On 30 November 2013, the State Council of China issued the Guiding Opinions on the Pilot Launch of Preference Shares (the "Guiding Opinions") allowing listed companies ( ) and unlisted public companies ( ) to issue preference shares in both public and private markets in China on a trial basis.
Following the issuance of the Guiding Opinions, on 13 December 2013, the China Regulatory Securities Commission ("CSRC") issued the draft Administrative Measures of the Preference Shares Pilot Program (the "Draft Administrative Measures") seeking comments from the public. Shortly thereafter, on 10 January 2014, the China Securities Depositary and Clearing Corporation Limited ( ) ("CSDCC") issued the draft Implementing Rules of the Depositary and Clearing Matters regarding Preference Shares (the "Draft Implementing Rules") seeking comments from the public in order to implement and facilitate the registration and deposit of preference shares with the CSDCC (discussed below). The Draft Administrative Measures and the Draft Implementing Rules were issued pursuant to the Guiding Opinions and their respective definitive versions have not been issued to date.
The issuance of the Guiding Opinions, the Draft Administrative Measures and the Draft Implementing Rules are certainly intended to open up additional avenues of financing for listed and public companies, including as an additional instrument for funding M&A transactions. It is also expected that listed commercial banks will be the first to avail themselves of this fund raising opportunity in order to meet increasingly tougher capital adequacy rules.
What remains to be seen is whether the Guiding Opinions, the Draft Administrative Measures and the Draft Implementing Rules represent the first steps towards a more pervasive concept of preferred rights that afford investors engaged in pre-IPO private equity investments the long sought after added rights and
protections for their investments in China similar to those afforded to preference shares in other jurisdictions. Practitioners have structured ingenious ways to try and replicate preference share rights in Chinese corporate entities, some of which are already provided statutorily (pre-emption rights of shareholders in joint venture entities for example), whilst others such as redemption rights were not explicitly recognized.
Importantly, the Guiding Opinions, the Draft Administrative Measures and the Draft Implementing Rules indicate that the authorities recognize the concept of preference rights and their understanding of such rights (as discussed below) are by and large similar to those in the international domain. However, there is one substantive and significant limitation on this development: the type of companies which can issue preference shares is limited to listed companies and unlisted public companies. Private companies (which would include domestic private companies as well as companies with foreign investment such as wholly foreign-owned enterprises, equity joint ventures and co- operative joint ventures (together "FIEs")) are not included within the scope of the Guiding Opinions and Draft Administrative Measures and are therefore unable to issue preference shares.
Definition of Preference Shares
Preference shares are defined under the Guiding Opinions and Draft Administrative Measures as a class of shares prescribed under the Company Law1 other
1 Company Law of the People's Republic of China revised and adopted at the 18th session of the Standing Committee of the Tenth National People's Congress of the People's Republic of China on 27 October 2005 taking effect on 1 January 2006 (the "Company Law"). On 12 December 2013, the 6th session of the Standing Committee of the Twelfth National People's Congress of the People's Republic of China revised the Company Law, and the revised version will come into effect on 1 March 2014 (the "New Company Law").
than ordinary shares whose holders shall have priority rights over ordinary shareholders in relation to distribution of profits and residual assets (these are essentially preferred dividend and liquidation rights). However, it goes on to say that preference shareholders' rights to participate in the decision- making process and management of the issuer are restricted, which could be interpreted as referring to them having limited voting rights.
Interestingly, the Guiding Opinions and Draft Administrative Measures each provide that during the term of the pilot program2, the issuer is not permitted to
issue preference shares with differing priority orders in terms of dividend and liquidation rights, but may do so with respect to other preference rights. It is unclear why dividend and liquidation preference rights have been carved out specifically and why it is possible to have differing priority orders with respect to other rights. However, the restriction on dividend and liquidation rights will certainly limit the attractiveness of the issuer's preference shares to subsequent investors and will therefore have an impact on financings, which are typically done in series A to D with the later investors obtaining rights which are equal to, or prevail over, those of investors in earlier series. Of course the requirement for issuers to be listed companies or unlisted public companies will, of itself, preclude the use of preference shares in the financing of most early stage companies.
Scope of Issuers
As mentioned above, the Guiding Opinions and Draft Administrative Measures only allow listed companies and unlisted public companies to issue preference shares.
exchanges but established in China are only able to issue preference shares in the private market.
Unlisted public companies are also permitted to issue preference shares in the private market. An unlisted public company is a company limited by shares (sometimes called a joint stock company) which is not listed but has either issued or transferred shares to more than 200 designated shareholders in aggregate or transferred shares publicly ()3.
The limitation on issuers of preference shares does not come as a surprise, as private companies referred to in this note take the form of limited liability companies as opposed to companies limited by shares. Limited liability companies in China do not issue shares, instead investors subscribe for undivided equity interests () in these entities corresponding to a percentage of the registered capital. There are, therefore, difficulties in replicating preference share concepts in private companies which are not able to issue divided shares, let alone different classes of shares. However it is arguably in the private, unlisted sector where the use of preference shares is most prevalent and necessary in order to convince outside investors to invest. There are stringent requirements in order to qualify as a company limited by shares, one of which is a minimum capitalisation of Renminbi ("RMB")30 million where foreign shareholding is involved (i.e. a Foreign-invested
Company Limited by Shares4). Needless to say,
therefore, that only listed companies and unlisted public companies in the form of companies limited by shares are able to issue preference shares.
Listed companies refer to companies listed on a stock 3
exchange in China and also companies listed on
The transfer of shares publicly in China is subject to
overseas stock exchanges, provided that such companies are incorporated in China (for example, H share companies listed on The Stock Exchange of Hong Kong). Only companies listed on a stock exchange in China are able to issue preference shares either in the public market (if approved by CSRC) or in the private market. Companies listed on overseas stock
2 Both the Guiding Opinions and Draft Administrative Measures do not discuss the term of the pilot program.
specific rules, approvals, disclosure and filing requirements with the
relevant authorities (including CSRC). The Guiding Opinions provide that details of public and non-public offerings shall be issued in accordance with the relevant laws.
The requirements for the establishment or conversion into a Foreign-invested Company Limited by Shares are set out in the Interim Provisions on Certain Issues Concerning the Establishment of Foreign-invested Company Limited by Shares issued by the Ministry of Foreign Trade and Economic Cooperation (predecessor of the Ministry of Commerce ("MOFCOM")) effective 10 January 1995. The main barrier to turn FIEs into joint stock companies with foreign investment is the three year track record of profitability prior to the application.
As mentioned above, the Guiding Opinions discuss a number of preference rights attaching to preference shares which are:
Dividend rights. Preference shareholders shall have priority over the ordinary shareholders on dividend distributions pursuant to agreed dividend rates. Furthermore, the following rights can be specified in the issuer's articles of association: (i) whether the dividend rate is based on a fixed or floating rate and the calculation method, (ii) whether the issuer has to distribute the dividends if the issuer has distributable profits (i.e. if it is payable only upon declaration by the board of directors); (iii) in the event that the issuer fails to pay the dividends to the preferred shareholders in full due to insufficient proceeds, whether the difference shall be accumulated and payable in the next fiscal year
(i.e. cumulative dividend right); (iv) whether the
preference shareholders can participate in the distribution of the remaining proceeds after they have received the dividends pursuant to the agreed interest rate (i.e. participating preferred dividend right); and (v) other matters concerning the distribution of dividends of the preference shares. Clearly, the authorities have recognized some of the key concepts in preferred dividend rights in international practice which is a positive sign for investors.
Liquidation rights. In the event the issuer has to be liquidated due to dissolution, bankruptcy or other reasons, after distributions are made pursuant to the
Company Law and Insolvency Law5, any unpaid
preferred dividend payments and the liquidation payment amounts due to the preference shareholders as set forth in the articles of association shall be made to the preference shareholders. This may be of limited value in an insolvency situation, given that shareholders (including preference shareholders) are last in the pecking order for distributions on insolvency (which is ordinarily the case), but pushes preference shareholders ahead of ordinary shareholders in the
The People's Republic of China Enterprise Insolvency Law, adopted at the 23rd Meeting of the Standing Committee of the Tenth National People's Congress of the People's Republic of China on 27 August 2006 taking effect on 1 June 2007 (the "Insolvency Law"). Presumably a reference to the priority order of creditors set out in the Insolvency Law.
queue where there are residual assets after paying all priority creditors. If the amount is insufficient, the remaining assets shall be distributed proportionately amongst the preference shareholders based on their shareholdings.
Conversion and redemption rights. The Guiding Opinions provide that the conditions, price and percentage for the conversion of preference shares into ordinary shares and redemption of preference shares by the issuer shall be set forth in the articles of association of the issuer. The issuer and preferred shareholders may be granted conversion rights or redemption rights. Any redemption right exercised by the issuer shall require the prior payment of any outstanding dividend payments.
Voting rights. The Guiding Opinions provide that preference shares shall have no voting rights and preference shareholders shall not attend any general meetings of the shareholders save and except where it relates to the following matters, whereby the approval of more than 2/3 of the votes of the preference shareholders present in a meeting shall be required: (i) any amendment to provisions in the articles of association relating to the preference shares; (ii) where there is a reduction of more than 10% of the registered capital of the issuer; (iii) where there is a merger, split (demerger), dissolution or change of the corporate form of the issuer; (iv) where there is a new issuance of preference shares; and (v) other acts as set forth in the articles of association (collectively the "Protective Provisions"). These reflect the key matters commonly seen in protective provision clauses. Further, sub-item
(v) allows the issuer and the preference shareholder to
include additional matters. Whether a list of matters customarily seen in international transactions will be permitted remains to be seen, but it would seem to be workable on the face of it.
Interestingly, the Guiding Opinions also provide that in the event the issuer fails to pay any interest due to a preference shareholder, in certain circumstances, the preference shareholder's voting rights are restored and the preference shareholders is then entitled to attend the shareholders general meeting to vote in accordance with the articles of association. However, it is unclear if the matters on which a preference shareholder can vote in such event extend beyond the Protective Provisions and would be equivalent to those enjoyed by holders of ordinary shares (common stock).
Transfer, trading and registration of preference shares. The preference shares shall be transferred or traded on stock exchanges, National Equities Exchange and Quotations () or other
exchanges approved by the State Council. In addition, the preference shares shall be registered with, and deposited with, the CSDCC.
Size of preference share offering. The Guiding Opinions impose restrictions on the percentage of the issuer's capital comprising preference shares and the value of the amount raised by issuing preference shares relative to the net assets of the issuer. The aggregate number of outstanding preference shares shall not exceed 50% of the total number of the outstanding ordinary shares of the issuer, and the capital raised from the issuance of preference shares shall not exceed 50% of the net assets of the issuer immediately prior to such issuance. This may limit the size of subsequent rounds in venture capital financings.
Disclosure of information. Where a company is issuing preference shares, it must set out the rights and obligations attaching to the preference shares in the issue documents and disclose truthfully, accurately, fairly and in a timely and complete fashion or provide information, without any false or misleading representations or material omissions.
Mergers and acquisitions. Preference shares can be used as consideration in mergers and acquisitions as well as in restructuring transactions. A tender offer for a listed company must be extended to all shareholders, including the preference shareholders, but different terms may be offered to the ordinary shareholders and preference shareholders.
Market access for foreign investment. Where there is a statutory maximum foreign shareholding percentage, the shareholding percentage of foreign investors shall be calculated by aggregating the number of both preference shares and ordinary shares.
How does it all fit in with the current regime?
There are some questions marks over how the Guiding Opinions fit in with the current regulatory regime as some of its provisions are in stark contrast to the current laws, especially, the Company Law.
Fundamentally, both the Company Law (Article 127) and the New Company Law (Article 126) provide that
shares are issued on the basis of applying the principles of impartial treatment and fairness, and each share of the same type of shares must enjoy the same rights. Ordinary shares and preference shares are not the same type of shares and therefore, it would be possible to differentiate their rights. However, amongst different series of preference shares, for example Series A and Series B preference shares, it is uncertain whether the Company Law and the New Company Law allows different rights to be attached to each series of preference shares as envisaged under the Guiding Opinions.
Moreover, the Guiding Opinions allows the parties to agree on the conditions for the exercise of redemption rights () as explained above. Again, both the Company Law (Article 143) and the New Company Law (Article 142) do not grant that much freedom to the parties as they list the circumstances in which an issuer is permitted to buy back its own shares (
) which is in essence a redemption by the issuer. These include a reduction of the issuer's registered capital (which requires approval from the relevant authorities including MOFCOM), in a merger scenario where the target holds shares in the issuer, as part of an employee share incentive plan or where required by a shareholder who is objecting to a merger or split involving the issuer.
Separately, the Measures for the Administration of Listed Company Acquisitions issued by the CSRC effective 1 September 2006 ("Listed Company Measures") allows preference shares to be used as consideration in an acquisition under Article 36 which is consistent with the Guiding Opinions. However, a tender offer under the Listed Company Measures can either be a general tender offer (to all the target company's shareholders) or a partial tender offer. It is unclear whether the Guiding Opinions is precluding partial tender offers as it refers only to offers extended to all shareholders. Further, Article 26 of the Listed Company Measures requires that all shareholders of the target company are to be treated fairly and shareholders who hold the same type of shares shall be treated equally. Again, ordinary shares and preference shares are not the same type of shares so different terms may be offered, but query whether different offers can be made to holders of different series of preference shares.
It is uncertain how all the pieces will fit in to the puzzle. Pursuant to the Legislation Law, the provisions of the Company Law prevail over the Guiding Opinions in the
event of any conflict, as laws are placed above administrative regulations in China's legal hierarchy. On a related note, Article 132 of the Company Law and Article 131 of the New Company Law provide that "the
State Council may issue separate regulations governing the issue of types of shares other than those specified in this law6" ("Authorization") and this may be the critical piece to the puzzle. One interpretation is that
the State Council has issued the Guiding Opinions by relying on the Authorization and thereafter, the Draft Administrative Measures and the Draft Implementing Rules were issued by CSRC and CSDCC respectively based on the authority granted under the Guiding
Opinions7. Nonetheless, this does not resolve the
conflicts raised above as the New Company Law will need to be amended for consistency with the Guiding Opinions.
The Guiding Opinions are a first step in diversifying investment channels and options for investors in China. There is a lot of work to be done and detailed rules and regulations will need to be issued similar to the Draft Administrative Measures and Draft Implementing Rules in order to implement the key principles as outlined in the Guiding Opinions. The conflicts with the existing regulatory regime will also need to be ironed out. The authorities will need to clarify how the pilot program will be implemented, and it will be crucial to see how the market reacts to the offering of preference shares both publicly and privately. This development would, however, take on a whole new meaning if it were extended to the private unlisted sector, where arguably it is most needed. This would involve amendments to the law either to allow private companies to issue divided shares or to issue equity interests with different rights attaching to them.
Nonetheless, a key takeaway for now is the recognition by the authorities for the issuance of different classes of shares with different rights attached to them. Until now, there has not been any explicit recognition of preference rights under the Company Law or other laws and regulations other than the requirement that the
same type of shares must enjoy the same rights. Notwithstanding the limited scope of issuers, the Guiding Opinions, the Draft Administrative Measures and Draft Implementing Rules are certainly bold steps in the right direction by the authorities which should lead to better protection of investor rights in China.
Perhaps the promulgation of the Guiding Options should be seen as a first, but important step towards bringing back onshore some of the venture capital financings that have historically moved offshore due to the lack of flexibility in Chinese law. The lack of express recognition of preference share rights has historically long been seen as a major impediment to developing a local venture capital financing market, but this is not the only factor at play here: it will take a much wider and far-reaching set of reforms, including lighter touch regulation, taxation and lifting of foreign exchange controls before China starts being broadly comparable with the Cayman Islands, Singapore or Hong Kong where such financings currently typically take place.