2. INTRODUCTION: RTOs vs. IPOs
Historically, reverse takeovers (“RTOs”) have been used as an alternative means of achieving a stock exchange listing. In a typical reverse takeover, a company (the “Acquiree”) will identify a target listed company. The listed company will then acquire the equity interests in the Acquiree or another company or other assets of the Acquiree and will issue shares (ordinary or preference shares) and/or convertible bonds in consideration, which results in the Acquiree obtaining a controlling stake in the listed company. The fact that no significant regulatory review was required (and there was no prospectus requirement) meant that the timeframe for completion of an RTO was considerably shorter than that for an IPO. In addition, RTOs are not subject to the vagaries of the market, as is an IPO, and the new owners of the listed company will generally suffer less share dilution and thus have greater control. Costs can also be saved due to the lack of an underwriter. It will be much easier for the company acquiring the listed company to raise capital, as investors will have a clearly defined exit strategy through the public market.
Some of the drawbacks to RTOs are that their speed and eventual value are sometimes overestimated, and they are sometimes completed without enough regard for the uninvolved shareholders.
In many countries RTOs still offer an alternative route to listing status, although there have been moves recently, notably in the United States (U.S.) and China, to tighten the regulation of RTOs following a number of accounting scandals involving Chinese companies that listed by this route. In the U.S. and Canada, reverse takeovers had been encouraged in the past, especially for small and micro-cap companies who were unlikely to be able to afford the underwriter necessary for an IPO. In the U.S., for example, it is possible to trade shares in listed shells – the investment objective being presumably to achieve a gain when there is an RTO of the shell. However, problems can arise when RTOs are under-regulated. Singapore had several high-profile reverse takeovers fall through due to concerns over profit guarantees, leading to the Singapore Stock Exchange publishing additional prescriptions for prospective RTOs including a minimum issue price for reverse takeovers and new requirements for the listed company and its financial adviser in assessing acquisitions involving profit guarantees, denounced as a gimmick during the bull run of 2007.
3. Background to HONG KONG’S POSITION ON RTos
The listing rules of the Stock Exchange of Hong Kong Ltd. (the “Exchange”) provide for stringent regulation of RTOs. Major amendments to the Exchange’s listing rules (“Listing Rules”) took effect on 31 March, 2004 which introduced specific reverse takeover rules (“RTO Rules”) to the Main Board Rules for the first time (previously RTO Rules were contained in the Listing Rules for the Exchange’s Growth Enterprise Market (“GEM”)) and aligned the existing GEM RTO Rules with the new Main Board RTO provisions. The RTO Rules were aimed at putting a stop to “back door listings” to which the Exchange had long objected: its argument being that they were being used to circumvent the Listing Rules.
The RTO Rules, in essence, require:
- an acquisition (or series of acquisitions) of assets which constitute both an attempt to achieve a listing of the relevant assets and a means of circumventing the Listing Rules’ requirements for new listing applicants, to be treated as a new listing;
- the assets to be acquired or the enlarged group to be able to meet the minimum criteria for listing;
- the preparation of a listing document containing both the information required in a new applicant’s listing document and the information required for a very substantial acquisition under Main Board Rule 14.69 (GEM Rule 19.69); and
- Compliance with the announcement and shareholders’ approval requirements applicable to a VSA.
The Rules also contain anti-avoidance provisions15 to prevent a new controlling shareholder circumventing the RTO Rules by, for example, deferring the disposal of the listed issuer’s existing business until after the injection of assets to the listed issuer shortly after the change of control, thereby avoiding classification of the asset injection as a VSA.
3.1. RTOs as Back Door Listing Route
Back door listings had been particularly popular in Hong Kong in the early 1990s when a number of companies incorporated in the People’s Republic of China (“PRC”) listed in this manner. The Exchange however viewed reverse takeovers with suspicion and in the ten years prior to the introduction of the Main Board RTO Rules in March 2004, had virtually eliminated the practice of injecting non-listed assets without a suitable track record for listing into a listed shell in conjunction with a change of control.
This was achieved through the publication in 1993 of a joint announcement by the Exchange and the Securities and Futures Commission which set out the principles governing RTO transactions. An RTO was defined as a transaction (or series of transactions within 12 months) that: (i) constituted an acquisition of non-listed assets at the level of a Very Substantial Acquisition; and (ii) resulted in a change of control through the introduction of a new majority holder.
At the same time as steps were introduced to discourage RTOs, the Exchange also made it possible for PRC companies to be listed on the Exchange as H share companies.
3.2. RTOs as Work-Out Tool
In addition, backdoor listings provided a well-trodden route for bank creditor driven restructurings of distressed listed companies. The point has been made that the March 2004 Rule changes (whose primary aim was the improvement of listed companies’ corporate governance standards) stemmed from the Exchange’s view at the time, that the corporate governance standards of certain Hong Kong listed companies were below par and that these companies adversely affected the overall quality of the market. However, that overriding concern failed to acknowledge any distinction between a rescue and non-rescue situation. For creditors of a distressed listed company, the listing status was often the “asset” that was most capable of being realised. Previously, it had been possible for bank creditors to achieve a disposal of a “listed shell” through the entry of a White Knight and so achieve some level of recoveries from their bad debt positions. This was often supplemented by a well-timed exit from an equity position held by the banks following the restructuring. This route was often preferable to the alternative of a liquidation from which the returns likely to be generated from the company’s underlying assets were less certain.
At the time of the 2004 amendments, the point was made that their likely effect would be to erode the value of listed shells and make it more difficult for White Knights to rescue troubled issuers.
4. DEFINITION OF REVERSE TAKEOVER
4.1. The Definition
The preamble to Main Board Rule 14.06(6) and GEM Rule 19.06(6) defines a reverse takeover as:
An acquisition or a series of acquisitions by a listed issuer which, in the opinion of the Exchange, constitutes, or is part of a transaction or arrangement or series of transactions or arrangements which constitute:
- an attempt to achieve a listing of the assets to be acquired; and
- a means to circumvent the requirements for new applicants set out in Chapter 8 (GEM Chapter 11) of the Listing Rules (the “Definition”). (our emphasis added)
This is a principle based test and gives the Exchange a very broad discretion to label a transaction as an RTO should it view the transaction as an attempt to circumvent the listing rules.
4.2. The Bright Line Tests
The Listing Rules do not define the specific transactions which amount to an RTO. Instead, paragraphs (a) and (b) of Rules 14.06(6) and 19.06(6) set out the bright line tests which apply to two specific types of RTO:
According to those paragraphs, a “reverse takeover” normally refers to:
- an acquisition or a series of acquisitions of assets (aggregated under Rules 14.22 and 14.23) by a listed issuer which constitute a very substantial acquisition (“VSA”) where there is, or which will result in, a change of control (as defined in the Takeovers Code (i.e. 30%)) of the listed issuer (other than at the level of its subsidiaries); or
- an acquisition or a series of acquisitions of assets (aggregated under Rules 14.22 and 14.23) by a listed issuer which constitute a VSA from a person or group (or their associates) under any agreement or arrangement entered into by the listed issuer within 24 months of that person or group gaining control of the listed issuer (where the original transaction did not constitute an RTO). In determining whether one or more transactions constitute a VSA, the denominator in the percentage ratio calculation is measured at the time of the change of control or the acquisition(s), whichever produces the lower figure.
A very substantial acquisition which falls within either of the bright line tests constitutes an RTO which will be treated as a new listing. Under the bright line tests, acquisitions in the 24 months after a change in control, which individually or together cross the threshold of a VSA, will constitute an RTO and be treated as a new listing.
4.3. VSAs within the Bright Line Tests
A VSA which falls within either of the bright line tests in Listing Rule 14.06(6)(a) or (b) (GEM Rule 19.06(6)(a) or (b)) constitutes an RTO and will be treated as a new listing notwithstanding that the requirements for a new listing are met. In Listing Decision LD29-2012 a listed issuer’s acquisition of a company from its controlling shareholder within 24 months of a change in control was found to be within Listing Rule 14.06(b) and hence subject to the RTO Rules.
The simplified group structure was as follows:
The case concerned an issuer listed on the Main Board of the Exchange (“Listco”) which proposed to acquire the Target from its controlling shareholder, Company B.
A year before the proposed acquisition, Company B acquired a controlling interest in Listco and accounted for Listco as a subsidiary.
Listco was principally engaged in the property business. Company B was engaged in various business activities including certain property projects held through the Target.
Listco proposed to acquire Target from Company B and would issue new shares to Company B as consideration.
The transaction was a very substantial acquisition for Listco based on its size. Although it was made within 24 months of a change in control of Listco, it was submitted that the transaction should not be classified as a reverse takeover because:
- Company A had been engaging in property business for many years. It had substantive business operations and was not a shell company.
- The Target and Listco were engaged in the same type of business.
- The transaction was a group reorganisation to consolidate Company B’s property business into Listco. Its purpose was not to achieve a listing of Target’s business.
- The Target’s business could meet the profit requirements for new listing applicants under Rule 8.05(1).
The transaction was found to constitute a reverse takeover for Listco under Rule 14.06(6)(b) because it was a very substantial acquisition and Target was to be acquired from Company B within 24 months after it acquired control of Listco.
Although the transaction was a reorganisation of property business within Company B’s group, Target was of a very significant size to Listco. The transaction, together with the change in control of Listco, was a means to list Target’s property business.
4.4. Waivers where Transaction is within Bright Line Tests
Where a transaction falls within the bright line tests, it may be possible for the listed issuer to obtain a waiver from the RTO Rules if it can satisfy the Exchange that circumvention of the Listing Rules is not a material concern. The listing decisions indicate that a waiver application is more likely to be successful where the acquisition is related to the issuer’s principal business. It should be noted however that the Exchange generally requires enhanced disclosure for VSAs which are very material to the listed issuer or may result in a fundamental change to its business.
Listing Decision LD59-2013: Successful Waiver Application
In Listing Decision LD59-2013, an electronic gaming company (“Company C”) attempted to acquire patents in an overseas market from an individual (“Mr. X”), an executive director and substantial shareholder of Company C. The transaction was a very substantial acquisition and connected transaction for Company C, which would provide cash and consideration shares as consideration. Mr. X would hold more than 30% of Company C’s enlarged share capital after the transaction, and would apply for a whitewash waiver under the Takeovers Code to avoid the requirement to make a mandatory general offer. Since this transaction was a very substantial acquisition that would result in a change of control in the listed issuer, it would be an RTO under Rule 14.06(6)(a).
Company C sought a waiver from Rule 14.06(6)(a) on the basis that the purpose of acquiring the patents was to expand its gaming business overseas and its existing business was profitable and operating on a substantive scale. The acquisition was not significantly larger than Company C. Additionally, Company C argued that its disclosure of the acquisition in its circular would be of a standard comparable to that required in an IPO prospectus, and would include a valuation report and details of its due diligence on the patents being acquired.
The Exchange considered that the acquisition of the patents was an RTO within the ambit of the under Rule 14.06(6)(a). However, it accepted Company C’s submission that the transaction was related to its principal business and was not an attempt to achieve a listing of the patents while circumventing the Listing Rule requirements. The Exchange therefore waived Rule 14.06(6)(a) and classified the acquisition as a very substantial acquisition and a connected transaction, but not an RTO.
Listing Decision LD58-2013 – Unsuccessful Waiver Application
A listed issuer is likely to have more difficulty in obtaining a waiver for a transaction falling within the bright line tests if it is a listed shell. In Listing Decision LD58-2013, the acquiring company (“Company A”) failed to obtain a waiver of Rule 14.06(6). Company A was a suspended Main Board company that had delisted and ceased operations because it did not maintain a sufficient level of assets or operations as required by Rule 13.24. Company A attempted to acquire the Target (as part of its proposal for the resumption of trading in its own securities) in exchange for the issue of consideration shares that would have comprised over 90% of its share capital. The vendor in the transaction would have become the controlling shareholder of Company A and it intended to place down its shares in Company A to meet the public float requirement before the resumption of trading.
The acquisition would be a very substantial acquisition that resulted in a change in control of Company A, a listed issuer, putting it within the bright line test under Rule 14.06(6)(a), thus making it an RTO. However, Company A requested that the Exchange should not regard the transaction as an RTO because the Target could meet the trading record requirements for a new listing applicant under Rule 8.05, citing Listing Decision LD95-1.
However, the Exchange refused to grant the waiver on the basis that:
- the transaction clearly fell within the ambit of Rule 14.06(6)(a);
- Company A was a shell company and the vendor in the transaction was trying to use that shell to achieve a listing of the Target’s business without going through the listing application process; and
- the circumstances of the case were unlike those of Listing Decision LD95-1 because, in that case, the investor who gained control over the listed issuer did not inject assets into it as the vendor would have injected assets into Company A.
4.5. Transactions outside the Bright Line Tests
The Listing Committee’s 2007 Annual Report confirmed that while the bright line tests in paragraphs (a) and (b) of Rule 14.06(6) refer to two specific forms of reverse takeovers, these are not meant to be exhaustive. Transactions which are in substance backdoor listings, but do not fall strictly within paragraphs (a) and (b) of the Rule, may still be considered reverse takeovers subject to the Listing Rules.
No Requirement for a Change of Control
It was made clear that a change of control of the listed issuer is not required for a transaction to be classified as an RTO in the Exchange’s Listing Decision 75-1 of October 2009.16 The case concerned a company (“Company A”) which had long been suspended from trading. At the time of suspension, Company A and its subsidiaries (the “Group”) were principally engaged in the business of nurturing, selling and trading tree seedlings and seeds. Company A agreed with a third party to dispose of its entire interest in a subsidiary, which at the time conducted the principal business of the Group (the “Disposal”). The Disposal constituted a VSA for Company A.
As part of the proposal to resume trading, Company A would enter other transactions and arrangements including:
- equity fund raising; and
- acquisitions of serviced apartments and elderly home businesses (“New Businesses”) from independent third party vendors for cash consideration (the “Acquisitions”).
Following the Disposal, the Group had ceased to operate its original principal business. Company A intended to focus on the New Businesses.
The Company argued that notwithstanding that based on the percentage ratio calculations, the Acquisitions would be a VSA, the transaction did not constitute an RTO since the Acquisitions and other transactions did not involve a change in control.
The Exchange disagreed. It referred to the statement in the 2007 Listing Committee Annual Report that paragraphs (a) and (b) of Rule 14.06(6) are not exhaustive and that transactions that are in substance backdoor listings but do not fall within the bright line tests may still be considered as reverse takeovers. It determined that:
- the Group had disposed of the subsidiary and no longer retained any material operating assets and ceased to conduct its original principal business. Company A was in substance a listed shell.
- The Acquisitions formed part of a series of transactions and arrangements which constituted an attempt to achieve a listing of the New Businesses.
- The Acquisitions would constitute a reverse takeover for Company A and Company A would be treated as a new listing applicant under Rule 14.54.
How does the Exchange look at “Change in Control”?
Listing Decision 75-2
The case involved a change in direct control between two subsidiaries of the municipal government. The simplified group structures before and after the Acquisition are:
- Company A was a Main Board listed company and proposed to acquire from the Vendor its interest in the Target (the “Acquisition”). Company A and the Target had the same line of business.
- Since Company A would settle part of the consideration by issuing new shares to the Vendor, the Acquisition would result in a change in its shareholding structure:
- the Holding Company’s shareholding in Company A would be diluted to about 20% of the enlarged issued share capital:
- the Vendor would hold more than 50% of Company A’s enlarged issued share capital. Under Note 6(a) to Rule 26.1 of the Takeovers Code, the Vendor was granted a waiver from its obligation to make a general offer for Company A as a result of the Acquisition.
- The Acquisition was a connected transaction for Company A as the Exchange had deemed the Vendor and its associates to be Company A’s connected persons since the listing of Company A. Based on the percentage ratio calculation, the Acquisition was also a very substantial acquisition.
- Company A sought the Exchange’s confirmation that the Acquisition was not a reverse takeover under Rule 14.06(6). It submitted that although the Acquisition would result in the Vendor acquiring a controlling interest in Company A, there would not be a change in control under Rule 14.06(6) because:
- Both Entity X and Entity Y were subordinate departments of the Municipal Government and under its supervision. Through these entities, the Municipal Government had exercised control over each of the Holding Company, Company A, the Vendor and the Target, including through the exercise of voting rights.
- The Municipal Government had, and would continue to have, ultimate control over Company A before and after the Acquisition.
The Acquisition was not regarded as a reverse takeover of Company A since the Municipal Government would remain Company A’s controlling shareholder following the acquisition, and there would not therefore be a change in its ultimate control as a result of the Acquisition.
The Exchange also took into account the assessment of “control” under the Takeovers Code. In this case, the Takeovers Executive had granted a waiver to the Vendor from its obligation to make a general offer under Note 6(a) to Rule 26.1 of the Takeovers Code. This was different from the situation where the control of an issuer changed and a whitewash waiver was granted subject to independent shareholders’ approval under the Takeovers Code.
The decision has implications for the possible use of reverse takeovers to restructure organizations, as so long as the ultimate control of the organization remains with the same entity, and that entity takes an active controlling role, then the subsidiaries should be free to change their lower level control structure.
15 Main Board Rules 14.92 to 14.93 and GEM Rules 19.92 to 19.93 discussed further at Section 5 below.