problematic and may necessitate payment of historical unpaid liabilities (which in some cases may be significant and weigh against the financial appeal of an IPO).
4. Management continuity
Under the Listing Rules, companies must have a minimum three-year operating track record under substantially the same management. This is normally interpreted to mean that at least a majority of the directors and senior management team of the company and any key operating subsidiaries must have been in place for the three financial years prior to IPO. Companies with significant management changes may therefore be unsuitable for listing. Investors considering taking stakes in companies planning IPOs in the near future will need to balance any nomination / appointment rights against the need to maintain overall management continuity.
5. Undue reliance on a parent
Companies need to be able to operate independently from any parent entities. Loans from, or guarantees provided by, parent entities must be repaid or released prior to IPO – which for companies without robust credit ratings or the ability to obtain stand-alone financing can be difficult to implement. Companies must also not rely excessively on either revenues from their parent or purchases of key supplies from their parent. Any board and senior management overlap should be kept to a minimum.
6. Connected transactions
Transactions between listed companies and “connected persons” (directors, CEO, shareholders holding 10% or more of the voting rights of the company or any of its subsidiaries, and various associated parties of such persons), are heavily regulated in Hong Kong and must (among other things) be on terms that an IPO sponsor is able to confirm as being arms-length normal commercial terms that are in the best interests of all shareholders of the company. Ongoing transactions above certain monetary thresholds must also be subject to renewal every three years, which is in turn subject to approval from uninterested shareholders. The need to reconfigure or revise key connected transactions to conform to Listing Rules requirements can give counterparties significant influence over the timing of an IPO, and may also fundamentally alter the economics of the transactions.
7. Historical instances of non-compliance
While it is not uncommon for companies to have minor instances of non-compliance with laws or regulations (for example, commencing operations or construction of a building prior to obtaining a particular license or permit), any significant instances of non-compliance, especially those that may call into question the credibility or ethics of management, can potentially prevent or delay an IPO (and, at a minimum, will necessitate detailed and unsightly disclosure in the company’s prospectus). For example, companies that have engaged in non-compliant bill financing are routinely subjected to a one-year delay to their listing applications.
8. VIE arrangements
The HKEx does not allow companies to list if they use VIE (or contractual) arrangements to own and operate businesses that are not “restricted” under the MOFCOM catalogue or other applicable foreign investment laws. Any businesses that can be legally owned by foreign-invested entities should be restructured accordingly – which may not always be practicable and could also involve significant friction costs.
9. Adverse publicity
The HKEx will, as a matter of course, perform a review of publicly available information of companies, their shareholders and management and raise questions on any adverse rumours, allegations or information they uncover. Furthermore, it is also common for anonymous complaint letters to be sent to the HKEx alleging irregularities. While this is largely unavoidable, companies and their advisers need to be mindful of any adverse rumours or allegations that have been publicly circulated and be well-prepared to address any queries raised by the HKEx or
10. Third party diligence
The HKEx and the Securities and Futures Commission impose a requirement on IPO sponsors to conduct due diligence meetings with third parties such as customers, suppliers and finance providers with a view to obtaining a well-rounded view of the sustainability and soundness of the company’s business. Companies will inevitably be required to help facilitate these meetings, which the third parties may not be receptive to participating in, and should expect IPO sponsors and their legal counsel to conduct a robust level of diligence to uncover any potential issues (especially those that may call into question the genuineness of revenues). If diligence meetings cannot be arranged, in the absence of a reasonable justification prudent IPO sponsors may query the reliability of information provided by company management and be unable to make required confirmations to the HKEx.
11. FCPA / bribery issues
It goes without saying that bribery is a crime and companies that have relied on crime to grow their businesses are likely to be found unsuitable for listing. It is important that companies (and investors considering making investments into companies that are considering an IPO in the near future) hire legal counsel with deep experience in the Foreign Corrupt Practices Act and other anti-bribery laws to ensure that satisfactory diligence is done to identify any issues and consider what measures might be adopted to mitigate any risks – if the illegal behaviour was relatively minor, conducted by a rogue former employee, and the company has adopted effective measures to ensure that no further instances occur, then the HKEx may nevertheless allow a company to list.
12. Pre-IPO investments
A perennial issue on IPOs. Companies raising capital in advance of an IPO by bringing on board pre-IPO investors need to keep in mind that the HKEx has a relatively developed set of guidelines relating to pre-IPO investments. These guidelines relate to matters such as the time periods during which investments may be made and the terms in pre-IPO investment agreements that the HKEx will expect to expire upon IPO. Failure to properly consider the HKEx’s guidelines at the time an investment is made may necessitate amendment to the terms closer to the time of IPO – and if those amendments takes place after the date falling 28 clear business days prior to filing of a listing application, the HKEx will require the company to wait at least 180 days until it can proceed with its IPO. Hiring legal counsel experienced in HKEx practice is therefore fundamental for any company or investor contemplating an investment in advance of a subsequent HK IPO.
As the saying goes, you can only play the hand of cards you’ve been dealt – and every company hoping to list on the HKEx will have in its hand one or more of the issues outlined above (and very likely many others). Experienced legal counsel will, however, be able to work with companies to identify any issues and help navigate through them in the most efficient manner possible. In some cases, the most efficient course of action may involve a significant restructuring of the company or other actions that may delay a proposed IPO timetable, so companies with a future IPO in mind would be wise to commence a dialogue with legal counsel well in advance of the formal “kick-off” of the listing application process.
