On 29 June 2018, the Stock Exchange of Hong Kong Limited ("HKEx") published the Consultation Paper on Backdoor Listing, Continuing Listing Criteria and other Rule Amendments (the "Consultation Paper") to address concerns about backdoor listing and shell company creation/trading activities by tightening the Main Board Listing Rules and the GEM Listing Rules (the "Listing Rules") regarding reverse takeovers ("RTOs"), extreme transactions, and the continuing listing criteria.
In recent years, due to the demand for shell companies for backdoor listings on HKEx, the value of a listing status on HKEx (the "Exchange") has substantially increased. HKEx noted that there has been a trend towards shell creation activities involving listing of new applicants whose sizes and prospects do not appear to justify the cost or purpose associated with a public listing. Meanwhile, some listed issuers with failed businesses would attempt to maintain their listing status by establishing new businesses that have a low entry barrier and/or can be easily established or discontinued.
HKEx considers that these activities invite speculative trading and may lead to opportunities for market manipulation and insider trading, and may undermine investor confidence and the overall quality of the Hong Kong market. In light of the above, HKEx has published the Consultation Paper to propose certain amendments to the Listing Rules on backdoor listing and continuing listing criteria. We summarized the most important proposed amendments to the Listing Rules as follows.
Major Proposed Amendments to the Listing Rules
- The present principle-based test and the six assessment criteria set out in Guidance Letter GL78-14 will be codified in the Listing Rules with the following modifications:
- One of the current criteria "issue of restricted convertible securities" will be extended to include any change in control (as defined in the Hong Kong Code on Takeovers and Mergers) or de facto control of the listed issuer; and
- The "series of arrangements" criterion will be clarified to mean any transactions and/or arrangements that are in reasonable proximity (normally within a three-year period) or are otherwise related, and it would no longer be required for the proposed (last) transaction to be an acquisition in order for the Listing Rules in relation to RTOs to be triggered.
- The bright line tests under Main Board Rule 14.06(6) / GEM Rule 19.06(6) will be retained and the aggregation period in Main Board Rules 14.06(6), 14.92 and 14.93 / GEM Rules 19.06(6), 19.91 and 19.92 will be extended from 24 months to 36 months.
- A restriction on any material disposal (or a material disposal by way of distribution in specie) of a listed issuer’s existing business (i) when there is a proposed or intended change in control of the listed issuer (other than at the level of its subsidiaries) or (ii) within 36 months after a change in control would be imposed, unless (i) the listed issuer's remaining business or (ii) the asset(s) acquired from the new controlling shareholder (and his/her/its associates) and any other person(s), would meet the new listing requirements under Main Board Rule 8.05 (or 8.05A or 8.05B) / GEM Rule 11.12A (or 11.14). HKEx will have discretion to apply the above restriction on material disposal (or material disposal by way of distribution in specie) at the time of or within 36 months after a change in the single largest substantial shareholder of the listed issuer.
- The current “extreme VSA” requirements in Guidance Letter GL78-14 will be codified and renamed as “extreme transaction”, and the following additional requirements will be imposed on extreme transactions:
- The listed issuer has been operating a principal business with substantial size (with annual revenue or total asset value of HK$1 billion or more) which will continue after the transaction; or
- The listed issuer has been under the control of a large business enterprise for a long period (normally not less than three years) and the transaction forms part of a business restructuring of the group and would not result in a change in control of the listed issuer.
- The following additional requirements applicable to RTOs and extreme transactions will be imposed:
- Both the acquisition target(s) and the enlarged group must be suitable for listing pursuant to Main Board Rule 8.04 / GEM Rule 11.06, and the acquisition target(s) must meet the requirements of Main Board Rule 8.05 (or Main Board Rule 8.05A or 8.05B) / GEM Rule 11.12A (or GEM Rule 11.14) (i.e. the track record requirements) and the enlarged group must meet all the other new listing requirements under Main Board Chapter 8 (except Main Board Rule 8.05) / GEM Chapter 11 (except GEM Rule 11.12A). For a listed issuer that does not have sufficient level of operations, each of the acquisition target(s) and the enlarged group must meet all the new listing requirements in Main Board Chapter 8 / GEM Chapter 11; and
- The applicable track record period shall normally cover the three financial years immediately prior to the issue of the circular or listing document in respect of a RTO or extreme transaction involving a series of transactions and/or arrangements.
- The current practice under Guidance Letter GL84-15 will be codified, with modifications, in that HKEx may refuse to grant listing approval for a large scale issue of new shares or convertible securities where the funds raised would be used to acquire and/or develop a new business which, in the opinion of HKEx, would be a means to circumvent the new listing requirements and to achieve a listing of new business.
Sufficiency of Operations and Assets
- The qualitative test under Main Board Rule 13.24 / GEM Rule 17.26 will be amended to require an 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.
- When considering the sufficiency of an issuer’s operations and assets under Main Board Rule 13.24 / GEM Rule 17.26, the issuer’s trading and/or investment in securities will be excluded (other than an investment company listed under Main Board Chapter 21).
- The definition of "short-dated securities" under Main Board Rule 14.82 / GEM Rule 19.82 (i.e. securities such as bonds, bills or notes which have less than 1 year to maturity) (the "cash company rules") will be extended to cover short-term investments that are readily realisable or convertible into cash, including advances to third parties. The cash company rules exemption will be confined to assets held on behalf of clients by an issuer engaging in securities brokerage business.
It is proposed that a transitional period of 12 months from the date of the amendment to the Listing Rules for the above proposals relating to sufficiency of operations and assets and cash companies would apply.
Significance of the Proposed Changes
- Discourage shell activities by limiting listed issuers’ involvement in new businesses after a change in control
The Consultation Paper sets out HKEx’s proposals to discourage activities related to the trading of, or acquisitions of, “listed shells” for backdoor listings. Under the current proposal, the aggregation period for bright line test and the restriction from material disposal will be extended from 24 months to 36 months from a change in control. The proposed modifications of the assessment criteria under the principle based test restrict listed issuers’ ability to circumvent the new listing requirements by building up a new business through a series of smaller acquisitions, or acquiring a new business and then disposing of its original business (resequencing transactions). In short, a listed issuer engaging in a business through greenfield operations coupled with acquisitions, which is different from the listed issuer's principal business before a change in control, or a business expansion which size and resources are inconsistent with that of the listed issuer, may be seen as an attempt to circumvent the new listing requirements and thus trigger the RTO rules.
- Impose additional requirements for the extreme transaction category
In assessing whether a transaction would qualify as an extreme transaction, HKEx proposes to impose two additional significant requirements. Only listed issuers with substantial business operations (with annual revenue or total asset value of HK$1 billion or more) or under the control of a large business enterprise for over three years and engaging in business restructuring may rely on the extreme transaction category to avoid the acquisition transactions from being treated as a RTO.
- Backdoor listing vs IPO
HKEx’s proposals are intended to increase the transaction costs associated with a backdoor listing. Taking into account, among other matters, the extension of the aggregation period to three years, the restrictions in engaging new business, undertaking large scale equity fundraisings and disposing/terminating of significant business, the cost in maintaining a viable and sustainable business, and the perceived premium attached to the listing status of a listed issuer, building up a track record for business/assets and then going for an IPO may instead be a more attractive option.