5. Restriction on Disposals after a Change of Control
5.1. Anti-Avoidance Provisions
In order to prevent circumvention of the RTO Rules, MB Rules 14.92 and 14.93 (GEM Rules 19.91 and 19.92) provide that an issuer may not dispose of its existing business within twenty-four months of a change of control unless the assets acquired after the change of control meet the requirements of Main Board Rule 8.05/GEM Rule 11.12A. If this is not the case, the transaction is treated as a new listing.
These Rules allow certain (i.e. small) assets to be sold, but the “existing business” must be maintained. The Rules pose a problem in cases where an outgoing shareholder is reluctant to sell the listed vehicle without retaining certain assets.
5.2. Guidance on Disposal of Existing Business after a Change of Control: Listing Committee Annual Report 2008
It was acknowledged in the Listing Committee’s 2008 Annual Report that the strict application of Rules 14.92 and 14.93 (and their GEM equivalents) went beyond the original intention behind them. The aim was to prevent circumvention of the RTO Rules by the new controlling shareholder structuring the RTO as a series of transactions, e.g. by deferring the disposal of the 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.
However, it was noted that the drafting of the Rules supports a narrower interpretation and could effectively restrict a listed issuer from disposing any of its existing businesses for legitimate reasons within 24 months of a change of control – even where there is no asset injection.
Consequently, at a policy meeting in April 2008, the Listing Committee endorsed a proposal to restore the original intention of the Rules by providing that the disposal restriction would apply in circumstances where: (a) there has been an injection of assets from the new controlling shareholder (thus raising a legitimate concern about a reverse takeover); and (b) where taking into account the disposal(s), the asset injection (or series of injections) from the new controlling shareholder during the period leading to and after the change in control would have resulted in a VSA.
Accordingly the disposal restriction applies only in the above circumstances and not to a disposal following a change in control where there has been no asset injection from the incoming controlling shareholder.
5.3. Exchange Listing Decision (HKEx-LD7-2011) regarding restrictions on disposal after change in control
The Exchange published in March 2011, a listing decision (HKEx-LD7-2011) on an attempt by a Main Board issuer (“Company A”) to circumvent certain elements of the regulatory regime, set out in Chapter 14 of the Listing Rules, governing the conduct of reverse takeovers. This effort at circumvention concerned Listing Rule 14.92, which prevents a listed issuer from disposing of its current business for a period of 24 months subsequent to a change in control. Company A sought a waiver from this Rule. However, the Exchange refused to grant the waiver, principally on the grounds that Company A was attempting to defeat the policy goals of Rule 14.92. The Exchange went on to state that if Company A persisted with the disposal, it would be treated as a new listing applicant under Rule 14.93.
The attempt at circumventing the relevant rules of Chapter 14 involved delaying the disposal of Company A’s current business until after it had signed an agreement to acquire another business, in the hope of avoiding triggering the percentage ratio17 which constitutes a “very substantial acquisition”18 under Chapter 14. The classification of an acquisition as a very substantial acquisition leads to the triggering of the RTO Rules.
The key point made by the Exchange was that Rules 14.92 and 14.93 are designed to eliminate the possibility of companies circumventing the effect of Rule 14.06(6). Examples of the kind of circumvention which these Rules are meant to prevent include situations where the new controlling shareholder structures a reverse takeover as a series of transactions. The specific example given by the Exchange is where the new controller(s) inject assets into the listed issuer soon after assuming control, but defer the disposal of the issuer’s existing business. This procedure permits the new controller(s) to avoid classifying the asset injection as a very substantial acquisition, as it ensures that the percentage ratios of the asset acquired will not reach 100% or more.
The Exchange noted that the wording of Rule 14.92 allows for a stricter reading of the section, one which prevents an issuer from selling any of its existing businesses within the 24 months subsequent to a change in control, even where there is no asset injection and the sale has a legitimate business rationale underlying it. The Exchange then stated in the decision that Rule 14.92 should be interpreted to meet the policy intent of obstructing the circumvention of Rule 14.06. With this in mind, the Exchange noted that a waiver from Rule 14.92 may be granted to issuers so long as:
- an injection of assets has not been made by the new controlling shareholder into the listed issuer; and
- after factoring in the disposal(s) of the existing business of the listed issuer, this asset injection (or injections), made in the lead up to and subsequent to the change in control, would not have constituted a very substantial acquisition on the part of the listed issuer.
In the case under review, the Exchange looked at the overall effect of the change in control, acquisition and disposal, and, having identified an attempt to undermine the policy goals of Rule 14.92, refused to grant the waiver.
6. VSAs OUTSIDE THE BRIGHT LINE TESTS
6.1. Exchange Guidance
The Exchange’s Guidance Letter HKEx-GL78-14 published in May 2014 sets out the Exchange’s current practice on the application of the RTO Rules. If a transaction falls outside the bright line tests, the Exchange will apply the principle based test to assess whether the acquisition constitutes an attempt to achieve a listing of the assets to be acquired and a means to circumvent the requirements for new listing. The Exchange will treat the transaction as an RTO only if it considers it to be an “extreme case”.19
6.2. Relevant Factors in “Extreme Case” Determination
The following factors are taken into account in determining whether a backdoor listing is an extreme case:
- The size of the acquisition relative to the size of the issuer.The Exchange does not prescribe an absolute threshold in determining whether the size of a transaction is extreme. Instead, in assessing the impact of the acquisition on the issuer, the Exchange takes into account other criteria such as the nature and scale of the issuer’s existing business after the acquisition, and whether the acquisition will result in a fundamental change in the issuer’s business.
- Quality of the acquired business – whether it can meet the trading record requirements for new listings, or whether it is unsuitable for listing.An acquisition of a target business unsuitable for listing will likely be considered a circumvention of the new listing requirements (e.g. early exploration companies or illegally operated businesses).
Acquisitions of new businesses or assets that have no track record or have yet to commence operations are more likely to be treated as new listings since enhanced disclosure is likely to be of limited use. This is particularly so where the target’s business is completely different from that of the issuer (see Listing Decision LD95-4 which is summarised in Annex C)
- The nature and scale of the issuer’s business before the acquisition (a key question is whether it is a listed shell).If an issuer carries carries on minimal operations (e.g. a shell company), a material asset injection is more likely to be considered as “extreme” because the target assets would be listed post-acquisition (e.g. a PN17 company20).
The Exchange will consider the nature of the issuer’s existing business and its financial position. An issuer’s business is more likely to be considered as a shell company if the issuer operates:
- a trade business that has a low level of activities and generates minimal gross profit and losses; or
- a business of “treasury management” of its substantial positions in cash and short-term investments.
- Any fundamental alteration to the issuer’s principal business (e.g. the existing business would be discontinued or very immaterial to the enlarged group’s operations post acquisition).Acquisition of a business that is completely different to the issuer’s existing business is more likely to be viewed as a means to achieve the listing of the target assets, particularly:
- where the target business is specialised while the present management is not; and
- where the issuer’s existing business is so immaterial that the issuer would be substantially carrying on only the new business post-acquisition.
The Exchange does not normally consider acquisitions of assets for expansion or development of existing business as “extreme”.
- Any other events and transactions, whether historical, proposed or intended, which, together with the acquisition, form a series of arrangements designed to circumvent the RTO Rules (e.g. a disposal of the issuer’s original business simultaneously with a very substantial acquisition).Proposals involving an asset swap, or disposal of the existing business to the exiting shareholder may be indications that the issuer is “cleaning” its “shell” to achieve a listing of the target business.
- Any issue to the vendor of Restricted Convertible Securities which would provide it with de facto control of the issuer. Restricted Convertible Securities are highly dilutive convertible securities with a conversion restriction mechanism (e.g. restriction from conversion that would cause the securities holder to hold 30% interest or higher) which avoids triggering a change of control under the Code on Takeovers and Mergers.
6.3. Treatment of Extreme Cases
The flowchart below summarises the RTO assessment and requirements.
Extreme cases unable to meet new listing requirements
Where the Exchange considers a VSA to be an “extreme case” by reference to the criteria set out in paragraph 6.2 above, it will be treated as an RTO if the assets to be acquired (or the enlarged group) do not satisfy the conditions for a new listing. The transaction will therefore not be able to proceed.
Extreme cases able to meet new listing requirements
A VSA which the Exchange considers to be an “extreme case” will be treated as an extreme very substantial acquisition (“extreme VSA”) where:
- the assets to be acquired can meet the minimum profit requirement under Rule 8.05 (the positive cash flow requirement under GEM Rule 11.12A); and
- circumvention of the new listing requirements is not a material concern.
Extreme VSAs are presented to the Listing Committee for its decision.
If the Listing Committee determines that the RTO Rules apply, the issuer will be treated as a new listing applicant and will be subject to the listing requirements for new applicants (see paragraph 7 below).
If the Listing Committee determines that the RTO Rules will not apply, the issuer will be required to:
- prepare a transaction circular under an enhanced disclosure and vetting approach; and
- appoint a financial adviser to conduct due diligence on the acquisition.21
For further information on these requirements, please see paragraph 9 below. The transaction also needs to follow the requirements for VSAs under Chapter 14 (GEM Chapter 19) including the requirement for shareholders’ approval.
6.4. Treatment of non-extreme cases
If a VSA is not considered to be extreme, the issuer may nevertheless be required to prepare a transaction circular under an enhanced disclosure and vetting approach.
7. LISTING RULE REQUIREMENTS FOR AN RTO
7.1. Treatment as New Listing
Where a listed issuer proposing a reverse takeover is treated as a new listing applicant, the enlarged group or the assets to be acquired must be able to meet the financial tests in Main Board Rule 8.05 or GEM Rule 11.12A and the enlarged group must be able to meet all other listing criteria of Main Board Chapter 8 or GEM Chapter 11 of the Listing Rules (Main Board Rule 14.54/GEM Rule 19.54).
The listed issuer must comply with the procedures and requirements for new listing applicants set out in Chapter 9 of the Main Board Rules (Chapter 12 of the GEM Rules) and must issue a listing document and pay the initial listing fee. A reverse takeover listing document is required to include virtually all the information required by Part A of Appendix 1 to the Listing Rules in addition to the information required for a very substantial acquisition under Main Board Rules 14.63 and 14.69 (GEM 19.63 to 19.69). The listed issuer is additionally required to appoint a sponsor which will need to conduct full due diligence and the new listing will need to be approved by the Exchange’s Listing Committee or its Listing Division in the case of an issuer listed on GEM.
7.2. Announcement Requirement
The applicant must make an announcement to all shareholders regarding the RTO in accordance with Main Board Rule 2.07C/ GEM Rule 16.17. Under Rule 13.52(2)(a) (GEM Rule 17.53(2)(a)), an announcement of a reverse takeover (or a VSA) is subject to pre-vetting by the Exchange. The announcement must contain all pertinent information about the transaction, including the matters listed in Main Board Rules 14.58 and 14.60 (GEM Rules 19.58 and 19.60). Any other pertinent information must also be included.
An issuer may be required to suspend trading in its shares pending publication of the acquisition announcement. The suspension period must be kept as short as possible and issuers should note that suspension does not relieve them of their obligation to announce inside information under the Securities and Futures Ordinance.
Documents to be submitted with the acquisition announcement for pre-vetting
The issuer should submit the following documents to the Exchange together with the acquisition announcement for pre-vetting:
- draft financial statements / accounts of the target business over the track record period;
- where the consideration for the acquisition is supported by a valuation, the valuation report and the underlying assumptions;
- for an acquisition of natural resources, the competent person’s report to support the amount of estimated resources and reserves, the working capital forecast memorandum to demonstrate sufficiency of the enlarged group’s working capital; and
- for an acquisition of business under contractual arrangements, a legal opinion to demonstrate that such arrangements meet the conditions set out in Exchange Guidance Letter HKEx-GL77-14.
7.3. Requirement for Shareholders’ Approval
An RTO must be made conditional on being approved by shareholders in general meeting and the listing document must be sent to shareholders at the same time as, or before, the listed issuer gives notice of the general meeting to approve the transaction. The announcement of the reverse takeover must state the expected date of despatch of the listing document and, if this is more than 15 business days after the publication of the announcement, reasons for this must be given. The listing document must include an accountants’ report for the 3 preceding financial years on the business, company or companies to be acquired (Main Board Rule 14.69(4) and GEM Rule 19.69(4)).
At a general meeting to approve an RTO, any shareholder and his associates are barred from voting if the shareholder has a “material interest” in the transaction. In relation to an RTO, the Listing Rules further require that where there is a change in control of the listed issuer and the existing controlling shareholder(s) will dispose of shares to any person, the existing controlling shareholder(s) cannot vote in favour of the acquisition of assets from the incoming controlling shareholder or his associates at the time of the change in control. This prohibition does not however apply where the decrease in the outgoing shareholder’s shareholding results solely from a dilution through the new issue of shares to the incoming controlling shareholder rather than a disposal of shares by the outgoing shareholder.
7.4. Other Regulatory Issues
Rule 25 of the Takeovers Code on Special Deals with Favourable Conditions prohibits an offeror and its associates from entering into a deal to buy a company’s shares which involves favourable conditions being offered to one or more shareholders which are not available to all the other shareholders.
In addition, if there is a whitewash application for a waiver from the obligation to make a general offer to all shareholders by the incoming shareholder, all connected shareholders are likely to be barred from voting on it, as one of the conditions for the grant of a waiver of the mandatory offer obligation is that the transaction is approved at a shareholders’ meeting by an “independent vote” – i.e. by shareholders “who are not involved in or interested in, the transaction”. (Note 1 to Rule 26)
17 Under Rule 14.07 the percentage ratios are the figures, expressed as percentages, which are the result of various calculations designed to relate the scale of a transaction to the scale of a listed issuer engaged in a transaction. For example, the total assets which are the subject of the transaction divided by the total assets of the listed issuer will give one the assets ratio of the transaction.
18 Rule 14.06 (5) defines a very substantial acquisition as an acquisition or a series of acquisitions (aggregated under rules 14.22 and 14.23) of assets by a listed issuer where any percentage ratio is 100% or more.
19 Exchange Guidance Letter HKEx-GL78-14 at paragraph 7.
21 Exchange Guidance Letter HKEx-GL78-14 at paragraph 9.