7. Conversion of B shares to H shares
In December 2012, China International Marine Containers Group became the first PRC B share company to convert its B-share listing into an H-share listing on the Exchange by way of introduction following approval by the CSRC and the Exchange.
Listing by way of introduction
Listing by introduction is a means of listing shares already in issue on another stock exchange where no marketing arrangements are required because the shares are already widely held. As only existing shares are listed by introduction, no additional funds are raised.
Listing Rule 7.15 states that an introduction will only be permitted in exceptional circumstances if there has been a marketing of the securities in Hong Kong within the six months prior to the proposed introduction where such marketing was made conditional on listing being granted for those securities. Furthermore, there may be other factors, such as a pre-existing intention to dispose of securities, a likelihood of significant public demand for the securities or an intended change of the issuer’s circumstances, which would render an introduction unacceptable to the Exchange. An introduction will not be permitted if a change in the nature of the business is contemplated.
There are problems which may hinder B shares conversion to H shares due to regulatory differences such as differences in accounting systems and financial reporting and requirements of independent non-executive directors (“INEDs”).
Exchange Guidance Letter GL53-13 provides guidance to issuers seeking to list by way of introduction on arrangements to facilitate liquidity of issuers’ securities to meet demand on the Hong Kong market during the initial period after listing.
Listing decision HKEx-LD52-2013 provides a detailed explanation for the Exchange’s decision to allow an un-named company listed on a PRC stock exchange to convert its entire B shares into H shares to be listed on the Exchange by way of introduction.
8. Regulation of Red Chip Listings
Circular 10 – the M&A Rules
In the past, the reorganisation and PRC regulatory approval process for red-chip listings was more straightforward than that for H-share listings. However, that changed with the issue of the Provisions on the Takeover of Domestic Enterprises by Foreign Investors (the “M&A Rules” or “Circular 10”), which came into effect in September 2006.
Issued by the Ministry of Commerce (“MOFCOM”), with six other governmental departments, the M&A Rules represented a significant step in the development of China’s regulation of foreign acquisitions of Chinese companies. The requirements imposed had significant consequences both for round-trip investments and red-chip listings. Since the M&A Rules came into force, there have been virtually no approvals for restructurings of Chinese companies into offshore holding companies.
In a red-chip listing of a PRC domestic company, the PRC shareholders would set up an offshore holding company typically in the Cayman Islands or Bermuda. The offshore company would then purchase the PRC company which would become its wholly owned subsidiary.
The use of an offshore SPV to achieve an offshore listing of a Chinese company is effectively prevented by the M&A Rules, since MOFCOM approval at the central government level is required for:
- the establishment of an offshore SPV for the purpose of achieving an overseas listing where the offshore company is directly or indirectly controlled by a Chinese company or Chinese individuals; and
- the acquisition by the offshore SPV of the affiliated Chinese company.
The M&A Rules additionally require CSRC approval for the listing of an SPV holding China assets on an overseas stock exchange.
The M&A Rules impose an obligation on the parties to an acquisition to declare whether they are affiliated. If two parties to a transaction are under common control, the identities of the ultimate controlling parties must be disclosed to the approving authorities, together with an explanation of the purpose of the M&A transaction and a statement as to whether the appraised value represents fair market value. The use of trusts or other arrangements to avoid this requirement is expressly prohibited (Article 15).
A further hurdle to a red chip listing is that the M&A Rules provide that the listing price of the SPV’s shares on the overseas exchange may not be less than the valuation of the onshore equity interest as determined by a PRC asset valuation company.
There is also a requirement that the proceeds of the offshore listing, as well as dividends and the proceeds of changes in the capital of Chinese shareholders must be repatriated to China within 180 days / 6 months.
Circular 10 did not however put a stop to offshore financings and listings of Chinese companies. The number of both has remained high, although many such deals involved companies that were restructured prior to Circular 10’s effective date. Other Chinese businesses have been listed using different re-organisation structures to take them outside the ambit of Circular 10. Chief among these has been the variable interest entity (“VIE”) structure.
In 2012, China Zhongsheng Resources Holdings Limited (2623.hk), originally a PRC company, transformed itself into a Sino-foreign enterprise and then a wholly foreign-owned enterprise and successfully listed in Hong Kong. The company only commenced the red-chip restructuring in 2010 after the implementation date of Circular 10. At various stages of the restructuring, approvals of the provincial bureau of commerce were granted. The company’s successful listing is seen as a circumvention of the regulations prohibiting red-chip listing. It remains to be seen whether the listing resulted from a change in MOFCOM’s policy towards red-chip listing, or merely an exception based on the company’s particular facts and circumstances.
9. VIE structures
Alternative structures have been used to address the challenges to round trip investments posed by Circular 10 and Circular 75. Many of these have involved variations on the VIE structure.
VIE structures are used to obtain an overseas listing of PRC businesses which operate in industries subject to restrictions on foreign investment under PRC law (“restricted businesses”) (e.g. internet content provision, media, telecom). Under a VIE structure, all relevant licences and permits for operating the restricted business are held by PRC operating companies (OPCOs) which are wholly owned by PRC shareholders, and the foreign investors control and obtain economic benefits from the OPCO through a series of agreements referred to as “contractual arrangements” or structured contracts.
In a typical VIE structure, the PRC shareholder(s) establish an offshore SPV (usually incorporated in Bermuda or the Cayman Islands) which will normally become the listed company. The offshore SPV will establish a subsidiary in the PRC which will be a wholly foreign-owned enterprise (“WFOE”). The WFOE will enter into contractual arrangements with the OPCOs and their PRC shareholders which give it control over the OPCOs and enable the listed company to consolidate their financial results in the group’s financial statements.
The VIE structure was first adopted by Sina in its 2000 listing on Nasdaq, followed by a number of leading internet or media companies listed overseas, including Sohu, Netease, Baidu, Focus Media, Youku and Dangdang (all listed on Nasdaq or NYSE) and Tencent and Alibaba (both listed on the Exchange, although Alibaba subsequently delisted).
Over the years, the VIE structure was never officially or publicly blessed by the PRC authorities, although it was generally regarded as a structure established to intentionally circumvent the restrictions on foreign investment. In the past, however, it was at least acquiesced by the Chinese regulatory authorities.
A typical VIE structure is illustrated in the following diagram:
Typical contents of contractual arrangements between domestic company and the WFOE
Control over the OPCO is exercised through a series of contractual arrangements between (1) the PRC shareholder(s) and the WFOE; and (2) the OPCOs and the WFOE.
These contractual arrangements will normally include:
- Exclusive service agreement;
- Call option agreement;
- Equity pledge agreement;
- Loan Agreement; and
- Voting right agreement or power of attorney.
Exclusive Service Agreement
The exclusive service agreement is entered into between the WFOE and the OPCO pursuant to which the WFOE provides exclusive consulting, management or technology support services to the OPCOs for a fee for the purpose of shifting the profits of the OPCOs to the WFOE.
Call Option Agreement
The call option agreement is entered into between the WFOE and the PRC shareholder pursuant to which the WFOE is granted the option to acquire or designate a third party to acquire, all or a portion of the equity interest in the OPCO at the lowest permitted price under the applicable PRC laws and regulations.
Equity Pledge Agreement
The equity pledge agreement is entered into between the WFOE and the PRC shareholder, pursuant to which the PRC shareholder pledges all its equity interests in the OPCOs in favour of the WFOE to secure the due performance by the OPCOs of their obligations under the contractual arrangements. The equity pledge agreement is required to the registered with the local Administration of Industry and Commerce to perfect the security interest.
The loan agreement is entered into between the WFOE and the PRC shareholder, pursuant to which the WFOE grants a loan to the PRC shareholder for the purpose of capitalising the OPCOs.
Voting Rights Agreement or Power of Attorney
The voting rights agreement or power of attorney is entered into between the WFOE and the PRC shareholder pursuant to which the PRC shareholder irrevocably grants the WFOE all its shareholder rights, including voting rights.
However, just because VIE structures have been widely used does not mean they are legally risk-free. The continued existence of VIE structures very much depends on the “policy-winds” among government officials.
The risks associated with use of the VIE structure essentially fall into two categories: (i) the regulatory risk that the structure might be declared to be invalid by the PRC authorities; and (ii) the risk that the contractual arrangements on which it relies will be unenforceable or insufficient to retain control over the OPCO. With regard to both these issues, comfort needs to be sought from the PRC legal advisers.
The principal regulatory risk probably arises where the OPCO operates in a sector which is subject to restrictions on foreign investment. Although the foreign investor does not directly own equity in the OPCO, there is the possibility that the Chinese regulatory authorities could regard it as de facto foreign investment. Failure to obtain the required foreign investment approvals could lead to the Chinese authorities requiring the structure to be unwound. Another risk is that VIE structures could be declared to be subject to the requirement for MOFCOM approval under the M&A Rules.
Use of the VIE structure to facilitate foreign investment in areas subject to restrictions on such investment has however been common for a number of years and many of China’s best known companies have used the structure to obtain foreign venture capital financing and list offshore.
There have been attempts by individual PRC regulators to restrict or curtail the use of the structure in specific industries or to circumscribe its use in the past. For example, in relation to value added telecommunications businesses, a circular issued by the PRC Ministry of Information Industry in 2006, requires certain key assets, including trademarks and domain names, to be held by the company with the value added telecommunications service provider licence or its shareholders. As a result, in a VIE structure, the OPCO needs to hold key assets and cannot lease or license them from the WFOE. Although this increases the potential loss suffered by the WFOE if it loses control of the OPCO, the circular can also be regarded as acknowledging the use of the VIE structure in the value added telecommunications industry.
Another example is the notice of general administration of press and publication issued in 2009 – targeting the online gaming business. Under the notice, foreign investors are not allowed to control or participate in a domestic online gaming business by setting up a joint venture company, through contractual arrangements, or providing technical support.
In September 2011, the measures on the security review system of mergers and acquisitions of Chinese enterprise by foreign investors were issued. These require MOFCOM approval for foreign investment in industries deemed sensitive to China’s national security interests. The measures specifically prohibit foreign investors from adopting indirect or contractual arrangements so as to avoid the national security review requirements. This is considered to take aim specifically at VIE structures.
A potential risk is that a VIE structure will be declared invalid on public policy grounds. Buddha Steel, a small steel maker, applied for listing in the United States through a VIE structure. In March 2011, it was advised by the local government authorities of Hebei Province that the VIE contractual arrangements contravened existing Chinese management policies relating to foreign invested enterprises and as a result, were against public policy. Buddha Steel terminated the VIE contracts and withdrew its listing application.
Buddha Steel has not however been viewed as an indication of Chinese authorities’ disapproval of the VIE structure. Rather, it has been seen as the regulatory authorities tightening control on foreign investment in certain core and important industries, including the steel production industry.
China’s Draft Foreign Investment Law
Since the PRC Ministry of Commerce published a consultation draft of a new Foreign Investment Law (the “FIL”) in January 2015, there have been increased concern over the legality and validity of the structured contracts used in VIE arrangements. The key changes in relation to VIEs proposed by the Draft FIL are that:
- the legal validity of VIE structures will be recognised;
- a VIE structure controlled by a foreign investor will have to comply with restrictions on investment in “restricted” and “prohibited” industries.
Control is defined in Article 18 of the draft FIL as:
- holding (directly or indirectly) more than 50% of the shares, voting rights or similar equity interests;
- having the right or ability to appoint or nominate at least half of the board of directors (or of a similar governance body);
- having the ability to exercise a major influence on shareholders’ or directors’ decisions; or
- having the ability to have a decisive influence over an entity’s operations, finances, human resources or technology through contract, trust or other arrangements (contractual control).
The Exchange thus now requires PRC companies that use VIE structures to list on the Exchange to demonstrate that they are (and will continue to be) “controlled” by PRC nationals.
When the draft FIL was published for consultation, it was thought that it would be implemented in the relatively near future. However, consultation conclusions have not been published since the draft FIL was published in January 2015. Many PRC lawyers now believe that it is unlikely that the new FIL will be implemented in the near future in its present form. Moreover, it’s generally expected that if it is finally implemented, there will be some form of grandfathering provision to either exempt currently listed VIE structures or allow a grace period for them to amend their structure to comply with the new requirements. Nevertheless, the Exchange’s current policy requires Chinese VIE structures to be controlled by PRC nationals on the date of listing.
Given the provisions of the draft FIL, the Exchange requires the controlling shareholders of a listed issuer using a VIE structure to give undertakings to the listed issuer that they will:
- hold or control at least 50% of the voting rights in the listed issuer’s share capital;
- maintain his/her PRC nationality; and
- procure that any arrangement in support of maintaining the holding or control of at least 50% of the listed issuer’s share capital would only be terminated when the listed issuer’s shares cease to be listed on the Exchange.