Reverse Takeover Trends in Hong Kong
The recent increased activity in the sale and purchase of controlling stake in shell companies (i.e. listed companies that no longer have material business operations or assets) has contributed to their price surge. Some, if not most, of these purchasers would, sooner or later, inject their own assets to the acquired shell company. In doing so, they must beware of the reverse takeover rules promulgated by the Hong Kong Stock Exchange (HKEx).
Reverse takeover, sometimes referred to as backdoor listing, represents an attempt to list assets or businesses while circumventing the new listing requirements. Regulators have expressed their concerns on the quality of the assets or businesses involved, which may not meet the listing requirements. The reverse takeover rules aim to protect the investors by applying the new listing requirements to backdoor listings (i.e. full due diligence by sponsors and full and quality disclosure of information in their listing documents). In addition, the new listing must be approved by the Listing Committee of HKEx for main board companies (or the Listing Division of HKEx for GEM companies) which will decide that the enlarged group meets all listing requirements and the assets to be acquired meet the trading record requirement before the transaction can proceed. As new listing usually comes with higher degree of uncertainty, longer closing timetable and higher costs, business owners are tempted by alternative ways to inject their business into listed companies without triggering the new listing requirements.
HKEx’s policy on reverse takeover aims to strike a balance between allowing legitimate business expansions through acquisitions without imposing unnecessary burden and the need to maintain market quality, which would be downgraded by the backdoor listing of inferior assets. Under the current reverse takeovers rules, HKEx applies two tests, namely the “bright line test” and the “principle based test”, to determine whether an acquisition should be regarded as a reverse takeover or not.
Bright Line Test
Under the bright line test, a transaction will be considered as a reverse takeover if it meets any of the criteria below:
- the acquisition or series of acquisition constitutes a very substantial acquisition involving a change of control of the listed company;
- the acquisition or series of acquisition from the incoming shareholder or his associates within 24 months of the incoming shareholder gaining control, either individually or together constitute a very substantial acquisition.
The terms “very substantial acquisition” refer to an acquisition or a series of acquisitions of assets by a listed company where the percentage ratio resulting from any of the five test indicators (i.e. assets, revenue, consideration, profits and equity capital) is 100% or more (as defined under Chapter 14 of the Main Board listing rules and Chapter 19 of the GEM listing rules), whereas “control” normally refers to the holding of 30% or more of the voting rights in the listed company.
If an acquisition falls within any of the two situations above, it will be regarded as a reverse takeover and subject to its rules, unless a waiver is granted by HKEx. For example, in the listing decision LD-59-2013, HKEx granted a waiver to a listed company even though its acquisition of a number of patents was caught by the bright line test, and treated it as a very substantial acquisition instead of a reverse takeover on the basis that the acquisition was related to the principal business of the listed company and not motivated by the circumvention of the new listing requirements.
To discourage business owners to defer the disposal of existing business until the asset are injected in the listed company, hence avoiding the classification as being a very substantial acquisition, the listing rules further provide that a listed company may not dispose of its existing business for a period of 24 months after a change in control unless the assets acquired after the change in control can meet the trading record for a new listing.
However, this doesn’t prevent certain companies from planning around the bright line test and structure their backdoor listing accordingly. For example, incoming shareholders who intend to circumvent the bright line test may hold off injecting material assets until after the 24-month period expires. The parties may also structure an acquisition where the listed company issues highly dilutive convertible securities with a conversion restriction avoiding triggering a change of control. In case the listed company raises fund for the purpose of subsequent acquisition, there is also a possible implication on whether the listed company will be treated as a cash company (i.e. its assets consist entirely or largely of cash or short dated securities) and if so, it may lead to the listed company not being regarded as fit for listing and trading in its securities being suspended (for example in Listing Decision LD95-1).
Principle Based Test
The principle based test is a complementary test developed by HKEx to address the shortcomings of the bright line test. The principle based test empowers HKEx to give an opinion on whether an acquisition is an attempt to achieve a listing of assets to be acquired and a means to circumvent the new listing requirements or not. HKEx will take into account the following factors to draw its conclusion:
- size of the acquisition compared to the size of the listed company;
- quality of the acquired business (i.e. whether it can meet the trading record requirements for listings, or whether it is unsuitable for listing);
- nature and scale of the listed company’s business before the acquisition;
- any fundamental alterations to the listed company’s principal business;
- any other events and transactions which, coupled with the acquisition, form a series of arrangements designed to circumvent the reverse takeovers rules; and
- whether the listed company issues any highly dilutive convertible securities with a conversion restriction mechanism that doesn’t trigger a change of control while providing the vendor with de facto control of the listed company.
When HKEx considers an acquisition (or a series of acquisitions) to be “extreme” based on the above factors, the case will be passed to the Listing Committee who will then decide whether such acquisition(s) should be considered as reverse takeover or an extreme “very substantial acquisition”. The Listing Committee is likely to treat such acquisitions as extreme “very substantial acquisition” (instead of reverse takeover) if the assets to be acquired can meet the minimum profit requirement under the listing rules, hence making the circumvention of new listing requirements immaterial.
If the Listing Committee concludes the acquisition is:
- a reverse takeover, the listed company will be treated as if it were a new listing applicant and will be subject to all applicable listing requirements for new applicants;
- an extreme “very substantial acquisition”, the listed company will be required to prepare a transaction circular under an enhanced disclosure and vetting approach, and to appoint a financial adviser to conduct due diligence akin to the new listing requirements.
In either case, the acquisition is also conditional upon the listed company’s shareholders’ approval in general meeting.
Under the principle based test, it is not necessary to invoke any change of control of the listed company before any acquisition(s) is(/are) treated as reverse takeover. In one of our recent projects on a proposed very substantial acquisition that passed the bright line test, HKEx is prepared to treat the acquisition as a reverse takeover under the principal based test, on the ground that:
- there is a change in de facto control in the listed company as the vendor would become the single largest shareholder and its interest will exceed 30% upon full conversion of the convertible securities held;
- neither the target assets nor the enlarged group after acquisition can meet the track record requirements;
- the target assets are not suitable for listing because the viability and sustainability of the business model are not robust;
- the acquisition may lead to a fundamental change in the listed company’s principal business; and
- the size of acquisition is significant to the listed company.
If the factors above and listing decisions published by HKEx provide insight on whether an acquisition will be caught by the reverse takeover rules, the underlying subjectivity of the principle based test enables HKEx to judge on a case-by-case basis, which means that any material acquisitions, in particular those involving the change in the principal business of the listed company, may be caught. Therefore it is prudent to seek guidance from HKEx before finalising the structure of any material acquisition that may constitute a reverse takeover, and avoid incurring unnecessary costs and time.