The Stock Exchange of Hong Kong Limited (the Exchange), on 13 October 2010, announced interim guidance on pre-IPO investments, pending consultation on possible amendments to its Listing Rules (Listing Rules).
Under the interim guidance, the Exchange will generally require, except in very exceptional circumstances, that pre-IPO investments must be completed either (a) at least 28 clear days before the date of the company’s first listing application or (b) 180 clear days before the first day of trading of the company’s securities. Pre-IPO investments are considered completed when the funds are irrevocably settled and received by the company.
General principles: fair and equal
There is no bright-line test under the Listing Rules as to what is permissible or prohibited in relation to pre-IPO investments. Practical guidance is available from precedent cases and a series of Listing Decisions issued by the Exchange. The concern about pre-IPO investments has always been whether IPO investors are being treated fairly and equally if the terms of the pre-IPO investment are different from or even better than those offered to IPO investors.
The guiding principles of the Listing Rules are that all investors in a public offering should be treated fairly and equally, and that the process should be conducted in a fair and orderly manner. The requirement to treat all investors equally can present a challenge for companies (and their advisors) who have recently raised capital privately or taken on additional investors when these companies begin preparing for an IPO. However, these general principles may cause uncertainty and inconsistency in terms of what is permissible and what is not for pre-IPO investments.
Previous decisions: case-by-case approach
In evaluating a pre-IPO investment, the Exchange has applied the above “fair and equal” test which involves assessing a totality of factors. The following key questions will be considered in assessing whether the pre-IPO investment is fair and equal to new investors in the IPO: Is the pre-IPO investment just another tranche of the IPO in disguise? Has the pre-IPO investor taken sufficient investment risk? Are there sufficient reasons to justify the terms of the pre-IPO investment? One factor which has been determinative is whether the pre-IPO investor is providing strategic value to the business rather than acting as a pure financial investor, thus justifying preferential treatment over IPO investors. By way of example, a company in severe financial distress may provide justification for more favourable pre-IPO investment terms.
Based on an analysis of previous Listing Decisions, the following features of pre-IPO investment will be rejected:
- Delays in making payment of an agreed investment until a time when the prospect of a listing becomes certain or at milestones of the listing approval process; the key will be how early money actually changes hands and whether the pre-IPO investment is dependent on any aspect of the listing process;
- Exit or “repurchase” options in the event listing does not occur;
- Guaranteed discounts to the IPO price;
- Price reset mechanisms based on post-listing share prices, because it could lead to unfair on “toxic” post-listing dilution;
- Veto rights on reserved matters, because such rights cannot be extended to other shareholders and are not suitable for listed companies;
- Rights for a particular investor to nominate directors, because such rights cannot be extended to other shareholders; and
- Negative pledge and anti-dilution rights.
The interim guidance has provided some clarity as to when pre-IPO investments must be completed. The Exchange aims to start consultation on possible amendments to the Listing Rules in the near future. As the regulatory approach and market practices develop, it remains to be seen whether and if so what comprehensive guidance will emerge for pre-IPO investments. Should there be questions concerning pre-IPO investments, companies wishing to make listing application are encouraged to consult the Exchange in advance.