Introduction

2016 is another active year for the acquisitions, disposals and restructurings of shell companies listed on The Stock Exchange of Hong Kong Limited (HKSE). Market participants appear to have gradually become accustomed to the requirements published by the HKSE in guidance letter HKEx-GL78-14 (May 2014) which clarifies the requirements for triggering a reverse takeover (RTO) and extreme very substantial acquisition (Extreme VSA), and guidance letter HKEx- GL84-15 (December 2015) which clarifies the cash company rules for issuers engaging in large scale fundraising activities.

As the size of a shell company is typically very small and a common feature of these transactions is that the shell company will proceed to operate a new business which is substantially larger than the original business, a key issue in structuring transactions involving shell companies is to consider whether the proposed transaction will trigger the principles set out in the two guidance letters, as well as the requirement that an issuer must have a sufficient level of operations or assets to warrant the continued listing of its securities under Main Board Listing Rule 13.24 or GEM Listing Rule 17.26. In 2016, the HKSE published a series of listing decisions to illustrate how it would apply these principles in practice. This article discusses the implication of the guidance letters and the relevant listing decisions as well as their impact on structuring a transaction of this nature.

Guidance Letter HKEx-GL78-14 (the RTO Guidance Letter)

Definition of RTO and Extreme VSA

The RTO Guidance Letter explains that under Main Board Listing Rule 14.06(6) and GEM Listing Rule 19.06(6), there are two applicable tests to determine whether an acquisition constitutes an RTO, namely the “principle based test” and the “bright line tests”. Under the principle based test, an RTO refers to an acquisition or a series of acquisitions of assets which, in the opinion of the HKSE, constitutes an attempt to achieve listing of the assets to be acquired and a means to circumvent the listing requirements for new listing applicants. The words in italics indicate that the principle based test involves an application of judgment by the HKSE rooted on the principle that RTO rules are anti-avoidance provisions designed to prevent circumvention of the new listing requirements. On the other hand, the bright line tests have two limbs and triggering either of them will give rise to an RTO — (i) an acquisition (or a series of acquisitions) which constitutes a very substantial acquisition1 where there is or which will result in a change in control of the issuer; or (ii) an acquisition (or acquisitions) from the incoming shareholder or his associate(s) within 24 months of the incoming shareholder gaining control, which individually or together constitute a very substantial acquisition. The term “control”, as defined in the Takeovers Code, means a holding, or aggregate holdings, of 30% or more of the voting rights of a company, irrespective of whether that holding or holdings gives de facto control.

Prior to the publication of the RTO Guidance Letter and perhaps due to the lack of guidance on the principle based test, there was a tendency by certain market participants to treat the bright line tests as the defining benchmarks for RTOs. Before, it was not uncommon to have the confusion that where there is no change of control, a proposed transaction will not be treated as an RTO. Subsequent to the publication of the RTO Guidance Letter, it is now clear that a transaction may be treated as an RTO under the principle based test even if it falls outside either of the two limbs of the bright line tests. The flowchart below sets forth the correct thinking process in considering whether the RTO rules apply.

To recap, where a proposed transaction falls outside the bright line tests but is treated as “extreme” under the principle based test, and the injected assets do not meet new listing requirements,2 the proposed transaction will be treated as an RTO. If, however, the injected assets can satisfy the new listing requirements, the proposed transaction will be treated as an Extreme VSA and presented to the Listing Committee to further resolve whether the RTO rules apply. If the Listing Committee decides that the RTO rules do not apply, it will require the issuer to prepare a shareholders’ circular under an enhanced disclosure and vetting regime and appoint a financial adviser to conduct due diligence on the acquisition. The extent of the financial adviser’s work and scope of the due diligence should be referenced to Practice Note 21 to the Main Board Listing Rules or Practice Note 2 to the GEM Listing Rules. In undertaking that due diligence, the financial adviser is expected to refer to the procedures that sponsors would typically perform.

The RTO Guidance Letter states that where a very substantial acquisition is not considered to be an RTO but amounts to a material change to the issuer’s business, management and/or mode of operations, the issuer may nevertheless be required to prepare a shareholders’ circular under an enhanced disclosure and vetting regime but without the need to appoint a financial adviser to conduct additional due diligence. In short, the enhanced disclosure and vetting regime will include a lot more information about the target and the future business prospects of the issuer, applying the standard of disclosure for listing documents for new listing applicants. A major transaction or discloseable transaction, which is not extreme, is not subject to the enhanced disclosure and vetting regime.

Source: The RTO Guidance Letter

Click here to view the letter.

What constitutes an “extreme” transaction

The RTO Guidance Letter puts forth the following criteria for the HKSE to determine whether an acquisition should be regarded as “extreme”:

(i) size of the acquisition relative to the size of the issuer;

(ii) quality of the business to be acquired — whether it can meet the trading record requirements for listings or whether it is unsuitable for listing;

(iii) nature and scale of the issuer’s business before the acquisition (e.g. whether it is a listed shell);

(iv) any fundamental change in the issuer’s principal business (e.g. the existing business would be discontinued or very immaterial to the enlarged group’s operations after the acquisition);

(v) other events and transactions (historical, proposed or intended) which, together with the acquisition, form a series of arrangements to circumvent the RTO rules (e.g. a disposal of the issuer’s original business simultaneously with a very substantial acquisition); and

(vi) any issue of restricted convertible securities to the vendor which would provide it with de facto control of the issuer.

Consequences of triggering an RTO

Where a proposed transaction is treated as an RTO, according to Main Board Listing Rule 14.54 and GEM Listing Rule 19.54, the HKSE will treat the issuer as if it were a new listing applicant. It will be required to comply with all applicable listing requirements for new applicants, in particular, the enlarged group or assets to be acquired must meet the track record requirements for new applicants under Main Board Listing Rule 8.05 or GEM Listing Rule 11.12A, and the enlarged group must meet all other new listing requirements under Chapter 8 of the Main Board Listing Rules or Chapter 11 of the GEM Listing Rules. An RTO must also be approved by the shareholders of the issuer and the shareholders’ circular needs to be a listing document applying the same disclosure standards applicable to the prospectus of a new listing applicant. The issuer is also required to appoint a sponsor for the new listing application.

Guidance Letter HKEx-GL84-15 (the Cash Company Guidance Letter)

As an alternative method to make the acquisition of shell companies faster and easier, from the beginning to mid-2015 a number of issuers proposed large scale fundraising activities involving injections of substantial amount of cash into the issuer by their acquirers in exchange for new shares and/or convertible securities to be issued by these issuers to their acquirers and/or their affiliates. One obvious advantage of this approach is that the acquirer can legitimately avoid the need to extend general offers to shareholders of the issuer through obtaining a whitewash waiver from the Securities and Futures Commission under the Takeovers Code, assuming the relevant dispensation conditions under the notes on dispensations from Rule 26 and Schedule VI of the Takeovers Code are duly met. The issuer will then be equipped with a significant amount of cash to prepare for its future acquisitions and/or operations.

Before the publication of the Cash Company Guidance Letter, the requirements under Main Board Listing Rules 14.82 to 14.84 and GEM Listing Rules 19.82 to 19.84 — namely, that if the assets of an issuer (except an investment company as defined under Chapter 21 of the Main Board Listing Rules and a company solely or mainly engaged in the securities brokerage business) consist wholly or substantially of cash or short-dated securities such as bonds, bills or notes with less than one year to maturity, it will be regarded as a cash company not suitable for listing — were not entirely clear as there was no clear definition for a cash company. The consequences for being deemed as a cash company are serious as trading for its shares must be suspended and the issuer may only apply to the HKSE to lift the suspension once it has a business suitable for listing. The HKSE will treat such application as if it were for a new listing.

Whilst the Cash Company Guidance Letter states that there is no prescribed quantitative threshold in the Listing Rules to assess whether a company’s assets consist substantially of cash, in general an issuer with less than 50% of its total assets being cash as a result of a fundraising will not be regarded as a cash company. Conversely, It will massively increase the chance of the issuer being deemed as a cash company if more than 50% of its total assets consist of cash. A holistic approach should be taken to assess all background facts and circumstances of the issuer’s business, operation and financial position on a case-by-case basis. Some common features of a cash company include: (i) engaging in a significant size of fundraising with no or little correlation with the issuer’s current business; (ii) using funds raised in largely greenfield operations of new businesses with no or little correlation with the issuer’s current business; (iii) the fund providers acquiring control of the issuer and intending to manage the new businesses; and (iv) the issuer operating new businesses substantially larger than the original business.

Summary and Analysis of a Series of Listing Decisions Published in 2016

In March 2016, the HKSE published a series of listing decisions that provide additional insight and practical examples on how the HKSE would apply the principles set out in the guidance letters in practice.

HKEX-LD94-2016

This issuer carried on the principal business of property investment, fund management and fund and securities investment. It proposed to subscribe for an interest as a limited partner in a fund for approximately HK$4.5 billion, which was about 80% of the size of the fund and over 900% of the issuer’s market capitalization. The fund was a newly established partnership. It did not have any investments, assets or liabilities, and had not recorded any income or expenses. The issuer submitted that the fund had a clear investment objective to invest in debt instruments of PRC real estate developers and the proposed subscription allowed the issuer to leverage on the fund to source and manage potential investments in the PRC real estate market.

Whilst the proposed subscription fell outside the bright line tests (i.e., there was no change of control in the issuer), the HKSE applied the principle based test with reference to the criteria set out in the RTO Guidance Letter to treat the proposed subscription as an RTO. The key determining factors included the fund not having any track record to demonstrate satisfaction of the profit requirements under Main Board Listing Rule 8.05; the size of the subscription was significant to the issuer and the issuer had no control over or right to participate in the management of the fund or the investments to be made by the fund. All these raised concerns about the issuer’s suitability of listing upon completion of the subscription.

HKEX-LD95-2016

This issuer manufactured and sold household products. It proposed to acquire a target that had not yet started operation in holding inventories, machinery and equipment for the production of beverage products. The asset ratio and the consideration ratio for the proposed acquisition was about 300% and 200%, respectively. The issuer would satisfy the consideration by issuing new shares and convertible bonds (with a conversion restriction that prevented owner of the target from holding a 30% interest or higher in the issuer) to the vendor of the target. As a result, the vendor would become the single largest shareholder (28%) of the issuer upon completion of the acquisition.

This is another instance where the proposed acquisition fell outside the bright line tests (i.e., there was no change of control in the issuer) but, after applying the principle based test, the HKSE considered that the proposed acquisition would constitute an RTO and the listing requirements would be circumvented as the target did not have any trading record to meet the profit requirement for new listings, and it had to rely heavily on another company for both the production and sale of its products. Not only was the value of the target’s assets significant to the issuer (approximately three times of the issuer’s asset value), the target’s business was also entirely different from the issuer’s existing business. The proposed acquisition would be a means for the owner of the target to list the target by injecting it into the issuer.

This issuer subsequently submitted a revised proposal to only acquire 30% interest in the target, thereby reducing the asset ratio and consideration ratio to about 80% and 90%, respectively. However, the revised proposal was considered by the HKSE as triggering an RTO. Given that the HKSE does not prescribe an absolute threshold in determining whether the size of a transaction is extreme, the revised proposal would still be a significant acquisition for the issuer based on the revised asset and consideration ratios, and a means to circumvent the new listing requirements as the target’s business was completely different from the issuer’s existing business and was not suitable for listing due to its heavy reliance on another company to sustain its business.

HKEX-LD96-2016

This issuer was principally engaged in trading food and beverage products. It proposed to acquire a target that produced and sold organic fertilizers. The consideration would be settled by the issuer issuing convertible bonds to the vendor of the target with a conversion restriction that prevented the vendor from holding a 30% interest or higher in the issuer. The revenue, consideration and equity ratios of the proposed transaction were between 110% and 150%. The asset ratio was about 90%.

The proposed acquisition fell outside the bright line tests (i.e., there was no change of control in the issuer). However, the HKSE applied the principle based test to conclude that the proposed acquisition was an RTO. The target was considered unsuitable for listing since it could not carry on its business independently from the vendor because the vendor was the target’s sole supplier of a major raw material that was critical to the target’s business. Whilst the target had plans to manufacture such material independently, it was uncertain as to whether and when it would be able to do so, and the impact of any such change on its financial results. In addition, the issuer and the target carried on businesses in completely different industries and the target’s business would be significant to the issuer upon completion of the proposed acquisition.

HKEX-LD97-2016

This issuer was engaged in the property construction business and has diversified into the property management business and trading of financial products. It proposed to dispose of its property construction business to its former controlling shareholder who had ceased to be the issuer’s controlling shareholder about three years ago when he sold his entire interest in the issuer to the current controlling shareholder. The disposal would reduce the issuer’s revenue and assets by about 70%, constituting a major disposal subject to shareholders’ approval. The issuer proposed to continue its property management business and trading of financial products as its remaining business.

The HKSE considered that the issuer would not have sufficient operations or assets to meet Main Board Listing Rule 13.24 upon completion of the disposal. Since property construction business accounted for 70% of its revenue and assets, the disposal substantially reduced the issuer’s scale of operations and assets. Upon completion of the disposal, the issuer would be left with the remaining businesses that were merely acquired or established for less than a year. The remaining businesses recorded a loss or minimal profit in the last financial year and the underlying assets were mainly cash and trade receivables. These assets were insufficient to meet Main Board Listing Rule 13.24 as the issuer could not demonstrate that the operations of these assets can generate sufficient revenue and profits to justify a listing.

HKEX-LD98-2016

This issuer carried on event operation and entertainment business. It proposed to first dispose of a 25% interest in the subsidiary to a purchaser, which constituted a discloseable transaction, and second, grant a call option to a third party purchaser over the remaining 75% interest in the subsidiary upon completion of the first disposal. The call option would be exercisable 24 months after the first disposal. The disposal, together with the granting of the call option, constituted a very substantial disposal of the issuer with revenue and asset ratios hitting nearly 100%. The issuer intended to diversify into other business areas.

The HKSE considered that the issuer would be unsuitable for listing upon completion of the disposal. As the issuer had prepared to lose ownership and control over the subsidiary by granting the call option whose exercise was entirely at the purchaser’s discretion, it would not have any other material business operations or assets upon completion of the disposal. Further, the issuer’s mere intention of carrying out other businesses after the proposal failed to demonstrate that it would have a new business suitable for listing upon completion of the disposal.

HKEX-LD99-2016

This issuer and its subsidiaries were engaged in the manufacturing and distribution of multimedia and communication products. One of its subsidiaries carried on the business of manufacturing and distribution of communication products of a major brand of the issuer, accounting for 90% and 75% of the issuer’s revenue and assets. The proposed transactions involved (i) the disposal of the subsidiary by the issuer to its controlling shareholder, constituting a very substantial disposal and connected transaction subject to independent shareholders’ approval; and (ii) the controlling shareholder selling all his shares in the issuer to a third party, who would then extend general offers to acquire all the remaining shares in the issuer from the other shareholders. The second transaction was conditional on the completion of the first disposal.

The issuer was of the view that it could meet Main Board Listing Rule 13.24 upon completion of the disposal because (i) for the latest financial year, the remaining business recorded revenue and profit of over HK$200 million and HK$4 million, respectively; (ii) upon completion of the disposal, the issuer group would have total assets of about HK$450 million; (iii) based on the issuer’s profit forecast, the remaining business should continue to record profit and grow steadily; and (iv) the product line of the subsidiary was loss-making and the disposal allowed the issuer to focus on other product lines with better prospect and profitability.

However, the HKSE did not agree that the issuer would have sufficient operations or assets upon completion of the subsidiary’s disposal. Completion of such disposal substantially reduced the issuer’s scale of operations and assets as the subsidiary accounted for 90% and 75% of the issuer’s revenue and assets, and the remaining business recorded only minimal profit for the latest financial year and had been loss-making before. The remaining business did not have sufficient assets or a proven track record of sustainability and viability. The other assets of the issuer group were mainly cash proceeds generated from the disposal but the issuer had failed to demonstrate how it could use such proceeds to substantially improve its operations.

Key Considerations in Structuring Corporate Transactions for Shell Companies

Given the complexity of these rules and the highly judgmental nature of certain aspects of the rules, each proposed transaction must be considered on a case-by-case basis by applying a holistic approach to consider all the relevant facts concerned. Certain key considerations can be extracted from the observations above.

  • Do not ignore or under-estimate the principle based test

The RTO rules are anti-avoidance provisions designed to prevent circumvention of the new listing requirements. A proposed transaction that falls outside the bright line tests does not necessarily imply that it is not an RTO. Listing Decisions HKEX-LD94-2016, HKEX-LD95-2016 and HKEX-LD96-2016 are clear illustrations of RTOs being triggered as a result of the principle based test. The Listing Committee of the HKSE had considered the RTO rules and their application in November 2009, August 2010 and October 2013 before the publication of the RTO Guidance Letter, and the principle based test is not a new creation that does not exist before.

The principle based test involves an application of judgment. Neither does it have any duration requirement. Whilst the second limb to the bright line tests captures an acquisition (or acquisitions) from the incoming shareholder or his associate(s) within 24 months of the incoming shareholder gaining control, there is no limitation period with respect to the application of the principle based test. As such, any proposed acquisition occurring at any given time may be treated as an RTO if, based on the factors set out in RTO Guidance Letter, it constitutes an attempt to achieve listing of the assets to be acquired and a means to circumvent the listing requirements for new listing applicants in the opinion of the HKSE. The theory that after the initial 24-month period has lapsed upon the incoming shareholder gaining control of the shell company, the incoming shareholder can inject whatever assets into the shell company without the risk of such injection being caught as an RTO is clearly a misconception that does not fit in with the RTO Guidance Letter.

  • There is no one single factor or threshold in determining whether the size of a transaction is extreme

The RTO Guidance Letter sets out a list of criteria to determine whether the transaction will be considered as “extreme” (see above) and the related listing decisions indicate that the HKSE does not prescribe an absolute threshold in determining whether the size of a transaction is extreme. Despite the necessity to adopt a holistic approach giving considerations to a combination of factors, it is self-evident from the listing decisions that certain factors are important and prevailing, including:

(i) Percentage ratios of the proposed acquisition – in the examples provided in the listing decisions above, those proposed acquisitions all had very high percentage ratios, which might give the HKSE a firsthand impression that the size of transaction is extreme relative to the size of the issuer as a whole.

(ii) Quality of the assets to be injected – apart from whether the acquisition target has any trading record to meet the profit requirement for new listings, it is also important to consider whether the target is indeed suitable for listing. The fact pattern in HKEX-LD96-2016 (i.e., target unable to operate independently) presented a classic suitability issue that drove the HKSE to treat the proposed acquisition as an RTO. It is therefore important to provide the HKSE with a solid and reliable profit and working capital forecast in its transaction vetting process.

(iii) Fundamental change of the issuer’s business – the Listing Rules do not prohibit the board of an issuer to venture the issuer into a new business area whether by acquisitions, business combinations or organic expansion. Acquiring a new business different to the principal businesses of the issuer will not de facto render the acquisition as an RTO. If the change in business is, however, coupled with a combination of other factors as per the above, the likelihood of the transaction being treated as an RTO or an Extreme VSA will increase significantly.

  • Disposal of unwanted assets shall only be carried out at an appropriate time

Listing decisions HKEX-LD97-2016, HKEX-LD98-2016 and HKEX-LD99-2016 all highlight the importance of ensuring an issuer must be able to meet the “sufficient operations” requirement under Main Board Listing Rule 13.24 or GEM Listing Rule 17.26 at all material times. Where it is necessary to dispose of the unwanted assets of an issuer, the issuer must ensure it will continue to own material business operations or assets upon completion of the disposal. It is important to time the disposal to occur only at a time when the new business acquired by the issuer is able to, by itself and without the disposed business, comfortably satisfy the sufficient operations requirement with a proven track record of sustainability and viability.

Indeed, it is now extremely uncommon for an acquirer of a shell company to make its acquisition conditional on the simultaneous disposal of the shell company’s assets unwanted by the acquirer by way of a special deal under Rule 25 of the Takeovers Code (which was a common method in acquiring shell companies by way of the acquirer extending mandatory general offers to shareholders before), as the shell company is unlikely to have any sufficient operations and/or it will become a cash company upon completion of the disposal.

Main Board Listing Rules 14.92 and 14.93 or GEM Listing Rules 19.91 and 19.92 state that an issuer may not dispose of its existing business within 24 months after a change in control, unless the asset injection(s) from the new controlling shareholder and his associates and any assets acquired during the period leading to and after the change in control would meet the trading record requirement under Main Board Listing Rule 8.05 or GEM Listing Rule 11.12A. The RTO rules discourage circumvention of the bright line tests by deferring a disposal such that the assets acquired would not result in a very substantial acquisition.

  • Changing the shell company’s business gradually through a series of small scale acquisitions, business combinations and organic expansions could be the way forward

To a certain extent, all the listing decisions above involve a drastic change in the issuer’s fundamental business through an apparently significant acquisition or disposal that attracts very high percentage ratios.

Nothing in the Listing Rules prohibits a shell company to be engaged in legitimate business activities such as business combinations or organic expansions. Neither would the principle based test nor the bright line tests be triggered if there is no “acquisition”. If the acquirer of the shell company is patient enough to gradually alter the fundamental business of the issuer through a series of small scale acquisitions, business combinations and organic expansions over a period of time, in the absence of any significant acquisition or disposal, it will be easier to achieve the ultimate objective of the acquirer; and we have witnessed a number of successful cases injecting assets into a shell company on such basis without running into the issues discussed herein. However, it is to be noted that in classifying notifiable transactions, the HKSE may require issuers to aggregate a series of transactions and treat them as if they were one transaction if they are all completed within a 12-month period or are otherwise related. Transactions are related if they are entered into by the issuer with the same party or with parties connected or otherwise associated with one another. In such cases, the issuer must comply with the requirements for the relevant classification of the transaction on an aggregated basis.

Conclusions

Without doubt, backdoor listings will continue to be an important part of the corporate finance activities in Hong Kong. The horrendously long queue of companies waiting to complete their A-share listings in the PRC will continue to provide incentives for PRC entities to seek a backdoor listing of their businesses on the HKSE. Notwithstanding the issues and considerations discussed above, the HKSE is not deterring valid and legitimate transactions but it will be vigilant in screening out those transactions that cannot meet the applicable requirements in its continued attempt to maintain market quality and protect shareholders’ and investors’ interests.