An issuer that pursues an initial public offering (IPO) in the United States (US) would make sure it has carefully considered all of the accounting and tax implications of the issuance of any securities, including stock or options to employees, during at least the 12-month window before the filing of an IPO registration statement at a price that is substantially below the contemplated IPO price (often referred to as "cheap stock"). If the US Securities & Exchange Commission (SEC) determines that there is a cheap stock issue, the issuer may suffer a double accounting hit by (i) having to take a charge on its earnings, and (ii) including the additional securities when calculating the earnings per share. The main focus of the US SEC appears to be whether a portion of the issuer's compensation or other expenses may not have been accounted for because of the issuance of stock, options or other securities at below fair value.

In Hong Kong, the volume of pre-IPO investments into Chinese businesses has steadily increased in recent years, with many private equity funds participating. Common instruments in pre-IPO investments include exchangeable debt, convertible debt (less so in recent years after the market has grown more concerned with the potential accounting charges) as well as preferred equity.

The Hong Kong Stock Exchange (the HKSE) also examines the timing, pricing and rationale of pre-IPO investments during the listing application process, albeit with more of a focus on fairness between the pre-IPO investors and the public investors. Frequently, questions from the HKSE center on whether the pre-IPO investors took "genuine investment risk" that would justify the price differential. To answer the questions, one would typically take into account the timing of the investment, the timing of the listing application process, the condition of the issuer at the time of investment, the magnitude of the price differential, and so forth. However, some market practitioners have observed that recent decisions by the HKSE on this issue have raised questions about how the HKSE applies its principles and how it conducts its practice. A consultant engaged by the Board of the HKSE also noted that market practitioners find it difficult to identify consistent requirements on pre-IPO investments.

On October 13, 2010, the HKSE issued an interim guidance, under which it would generally require that pre-IPO investments must be completed either (a) at least 28 clear days before the date of the first submission of the first listing application form, or (b) 180 clear days before the first day of trading of the issuer's securities. Pre-IPO investments are considered "completed" when the funds are irrevocably settled and received by the applicant. "Clear days" exclude the day of the pre-IPO investment completion, the day of the submission of the listing application form and the first day of trading of securities.

Despite this general interim guidance, the Listing Committee of the HKSE recognizes that there may be circumstances where pre-IPO investments on terms more favorable than those offered to IPO investors may be justifiable. Interestingly, departing from past reluctance to engage in a discussion of this issue until the listing application process has commenced, the HKSE stated in its news release that "potential applicants are encouraged to consult the Listing Division before submission of listing applications if they have any questions."

At Orrick, our Private Equity team will continue to work closely with our Capital Markets team when structuring pre-IPO investments, and until the HKSE issues final rules on the issue (which may not come until there is an overall amendment of the Listing Rules as a whole), our Capital Markets team members will help with not only interpreting past Listing Decisions but perhaps consulting the Listing Division as well. In the meantime, we shall report any significant developments in this space.