PIPEs on the Stock Exchange of Hong Kong: A Primer for Private Equity and Hedge Funds
Private investments in public entities (“PIPEs”) listed on the Stock Exchange of Hong Kong (“SEHK”) present complex regulatory issues quite apart from the already difficult commercial and legal issues in any private equity investment. In fact, terms of investment designed to minimize commercial and legal risks may run afoul of regulatory requirements. As a result, investments in companies listed or to be listed on the SEHK call for some understanding of the Listing Rules of the SEHK (“Listing Rules”), the Code on Takeovers and Mergers (“Takeovers Code”) and the Securities and Futures Ordinance (“SFO”). In this article, we review key elements of the regulatory framework applicable to 3 types of PIPE transactions: (i) investments prior to an initial public offering (“IPO”), (ii) investments during IPO and (iii) investments post-IPO.
Pre-IPO investors may invest in an issuer as early as a number of years prior to listing or when listing plans are already at an advanced stage. The latter type of investment may be regarded as a PIPE transaction and may be subject to particular scrutiny by the SEHK.
Fair and Equal Treatment of Shareholders
The Listing Rules set out general principles to ensure that investors have and can maintain confidence in the market. One general principle is that all holders of listed securities are treated fairly and equally. In this last respect, the Listing Rules seek to secure for holders of securities, other than controlling interests, certain assurances and equality of treatment which their legal position might not otherwise provide.
Under this general principle, in the case of a pre-IPO investment in a listing applicant, the SEHK may require PIPE investors to surrender contractual rights they may have in respect of the listing applicant as a condition of listing. This is so even where such contractual rights may be typical for private equity investments.
There is no bright line test for which contractual rights may fall afoul of the general principle. Investors may argue that their rights should survive on the basis that they assumed risks not applicable to other shareholders and that their investment itself gave the issuer the financial backing and standing, accountability and transparency to proceed to listing. Past experience suggests that the greater the passage of time between an investment and a listing, the greater the level of real investment risk, and the greater the benefit brought by the investor to the listing applicant, the more likely it is that particular rights under that investment will survive. The overriding requirement is that shareholders be treated fairly and equally.
Pre-IPO investors will typically invest through debt or preferred equity instruments which are convertible into ordinary shares upon or after an IPO. The SEHK will scrutinize any subscription for ordinary shares or securities convertible into ordinary shares where the subscription or conversion price may represent a discount to the eventual IPO price.
In a 2008 IPO, the SEHK did not object to pre-IPO investors holding preference shares giving them (i) a right of priority on liquidation, (ii) a right, prior to the global offering, to convert the preference shares into ordinary shares at a discount of between 4.29 per cent. and 27.49 per cent. (based on the pre-listing indicative offer price range), (iii) a right to nominate members of the board of directors, and (iv) various information and minority protection rights. The SEHK allowed this on the basis that the investment risks of the pre-IPO investors were entirely different from the risks which the investing public would have to bear in the context of the global offering. The pre-IPO investment price reflected the bargaining positions of the parties, the illiquidity of the shares and the historical financial performance of the issuer at the time of investment.
Conversely, in a 2007 IPO, pre-IPO investors acquired convertible bonds 5 months ahead of a listing. The bonds entitled the investors at any time within 5 years after listing to convert the bonds into ordinary shares at a 15 per cent. discount to the final offer price following the listing, whatever that price might be. The SEHK decided that investment risk alone was insufficient to justify this right.
Non-pricing terms may also be the subject of SEHK scrutiny. By way of example, in the past, the SEHK has required the surrender of the following pre-IPO investment rights:
- the right to require a controlling shareholder of a listing applicant to repurchase an investor’s shares at the original subscription price if final listing approval was not granted; and
- the right to veto certain corporate actions including the petitioning for winding-up, amendments to the memorandum and articles of association, the amalgamation or merger of any member of the listing applicant’s corporate group, the carrying on of business by any member of the applicant’s corporate group outside prescribed parameters, the declaration of dividends, changes in directors, the sale of any part of the listing applicant’s business, and the creation of any security interest over the listing applicant’s assets.
This is not to say that such rights will never survive listing. Each case will be assessed on its own individual merits.
Given this uncertainty, in October, 2010, pending a market consultation, the SEHK issued interim guidance on pre-IPO investments. The guidance provides that such investments must be completed (i.e. funds irrevocably settled and received by the unlisted issuer) either (i) at least 28 clear days before the date of the first submission of the first listing application form, or (ii) 180 clear days before the first day of trading of the listed issuer’s securities. The guidance also noted that in certain circumstances (such as the severe financial distress of the issuer), special rights afforded to pre-IPO investors may be acceptable.
Directors to Act in the Interests of Shareholders as a Whole
A general principle under the Listing Rules related to the fair and equal treatment principle is that directors of a listed issuer must act in the interests of the shareholders of the listed issuer as a whole. Whilst this general principle requires that directors appointed by controlling shareholders take into account the interests of non-controlling shareholders, it also requires that directors nominated by a pre-IPO investor must do so.
This general principle reinforces common law fiduciary duties for directors, which require directors to act in the bests interests of a listed issuer and to avoid conflicts of interests. However, it goes further to suggest that mere ratification of corporate action by a controlling shareholder may be insufficient where such action is prejudicial to minority shareholders.
Pre-IPO investors will typically wish to avoid becoming connected persons of a listed issuer. In this regard, a “connected person” includes a person holding 10 per cent. or more of the voting power of the listed issuer.
For the pre-IPO investor, a disadvantage of becoming a connected person is that it will not be able to either acquire or dispose of shares of the issuer between the time of the listing hearing and the actual listing. Another disadvantage is that post-listing, business dealings between the pre-IPO investor and the issuer, including certain share issuances, may be subject to additional disclosure or shareholder approval requirements.
For the listed issuer, a disadvantage of a pre-IPO investor becoming a connected person is that connected persons cannot count toward the minimum public float. Under the Listing Rules, listed issuers must maintain a minimum number and spread of shares in public hands.
In this regard, in 2008, the SEHK issued a Combined Consultation Paper on Proposed Changes to the Listing Rules proposing, amongst other things, to exclude holders of 5 per cent. or more of a listed issuer’s shares from the public float.
Pre-IPO investors may be subject to lock-ups. These lock-ups restrict such investors from selling their investments for a fixed period of time following listing. Lock-ups may be mandatory or voluntary:
- Mandatory - Under the Listing Rules, shareholders or groups of shareholders holding 30 per cent. or more of the voting power of a company are subject to a lock-up of 6 to 12 months post-listing. At the same time, the SEHK may, based on individual circumstances, subject pre-IPO investors with shareholdings of less than 30 per cent. to a lock-up. Thus, for example, the SEHK has subjected a pre-IPO investor holding convertible bonds to a lock-up period of 6 months following listing in respect of any ordinary shares received as a result of the conversion of the bonds on the basis that the convertible bonds contained terms not available to other shareholders. Equally, for example, the SEHK has subjected a pre-IPO investor to a lock-up period of 6 months following listing where the pre-IPO investor completed his investment shortly before listing at a substantial discount to the offer price.
- Voluntary –A listing applicant or its underwriters may request that a pre-IPO investor voluntarily subject itself to a lock-up following listing to facilitate the issue.
Investments made during an IPO are typically made under the institutional placement tranche. For a listing applicant and its underwriters, pre-arranged placements offer greater certainty in capital raising. For an investor, such placements may offer greater certainty of price and allocation. However, both the price and the number of shares which are placed to the investor are potentially affected by the Listing Rules.
The SEHK generally encourages retail participation in IPOs. In this regard, where an IPO comprises both a public offer for subscription and an institutional placing, the Listing Rules provide that at least 10 per cent. of the shares offered under an IPO must be allocated to the public subscription tranche.
However, where the public subscription tranche is heavily oversubscribed, the Listing Rules requires that shares originally allocated to the institutional placing be re-allocated to the public subscription tranche under a clawback. Thus, for example, where the total demand for shares in the public subscription tranche is between 15 and 50 times the initial allocation, shares must be clawed back from the institutional placing tranche and re-allocated to the public subscription tranche so that the number of shares in the subscription tranche must be increased to at least 30 per cent. of the shares offered in the IPO.
To deal with a potential trigger of the clawback rules, private investors sometimes negotiate a guaranteed allocation of shares which will not be reduced in the event of a clawback due to an over-subscription for the public tranche of the IPO. This is permissible provided that sufficient shares would otherwise be available for reallocation to the public subscription tranche pursuant to any clawback.
In a typical IPO, the final offer price is not determined until the shortly after the close of the offer. Whilst the IPO listing document will specify a minimum and a maximum price range, there is some uncertainty over the final offer price payable in respect of a private investor’s commitment to subscribe to a given number of shares upon an IPO.
The final offer price is set by agreement between the listed issuer and the global coordinator taking into account the demand in the IPO, including the public subscription tranche and, where applicable, the institutional placing tranche.
Post-IPO involve significant regulatory risks, bringing into play issues of insider dealing and the prospect of a mandatory general offer.
Mandatory General Offer
The Takeovers Code requires that a person who acquires 30 per cent. or more of the voting rights of a public company in Hong Kong must make a general offer (“mandatory general offer”) to acquire all the shares of the company, whether voting or not, and all the voting non-equity capital of the company.
In a mandatory general offer, unless otherwise waived by the Takeovers Executive, the consideration must be in cash or include a cash alternative and the price must be no less than the highest price paid by the offeror or persons acting in concert with it for shares during the 6 months prior to the commencement of the offer.
Generally, a private investor will wish to avoid triggering a mandatory general offer. In this regard, the Takeovers Code establishes a number of rules to prevent circumvention of the mandatory general offer requirement. Most significantly, it aggregates the holdings of persons “acting in concert” for the purpose of determining whether a mandatory general offer arises.
However, it is possible to apply to the Takeovers Executive for exemption from the mandatory general offer in prescribed circumstances, including:
- Whitewash Waiver –Where the independent shareholders of a listed issuer approve a cash subscription by an investor, the investor may not be required to make a mandatory general offer even if as a result of the subscription it holds 30 per cent. or more of the voting rights of the listed issuer. However, the Takeovers Executive may not waive the mandatory general offer if the investor acquires voting rights in the listed issuer in the period from the time discussions in relation to the subscription began until the time of completion of the subscription.
- Rescue - Where a listed issuer is in such serious financial distress that the only way it can be saved is by the urgent issuance of shares without approval by a vote of independent shareholders, the Takeovers Executive may waive the mandatory general offer. In exercising its discretion, the Takeovers Executive will consider the views of the listed issuer’s directors and advisers and, naturally, will wish to satisfy itself that the rescue is urgent and that it is in fact impractical for independent shareholders to vote to approve the issuance.
Where a private investor conducts due diligence on a listed issuer in connection with a post-IPO investment and such due diligence involves more than an analysis of publicly available documents, the investor must be cognizant of insider dealing concerns.
As a broad concept, all investors should deal in a listed issuer on the basis of equal information. So long as the listed issuer has disclosed all material information in accordance with the requirements of the Listing Rules, it is arguable that all information which is likely to materially affect the price of the issuer’s securities is already in the public domain. However, on the basis that the due diligence involves a review of source documents underlying publicly disclosed information, the investor may discover information which it considers material but which has not been fully disclosed to the public. If the investor deals in these circumstances, it may be at risk of insider dealing.
Rights of Pre-Emption
A post-IPO investor should be aware that placements made to it may be subject to shareholder approval. Under the Listing Rules, as a general principle, all new issues of equity securities by a listed issuer should first be offered to existing shareholders by way of rights unless they have agreed otherwise. Thus, shareholder approval is required prior to a listed issuer issuing securities on a non pro rata basis (and for this purpose, the exclusion of foreign shareholders due to securities law restrictions does not itself affect whether the issuance is pro rata).
In practice, most listed issuers obtain a general mandate, approved annually by shareholders at the annual general meeting, authorizing the listed issuer to issue securities subject to a restriction that the maximum number of securities issued may not exceed 20 per cent. of the existing share capital of the issuer.
However, a listed issuer may not proceed by general mandate in the following circumstances:
- Connected Persons – Independent shareholder approval may be required for the issuance of securities on a non pro rata basis to investors who already hold 10 per cent. or more of the listed issuer’s share capital.
- Change of Control –Approval of the shareholders in general meeting is required if any issuance of securities would effectively alter the control of the listed issuer.
Disclosure of Interests
The SFO requires substantial shareholders to disclose their holdings and material changes to their holdings. These requirements play a role in the structuring of any exit on the open market.
Under the SFO, where an investor acquires 5 per cent. or more of an interest in the relevant share capital of a listed issuer, it is required to disclose such interest to the public via the SEHK. Furthermore, in broad terms, changes in the level of interest crossing a whole percentage threshold are generally discloseable subject to prescribed exemptions.
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